U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-QSB
(X) QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934:
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from ____________ to ____________.
Commission File Number 1-13012
H.E.R.C. PRODUCTS INCORPORATED
(Name of small business issuer as specified in its charter)
State of Incorporation: Delaware IRS Employer Identification
Number: 86-0570800
1420 Columbus Avenue
Portsmouth, Virginia 23704
(Address of principal executive offices)
(757) 393-0002
(Issuer's telephone number)
Check whether the issuer: (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.
YES X NO______
-------
Indicate by check mark whether the registrant is an accelerated filer (as
defined by Rule 12b-2 of the Exchange Act). YES ______ NO X
-------
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date.
Outstanding at
---------------
Class July 1, 2004
----- ---------------
Common Stock, $.01 par value 12,551,298
H.E.R.C. PRODUCTS INCORPORATED AND SUBSIDIARIES
Index To Consolidated Financial Statements
PART I. FINANCIAL INFORMATION Page No.
Item 1. Financial Statements
Consolidated Financial Statements:
Consolidated Balance Sheets June 30, 2004 and December 31, 2003 3
Consolidated Statements of Operations Three and Six Months
Ended June 30, 2004 and 2003 5
Consolidated Statements of Cash Flows Six Months Ended
June 30, 2004 and 2003 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 18
Item 3. Controls and Procedures 27
PART II. OTHER INFORMATION
Item 2 - Changes in Securities 28
Item 6 - Exhibits and Reports on Form 8-K 28
Signatures 28
Certifications 29
ITEM 1. FINANCIAL STATEMENTS
H.E.R.C. PRODUCTS INCORPORATED AND SUBSIDIARIES
Consolidated Balance Sheets
June 30, December 31,
2004 2003
(Unaudited) (Note 1)
--------------- ------------
ASSETS
CURRENT ASSETS
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 55,729 $ 49,534
Trade accounts receivable, net of allowance for
doubtful accounts of $197,000 and $169,000, respectively. . . . . . . . . . . 409,574 614,660
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,231 79,175
Costs of uncompleted contracts. . . . . . . . . . . . . . . . . . . . . . . . . . . 27,633 102,204
Unbilled and other receivables. . . . . . . . . . . . . . . . . . . . . . . . . . . 345,596 291,897
Prepaid expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262,009 43,160
------------- --------------
Total current assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,163,772 1,180,630
------------- --------------
EQUIPMENT AND LEASEHOLDS
Equipment and leaseholds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,616,538 1,576,336
Less: accumulated depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . (1,409,041) (1,316,322)
------------- --------------
Net equipment and leaseholds. . . . . . . . . . . . . . . . . . . . . . . . . 207,498 260,014
------------- --------------
OTHER ASSETS
Patents, net of accumulated amortization of $148,488 and $140,100, respectively . . 82,333 84,029
Patents pending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164,375 146,488
Refundable deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,766 13,722
------------- --------------
Total other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257,474 244,239
------------- --------------
$ 1,628,744 $ 1,684,883
------------- --------------
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 97,485 $ 180,000
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 566,930 650,020
Accrued wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119,850 100,184
Accrued waste disposal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114,500 114,500
Other accrued expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124,147 77,376
------------- --------------
Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . 1,022,912 1,122,080
------------- --------------
LONG-TERM LIABILITIES
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564,000 400,000
Deferred royalty revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000 -
------------- --------------
Total long-term liabilities. . . . . . . . . . . . . . . . . . . . . . . . . 814,000 400,000
------------- --------------
STOCKHOLDERS' EQUITY
Preferred stock, $0.01 par value; authorized 1,000,000 shares;
issued and outstanding zero shares . . . . . . . . . . . . . . . . . . . . . - -
Common stock, $0.01 par value; authorized 40,000,000 shares; issued and
outstanding 12,551,298, and 12,365,586 shares, respectively. . . . . . . . . 125,513 123,656
Additional paid-in capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,061,599 14,051,457
Accumulated deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (14,395,280) (14,012,310)
------------- --------------
Total Stockholders' Equity . . . . . . . . . . . . . . . . . . . . . . . . . (208,168) 162,803
------------- --------------
$ 1,628,744 $ 1,684,883
============= ==============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.
H.E.R.C. PRODUCTS INCORPORATED AND SUBSIDIARIES
Consolidated Statements of Operations
(Unaudited)
Three Months Ended June 30, Six Months Ended June 30,
2004 2003 2004 2003
------------ ------------ ------------ ------------
SALES. . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,500,579 $ 1,199,147 $ 3,035,479 $ 2,442,407
COST OF SALES. . . . . . . . . . . . . . . . . . . . . . 1,028,967 858,516 2,017,369 1,602,313
------------ ------------ ------------ -----------
GROSS PROFIT . . . . . . . . . . . . . . . . . . . . . . 471,612 340,631 1,018,110 840,094
SELLING EXPENSES . . . . . . . . . . . . . . . . . . . . 107,700 85,556 185,827 183,431
GENERAL AND ADMINISTRATIVE EXPENSES. . . . . . . . . . . 633,445 506,459 1,118,317 1,075,393
------------ ------------ ------------ -----------
OPERATING LOSS . . . . . . . . . . . . . . . . . . . . . (269,533) (251,384) (286,034) (418,730)
------------ ------------ ------------ -----------
OTHER INCOME (EXPENSE)
Interest expense. . . . . . . . . . . . . . . . . . . . (37,722) (25,582) (76,861) (44,680)
Other . . . . . . . . . . . . . . . . . . . . . . . . . (20,075) - (20,075) -
------------ ------------ ------------ -----------
Total Other Income (Expense). . . . . . . . . . (57,797) (25,582) (96,936) (44,680)
------------ ------------ ------------ -----------
NET LOSS BEFORE INCOME TAXES . . . . . . . . . . . . . . (327,330) (276,966) (382,970) (463,410)
Income tax provision. . . . . . . . . . . . . . . . - - - -
------------ ------------ ------------ -----------
NET LOSS . . . . . . . . . . . . . . . . . . . . . . . . $ (327,330) $ (276,966) $ (382,970) $ (463,410)
============ ============ ============ ===========
NET LOSS PER COMMON SHARE -BASIC AND DILUTED . . . . . . $ (0.03) $ (0.02) $ (0.03) $ (0.04)
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
BASIC. . . . . . . . . . . . . . . . . . . . . . . . . . 12,551,298 12,204,873 12,508,678 12,167,580
============ ============ ============ ===========
DILUTED. . . . . . . . . . . . . . . . . . . . . . . . . 12,551,298 12,204,873 12,508,678 12,167,580
============ ============ ============ ===========
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.
H.E.R.C. PRODUCTS INCORPORATED AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Unaudited)
Six Months Ended June 30,
2004 2003
------------ ----------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(382,970) $(463,410)
Adjustments to reconcile net loss to net cash
(used in) operating activities
Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . 101,101 106,113
Common stock issued for services. . . . . . . . . . . . . . . . . . . . . 11,999 15,003
Bad debt expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,544 4,786
(Increase) decrease in assets
Trade accounts receivable . . . . . . . . . . . . . . . . . . . . . . 176,542 14,307
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,944 (63,597)
Costs of uncompleted contracts. . . . . . . . . . . . . . . . . . . . 74,571 103,021
Other receivables . . . . . . . . . . . . . . . . . . . . . . . . . . (53,699) (118,512)
Prepaid expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . (218,849) (242,399)
Refundable deposits and other assets. . . . . . . . . . . . . . . . . . 2,956 7,168
Increase (decrease) in liabilities
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . (83,090) 99,408
Accrued wages and other accrued expenses. . . . . . . . . . . . . . . . 66,437 (58,574)
Defered royalty revenue . . . . . . . . . . . . . . . . . . . . . . . . 250,000 -
------------ ----------
Net cash (used in) operating activities. . . . . . . . . . . . (10,514) (596,686)
------------ ----------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (40,202) (38,677)
Expenditures related to patents and patents pending . . . . . . . . . . . . . (24,573) (2,864)
------------ ----------
Net cash (used in) investing activities. . . . . . . . . . . (64,775) (41,542)
------------ ----------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of notes payable . . . . . . . . . . . . . . . . . . . . 205,348 769,600
Principal payments under notes payable. . . . . . . . . . . . . . . . . . . . .(123,864) (246,523)
------------ ----------
Net cash used in financing activities. . . . . . . . . . . . . 81,484 523,078
------------ ----------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS. . . . . . . . . . . . . . . . . . 6,195 (115,150)
CASH AT BEGINNING OF PERIOD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,534 254,859
------------ ----------
CASH AT END OF PERIOD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 55,729 $ 139,709
------------ ----------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest. . . . . . . . . . . . . . . . . . . . . . . $ 73,102 $ 44,680
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES
Prepaid insurance financed with note payable. . . . . . . . . . . . . . . . . . . . . $ 205,348 $ 369,600
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
JUNE 30, 2004
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements (except for the
balance sheet at December 31, 2003, which is derived from audited financial
statements) have been prepared in accordance with accounting principles
generally accepted in the United States of America for interim financial
information and with the requirements of regulation S-B of the Securities and
Exchange Commission and consequently do not include all of the disclosures
normally made in complete annual financial statement filing. Accordingly, the
consolidated financial statements of H.E.R.C. Products Incorporated included
herein should be reviewed in conjunction with the consolidated financial
statements and the accompanying footnotes included within the Company's Form
10-KSB for the year ended December 31, 2003.
