1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2000 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to ____________ Commission file number 000-22427 HESKA CORPORATION (Exact name of Registrant as specified in its charter) DELAWARE 77-0192527 (State or other jurisdiction (I.R.S. Employer Identification No.) of incorporation or organization) 1613 PROSPECT PARKWAY FORT COLLINS, COLORADO 80525 (Address of principal executive offices) (970) 493-7272 (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No The number of shares of the Registrant's Common Stock, $.001 par value, outstanding at May 12, 2000 was 33,720,156 ================================================================================ 2 HESKA CORPORATION FORM 10-Q QUARTERLY REPORT TABLE OF CONTENTS PAGE ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements: Consolidated Balance Sheets (Unaudited) as of March 31, 2000 and December 31, 1999................................................. 3 Consolidated Statements of Operations and Comprehensive Loss (Unaudited) for the three months ended March 31, 2000 and 1999.... 4 Condensed Consolidated Statements of Cash Flows (Unaudited) for the three months ended March 31, 2000 and 1999... .................... 5 Notes to Consolidated Financial Statements (Unaudited).............. 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............................................. 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk.......... 21 PART II. OTHER INFORMATION Item 1. Legal Proceedings................................................... Not Applicable Item 2. Changes in Securities and Use of Proceeds........................... 22 Item 3. Defaults Upon Senior Securities..................................... Not Applicable Item 4. Submission of Matters to a Vote of Security Holders................. Not Applicable Item 5. Other Information................................................... Not Applicable Item 6. Exhibits and Reports on Form 8-K.................................... 22 Exhibit Index............................................................... 23 Signatures.................................................................. 24 2 3 HESKA CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (dollars in thousands) (unaudited) ASSETS MARCH 31, DECEMBER 31, 2000 1999 --------- ------------ Current assets: Cash and cash equivalents ............................................. $ 3,881 $ 1,499 Marketable securities ................................................. 10,181 22,482 Accounts receivable, net .............................................. 13,139 9,652 Inventories, net ...................................................... 14,202 13,957 Other current assets .................................................. 1,186 1,027 --------- --------- Total current assets ........................................ 42,589 48,617 Property and equipment, net ........................................................ 18,170 19,574 Intangible assets, net ............................................................. 1,286 1,629 Restricted marketable securities and other assets .................................. 1,638 1,348 --------- --------- Total assets ................................................ $ 63,683 $ 71,168 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable ...................................................... $ 6,694 $ 6,928 Accrued liabilities ................................................... 3,447 4,369 Deferred revenue ...................................................... 593 930 Current portion of capital lease obligations .......................... 516 604 Current portion of long-term debt ..................................... 7,888 7,552 --------- --------- Total current liabilities ................................... 19,138 20,383 Capital lease obligations, less current portion .................................... 595 718 Long-term debt, less current portion ............................................... 3,958 4,428 Other long-term liabilities ........................................................ 200 200 --------- --------- Total liabilities ........................................... 23,891 25,729 --------- --------- Commitments and contingencies Stockholders' equity: Preferred stock, $.001 par value, 25,000,000 shares authorized; none outstanding .................................................. -- -- Common stock, $.001 par value, 40,000,000 shares authorized; 33,710,765 and 33,436,669 shares issued and outstanding, respectively ...................................................... 34 33 Additional paid-in capital ............................................ 199,296 199,156 Deferred compensation ................................................. (494) (648) Stock subscription receivable from officers ........................... (126) (124) Accumulated other comprehensive loss .................................. (386) (376) Accumulated deficit ................................................... (158,532) (152,602) --------- --------- Total stockholders' equity .................................. 39,792 45,439 --------- --------- Total liabilities and stockholders' equity .................. $ 63,683 $ 71,168 ========= ========= See accompanying notes to consolidated financial statements 3 4 HESKA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (in thousands, except per share amounts) (unaudited) THREE MONTHS ENDED MARCH 31, ---------------------------- 2000 1999 -------- -------- Revenues: Products, net ....................................................... $ 12,423 $ 11,010 Licenses and royalties .............................................. 1,700 -- Research and development ............................................ 240 41 -------- -------- Total revenues ................................................... 14,363 11,051 Cost of goods sold ..................................................... 8,422 7,709 -------- -------- 5,941 3,342 -------- -------- Operating expenses: Selling and marketing ............................................... 4,288 3,410 Research and development ............................................ 4,003 4,244 General and administrative .......................................... 2,819 2,736 Amortization of intangible assets and deferred compensation ......... 194 857 Restructuring expense ............................................... 435 -- -------- -------- Total operating expenses ......................................... 11,739 11,247 -------- -------- Loss from operations ................................................... (5,798) (7,905) Other income (expense), net ............................................ (131) 22 -------- -------- Net loss ............................................................... $ (5,929) $ (7,883) ======== ======== Other comprehensive income (loss): Foreign currency translation adjustments ............................ $ 27 $ (40) Unrealized gain (loss) on marketable securities ..................... 51 (345) -------- -------- Other comprehensive income (loss) ...................................... 78 (385) -------- -------- Comprehensive loss ..................................................... $ (5,851) $ (8,268) ======== ======== Basic and diluted net loss per share ................................... $ (0.18) $ (0.30) ======== ======== Shares used to compute basic and diluted net loss per share ............ 33,602 26,605 ======== ======== See accompanying notes to consolidated financial statements 4 5 HESKA CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited) THREE MONTHS ENDED MARCH 31, ---------------------------- 2000 1999 -------- -------- CASH FLOWS USED IN OPERATING ACTIVITIES: Net cash used in operating activities ....................... $ (9,462) $ (9,193) -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sale of marketable securities .......................... 12,267 11,000 Proceeds from disposition of property and equipment .................. 165 262 Purchases of property and equipment .................................. (534) (1,344) -------- -------- Net cash provided by investing activities ................... 11,898 9,918 -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock ............................... 120 186 Proceeds from borrowings ............................................. 1,101 1,562 Repayments of debt and capital lease obligations ..................... (1,226) (2,649) -------- -------- Net cash used in financing activities ....................... (5) (901) -------- -------- EFFECT OF EXCHANGE RATE CHANGES ON CASH ........................................... (49) (180) -------- -------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS .................................. 2,382 (356) CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD .................................... 1,499 5,921 -------- -------- CASH AND CASH EQUIVALENTS, END OF PERIOD .......................................... $ 3,881 $ 5,565 ======== ======== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid for interest ............................................................ $ 380 $ 525 See accompanying notes to consolidated financial statements 5 6 HESKA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2000 (UNAUDITED) 1. ORGANIZATION AND BUSINESS Heska Corporation ("Heska" or the "Company") is primarily focused on the discovery, development and marketing of companion animal health products. In addition to manufacturing certain of Heska's companion animal health products, the Company's primary manufacturing subsidiary, Diamond Animal Health, Inc. ("Diamond"), also manufactures bovine vaccine products and pharmaceutical products that are marketed and distributed by third parties. In addition to manufacturing veterinary allergy products for marketing and sale by Heska, Heska's subsidiaries, Center Laboratories, Inc. ("Center") and CMG-Heska Allergy Products S.A. ("CMG"), a Swiss corporation, also manufacture and sell human allergy products. The Company also offers diagnostic services to veterinarians at its Fort Collins, Colorado location. From the Company's inception in 1988 until early 1996, the Company's operating activities related primarily to research and development activities, entering into collaborative agreements, raising capital and recruiting personnel. Prior to 1996, the Company had not received any revenues from the sale of products. During 1996, Heska grew from being primarily a research and development concern to a fully-integrated research, development, manufacturing and marketing company. The Company accomplished this by acquiring Diamond, a licensed pharmaceutical and biological manufacturing facility in Des Moines, Iowa, hiring key employees and support staff, establishing marketing and sales operations to support Heska products introduced in 1996, and designing and implementing more sophisticated operating and information systems. The Company also expanded the scope and level of its scientific and business development activities, increasing the opportunities for new products. In 1997, the Company introduced additional products and expanded in the United States through the acquisition of Center, a Food and Drug Administration ("FDA") and United States Department of Agriculture ("USDA") licensed manufacturer of allergy immunotherapy products located in Port Washington, New York, and internationally through the acquisitions of Heska UK Limited ("Heska UK", formerly Bloxham Laboratories Limited), a veterinary diagnostic laboratory in Teignmouth, England and CMG (formerly Centre Medical des Grand'Places S.A.) in Fribourg, Switzerland, which manufactures and markets allergy diagnostic products for use in veterinary and human medicine, primarily in Europe. Each of the Company's acquisitions during this period was accounted for under the purchase method of accounting and accordingly, the Company's financial statements reflect the operations of these businesses only for the periods subsequent to the acquisitions. In July 1997, the Company established a new subsidiary, Heska AG, located near Basel, Switzerland, for the purpose of managing its European operations. During the first quarter of 1998 the Company acquired Heska Waukesha (formerly Sensor Devices, Inc.), a manufacturer and marketer of patient monitoring devices used in both animal health and human applications. The operations of Heska Waukesha were combined with existing operations in Fort Collins, Colorado and Des Moines, Iowa during the fourth quarter of 1999. The Heska Waukesha facility was closed in December 1999. In the fourth quarter of 1999, the Company announced its intent to sell Heska UK. The transaction was completed in March 2000. The Company has incurred net losses since its inception and anticipates that it will continue to incur additional net losses in the near term as it introduces new products, expands its sales and marketing capabilities and continues its research and development activities. Cumulative net losses from inception of the Company in 1988 through March 31, 2000 have totaled $158.5 million. 6 7 The Company's ability to achieve profitable operations will depend primarily upon its ability to successfully market its products, commercialize products that are currently under development, develop new products and efficiently integrate acquired businesses. Most of the Company's products are subject to long development and regulatory approval cycles and there can be no guarantee that the Company will successfully develop, manufacture or market these products. There can also be no guarantee that the Company will attain profitability or, if achieved, will remain profitable on a quarterly or annual basis in the future. Until the Company attains positive cash flow, the Company may continue to finance operations with additional equity and debt financing. There can be no guarantee that such financing will be available when required or will be obtained under favorable terms. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. The balance sheet as of March 31, 2000, the statements of operations and comprehensive loss for the three months ended March 31, 2000 and 1999 and the statements of cash flows for the three months ended March 31, 2000 and 1999 are unaudited but include, in the opinion of management, all adjustments (consisting of normal recurring adjustments) which the Company considers necessary for a fair presentation of its financial position, operating results and cash flows for the periods presented. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries since the dates of their respective acquisitions when accounted for under the purchase method of accounting, and for all periods presented when accounted for under the pooling-of-interests method of accounting. All material intercompany transactions and balances have been eliminated in consolidation. Although the Company believes that the disclosures in these financial statements are adequate to make the information presented not misleading, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. Results for any interim period are not necessarily indicative of results for any future interim period or for the entire year. The accompanying financial statements and related disclosures have been prepared with the presumption that users of the interim financial information have read or have access to the audited financial statements for the preceding fiscal year. Accordingly, these financial statements should be read in conjunction with the audited financial statements and the related notes thereto for the year ended December 31, 1999, included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 23, 2000. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Inventories, net Inventories are stated at the lower of cost or market using the first-in, first-out method. If the cost of inventories exceeds fair market value, provisions are made for the difference between cost and fair market value. 7 8 Inventories, net of provisions, consist of the following (in thousands): MARCH 31, DECEMBER 31, 2000 1999 -------- -------- Raw materials.............................. $ 2,955 $ 3,436 Work in process............................ 7,244 6,445 Finished goods............................. 