In the opinion of management, the consolidated financial statements reflect all
adjustments necessary to fairly report the Company's financial position and
results of operations for the interim period. All such adjustments are normal
and recurring in nature. The interim consolidated results of operations are not
necessarily indicative of results to be expected for the year ending December
31, 2004.
The Company applies Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issues to Employees" and related interpretations to account for its stock
option plans. The Company grants options for common stock at an option price
equal to the fair market value of the stock at the date of grant. Accordingly,
the Company does not record stock-based compensation expense for these options.
The Company's stock option plans are more fully described in the Company's
Annual Report on Form 10-KSB for the year ended December 31, 2003.
The following table illustrates the effect on net losses, net losses per basic
common share and net losses per diluted common share, as if compensation cost
for all options had been determined based on the fair market value recognition
provision of a Statement of Financial Accounting Standards ("SFAS") No. 123,
"Accounting for Stock-Based Compensation" as amended by SFAS No. 148,
"Accounting for Stock-Based Compensation-Transition and Disclosure:"
Three months ended June 30,
2004 2003
----------------------------
Net loss applicable to common stockholders. . . . . $ (327,330) $(276,966)
Deduct: Total stock-based employee expense
determined under the fair value based method
for all awards, net of related tax benefits. . . (1,696) (1,884)
------------ ----------
Pro-forma net loss applicable to common
Stockholders . . . . . . . . . . . . . . . . . . $ (329,026) $(278,850)
------------ ----------
Basic and diluted losses per common share . . . . . $ (0.03) $ (0.02)
Pro-forma basic and diluted losses per common share $ (0.03) $ (0.02)
Six months ended June 30,
2004 2003
----------------------------
Net loss applicable to common stockholders. . . . . $ (382,970) $(463,410)
Deduct: Total stock-based employee expense
determined under the fair value based method
for all awards, net of related tax benefits. . . (2,756) (3,769)
------------ ----------
Pro-forma net loss applicable to common
Stockholders . . . . . . . . . . . . . . . . . . $ (385,726) $(467,179)
------------ ----------
Basic and diluted losses per common share . . . . . $ (0.03) $ (0.04)
Pro-forma basic and diluted losses per common share $ (0.03) $ (0.04)
2. REVENUE RECOGNITION
For chemical product sales, the Company recognizes revenue at the time products
are shipped to customers. For most service projects, the Company recognizes
revenue and costs when the services are completed. For fixed price contracts in
excess of 3 month duration, revenue is recognized on the percentage of
completion method, measured by the percentage of cost incurred to date to
estimated total cost for each contract. This method is used because management
considers total cost to be the best available measure of progress on these
contracts.
Contract costs include all direct material, labor and other costs related to
contract performance, such as indirect labor, supplies, tools and repairs.
Selling, general and administrative costs are charged to expense as incurred.
Provisions for estimated losses on uncompleted contracts are made in the period
in which such losses are determined. Changes in job performance, job
conditions, and estimated profitability, including those arising from contract
penalty provisions and final contract settlements may result in revisions to
estimates of contract costs and profits and are recognized in the period in
which the revisions are determined.
The current asset, "unbilled receivables" represents revenue recognized in
excess of amounts billed. Royalty revenue is recorded when the licensee
acknowledges that royalties have been earned on their related sales. Royalties
are calculated based upon a certain percentage of the related licensee sales.
3. AGREEMENT WITH FACTOR
The Company has an arrangement for a factoring facility whereby the factor
purchases eligible receivables and advances 85% of the purchased amount to the
Company. Purchased receivables may not exceed $1,500,000 at any one time.
Either party may cancel the arrangement with 30 days notice. At June 30, 2004,
there was $861,273 of factored receivables ($650,165 at June 30, 2003), of which
the Company has received $852,092 from the factor. This $852,092 and the $9,181
in interest expense are not shown as receivables. This arrangement is accounted
for as a sale of receivables on which the factor has recourse to the 15%
residual of aggregate receivables purchased and outstanding. Interest payable
by the Company to the factor is calculated as a fixed discount fee equal to 1.0%
of the amount of the receivable factored plus a variable (1.5% above the
institutions base rate, with a minimum of 7%) discount fee computed on the
amount advanced to the Company and accruing on the basis of actual days elapsed
from the date of the 85% advance until 3 days after collection of such account
receivable by the factor at a per annum rate equal to an internal rate set by
the factor. On April 5, 2004, the Company executed a third Amendment to its
factoring agreement. The Amendment increased the fixed discount rate from 0.75%
to 1.0% in exchange for the removal of the tangible net worth financial
covenant. The rate at June 30, 2004 was 7%. In the event of a breach of
representation, warranty or agreement, the institution has a security interest
in the Company's assets.
4. SEGMENT INFORMATION
Information by segment for the three months ended June 30, 2004:
Industrial
Cleaning Chemical
Services Products Corporate Consolidated
---------------------------------------------------
Sales. . . . . . . . . . . . . . . . . . $ 1,387,436 $ 113,143 $ - $ 1,500,579
Income (loss) from continuing operations 97,461 (3,329) (421,462) (327,330)
Total assets . . . . . . . . . . . . . . 947,291 113,121 568,332 1,628,744
Depreciation and amortization. . . . . . 43,209 1,361 7,222 51,792
Capital expenditures . . . . . . . . . . 11,514 - - 11,514
Information by segment for the three months ended June 30, 2003:
Industrial
Cleaning Chemical
Services Products Corporate Consolidated
---------------------------------------------------
Sales. . . . . . . . . . . . . . . . . . $ 1,135,325 $ 63,822 $ - $ 1,199,147
Income (loss) from continuing operations (3,908) 64,598 (337,656) (276,966)
Total assets . . . . . . . . . . . . . . 950,766 81,666 677,522 1,709,954
Depreciation and amortization. . . . . . 46,683 1,495 14,385 62,563
Capital expenditures . . . . . . . . . . - - - -
Information by segment for the six months ended June 30, 2004:
Industrial
Cleaning Chemical
Services Products Corporate Consolidated
---------------------------------------------------
Sales. . . . . . . . . . . . . . . . . . $ 2,836,763 $ 198,716 $ - $ 3,035,479
Income (loss) from continuing operations 278,929 79,238 (741,137) (382,970)
Total assets . . . . . . . . . . . . . . 947,291 113,121 568,332 1,628,744
Depreciation and amortization. . . . . . 84,903 2,721 13,477 101,101
Capital expenditures . . . . . . . . . . 34,489 - 5,713 40,202
Information by segment for the six months ended June 30, 2003:
Industrial
Cleaning Chemical
Services Products Corporate Consolidated
---------------------------------------------------
Sales. . . . . . . . . . . . . . . . . . $ 2,295,759 $ 146,648 $ - $ 2,442,407
Income (loss) from continuing operations 170,951 97,557 (731,918) (463,410)
Total assets . . . . . . . . . . . . . . 950,766 81,666 677,522 1,709,954
Depreciation and amortization. . . . . . 89,353 2,989 13,770 106,113
Capital expenditures . . . . . . . . . . 38,677 - - 38,677
Segment profitability is determined before allocation of corporate overhead.