4,003 4,076 -------- -------- $ 14,202 $ 13,957 ======== ======== Revenue Recognition Product revenues are recognized at the time goods are shipped to the customer, or at the time services are performed, with an appropriate provision for returns and allowances. License revenues under arrangements to sell product rights or technology rights are recognized upon the sale and completion by the Company of all obligations under the agreement. No royalty revenue has been recognized to date. Royalties will be recognized as products are sold to customers. The Company recognizes revenue from sponsored research and development as research activities are performed or as development milestones are completed under the terms of the research and development agreements. Costs incurred in connection with the performance of sponsored research and development are expensed as incurred. The Company defers revenue recognition of advance payments received during the current year until research activities are performed or development milestones are completed. In addition to its direct sales force and a contract sales force specializing in equine products, the Company utilizes both distributors and sales agency organizations to sell its products. Distributors purchase goods from the Company, take title to those goods and resell them to their customers in the distributors' territory. Sales agents maintain inventories of goods on consignment from the Company and sell these goods on behalf of the Company to customers in the sales agents' territory. The Company recognizes revenue at the time goods are sold to the customers by the sales agents. Sales agents are paid a fee for their services, which include maintaining product inventories, sales activities, billing and collections. Fees earned by sales agents are netted against revenues generated by these entities. In December 1999, the Securities and Exchange Commission ("SEC") staff released Staff Accounting Bulletin No. 101, Revenue Recognition ("SAB 101"). SAB 101 provides interpretive guidance on the recognition, presentation and disclosure of revenue in financial statements. The accounting impact of SAB 101 is required to be determined no later than the Company's second fiscal quarter of 2000. If the Company determines that its revenue recognition policies must change to be in compliance with SAB 101, the implementation of SAB 101 will be reflected as a cumulative effect of change in accounting principle as if SAB 101 had been implemented on January 1, 2000. The Company is currently reviewing SAB 101 to determine what impact, if any, the adoption of SAB 101 will have on its financial position and results of operations. Basic and Diluted Net Loss Per Share The Company presents basic and diluted net loss per share in accordance with Statement of Financial Accounting Standards ("SFAS") No. 128, Earnings per Share, which establishes standards for computing and presenting basic and diluted earnings per share. Also, the Company has adopted the guidance of SEC Staff Accounting Bulletin No. 98 and related interpretations. Basic net loss per common share is computed using the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed using the sum of the weighted average number of shares of common stock outstanding and, if not anti-dilutive, the effect of outstanding stock options and warrants determined using the treasury stock method. 8 9 Foreign Currency Translation The functional currencies of the Company's international subsidiaries are the French Franc and the Swiss Franc. Assets and liabilities of the Company's international subsidiaries are translated using the exchange rate in effect at the balance sheet date. Revenue and expense accounts are translated using an average of exchange rates in effect during the period. Cumulative translation gains and losses, if material, are shown in the consolidated balance sheets as a separate component of stockholders' equity. Exchange gains and losses arising from transactions denominated in foreign currencies (i.e., transaction gains and losses) are recognized in current operations. To date, the Company has not entered into any forward contracts or hedging transactions. 3. RESTRUCTURING EXPENSES During the first quarter of fiscal 2000, the Company initiated a cost reduction and restructuring plan at its Diamond subsidiary. The restructuring resulted from the rationalization of Diamond's business including a reduction in the size of its workforce and the Company's decision to vacate a leased warehouse and distribution facility no longer needed after the Company's decision to discontinue contract manufacturing of certain low margin human healthcare products. The charge to operations of approximately $435,000 related primarily to personnel severance costs for 12 individuals and the costs associated with closing the leased facility, terminating the lease and abandoning certain leasehold improvements. The facility was closed in April 2000. In August 1999, the Company announced plans to consolidate its Heska Waukesha operations with existing operations in Fort Collins, Colorado and Des Moines, Iowa. This consolidation was based on the Company's determination that significant operating efficiencies could be achieved through the combined operations. The Company recognized a charge to operations of approximately $1.2 million for this consolidation. These expenses related primarily to personnel severance costs for 40 individuals and the costs associated with facilities being closed and excess equipment, primarily at the Company's Waukesha, Wisconsin location. This facility was closed in December 1999. Shown below is a reconciliation of restructuring costs for the quarter ended March 31, 2000 (in thousands): Payments/Charges Balance at Additions for the For the Three Balance at December 31, Three Months Ended Months Ended March 31, 1999 March 31, 2000 March 31, 2000 2000 ------------ ------------------ --------------- ----------- Severance pay, benefits and relocation expenses..... $ 429 $ 121 $ (525) $ 25 Noncancellable leased facility closure costs........ 694 314 (504) 504 ------ ----- ------- ---- Total.......................................... $1,123 $ 435 $(1,029) $529 ====== ===== ======== ==== The balances of $529,000 and $1.1 million are included in accrued liabilities in the accompanying consolidated balance sheets as of March 31, 2000 and December 31, 1999, respectively. 4. MAJOR CUSTOMERS One customer accounted for approximately 10% of total revenue during the three months ended March 31, 2000. No customer accounted for more than 10% of total revenue during the three months ended March 31, 1999. 9 10 5. SEGMENT REPORTING The Company has adopted the provisions of SFAS No. 131, Disclosures About Segments of an Enterprise, which changes the way the Company reports information about its operating segments. The Company divides its operations into two reportable segments, Animal Health, which includes the operations of Heska, Diamond, and Heska AG, and Allergy Diagnostics and Treatment, which includes the operations of Center and CMG. Summarized financial information concerning the Company's reportable segments is shown in the following table (in thousands). The "Other" column includes the elimination of intercompany transactions and other items as noted. ALLERGY ANIMAL DIAGNOSTICS HEALTH AND TREATMENT OTHER TOTAL ---------- ------------- --------- ----------- THREE MONTHS ENDED MARCH 31, 2000: Revenues........................................ $ 13,360 $ 1,690 $ (687) $ 14,363 Operating loss.................................. (5,325) (38) (435) (a) (5,798) Total assets.................................... 91,654 7,445 (35,416) 63,683 THREE MONTHS ENDED MARCH 31, 1999: Revenues........................................ $ 10,031 $ 1,773 $ (753) $ 11,051 Operating loss.................................. (7,078) (74) (753) (7,905) Total assets.................................... 117,337 7,749 (36,663) 88,423 - ------------- (a) Includes restructuring expenses of $435,000 (See Note 3). The Company manufactures and markets its products in two major geographic areas, North America and Europe. The Company's primary manufacturing facilities are located in North America. Revenues earned in North America are attributable to Heska, Diamond and Center. Revenues earned in Europe are primarily attributable to CMG and Heska AG. There have been no significant exports from North America or Europe. In the three months ended March 31, 2000 and 1999, European subsidiaries purchased products from North America for sale to European customers. Transfer prices to international subsidiaries are intended to allow the North American companies to earn profit margins commensurate with their sales and marketing efforts. Certain information by geographic area is shown in the following table (in thousands). The "Other" column includes the elimination of intercompany transactions. NORTH AMERICA EUROPE OTHER TOTAL ------- ------ ----- ----- THREE MONTHS ENDED MARCH 31, 2000: Revenues............................................ $ 14,209 $ 841 $ (687) $ 14,363 Operating loss...................................... (5,084) (279) (435)(a) (5,798) Total assets........................................ 95,815 3,285 (35,417) 63,683 THREE MONTHS ENDED MARCH 31, 1999: Revenues............................................ $ 10,798 $ 1,006 $ (753) $ 11,051 Operating loss...................................... (7,455) (450) -- (7,905) Total assets........................................ 120,802 4,284 (36,663) 88,423 - ------------- (a) Includes restructuring expenses of $435,000 (See Note 3). 10 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion contains, in addition to historical information, forward-looking statements that involve risks and uncertainties. Our actual results and the timing of certain events could differ materially from the results discussed in the forward-looking statements. When used in this discussion the words "expects," "anticipates," "estimates" and similar expressions are intended to identify forward-looking statements. Such statements, which include statements concerning future revenue sources and concentration, gross margins, research and development expenses, selling and marketing expenses, general and administrative expenses, capital resources, additional financings or borrowings and additional losses, are subject to risks and uncertainties, including those set forth below under "Factors that May Affect Results" that could cause actual results to differ materially from those projected. These forward-looking statements speak only as of the date hereof. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions, or circumstances on which any such statement is based. OVERVIEW We are primarily focused on the discovery, development and marketing of companion animal health products. In addition to manufacturing certain of our companion animal products, our primary manufacturing subsidiary, Diamond, also manufactures bovine vaccine products and pharmaceutical products that are marketed and distributed by third parties. In addition to manufacturing veterinary allergy products for marketing and sale by us, our subsidiaries, Center and CMG, also manufacture and sell human allergy products. We also offer diagnostic services to veterinarians at our Fort Collins, Colorado location. From our inception in 1988 until early 1996, our operating activities related primarily to research and development activities, entering into collaborative agreements, raising capital and recruiting personnel. Prior to 1996, we had not received any revenues from the sale of products. During 1996, we grew from being primarily a research and development concern to a fully-integrated research, development, manufacturing and marketing company. We accomplished this by acquiring Diamond, a licensed pharmaceutical and biological manufacturing facility in Des Moines, Iowa, hiring key employees and support staff, establishing marketing and sales operations to support our products introduced in 1996, and designing and implementing more sophisticated operating and information systems. We also expanded the scope and level of our scientific and business development activities, increasing the opportunities for new products. In 1997, we introduced additional products and expanded in the United States through the acquisition of Center, an FDA and USDA licensed manufacturer of allergy immunotherapy products located in New York, and internationally through the acquisitions of Heska UK, a veterinary diagnostic laboratory in England and CMG in Switzerland, which manufactures and markets allergy diagnostic products for use in veterinary and human medicine, primarily in Europe. Each of our acquisitions during this period was accounted for under the purchase method of accounting and accordingly, our financial statements reflect the operations of these businesses only for the periods subsequent to the acquisitions. In July 1997, we established a new subsidiary, Heska AG, located near Basel, Switzerland, for the purpose of managing our European operations. During the first quarter of 1998, we acquired a manufacturer and marketer of patient monitoring devices. The financial results of this entity have been consolidated with ours under the pooling-of-interests accounting method for all periods presented. These operations were consolidated with our existing operations in Fort Collins, Colorado and Des Moines, Iowa as of December 31, 1999, and our facility in Waukesha, Wisconsin was closed. In December 1999, we announced our intent to sell our subsidiary in the United Kingdom, Heska UK. The sale was completed in March 2000. 11 12 We have incurred net losses since our inception and anticipates that we will continue to incur additional net losses in the near term as we introduce new products, expand our sales and marketing capabilities and continue our research and development activities. Cumulative net losses from our inception in 1988 through March 31, 2000 have totaled $158.5 million. Our ability to achieve profitable operations will depend primarily upon our ability to successfully market our products, commercialize products that are currently under development and develop new products. Most of our products are subject to long development and regulatory approval cycles and there can be no assurance that we will successfully develop, manufacture or market these products. There can also be no assurance that we will attain profitability or, if achieved, will remain profitable on a quarterly or annual basis in the future. Until we attain positive cash flow, we may continue to finance operations with additional equity and debt financing. There can be no assurance that such financing will be available when required or will be obtained under favorable terms. See the discussion later in this section titled "Factors That May Affect Results" for a more in-depth explanation of risks faced by us. RESULTS OF OPERATIONS Three Months Ended March 31, 2000 and 1999 Total revenues, which include product, license and royalty and research and development revenues, increased 30% to $14.4 million in the first quarter of 2000 compared to $11.1 million for the first quarter of 1999. Product revenues increased 13% to $12.4 million in the first quarter of 2000 compared to $11.0 million for the first quarter of 1999. The growth in revenues during 2000 was primarily due to sales of new products introduced 12 13 during 1999, improved instrumentation sales, the sale of our canine periodontal disease therapeutic product line and various licensing transactions. During the quarter ended March 31, 2000, we recognized $1.7 million of license and royalty revenue. These revenues were primarily attributable to the sale of the PERIOceutic(TM) Gel product line and the licensing of certain recombinant allergen technology. In connection with the product line sale, we expect to receive royalty revenues in future periods with respect to product sales. Revenues from sponsored research and development increased to $240,000 in the first quarter of 2000 from $41,000 in the first quarter of 1999. Fluctuations in revenues from sponsored research and development are generally the result of changes in the number of funded research projects as well as the timing and performance of contract milestones. Cost of goods sold totaled $8.4 million in the first quarter of 2000 compared to $7.7 million in the first quarter of 1999, and the resulting gross profit from product sales for 2000 increased to $4.0 million from $3.3 million in 1999. The improvement in gross profit as a percentage of product sales in the first quarter of 2000 compared to 1999 reflects the increase in sales of our proprietary products and the elimination of certain low-margin products during 1999. Selling and marketing expenses increased to $4.3 million in the first quarter of 2000 from $3.4 million in the first quarter of 1999. This increase reflects primarily the expansion of our sales and marketing organization and costs associated with the introduction and marketing of new products. Research and development expenses decreased to $4.0 million in the first quarter of 2000 from $4.2 million in the first quarter of 1999. Fluctuations in research and development expenses are generally the result of the number of research projects in progress. General and administrative expenses increased slightly to $2.8 million in the first quarter of 2000 from $2.7 million in the first quarter of 1999. Amortization of intangible assets and deferred compensation decreased to $194,000 in the first quarter of 2000 from $857,000 in 1999. The decrease in amortization expense from 1999 is due primarily to the completed amortization of certain intangible assets, and to the write-off of intangible assets related to the sale of Heska UK and certain other intangible assets in 1999. Intangible assets resulted primarily from our 1997 and 1996 business acquisitions and are being amortized over lives of 2 to 10 years. The amortization of deferred compensation resulted in a non-cash charge to operations in the first quarter of 2000 of $154,000 compared to $189,000 in the first quarter of 1999. In connection with the grant of certain stock options in 1997 and 1996, we recorded deferred compensation representing the difference between the deemed value of the common stock for accounting purposes and the exercise price of such options at the date of grant. During the first quarter of fiscal 2000, we initiated a cost reduction and restructuring plan at Diamond. The restructuring resulted from