In prior periods the Company reported separate business segments for "Pipe
Cleaning" and "Tank Cleaning". Separate business segment reporting for pipe and
tank cleaning activities in prior periods reflected the fact the Company engaged
in the specific business of marine and industrial pipe cleaning before the
purchase acquisition of tank cleaning assets and related personnel in February
of 2001. Thereafter, the pipe and tank cleaning business segments were managed,
accounted for and reported as distinct lines of business through the first
quarter of 2004. Pursuant to a new business model developed in the fourth
quarter of 2003 and implemented primarily in the second quarter of 2004, the
Company downsized its workforce through elimination of marketing and operating
personal in the industrial pipe cleaning business and commenced utilizing both
pipe and tank cleaning personnel for all of the Company's cleaning services.
The Company's expansion to the U.S. west coast and Pacific geographic markets
through the establishment of an office presence in the San Diego port during the
first quarter of 2004 required both pipe and tank cleaning employees to be
deployed for all services out of both of the Company's bi-coastal offices.
While the Company will continue to measure pipe and tank cleaning revenues as
distinct services for internal management purposes, effective in the second
quarter of 2004 the Company will report combined pipe and tank cleaning services
as the "Cleaning Services" business segment distinct from the "Industrial
Chemical Products" business. Following is the statement of the Segment
Information from the 2003 10-KSB in its original form and new form.
Information by segment for the year ended December 31, 2003, as previously
reported:
Pipe Tank Industrial
Cleaning Cleaning Chemical
Services Services Sales Corporate Consolidated
----------------------------------------------------------------
Sales. . . . . . . . . . . . . . . . . . $2,132,434 $3,433,128 $ 272,526 $ -0- $5,838,088
Income (loss) from continuing operations (14,598) 622,702 104,993 (1,456,849) (743,752)
Total assets . . . . . . . . . . . . . . 720,832 491,397 73,204 399,450 1,684,883
Depreciation and amortization. . . . . . 128,519 57,706 5,979 27,027 219,231
Capital expenditures . . . . . . . . . . 47,627 33,580 -0- -0- 81,207
Information by segment for the year ended December 31, 2002, as previously
reported:
Pipe Tank Industrial
Cleaning Cleaning Chemical
Services Services Sales Corporate Consolidated
----------------------------------------------------------------
Sales. . . . . . . . . . . . . . . . . . $3,176,334 $3,142,805 $ 171,974 $ -0- $6,491,113
Income (loss) from continuing operations 386,329 900,328 108,301 (1,598,738) ,(203,780)
Total assets . . . . . . . . . . . . . . 514,372 432,133 83,114 564,831 1,594,450
Depreciation and amortization. . . . . . 145,149 37,539 10,010 57,559 250,257
Capital expenditures . . . . . . . . . . 57,342 104,221 -0- 16,452 178,015
Information by segment for the year ended December 31, 2003:
Cleaning Industrial
Services Cleaning
(restated) Sales Corporate Consolidated
------------------------------------------------------
Sales. . . . . . . . . . . . . . . . . . $5,565,562 $ 272,526 $ -0- $ 5,838,088
Income (loss) from continuing operations 608,104 104,993 (1,456,849) (743,752)
Total assets . . . . . . . . . . . . . . 1,212,229 73,204 399,450 1,684,883
Depreciation and amortization. . . . . . 186,225 5,979 27,027 219,231
Capital expenditures . . . . . . . . . . 81,207 -0- 0- 81,207
Information by segment for the year ended December 31, 2002:
Cleaning Industrial
Services Cleaning
(restated) Sales Corporate Consolidated
------------------------------------------------------
Sales. . . . . . . . . . . . . . . . . . $6,319,139 $ 171,974 $ -0- $ 6,491,113
Income (loss) from continuing operations 1,286,657 108,301 (1,598,738) (203,780)
Total assets . . . . . . . . . . . . . . 946,505 83,114 564,831 1,594,450
Depreciation and amortization. . . . . . 182,688 10,010 57,559 250,257
Capital expenditures . . . . . . . . . . 161,563 -0- 16,452 178,015
Segment profitability is determined before allocation of corporate overhead.
5. EARNINGS PER SHARE
A reconciliation of the basic and diluted loss per share (EPS) computation for
the quarter ended June 30, 2004 and 2003 is as follows:
--------------------------------------------------------
Three Months Ended June 30, 2004
--------------------------------------------------------
Net Income Shares Per Share
(Numerator) (Denominator) Amount
--------------------------------------------------------
Basic EPS. . . . . . . . . . . . . . $ (327,330) 12,551,298 $ (0.03)
===========
Effect of stock options and warrants - -
----------- ----------
Diluted EPS. . . . . . . . . . . . . $ (327,330) 12,551,298 $ (0.03)
=========== ========== ===========
--------------------------------------------------------
Three Months Ended June 30, 2003
--------------------------------------------------------
Net Income Shares Per Share
(Numerator) (Denominator) Amount
--------------------------------------------------------
Basic EPS. . . . . . . . . . . . . . $ (276,966) 12,204,873 $ (0.02)
===========
Effect of stock options and warrants - -
----------- ----------
Diluted EPS. . . . . . . . . . . . . $ (276,966) 12,204,873 $ (0.02)
=========== ========== ===========
--------------------------------------------------------
Six Months Ended June 30, 2004
--------------------------------------------------------
Net Income Shares Per Share
(Numerator) (Denominator) Amount
--------------------------------------------------------
Basic EPS. . . . . . . . . . . . . . $ (382,970) 12,508,678 $ (0.03)
===========
Effect of stock options and warrants - -
----------- ----------
Diluted EPS. . . . . . . . . . . . . $ (382,970) 12,508,678 $ (0.03)
=========== ========== ===========
--------------------------------------------------------
Six Months Ended June 30, 2003
--------------------------------------------------------
Net Income Shares Per Share
(Numerator) (Denominator) Amount
--------------------------------------------------------
Basic EPS. . . . . . . . . . . . . . $ (463,410) 12,167,580 $ (0.04)
===========
Effect of stock options and warrants - -
----------- ----------
Diluted EPS. . . . . . . . . . . . . $ (463,410) 12,167,580 $ (0.04)
=========== ========== ===========
6. NOTES PAYABLE
During the month of January 2004, we financed $64,673 of insurance premiums
payable in ten monthly installments of $6,586 at an annual percentage rate of
4.0%; we financed $72,150 of insurance premiums payable in nine monthly
installments of $8,017 at an annual percentage rate of 4.0%; and we financed
$30,095 of insurance premiums payable in nine monthly installments of $3,344 at
an annual percentage rate of 4.0%.
During the month of June 2004, we financed $38,430 of insurance premiums payable
in ten monthly installments of $3,967 at an annual percentage rate of 7.0%.
On February 23, 2003, we entered into a one-year renewable Interest Only
Non-Recourse Promissory Note and Security Agreement for $400,000 with one of our
Directors. The note is secured by a second position security interest behind the
secured interest of our accounts receivable factor and was renewable at the end
of the original term by the mutual agreement of both parties. On February 23,
2004 the note was renewed by extension with $200,000 of original principal due
February 23, 2005 and $200,000 of original principal due on February 23, 2007.
On August 13, 2004 the parties agreed to extend the $200,000 of principal due on
February 23, 2005 as previously extended to a new extended due date of December
31, 2005.
On September 12, 2003, we entered into a Promissory Demand Note for $30,000 with
our Chief Executive Officer and Board Chairman. The proceeds were used to expand
our CHT and tank cleaning business on the west coast and support working capital
needs in our current operations. No demand for payment was made on the Company.
On August 13, 2004 the parties agreed that the note be extended as a Promissory
Term Note with a due date of December 31, 2005.
On December 2, 2003, we entered into a Promissory Demand Note for $50,000 with
our Chief Executive Officer and Board Chairman. The proceeds were used to
expand our CHT and tank cleaning business on the west coast and support working
capital needs in our current operations. No demand for payment was made on the
Company. On August 13, 2004 the parties agreed that the note be extended as a
Promissory Term Note with a due date certain of December 31, 2005.
On December 8, 2003, we entered into a six-month renewable Promissory Term Note
for $50,000 with one of our directors. The proceeds were used to expand our CHT
and tank cleaning business on the west coast and support working capital needs
in our current operations. The note was renewed and extended by the mutual
agreement of both parties with an extended due date of December 31, 2005
effective at the end of the original term.
On December 17, 2003, we entered into a six-month renewable Promissory Term note
for $50,000 with the spouse of one of our directors. The proceeds were used to
expand our CHT and tank cleaning business on the west coast and support working
capital needs in our current operations. The note was renewed and extended by
the mutual agreement of both parties with an extended due date of December 31,
2005 effective at the end of the original term.
7. COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
From time to time, the Company is involved in various legal proceedings that, in
the opinion of management, are ordinary routine matters incidental to the normal
course of business. The Company is involved in one legal proceeding arising out
of operations in the ordinary course of business as a defendant on a claim for
$35,000 and believes the Company has meritorious defenses against that claim and
has filed cross claims against the plaintiff arising out of operations in the
ordinary course of business. The Company has entered into settlement
negotiations with the complainant party and believes a settlement is achievable
on terms favorable to the Company.
The Company is also involved in one legal proceeding, arising out of operations
in the ordinary course of business, in which the Company is the complainant
party. The suit, which seeks injunctive relief and damages, was brought to
preclude or otherwise limit the benefits the Company believes were wrongfully
obtained by the defendants as a result of the misappropriation and use of the
Company's confidential information and trade secrets by a former employee.
8. INCOME TAXES
The Company was in a consolidated tax loss position for the six months ended
June 30, 2004 and therefore has no current federal income tax expense. Deferred
tax assets as of June 30, 2004 arising primarily from loss carry forward
benefits have not been recorded because of the uncertainty of realizing such
benefits.
9. DEFERRED REVENUE
During January 2004, the Company granted a five-year exclusive license to Seiwa
Pro, Ltd. of Osaka, Japan to use substantially all of the Company's chemical
cleaning patents and technology to clean marine ship piping systems, municipal
potable distribution systems, commercial, institutional and industrial
infrastructure and facilities piping, water well rehabilitation, and fire
protection sprinkler systems in Japan, China, Taiwan, Korea, Singapore and
Malaysia. The license agreement provides that Seiwa will pay the Company
royalties at rates designated in the agreement ranging from 3-10% of sales, such
royalty percentage rates decreasing as sales volume increases. Seiwa agreed to
prepay royalties of $500,000, payable in two equal installments of $250,000 net
of total treaty withholding taxes of $50,000. The first installment was
received in February 2004, and accrues interest for the benefit of Seiwa at the
rate of 2.25% per annum. The second installment was paid during August 2004.
The total deferred royalty revenue will accrue interest at a rate of 4.5% per
annum. Any interest accrued on the deferred royalty revenue will increase the
amount of the deferred royalty revenue. The agreement requires Seiwa to meet
minimum royalties of $50,000 in 2005 and $100,000 in each of 2006, 2007, and
2008. Under the agreement if at the end of the primary term there is any
remaining deferred royalty revenue balance after application of credit for
minimum royalties, the Company will repay to Seiwa the balance plus accrued
interest. Alternatively under the agreement, in the event the parties agree on
applicable terms, the Company may permit Seiwa to convert any unearned deferred
royalty revenue balance into shares of the Company's common stock at a price and
number of shares to be negotiated at the end of the primary term.
10. RELATED PARTY AGREEMENTS
On June 25, 2004 the Company amended its consulting agreement with Admiral
Robert J. Spane and accepted an appointment to its Board of Directors. The
consulting agreement has a two year term with financial compensation of $3,500
payable monthly and an incentive fee of two percent (2%) of any gross sales of
services or products on the west coast and pacific markets. Mr. Spane was
issued 200,000 shares of incentive stock options vesting in six month increments
of 50,000 shares and expiring ten years after date of issuance. For his Board
service, Mr. Spane will be compensated separately in accordance with the
Company's policy for the compensation of outside directors.
11. MANAGEMENT'S PLANS
The Company continues to operationally recover from the decline of revenue
resulting from the extended Middle East military deployment in 2003 that reduced
the availability of United States Navy ships on which to provide marine pipe and
tank cleaning services from the fourth quarter of 2002 to the fourth quarter of
2003. The Company's recovery plan includes cost reductions implemented in 2003
and 2004, and revenue expansion opportunities in late 2003 and 2004 with the
return of the Navy fleet. During 2003, the Company down-sized personnel by
$620,000 and cut property, casualty and liability insurance premiums by $100,000
to save cash totaling $720,000 on an annualized basis. Effective June 30, 2004
the Company eliminated the position of specialty and potable division sales
manager and, together with other reductions of related marketing costs,
conserved about $180,000 of expense annually. The Company's most significant
affiliated lender, an outside director of the Company, agreed in the first
quarter to extend $200,000 of his $400,000 one year term note to a term of three
years, and on August 13, 2004 agreed to extend the due date of the balance of
$200,000 until December 31, 2005. The same affiliated lender agreed to renew
and extend a $50,000 six month term note due June 8, 2004 until December 31,
2005. The spouse of a director agreed to renew and extend a $50,000 six month
term note due June 8, 2004 until December 31, 2005. Promissory Demand Notes of
$30,000 and $50,000 respectively made by the Company to our Chief Executive
Officer were renegotiated as promissory term notes with a certain due date of
December 31, 2005. Revenue expansion will focus on providing more marine pipe,
tank cleaning and other system cleaning services to the U.S. Navy worldwide.
The most significant expansion of revenue is anticipated in the Navy's west
coast and Japanese ports that will be serviced through the Company's new offices
near San Diego, California established in the first quarter. The Company now
markets an expanded menu of services to marine customers, and intends to
continue to expand the menu of services offered to augment pipe and tank
cleaning. The Company continues to actively seek new licensees for specialty
and potable water pipe and fire protection cleaning technologies through
anticipated licensing of the Company's patents in both foreign and domestic
markets in addition to servicing existing specialty and potable customers and
licensees. The Company will continue to support sales and marketing efforts to
existing and new industrial chemical customers.
12. MAJOR CUSTOMERS
The Company's strategy has involved concentrating its efforts on providing
pipeline rehabilitation and other system cleaning services to a diverse group of
customers. The Company has undertaken and continues to undertake substantial
efforts to diversify its customer base and expand its geographic, product and
service markets. For the quarters ended June 30, 2004 and 2003, sales to the
U.S. Navy under the Portsmouth CIS contract were 3% and 45%, respectively, of
consolidated sales. Other major customer's sales for the quarter ended June 30,
2004 include GSA at 21% of revenue; Earl Industries at 25% of revenue, and
Northrop-Grumman at 19% of revenue.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
The statements contained in this report on Form 10-KSB that are not purely
historical are forward-looking statements within the meaning of the securities
laws. These statements typically use words or phrases like "believe,"
"expects," "anticipates," "estimates," "will continue" and similar expressions.
Actual results, however, may be materially different from the results
projected in the forward-looking statements, due to a variety of risks and
uncertainties. These risks and uncertainties include those set forth in Item 1,
"Description of Business-Risk Factors," in Item 6, "Management's Discussion and
Analysis," and elsewhere in this report.
The forward-looking statements in this report are current only as of the
date this report is filed with the Securities and Exchange Commission. After the
filing of this report, our expectations and beliefs may change, and we may come
to believe that certain forward-looking statements in this report are no longer
accurate. We do not have an obligation to correct or revise any forward looking
statements in this report, even if we believe the forward looking statements are
no longer true.
OVERVIEW
We provide chemical cleaning services for water pipe systems, waste water
systems, cooling towers and HVAC systems, tanks and boilers, and other
water-based and industrial chemical process systems using our proprietary line
of specialty chemical products and chemical cleaning processes. We use our
patented and proprietary chemical products and chemical cleaning processes to
remove scale and corrosion from pipeline systems, water systems, and surfaces.
Over time most water and water-based systems, such as potable water delivery
systems, fire sprinkler systems, waste systems, process water systems, holding
tanks, and water wells develop internal surface scale, corrosion, and
tuberculation. These corrosive substances reduce the diameter through which
water and waste can travel through the pipes, causing a less efficient or
non-functioning system. Our cleaning methodologies remove the corrosion and
restore the efficiency and flow characteristics of the system.
Our patented and other proprietary chemical products and processes are used
in our cleaning services. Our chemical formulation, when circulated through an
obstructed pipe system, dissolves and removes scale and corrosion build-up in
solution until flushed from the system. The system may then be treated with
other chemical products that retard corrosion or suppress the environment that
supports biological growth. Most of the chemicals that we use are non-fuming,
non-abrasive, and non-flammable. Most of our chemical products are certified
biodegradable by Scientific Certification Systems.
Chemical cleaning service markets are the main source of our revenue, which
include municipal, industrial, governmental, commercial, and other customers
serviced directly and through strategic marketing alliances. Our largest
customer is currently the U.S. Navy. We provide chemical cleaning services for
pipe systems and tanks on U.S. Navy and U.S. Coast Guard vessels.