the rationalization of Diamond's business including a reduction in the size of its workforce and our decision to vacate a leased warehouse and distribution facility no longer needed after our decision to discontinue contract manufacturing of certain low margin human health care products. The charge to operations of approximately $435,000 related primarily to personnel severance costs for 12 individuals and the costs associated with closing the leased facility, terminating the lease and abandoning certain leasehold improvements. The facility was closed in April 2000. Other income (expense), net decreased to net other expense of $131,000 for the three months ended March 31, 2000 compared to net other income of $22,000 for the same period in 1999 primarily due to lower interest income as cash has been used to fund current operations. This decrease in interest income was partially offset by lower interest expense as we have repaid outstanding debt. 13 14 LIQUIDITY AND CAPITAL RESOURCES Our primary source of liquidity at March 31, 2000 was our $14.1 million in cash, cash equivalents and marketable securities. As additional sources of liquidity, we and our subsidiaries have secured lines of credit and other revolving debt facilities totaling approximately $2.7 million, against which borrowings of approximately $1.8 million were outstanding at March 31, 2000. These financing facilities are secured by assets of the respective subsidiaries and by corporate guarantees of Heska. We expect to seek additional asset-based borrowing facilities. Cash used in operating activities was $9.5 million in the first quarter of 2000, compared to $9.2 million in the first quarter of 1999. The increase of $3.5 million in accounts receivable was mainly due to increased sales volume and the license and royalty revenues which were recognized in March 2000. Accounts payable and accrued liabilities decreased by $1.2 million in the first quarter of 2000. Expenses which were recognized as a result of our Waukesha restructuring in 1999 and paid in the first quarter of 2000 accounted for $667,000 of the reduction in accrued liabilities during the first quarter of 2000. Our investing activities provided cash of $11.9 million in the first quarter of 2000, compared to $9.9 million in cash provided by investing activities during the first quarter of 1999. Cash provided by investing activities was primarily related to the sale of marketable securities to fund our business operations. Expenditures for property and equipment totaled $534,000 for the first quarter of 2000 compared to $1.3 million in the first quarter of 1999. We have historically used capital equipment lease and debt facilities to finance equipment purchases and, if possible, leasehold improvements. We currently expect to spend approximately $2.0 million in 2000 for capital equipment, including expenditures for the upgrading of certain manufacturing operations to improve efficiencies as well as various enhancements to assure ongoing compliance with certain regulatory requirements. Our financing activities used $5,000 in the first quarter of 2000 compared to $901,000 used in the first quarter of 1999. The higher usage of cash in 1999 is primarily due to debt repayments in excess of new borrowings during the first quarter of fiscal 1999. Our primary short-term needs for capital, which are subject to change, are for our continuing research and development efforts, our sales, marketing and administrative activities, working capital associated with increased product sales and capital expenditures relating to developing and expanding our manufacturing operations. Our future liquidity and capital requirements will depend on numerous factors, including the extent to which our present and future products gain market acceptance, the extent to which products or technologies under research or development are successfully developed, the timing of regulatory actions regarding our products, the costs and timing of expansion of sales, marketing and manufacturing activities, the cost, timing and business management of current and potential acquisitions and contingent liabilities associated with such acquisitions, the procurement and enforcement of patents important to our business and the results of competition. We believe that our available cash, cash from operations, available borrowings and borrowings expected to be available under a corporate revolving line of credit currently being negotiated will be sufficient to satisfy our projected cash requirements for at least the next 12 months, assuming no significant uses of cash in acquisition activities. Thereafter, if cash generated from operations is insufficient to satisfy our cash requirements, we will need to raise additional capital to continue our business operations. There can be no assurance that such additional capital will be available on terms acceptable to us, if at all. Furthermore, any additional equity financing would likely be dilutive to stockholders and debt financing, if available, may include restrictive covenants which may limit our operations and strategies. 14 15 NET OPERATING LOSS CARRYFORWARDS As of December 31, 1999, we had a net operating loss carryforward of approximately $127.5 million and approximately $2.7 million of research and development tax credits available to offset future federal income taxes. The NOL and tax credit carryforwards, which are subject to alternative minimum tax limitations and to examination by the tax authorities, expire from 2003 to 2019. Our acquisition of Diamond resulted in a "change of ownership" under the provisions of Section 382 of the Internal Revenue Code of 1986, as amended. As such, we will be limited in the amount of NOL's incurred prior to the merger that we may utilize to offset future taxable income. This limitation will total approximately $4.7 million per year for periods subsequent to the Diamond acquisition. Similar limitations also apply to utilization of R&D tax credits to offset taxes payable. We believe that this limitation may affect the eventual utilization of our total NOL carryforwards. RECENT ACCOUNTING PRONOUNCEMENTS In December 1999, the Securities and Exchange Commission ("SEC") staff released Staff Accounting Bulletin No. 101, Revenue Recognition ("SAB 101"). SAB 101 provides interpretive guidance on the recognition, presentation and disclosure of revenue in financial statements. The accounting impact of SAB 101 is required to be determined no later than our second fiscal quarter of 2000. If we determine that our revenue recognition policies must change to be in compliance with SAB 101, the implementation of SAB 101 will be reflected as a cumulative effect of change in accounting principle as if SAB 101 had been implemented on January 1, 2000. We are currently reviewing SAB 101 to determine what impact, if any, the adoption of SAB 101 will have on our financial position and results of operations. We do not expect the adoption of any standards recently issued by the Financial Accounting Standards Board or the Securities and Exchange Commission to have a material impact on our financial position or results of operations. FACTORS THAT MAY AFFECT RESULTS We have a history of losses and may never achieve profitability. We have incurred net losses since our inception. At March 31, 2000, our accumulated deficit was $158.5 million. We anticipate that we will continue to incur additional operating losses in the near term. These losses have resulted principally from expenses incurred in our research and development programs and from general and administrative and sales and marketing expenses. We cannot assure you that we will attain profitability or, if we do, that we will remain profitable on a quarterly or annual basis in the future. We have limited resources to devote to product development and commercialization. Our strategy is to develop a broad range of products addressing companion animal healthcare. We believe that our revenue growth and profitability, if any, will substantially depend upon our ability to: o improve market acceptance of our current products; o complete development of new products; and o successfully introduce and commercialize new products. We have introduced some of our products only recently and many of our products are still under development. Because we have limited resources to devote to product development and commercialization, any delay in the development of one product or reallocation of resources to product development efforts that prove unsuccessful may delay or jeopardize the development of our other product candidates. If we fail to develop new products and bring them to market, our business could be substantially harmed. 15 16 We may experience difficulty in commercializing our products. Because several of our current products, as well as a number of products under development, are novel, we may need to expend substantial efforts in order to educate our customers about the uses of our products and to convince them of the need for our products. We cannot assure you that any of our products will achieve satisfactory market acceptance or that we will successfully commercialize them on a timely basis, or at all. If any of our products do not achieve a significant level of market acceptance, our business could be substantially harmed. We must obtain costly regulatory approvals in order to bring our products to market. Many of the products we develop and market are subject to regulation by one or more of the USDA, FDA, EPA and foreign regulatory authorities. The development and regulatory approval activities necessary to bring new products to market are time-consuming and costly. We have experienced in the past, and may experience in the future, difficulties that could delay or prevent us from obtaining the regulatory approvals necessary to introduce new products or to market them. We cannot assure you that the USDA, FDA, EPA or foreign regulatory authorities will issue regulatory clearance or new product approvals on a timely basis, or at all. Any acquisitions of new products and technologies may subject us to additional government regulation. If we do not secure the necessary regulatory approvals for our products, our business could be substantially harmed. Factors beyond our control may cause our operating results to fluctuate and many of our expenses are fixed. We believe that our future operating results will fluctuate on a quarterly basis due to a variety of factors, including: o the introduction of new products by us or by our competitors; o market acceptance of our current or new products; o regulatory and other delays in product development; o product recalls; o competition and pricing pressures from competitive products; o manufacturing delays; o shipment problems; o product seasonality; and o changes in the mix of products sold. We have high operating expenses for personnel, new product development and marketing. Many of these expenses are fixed in the short term. If any of the factors listed above cause our revenues to decline, our operating results could be substantially harmed. We may need to seek additional financing in the future. We have incurred negative cash flow from operations since inception. We do not expect to generate positive cash flow sufficient to fund our operations in the near term. We believe that our available cash, cash from operations, available borrowings and borrowings expected to be available under a corporate revolving line of credit currently being negotiated will be sufficient to satisfy our projected cash requirements for at least the next 12 months, assuming no significant uses of cash in acquisition activities. Thus, we may need to raise additional capital to fund our research and development, manufacturing, sales and marketing activities. Our future liquidity and capital requirements will depend on numerous factors, including: 16 17 o the extent to which our present and future products gain market acceptance; o the extent to which we successfully develop products from technologies under research or development; o the timing of regulatory actions concerning our products; o the costs and timing of expansions of our sales, marketing and manufacturing activities; o the cost, timing and business management of recent and potential acquisitions and contingent liabilities associated with acquisitions; o the procurement and enforcement of important patents, and o the results of competition. We cannot assure you that additional capital will be available on acceptable terms, if at all. Furthermore, any additional equity financing would likely be dilutive to stockholders, and debt financing, if available, may include restrictive covenants which may limit our currently planned operations and strategies. If adequate funds are not available, we may be required to curtail our operations significantly or to obtain funds by entering into collaborative agreements or other arrangements on unfavorable terms. If we fail to raise capital on acceptable terms when we need to, our business could be substantially harmed. A small number of large customers account for a large percentage of our revenues. We currently derive a substantial portion of our revenues from Diamond, which manufactures certain of our products and products for other companies in the animal health industry. Revenues from one Diamond customer comprised approximately 10% of total revenues in the first quarter of 2000. No customer accounted for more than 10% of total revenue during the three months ended March 31, 1999. We have limited experience in marketing our products. The market for companion animal healthcare products is highly fragmented, with discount stores and specialty pet stores accounting for a substantial percentage of sales. Because we sell our companion animal health products only to veterinarians, we may fail to reach a substantial segment of the potential market, and we may not be able to offer our products at prices which are competitive with those of companies that distribute their products through retail channels. We currently market our products to veterinarians through a direct sales force and through third parties. To be successful, we will have to continue to develop and train our direct sales force or rely on marketing partnerships or other arrangements with third parties to market, distribute and sell our products. We cannot assure you that we will successfully develop and maintain marketing, distribution or sales capabilities, or that we will be able to make arrangements with third parties to perform these activities on satisfactory terms. If we fail to develop a successful marketing strategy, our business could be substantially harmed. We operate in a highly competitive industry. The market in which we operate is intensely competitive. Our competitors include independent animal health companies and major pharmaceutical companies that have animal health divisions. Companies with a significant presence in the animal health market, such as American Home Products, Bayer, Merial Ltd., Novartis, Pfizer Inc., Schering Plough Corporation, Pharmacia & Upjohn, Inc. and IDEXX Laboratories, Inc., have developed or are developing products that compete with our products or would compete with them if developed. These competitors may have substantially greater financial, technical, research and other resources and larger, better-established marketing, sales, distribution and service organizations than us. Our competitors offer broader product lines and have greater name recognition than we do. We cannot assure you that our competitors will not develop or market technologies or products that are more effective or commercially attractive than our current or future products, or that would render our technologies and products obsolete. Moreover, we cannot assure you that we will have the financial resources, technical expertise or marketing, distribution or support capabilities to compete successfully. If we fail to compete successfully, our business could be substantially harmed. 17 18 We have granted third parties substantial marketing rights to our products under development. We have granted marketing rights to certain products under development to third parties, including Novartis, Bayer, Eisai and Ralston Purina. Novartis has the right to manufacture and market throughout the world (except in countries where Eisai has such rights) under the Novartis trade name any flea control vaccine or feline heartworm vaccine we develop on or before December 31, 2005. We have retained the right to co-exclusively manufacture and market these products throughout the world under our own trade names. Accordingly, Novartis and we may become direct competitors, with each party sharing revenues on the other's sales. We have also granted Novartis a right of first refusal pursuant to which, prior to granting rights to any third party for any products or technology we develop or acquire for either companion animal or food animal applications, we must first offer Novartis such rights. In Japan, Novartis also has the exclusive right, upon regulatory approval, to distribute our (a) heartworm diagnostics, (b) trivalent and bivalent feline vaccines and (c) certain other Heska products. Bayer has exclusive marketing rights to our canine heartworm vaccine, except in countries where Eisai has such rights. Eisai has exclusive rights in Japan and most countries