We derive the majority of our revenue from two primary sources, cleaning
sewer, "CHT", systems on U.S. Navy and U.S. Coast Guard vessels (pipe cleaning)
and cleaning bilge, fuel, oil, catapult and CHT tanks on ships (tank cleaning).
We have been particularly subject to the deployment and servicing schedules of
the U.S. Navy as well as the available maintenance funds in the Navy budget. The
impact of the Navy deployment to the Middle East in support of the Afghanistan
and Iraq military engagements in the first three quarters of 2003 significantly
reduced the availability of ships in port for maintenance and consequently our
service opportunities with our primary customer, and continues to impact their
repair and maintenance budgets. We have experienced increased service
opportunities in certain geographic markets with the Navy beginning in the
fourth quarter of 2003 and into the second quarter of 2004 after the return of
much of the Navy fleet from these extended deployments. The Company expanded its
operational presence through establishing an office in the San Diego port in
late 2003 and has benefited by increased CHT and tank cleaning service orders
from shipyards in that market. We understand Navy repair and maintenance budgets
have been largely diverted to fund operations for the remainder of the
federal fiscal budget year ending September 30, 2004. However, the recently
enacted federal defense budget appropriation for the fiscal year 2005 beginning
October 1 should significantly restore and increase repair and maintenance
funding available. While we expect the Navy to continue to make repair and
maintenance requisitions benefiting the ship repair and maintenance industry and
our Company through emergent work task orders for marine services through the
third quarter of 2004, we expect even more repair and maintenance funding to
address the demand for ship maintenance needs through expanding military budgets
over the coming fiscal years of defense budgeting.
The year ended December 2003 was a very difficult one for our Company and
the ship repair and maintenance industry due to the lengthy U.S. military
commitment in the Middle East in fourth quarter of 2002 through the first three
quarters of 2003, a difficulty particularly impacting the availability of the
Company's primary customer, the Navy, and the funding of repair and maintenance.
The lack of availability of the Navy fleet on which to perform marine services
from the fourth quarter of 2002 through 2003 caused a dramatic slowdown in
revenue opportunities for pipe and tanking cleaning. During the U.S. Navy
deployment to the Middle East in 2003, we believe as much as 75% of the total
Naval ships worldwide were on station and out of port on deployment and
significantly impacted Navy's routine peacetime repair and maintenance schedules
on which we depend. The Navy fleet began returning in July and August of 2003
and resulting maintenance purchase orders were not actively solicited by the
Navy until the fourth quarter of 2003 and first half of 2004. While service
opportunities increased in 2004 in comparison to 2003, the diversion of Defense
Department budget funds from repair and maintenance services to marine
operations requirements in support of the extended Navy deployments in 2003
continued to constrain available funds otherwise earmarked to purchase the
maintenance services in 2004 which our Company provides.
In response to this extended Navy deployment and the repair and maintenance
budget diversion to operations funding that resulted, we engaged in large scale
labor and cost reductions in our administration and operations in order to
preserve cash on a going forward basis. Operational related layoffs of two
supervisors and one administrative employee in the first quarter of 2003
resulted in over $140,000 of annual cash savings. The responsibilities of these
employees were reallocated to other personnel. During the third quarter of
2003, we terminated a supervisor, a division manager, an assistant sales
manager, and the Chief Financial Officer, and we re-assigned the Controller from
a full-time position to part-time for a total annual savings of $440,000. The
responsibilities of all terminated positions were reallocated to current
personnel with the Chief Executive Officer serving as the Acting Chief Financial
Officer, and all payroll functions were assumed by administrative personnel. In
the fourth quarter of 2003, we initiated a review of our company's property,
casualty, and liability insurance coverage for 2004, resulting in premium
savings of over $100,000 annually. During 2004 we financed $232,685 of prepaid
insurance premium expense in order to conserve cash. Taken together these cost
reductions in operations and administration have resulted in almost $700,000 of
total annual cash preservation.
The non-marine pipe cleaning service division, which has relied to a large
degree on the cash generated from the marine related service markets, has yet to
demonstrate positive cash flow apart from marine services. We reduced costs in
non-marine related services operations in favor of expanding these services
through patent licensing. At the end of the second quarter of 2004, we
implemented the plan to eliminate the position of specialty and potable division
sales manager and related marketing expenses to conserve about $180,000 of
expense annually. While we will continue to support non-marine service
operations through our cleaning business unit to satisfy existing customer
demands for these services, we have redirected our efforts to promote our
patented pipe cleaning technologies through licensing agreements in domestic and
foreign markets with relationships we have developed in the business over the
last three years. Such efforts have yielded an eastern Canadian license in the
fourth quarter of 2003 and a license of Far East markets to Seiwa Pro, Ltd. in
Japan in 2004 and we are seeking possible domestic licensees. See Notes to
Consolidated Financial Statements, Footnote 4 regarding Segment Information.
Taken together our annualized cost reductions of almost $900,000 greatly
exceed the amounts of affiliate borrowing of $580,000 in 2003 and we have not
sought external financing during the first half of 2004. The holder of the
$400,000 one year term note dated February 23, 2003, as extended to February 23,
2005, agreed to restructure $200,000 of the debt to a due date of February 23,
2007 and two six-month notes of $50,000 have been extended for a similar period.
Other debt or equity restructuring will necessarily depend on the expected
favorable circumstances we anticipate as a result of the return of the Navy to
port for the maintenance services we provide. While at the present time we do
not expect to require external financing during the remainder of the current
fiscal year, management has decided to prepare for the potential of seeking
external financing alternatives should the need develop or a favorable
opportunity arise. We do not expect to require external financing during the
current year, but due to the possibility of operating cash constraints we may
need to seek and obtain external debt or equity financing. We may request a
shareholder vote to increase the amount of authorized common shares to better
enable us to execute a potential strategic transaction. Due to the high cost to
a small business of the compliance burden for maintaining our status as a
publicly traded company under recently enacted federal securities laws,
administrative regulations and related stock exchange rules, in order to raise
the necessary operating capital to continue operations we may consider an
issuance of new shares, a merger or reverse merger acquisition transaction or
other possible corporate reorganization utilizing debt and/or equity, the sale
of significant operating assets, or the divestiture of a business segment or
segments. Prudent judgment may also require consideration of a "going private"
transaction. Alternatively, we may be financially forced into non-compliance
with public company filing and reporting requirements resulting in a de-listing
of the Company's stock. Any such sale of equity, merger, reverse merger, or
other corporate reorganization transaction, if necessary, would substantially
dilute the interest of our existing stockholders. We cannot provide any
assurance that we will be able to sell additional securities or execute a
corporate reorganization at terms acceptable to us. We may, in the future, make
acquisitions by utilizing debt financing. Any such acquisition or other debt
financing could have a material adverse impact on our liquidity and results of
operations. Significantly, we have demonstrated a history of operations since
1997 without requiring external debt financing prior to the 2003 extended
deployment of the U.S. Navy.
We are continuing to focus our efforts on increasing revenue and believe
there is the long-term demand and customer satisfaction with our cleaning
services. Therefore, we intend to expand our marketing and sales efforts in the
marine cleaning services aspect of our pipe cleaning business. The Navy's
SupShip Portsmouth has provided notice of intent to exercise its year third
option to extend our 2002 CHT chemical cleaning contract into September of 2005.
In addition, we have increased service opportunities with the Navy by expanding
our service deployment base to San Diego in association with private shipyards
having repair and maintenance contract packages with the Navy in that port. As
work schedules have increased since the return of the ships on the west coast,
Hawaii and Japan, the ship repair and maintenance business is busy in all ports.
In addition, we anticipate increased work on ships through our expanded menu of
marine services as we execute basic purchase order specifications on delivery
orders. We are servicing numerous marine systems in addition to our tradition
of CHT pipe and tank cleaning, and the Navy has approved of certain products for
direct use by Navy personnel. We believe the Navy is behind in maintenance work
due to the extended deployments and must catch up. We understand the Navy's
portion of the Department of Defense Appropriation bill has increased over prior
years and should, consequently, provide significant financial support for funded
repair and maintenance order opportunities for the Navy's 2005 fiscal year
beginning in October 2004.