in East Asia to market our feline and canine heartworm vaccines, our feline and canine flea control vaccine and our feline toxoplasmosis vaccine. In addition, we granted Ralston Purina the exclusive rights to develop and commercialize our discoveries, know-how and technologies in various pet food products. Our agreements with our corporate marketing partners generally contain no minimum purchase requirements in order for them to maintain their exclusive or co-exclusive marketing rights. We cannot assure you that Novartis, Bayer, Eisai or Ralston Purina or any other collaborative party will devote sufficient resources to marketing our products. Furthermore, there is nothing to prevent Novartis, Bayer, Eisai or Ralston Purina or any other collaborative party from pursuing alternative technologies or products that may compete with our products. If we fail to develop and maintain our own marketing capabilities, we may find it necessary to continue to rely on potential or actual competitors for third-party marketing assistance. Third party marketing assistance may not be available in the future on reasonable terms, if at all. We may face costly intellectual property disputes. Our ability to compete effectively will depend in part on our ability to develop and maintain proprietary aspects of our technology and either to operate without infringing the proprietary rights of others or to obtain rights to technology owned by third parties. We have United States and foreign-issued patents and are currently prosecuting patent applications in the United States and with various foreign patent offices. We cannot assure you that any of our pending patent applications will result in the issuance of any patents or that any issued patents will offer protection against competitors with similar technology. We cannot assure you that any patents we receive will not be challenged, invalidated or circumvented in the future or that the rights created by those patents will provide a competitive advantage. We also rely on trade secrets, technical know-how and continuing invention to develop and maintain our competitive position. We cannot assure you that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets. The biotechnology and pharmaceutical industries have been characterized by extensive litigation relating to patents and other intellectual property rights. In 1998, Synbiotics Corporation filed a lawsuit against us alleging infringement of a Synbiotics patent relating to heartworm diagnostic technology and this litigation remains ongoing. We cannot assure you that we will not become subject to additional patent infringement claims and litigation in the United States or other countries or interference proceedings conducted in the United States Patent and Trademark Office to determine the priority of inventions. The defense and prosecution of intellectual property suits, USPTO interference proceedings, and related legal and administrative proceedings are costly, time-consuming and distracting. We may also need to pursue litigation to enforce any patents issued to us or our collaborative partners, to protect trade secrets or know-how owned by us or our collaborative partners, or to determine the enforceability, scope and validity of the proprietary rights of others. Any litigation or interference 18 19 proceeding will result in substantial expense to us and significant diversion of the efforts of our technical and management personnel. Any adverse determination in litigation or interference proceedings could subject us to significant liabilities to third parties. Further, as a result of litigation or other proceedings, we may be required to seek licenses from third parties which may not be available on commercially reasonable terms, if at all. We license technology from a number of third parties. The majority of these license agreements impose due diligence or milestone obligations on us, and in some cases impose minimum royalty and/or sales obligations on us, in order for us to maintain our rights under these agreements. Our products may incorporate technologies that are the subject of patents issued to, and patent applications filed by, others. As is typical in our industry, from time to time we and our collaborators have received, and may in the future receive, notices from third parties claiming infringement and invitations to take licenses under third-party patents. It is our policy that when we receive such notices, we conduct investigations of the claims they assert. With respect to the notices we have received to date, we believe, after due investigation, that we have meritorious defenses to the infringement claims asserted. Any legal action against us or our collaborators may require us or our collaborators to obtain one or more licenses in order to market or manufacture affected products or services. However, we cannot assure you that we or our collaborators will be able to obtain licenses for technology patented by others on commercially reasonable terms, that we will be able to develop alternative approaches if unable to obtain licenses, or that the current and future licenses will be adequate for the operation of our businesses. Failure to obtain necessary licenses or to identify and implement alternative approaches could prevent us and our collaborators from commercializing certain of our products under development and could substantially harm our business. We have limited manufacturing experience and capacity and rely substantially on third-party manufacturers. To be successful, we must manufacture, or contract for the manufacture of, our current and future products in compliance with regulatory requirements, in sufficient quantities and on a timely basis, while maintaining product quality and acceptable manufacturing costs. In order to increase our manufacturing capacity, we acquired Diamond in April 1996 and certain assets of Center in July 1997. We must complete significant improvements in our manufacturing infrastructure in order to scale up for the manufacturing of our new products. We cannot assure you that we can complete such work successfully or on a timely basis. We currently rely on third parties to manufacture those products we do not manufacture at our Diamond or Center facilities. We currently have a supply agreement with Quidel Corporation for certain manufacturing services relating to our point-of-care diagnostic tests. Third parties also manufacture our patient monitoring instruments and associated consumable products. We cannot assure you that these partners will manufacture products to regulatory standards and our specifications in a cost-effective and timely manner. If one or more of our suppliers experiences delays in scaling up commercial manufacturing, fails to produce a sufficient quantity of products to meet market demand, or requests renegotiation of contract prices, our business could be substantially harmed. While we typically retain the right to manufacture products ourselves or contract with an alternative supplier in the event of a manufacturer's breach, any transfer of production would cause significant production delays and additional expense to us to scale up production at a new facility and to apply for regulatory licensure at that new facility. In addition, we cannot assure you that suitable manufacturing partners or alternative suppliers will be available for our products under development if present arrangements are not satisfactory. Our manufacturing facilities are subject to governmental regulation. Our manufacturing facilities and those of any third-party manufacturers we may use are subject to the requirements of and periodic regulatory inspections by one or more of the FDA, USDA and other federal, state and foreign regulatory agencies. We cannot assure you that we or our contractors will continue to satisfy these regulatory requirements. Any failure to do so could substantially harm our business, financial condition or results of operations. We cannot assure you that we will not incur significant costs to comply with laws and regulations in the future or that new laws and regulations will not substantially harm our business. 