We are increasing our efforts to expand the volume of sales of our
industrial chemical products business. Our chemical products and chemical
cleaning processes, developed to provide a more cost effective and efficient
means of cleaning pipe systems in contrast to replacement, mechanical scraping,
pigging, hydro blasting, or other pipe cleaning methods, are safer than many
other chemical cleaning methods. Our chemical products include: Pipe-Klean and
Well-Klean, which remove encrustation from water pumping and distribution
systems; Compound 360 and Compound 400, which clean and maintain cooling and
other water treatment systems; and Line-Out, which cleans drip irrigation
systems and removes salt from soil surfaces. We also sell private label
chemical products utilizing our patented and proprietary formulations or
products complementary to our formulations for key customers. We intend to
execute extended product supply agreements with new distributors and intend to
introduce our products into the oil field water injection well service business.
Our products and services are marketed through our industrial chemical and
marine cleaning division staffs, independent distributors, outside sales
representatives, strategic partnerships, and licensing and marketing agreements.
While we generate most of our revenue from relatively few customers, we expect
the high concentration levels to lessen in the future as we expand the menu of
marine services and industrial chemical products we provide to our existing
customers through multiple governmental procurement contract vehicles and
private contracting, and by licensing both our marine and land-based pipe
cleaning technologies to third-parties. Nonetheless, any material delay,
cancellation, or reduction of orders from these customers due to lack of
opportunity to perform routine maintenance on marine vessels out of port on
extended military deployments in the future, or other factors, could have a
material adverse effect on our results of operations and financial position.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
We consider the following accounting policies to be critical to an
understanding of our financial statements because their application places the
most significant demands on our judgment with financial reporting results
relying on estimates about the effect of matters that are inherently uncertain.
We base our estimates on historical experience and on various other assumptions
that we believe are reasonable under the circumstances. The results form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results could differ
significantly from those estimates under different assumptions and conditions.
Specific risks for these critical accounting policies are described in the
following paragraphs. For all of these policies, we caution that future events
rarely develop exactly as forecast, and the best estimates routinely require
adjustment.
Revenue Recognition
For chemical product sales, we recognize revenue at the time products are
shipped to customers. The terms of products sales are F.O.B. shipping point,
and we believe that revenue recognition is fully justified after the product has
left our blending plant with attendant financial risks assumed by our
purchasers.
For most marine, industrial and municipal service projects conducted at
fixed prices within a short period of time, we recognize revenue when the
services are completed. Most of these service engagements have a scope of
performance time less than three months and are not otherwise readily capable of
reasonably estimating percentages of completion based on costs incurred. For
fixed price contracts that are in excess of three months, we recognize revenue
on the percentage of completion method, measured as the percentage of cost
incurred to date of the estimated total cost for each contract. Due to the time
length and revenue size of these contracts, as an exception to our usual
experience of contract lengths of less duration and smaller revenue, we believe
the percentage of completion method more accurately matches revenue with costs
that would otherwise distort our financial reporting awaiting contract
completion for revenue recognition. We use this method because we consider the
percentage of the total cost to be the best available measure of progress on
these contracts. Our experience indicates that the percentage of completion
method is therefore required to be used on marine service engagements involving
large Navy surface fleet vessels such as aircraft carriers.
Contract costs include all direct material, labor, and other costs related
to contract performance, such as indirect labor, supplies, tools, and repairs
under the job order method of cost accounting. Selling, general, and
administrative costs are charged to overall corporate expenses as incurred, and
are not considered job order related costs. Provisions for estimated losses on
uncompleted contracts are made in the period in which such losses are
determined. Circumstances requiring provisions for estimated losses on
percentage of completion marine service jobs could arise when we are required by
our 2002 Portsmouth CHT contract to perform fixed price work on certain classes
of ships with inherently low gross profit margins resulting from the amount of
labor required to service the ship due largely to the age of the ship and its
systems. Changes in job performance, job conditions, and estimated
profitability, including those arising from contract penalty provisions and
final contract settlements, may result in revisions to estimates of contract
costs and profits, and are recognized in the period in which the revisions are
determined.
Allowance for Doubtful Accounts
We estimate the possible losses resulting from non-payment of outstanding
accounts receivable. We analyze accounts receivable customers to determine the
ultimate collectibility of those accounts. While most of our accounts
receivable stem from federal and local government contracts where collection is
reasonably assured, we perform ongoing evaluations of our customers for credit
worthiness, economic trends, changes in our customer payment terms, and
historical collection experience when evaluating the adequacy of our allowance
for doubtful accounts. Experience indicates that federal military contract
receivables are almost always paid within the expected time for collection when
we are the contracting party with the agency. Subcontracting on federal
military contracts within private shipyards subjects our Company to the risks of
the shipyard, and while most of our private shipyard payments are virtually
never in doubt, we have had occasion to experience uncollectible accounts from
certain federal contractors in this market. Municipal job experiences have been
less predictable for our Company as a subcontractor, yielding more provision for
doubtful accounts.
If information is available to us to make a determination that there exists
a reasonable probability that an account will not be collectible, we create a
reserve for that account at the time of the determination and recognize a
related expense. If the account is later collected, the reserve and expense are
reversed in the current accounting period. Since we must use our best judgment
as to which accounts will be collected, there exists the risk that some accounts
might not be collected and thus could have a negative impact on our liquidity
and results of operations.
Impairment of Long-Lived Assets
We periodically evaluate the carrying value of tangible assets dedicated to
chemical pipe and tank cleaning, and intangible patents and trademarks. We
review long-lived assets and certain identifiable intangible assets to be held
and used in operations for potential impairment whenever events or circumstances
indicate that the carrying amount of an asset may not be fully recoverable. An
impairment loss is recognized if the sum of the expected long-term undiscounted
cash flows is less than the carrying amount of the long-lived assets being
evaluated. Future losses may be recorded if cash flows are less than expected.
While we may determine that employing certain long-lived assets that remain
unprofitable requires the realization of the impairment of these assets, or the
consideration of strategic transactions involving these assets in an attempt to
recover these capitalized costs, we have determined to license some of our
patent assets and to continue to support our licensees while reducing certain
marketing and sales for non-marine operations involving these intangible assets.
We have not had, and do not have at this time, any plans to sell assets in
order to recoup capital costs. We do plan on continuing to license patents that
we have for rehabilitating water pipe systems in several countries and the
United States. The recent license agreement with Seiwa Pro, Ltd. for the Far
East is an example. The success of our cleaning process on water mains and fire
protection systems in 2003 has resulted in our representing the technology to
potential licensees. The Seiwa Pro license paid $250,000 of prepaid royalty and
the balance of the remaining $250,000 of prepaid royalties was paid in August
2004. The potential issuance of other license agreements would depend upon our
patent position in the country of location of the intended licensor, the profile
and competence of the licensor, and the economic terms of the license.
Accruals
Loss contingencies are recorded as liabilities when it is probable that a
liability has been incurred and the amount of the loss is reasonably estimable.
Disclosure is required when there is a reasonable possibility that the ultimate
loss will exceed the recorded provision. Contingent liabilities are often
resolved over long time periods. Estimating probable losses requires analysis
of multiple forecasts that often depend on judgments about potential actions by
third parties such as regulators.
RESULTS OF OPERATIONS
Three Months Ended June 30, 2004 Compared with Three Months Ended June 30, 2003
Sales for the three months ended June 30, 2004 were $1,500,579 compared
with $1,199,147 during the same period in 2003. Cleaning services accounted for
$1,387,436 during the three months ended June 30, 2004, of which $46,994 was
billed under the Portsmouth CHT contract with the United States Navy. For the
three months ended June 30, 2003, cleaning services accounted for $1,135,325 of
which $202,775 was billed under the Portsmouth CHT contract. Industrial chemical
sales were $113,143 during the three months ended June 30, 2004 compared with
$63,822 during the same period in 2003.
Consolidated sales during the second quarter of 2004 were 25% higher than
the same period in 2003. While fewer U.S. Navy ships being in port and available
for maintenance resulted in a significant increase in the competitiveness for
cleaning services in 2003, the return of the fleet available for servicing in
the fourth quarter of 2003 and the first quarter of 2004 provided increased
service opportunities. Consolidated gross margins were 31% during the three
months ended June 30, 2004 compared with 28% during the same period in 2003.
Gross margins for our cleaning services increased to 32% in 2004 compared with
23% in 2003. Gross margins for our industrial chemical services were 29% in 2004
compared with 25% in 2003.
Sales of cleaning services increased 22% during the three months ended June
30, 2004 compared to the same period in 2003. Sales of chemical products
increased 77% during the three months ended June 30, 2004 compared to the same
period in 2003. We are continuing efforts to diversify our revenue base by
offering different services to our customers in multiple service markets in
order to reduce our dependence on one marine service provided to one customer
location.
We are currently focusing specific sales and marketing efforts in the areas
of marine and land based tank cleaning. Due to liquidity and cash flow
constraints and the continuing absence of profitability in the area of municipal
markets, we reduced the related sales and marketing expenses in specialty and
potable water cleaning in favor of licensing these services to third parties.
While we have scaled back our non-marine pipe cleaning operations, we will
continue to support existing licensees and customer demands for these services.
In the future, we plan to continue our efforts to diversify our revenue sources
and thereby our reliance on one large customer.
Gross profit increased to $471,612 during the three months ended June 30,
2004 from $340,631 during the same period in 2003.
Performing cleaning services on different classes of ships in various ports
of service can cause our gross margins to vary widely from one quarter to the
next because we generate higher gross margins on certain classes of ships and
certain ports of service than we do on others. Margins are impacted due to the
fact that we receive service awards under various government contracts either
directly with the Navy or through subcontracts with shipyards, all of which are
subject to differing contract pricing limitations and factors of competition in
the award markets. Additionally, when we perform work under government contracts
outside of the Commonwealth of Virginia, we incur certain reimbursable travel
costs that are included in both revenue and cost of goods sold. These
reimbursable travel costs cause gross margins to be lower than the margins that
would have otherwise been recognized had the work been performed in Virginia. In
a planned effort to reduce travel costs and increase both our responsiveness to
customer demands and to develop new customer markets, we expanded our presence
to San Diego by establishing an office to serve the west coast and pacific
marine markets.
Total selling, general and administrative expenses during the three months
ended June 30, 2004 increased to $741,145 from $592,015 during the same period
in 2003. Selling expenses increased to $107,700 during the three months ended
June 30, 2004 from $85,556 during the same period in 2003, and general and
administrative expenses increased to $633,445 for the three months ended June
30, 2004 from $506,459 during the same period in 2003. The increase in selling
expenses was the result of the layoff package of one sales person, the addition
of a sales person for the west coast and the commissions earned as part of that
employment package. General and administrative expenses were higher as a result
of significantly increased outside legal, audit and accounting fees associated
with the preparation and filing of public company reports in the absence of a
full time Chief Financial Officer and the transfer of our Auditor offices from
Phoenix, AZ to Bethesda, MD, certain business litigation costs, and start-up
costs and hiring of office personnel for the new office in the west coast.
Other income and expense in the second quarter of 2004 reflected expense of
$57,797 versus expense of $25,582 in the second quarter of 2003.
For the three months ended June 30, 2004, we incurred a net loss of
($327,330), compared to net loss of ($276,966) during the same period in 2003.
Six Months Ended June 30, 2004 Compared with Six Months Ended June 30, 2003
Sales for the six months ended June 30, 2004 were $3,035,479 compared with
$2,442,407 during the same period in 2003. Cleaning services accounted for
$2,836,763 during the six months ended June 30, 2004, of which $123,317 was
billed under the Portsmouth CHT contract with the United States Navy. For the
six months ended June 30, 2003, cleaning services accounted for $2,295,759 of
which $572,736 was billed under the Portsmouth CHT contract. Industrial chemical
sales were $198,716 during the six months ended June 30, 2004 compared with
$146,648 during the same period in 2003.
Consolidated sales during the second quarter of 2004 were 24% higher than
the same period in 2003. While fewer U.S. Navy ships being in port and available
for maintenance resulted in a significant increase in the competitiveness for
cleaning services in 2003, the return of the fleet available for servicing in
the fourth quarter of 2003 and the first and second quarters of 2004 provided
increase service opportunities. Consolidated gross margins were 34% during the
six months ended June 30, 2004 and June 30, 2003. Gross margins for our cleaning
services were 31% in both 2004 and 2003. Gross margins for our industrial
chemical services were 64% in 2004 compared with 89% in 2003.
Sales of cleaning services increased 24% during the six months ended June
30, 2004 compared to the same period in 2003. Sales of chemical products
increased 36% during the six months ended June 30, 2004 compared to the same
period in 2003. We are continuing efforts to diversify our revenue base by
offering expanded services to our customers in multiple service markets in order
to reduce our dependence on one marine service provided to one customer
location.
We are currently focusing specific sales and marketing efforts in the areas
of marine and land based tank cleaning. Due to liquidity and cash flow
constraints and the continuing absence of profitability in the municipal
markets, we have reduced the related sales and marketing expenses in favor of
licensing these services to third parties. While we will scale back our
non-marine cleaning operations, we will continue to support existing licensees
and customer demands for these services. In the future, we plan to continue our
efforts to diversify our revenue sources and thereby our reliance on one large
customer.
Gross profit increased to $1,018,110 during the six months ended June 30,
2004 from $840,094 during the same period in 2003.
Performing cleaning services on different classes of ships in various ports
of service can cause our gross margins to vary widely from one quarter to the
next because we generate higher gross margins on certain classes of ships and
certain ports of service than we do on others. Margins are impacted due to the
fact that we receive service awards under various government contracts either
directly with the Navy or through subcontracts with shipyards, all of which are
subject to differing contract pricing limitations and factors of competition in
the award markets. Additionally, when we perform work under government contracts
outside of the Commonwealth of Virginia, we incur certain reimbursable travel
costs that are included in both revenue and cost of goods sold. These
reimbursable travel costs cause gross margins to be lower than the margins that
would have otherwise been recognized had the work been performed in Virginia. In
a planned effort to reduce travel costs and increase both our responsiveness to
customer demands and to develop new customer markets, we expanded our presence
to San Diego by establishing an office to serve the west coast and pacific
marine markets.
Total selling, general and administrative expenses during the six months
ended June 30, 2004 increased to $1,304,144 from $1,258,823 during the same
period in 2003. Selling expenses increased to $185,827 during the six months
ended June 30, 2004 from $183,430 during the same period in 2003, and general
and administrative expenses increased to $1,118,317 for the six months ended
June 30, 2004 from $1,075,393 during the same period in 2003. The overall
increase in selling expenses was minimal. General and administrative expenses
were higher as a result of significantly increased outside legal, audit and
accounting fees associated with the preparation and filing of public company
reports in the absence of a full time Chief Financial Officer and the transfer
of our Auditor offices from Phoenix, AZ to Bethesda, MD, certain business
litigation costs, and start-up costs and hiring of office personnel for the new
office in the west coast.
Other income and expense in the second quarter of 2004 reflected expense of
$96,936 versus expense of $44,680 in the second quarter of 2003.
For the six months ended June 30, 2004, we incurred a net loss of
($382,970), compared to net loss of ($463,410) during the same period in 2003.
LIQUIDITY AND CAPITAL RESOURCES
We have historically relied primarily on our internally generated operating
cash flow and our factoring arrangement to fund our operations and our business.
Due to revenue constraints associated with the Navy deployment in the Middle
East, during the fiscal year ended 2003 we primarily relied on a $400,000
director loan, two demand notes for $30,000 and $50,000 and two short-term notes
of $50,000 each from affiliated parties in addition to our factoring arrangement
to fund our operations and business. While we currently contract with a few
major customers responsible for a large percentage of our revenue and anticipate
the high concentration levels to continue, we expect to return to internally
generated operating cash flow and our factoring arrangement to fund our
operations. Thus, any material delay, cancellation or reduction of orders from
these customers, such as that experienced during the Navy deployment to the
Middle East, would have a material adverse effect on our liquidity and
operations. Our liquidity position improved during the first quarter primarily
as a result of receipt of prepaid royalty in the amount of $225,000 after we
incurred additional costs in securing, training and transporting the workforce
necessary for the anticipated increased business activity as a result of the
return of Navy ships from overseas deployment and our establishment of a west
coast office in San Diego. The increase in volume of Navy ship pipe and tank
cleaning work experienced during the first quarter over the prior period is
expected to continue.
Cash was $55,729 at June 30, 2004 and $49,534 at December 31, 2003. The
increase in cash was primarily the result of a reduction in net operating
losses, an acceleration in collections for the quarter resulting from fourth
quarter 2003 services rendered on Navy vessels returning from the Middle East,
and the receipt of the first installment of prepaid royalty on our license in
with Seiwa Pro, Ltd. in Japan. On January 29, 2004 we executed a license
agreement that granted certain foreign patents in exchange for cash payment of
$250,000 net of withholding taxes of $25,000 recorded as deferred royalty
revenue from Seiwa Pro, Ltd.