19 20 We depend on partners in our research and development activities. For certain of our proposed products, we are dependent on collaborative partners to successfully and timely perform research and development activities on our behalf. We cannot assure you that these collaborative partners will complete research and development activities on our behalf in a timely fashion, or at all. If our collaborative partners fail to complete research and development activities, or fail to complete them in a timely fashion, our business could be substantially harmed. We depend on key personnel for our future success. Our future success is substantially dependent on the efforts of our senior management and scientific team. The loss of the services of members of our senior management or scientific staff may significantly delay or prevent the achievement of product development and other business objectives. Because of the specialized scientific nature of our business, we depend substantially on our ability to attract and retain qualified scientific and technical personnel. There is intense competition among major pharmaceutical and chemical companies, specialized biotechnology firms and universities and other research institutions for qualified personnel in the areas of our activities. If we lose the services of, or fail to recruit, key scientific and technical personnel, our business could be substantially harmed. We must manage our growth effectively. We anticipate that our business will grow as we develop and commercialize new products, and that this growth will result in an increase in responsibilities for both existing and new management personnel. In order to manage growth effectively, we will need to continue to implement and improve our operational, financial and management information systems, to train, motivate and manage our current employees and to hire new employees. We cannot assure you that we will be able to manage our expansion effectively. Failure to do so could substantially harm our business. We may face product liability litigation and the extent of our insurance coverage is limited. The testing, manufacturing and marketing of our current products as well as those currently under development entail an inherent risk of product liability claims and associated adverse publicity. To date, we have not experienced any material product liability claims, but any claim arising in the future could substantially harm our business. Potential product liability claims may exceed the amount of our insurance coverage or may be excluded from coverage under the terms of the policy. We cannot assure you that we will be able to continue to obtain adequate insurance at a reasonable cost, if at all. In the event that we are held liable for a claim against which we are not indemnified or for damages exceeding the limits of our insurance coverage or which results in significant adverse publicity against us, our business could be substantially harmed. Side effects of our products may generate adverse publicity. Following the introduction of a product, adverse side effects may be discovered that make a product no longer commercially viable. Publicity regarding such adverse effects could affect sales of our other products for an indeterminate time period. We are dependent on the acceptance of our products by both veterinarians and pet owners. If we fail to engender confidence in our products and services, our ability to attain and sustain market acceptance of our products could be substantially harmed. We may be held liable for the release of hazardous materials. Our products and development programs involve the controlled use of hazardous and biohazardous materials, including chemicals, infectious disease agents and various radioactive compounds. Although we believe that our safety procedures for handling and disposing of such materials comply with the standards prescribed by applicable local, state and federal regulations, we cannot completely eliminate the risk of accidental 20 21 contamination or injury from these materials. In the event of such an accident, we could be held liable for any damages or fines that result. Our liability for the release of hazardous materials could exceed our resources. We may incur substantial costs to comply with environmental regulations as we expand our manufacturing capacity. We expect to experience volatility in our stock price. The securities markets have from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. The market prices of securities of many publicly-held biotechnology companies have in the past been, and can in the future be expected to be, especially volatile. The market price of our common stock may fluctuate substantially due to factors such as: o announcements of technological innovations or new products by us or by our competitors; o releases of reports by securities analysts; o developments or disputes concerning patents or proprietary rights; o regulatory developments; o changes in regulatory policies; o economic and other external factors; and o quarterly fluctuations in our financial results. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk represents the risk of loss that may impact the financial position, results of operations or cash flows due to adverse changes in financial and commodity market prices and rates. We are exposed to market risk in the areas of changes in United States and foreign interest rates and changes in foreign currency exchange rates as measured against the United States dollar. These exposures are directly related to our normal operating and funding activities. Historically and as of March 31, 2000, we have not used derivative instruments or engaged in hedging activities. Interest Rate Risk The interest payable on certain of our lines of credit and other borrowings is variable based on the United States prime rate and, therefore, affected by changes in market interest rates. At March 31, 2000, approximately $8.5 million was outstanding on these lines of credit and other borrowings with a weighted average interest rate of 10.3%. The line of credit matures in September 2001 and is subject to annual renewal. We manage interest rate risk by investing excess funds principally in cash equivalents or marketable securities which bear interest rates that reflect current market yields. Additionally, we monitor interest rates and at March 31, 2000 had sufficient cash balances to pay off the lines of credit should interest rates increase significantly. As a result, we do not believe that reasonably possible near-term changes in interest rates will result in a material effect on our future earnings, financial position or cash flows. Foreign Currency Risk At March 31, 2000, we had wholly-owned subsidiaries located in Switzerland and France. Sales from these operations are denominated in Swiss Francs, French Francs or Euros, thereby creating exposures to changes in exchange rates. The changes in the Swiss/U.S. exchange rate, French/U.S. exchange rate or Euro/U.S. exchange rate may positively or negatively affect our sales, gross margins and retained earnings. We do not believe that reasonably possible near-term changes in exchange rates will result in a material effect on future 21 22 earnings, fair values or cash flows, and therefore, have chosen not to enter into foreign currency hedging instruments. There can be no assurance that such an approach will be successful, especially in the event of a significant and sudden decline in the value of the Swiss Franc, French Franc or Euro. PART II. OTHER INFORMATION ITEM 2. SALES OF UNREGISTERED SECURITIES (c) Between October 1999 and March 2000, the Registrant issued 1,691 shares of Common Stock to consultants in consideration of services rendered in accordance with the terms of their consulting agreements between the Registrant and the respective consultant. The Registrant relied upon the exemption provided by Section 4(2) of the Act. In January 2000, the Registrant issued 4,000 shares of Common Stock to a product development services provider in consideration of the completion of certain research projects. The Registrant relied upon the exemption provided by Section 4(2) of the Act. Where required, the recipients of the above-described securities represented their intentions to acquire the securities for investment only and not with a view of distribution thereof. Appropriate legends were affixed, where required, to the stock certificates issued in such transactions. All recipients had adequate access, through employment or other relationships, to information about the Registrant. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits See Exhibit Index on Page 27 (b) Reports on Form 8-K No reports on Form 8-K were filed by the Company during the quarter ended March 31, 2000. 22 23 HESKA CORPORATION SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HESKA CORPORATION Date: May 12, 2000 By /s/ Ronald L. Hendrick ----------------------------------------- RONALD L. HENDRICK Executive Vice President and Chief Financial Officer (on behalf of the Registrant and as the Registrant's Principal Financial and Accounting Officer) 24 24 EXHIBIT INDEX Exhibit Number Description - ------- ----------- 27 Financial Data Schedule - --------------- 23