In January 2004, we financed $64,673 of corporate insurance premiums
payable in ten monthly installments of $6,586 at an annual percentage rate of
4.0%, $72,150 of workmen's compensation for Virginia insurance premiums payable
in nine monthly installments of $8,017 at an annual percentage rate of 4.0%, and
$30,095 of workmen's compensation for California insurance premiums payable in
nine monthly installments of $3,344 at an annual percentage rate of 4.0%.
In June 2004, we financed $38,430 of directors and officers insurance
premiums payable in ten monthly installments of $3,967 at an annual percentage
rate of 7.0%.
During 2002, we modified our factoring agreement. The initial payment when
the factor purchases eligible accounts receivable remained at 85%; the total
amount of the facility was increased from $1,000,000 to $1,500,000; the fixed
discount remained the same at 0.75% of the gross face amount payable; and
interest payable was reduced from the lender's Base Rate plus 2.0% to Base Rate
plus 1.5%. Interest on the outstanding balance accrues on the basis of actual
days elapsed from the date of the advance until three days after collection of
such account. Our inventory, accounts receivable, contract rights, and other
general intangibles secure the amounts factored under the agreement. On April
5, 2004, we executed a third amendment to our factoring agreement wherein the
fixed discount rate was increased from 0.75% to 1.0% in exchange for the
complete removal of the tangible net worth financial covenant.
We rely primarily on our internally generated operating cash flow and our
factoring arrangement to fund our operations. In 2003, we borrowed a total of
$580,000 from shareholders primarily utilized to expand our west coast
operations by establishing an office with attendant administrative and
operations personnel in San Diego.
We obtained external financing in 2003 used to expand our CHT and tank
cleaning business on the west coast and support other working capital needs in
current operations. On February 23, 2003, we entered into a one-year renewable
Interest Only Non-Recourse Promissory Note and Security Agreement for $400,000
with one of our Directors. The note is secured by a second position security
interest behind the secured interest of our accounts receivable factor and was
renewable at the end of the original term by the mutual agreement of both
parties. The note was renewed by extension until February 23, 2005 and the
parties agreed to extend the term of $200,000 of principal due on February 23,
2007. On August 13, 2004 the parties agreed to extend the $200,000 of principal
due on February 23, 2005 as previously extended to a new extended due date of
December 31, 2005. On September 12, 2003, we entered into a Promissory Demand
Note for $30,000 with our Chief Executive Officer and Board Chairman. On August
13, 2004 the demand note was renegotiated to a Promissory Term Note due December
31, 2005. On December 2, 2003, we entered into a Promissory Demand Note for
$50,000 with our Chief Executive Officer and Board Chairman. On August 13, 2004
the demand note was renegotiated to a Promissory Term Note due December 31,
2005. On December 8, 2003, we entered into a six-month renewable Promissory Term
Note for $50,000 with one of our directors that was renewed at the end of the
original term by the mutual agreement of both parties to an extended due date of
December 31, 2005. On December 17, 2003, we entered into a six-month renewable
promissory term note for $50,000 with the spouse of one of our directors that
was renewed by extension until December 31, 2005.
Although we expect that our annual rate of cash utilization will continue
to decrease during fiscal 2004 compared with fiscal 2003, we may be required to
reduce our operations or to obtain additional debt or equity financing if our
cash forecast proves inaccurate for any reason, including the following:
- - our revenue fails to meet our forecast and declines;
- - our gross profit fails to meet our forecast and continues to erode;
- - our operating expenses exceed our forecast;
- - our inability to acquire, compensate and retain a chief financial officer;
- - our inability to maintain our status as a publicly traded company; or
- - unanticipated events adversely effect our operations or cash flows.
In view of these and other scenarios potentially constraining our cash
position, we may need to implement an additional debt or equity financing
strategy to allow the Company to remain financially viable. We may request a
shareholder vote to increase the amount of authorized common shares to better
enable us to execute a potential strategic transaction. Due to the high cost to
a small business of the compliance burden for maintaining our status as a
publicly traded company under recently enacted federal securities laws,
administrative regulations and related stock exchange rules, in order to raise
the necessary operating capital to continue operations we may consider an
issuance of new shares, a merger or reverse merger acquisition transaction or
other possible corporate reorganization utilizing debt and/or equity, the sale
of significant operating assets, or the divestiture of a business segment or
segments. Prudent judgment may also require consideration of a "going private"
transaction. Alternatively, we may be financially forced into non-compliance
with public company filing and reporting requirements resulting in a de-listing
of the Company's stock. Any such sale of equity, merger, reverse merger, or
other corporate reorganization transaction, if necessary, would substantially
dilute the interest of our existing stockholders. We cannot provide any
assurance that we will be able to sell additional securities or execute a
corporate reorganization at terms acceptable to us. We may, in the future, make
acquisitions by utilizing debt financing. Any such acquisition or other debt
financing could have a material adverse impact on our liquidity and results of
operations.
ITEM 3. CONTROLS AND PROCEDURES
As a result of a decrease in our operating cost structure, during the third
quarter of fiscal 2003 we terminated our relationship with our Chief Financial
Officer and reduced our Controller from full-time to part-time employment. The
responsibilities of the Chief Financial Officer were assumed by our Chief
Executive Officer, who has been acting as our Chief Financial Officer since that
time. As a result, our lack of employing a Chief Financial Officer separate
from our Chief Executive Officer and our reduction of our Controller's time
could, in the future, materially affect our internal control over financial
reporting.
As of the end of the period covered by this report, under the supervision
of our Chief Executive Officer as acting Chief Financial Officer and our
Controller, we reviewed the Company's disclosure controls and procedures. Based
on this evaluation, our Chief Executive Officer as acting Chief Financial
Officer and Controller concluded that our disclosure controls and procedures
were effective, and except as discussed below, were adequate and timely in
alerting them to material information relating to the Company required to be
included in our periodic filings with the Securities and Exchange Commission.
In reviewing the disclosure controls and procedures, our management recognized
that any controls and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving the desired control objectives,
and our management necessarily was required to apply its judgment in evaluating
the cost-benefit relationship of possible controls and procedures. We reviewed
our disclosure controls and procedures to reach a level of reasonable assurance
of achieving desired control objectives and, based on the referenced review, our
Chief Executive Officer as acting Chief Financial Officer and Controller believe
that our disclosure controls and procedures were effective at reaching that
level of reasonable assurance, except as discussed below.
In conjunction with our annual audit for the 2003 year, we identified four
potential deficiencies within our internal control framework. The first two
relate to segregation of duties deficiencies. As previously discussed, we have
limited financial resources and have limited personnel resources within certain
areas. As a result, we are aware there are instances where certain duties
performed by the Controller that should be split between the Controller and the
acting Chief Financial Officer to strengthen the overall internal control
framework. We implemented routine testing by the acting Chief Financial Officer
of financial transactions originally performed by the Controller to verify
accuracy and timeliness of recording. Additionally, we are aware there are
instances where certain duties performed by the payroll clerk that should be
split between the clerk for ordinary payroll preparation and another individual
for manual payroll check preparation. We implemented a split of these
functions between different payroll personnel.
The third potential deficiency related to inadequate preparation of
supporting documentation to assure the proper timing of accounting for certain
transactions involving payroll transfers between multi-state bank accounts. As a
result, management reorganized specific areas to assure proper and timely
documentation of these transfers to address these deficiencies in order to
confirm accountability and will continue to adequately monitor internal
controls.
The fourth potential deficiency related to inadequate documentation of
approval of certain expenses. In response management implemented use of approval
for payment forms for routine application to expense payment documentation.
PART II: OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES
RECENT SALES OF UNREGISTERED SECURITIES
During the second quarter of 2004 the Company issued 85,713 shares of
common stock as compensation to its outside Board of Directors. These shares
were issued under an exemption from registration pursuant to Section 4(2) of the
Securities Act of 1933.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Reports on Form 8-K: None
Exhibits:
31 Certification of the Chief Executive Officer and Acting Chief
Financial Officer of the Registrant, pursuant to Rule 13a-14(a) and Rule
15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
32 Certification of the Chief Executive Officer and Acting Chief
Financial Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Signature
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
H.E.R.C. PRODUCTS INCORPORATED
--------------------------------
Date: August 19, 2004 By: /s/ S. Steven Carl
--------------------------
S. Steven Carl
Chief Executive Officer and
Acting Chief Financial Officer
(Principal Executive
and Accounting Officer)