FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended December 31, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from to . Commission file number 0-15374 PENTECH INTERNATIONAL INC. (Exact name of registrant as specified in its charter) Delaware 23-2259391 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 195 Carter Drive, Edison, New Jersey 08817 (Address of principal executive offices) (Zip Code) (732) 287-6640 (Registrant's telephone number, including area code) (Former name, former address and former fiscal year, if changed since last report) 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 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 the number of shares outstanding of each of the issuer's classes of common stock, as of February 9, 2000: 12,571,258 shares of common stock, par value $.01 per share. INDEX Part I. Financial Information: Item 1. Financial Statements (Unaudited). Page Condensed Consolidated Balance Sheets as of December 31, 1999 and September 30, 1999 3-4 Condensed Consolidated Statements of Operations for the three months ended December 31, 1999 and 1998 5 Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 1999 and 1998 6-7 Notes to Condensed Consolidated Financial Statements 8-17 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. 18-20 Part II. Other Information: Item 6. Exhibits and Reports on Form 8-K 21 Signatures 22 PART I. FINANCIAL INFORMATION PENTECH INTERNATIONAL INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS ASSETS (000's omitted) (Substantially all pledged or assigned) December 31, 1999 September 30, 1999 (unaudited) Current Assets: Cash $ 263 $ - Accounts receivable, net of allowances for doubtful accounts of $56 at December 31, 1999 and $36 at September 30, 1999, respectively 10,631 15,301 Inventories (Note 1) 14,757 15,415 Prepaid expenses and other 1,667 1,633 Joint venture receivable (Note 7) 217 - Available-for-Sale Security (Note 6) 55 181 Total current assets 27,590 32,530 Furniture and equipment (Note 1) 9,334 9,472 Less accumulated depreciation (6,412) (6,318) 2,922 3,154 Other assets: Trademarks, net of amortization of $787 at December 31, 1999 and $762 at September 30, 1999 (Note 1) Due from officer 224 236 174 174 398 410 $30,910 $36,094 See notes to condensed consolidated financial statements. PENTECH INTERNATIONAL INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS LIABILITIES AND SHAREHOLDERS' EQUITY (000's omitted) December 31, 1999 September 30, 1999 (unaudited) Current liabilities: Notes payable, bank (Note 2) $12,686 $13,882 Accounts payable 1,792 3,322 Accrued expenses 1,660 3,056 Settlement note payable (Note 5) 300 300 Deferred income from joint venture (Note 7) 84 - Total current liabilities 16,522 20,560 Other liabilities: Royalty payable, long-term (Note 5) 50 50 Settlement note payable, long-term (Note 5) 1,500 1,500 1,550 1,550 Commitments and contingencies (Note 3) Shareholders' equity: Preferred stock, par value $.10 per share; authorized 500,000 shares; issued and outstanding none - - Common stock, par value $.01 per share; authorized 20,000,000 shares; 12,571,258 shares issued and outstanding at December 31, 1999 and September 30, 1999, respectively 125 125 Capital in excess of par 6,839 6,839 Retained earnings 5,819 6,839 Accumulated other comprehensive income (Note 7) 55 181 12,838 13,984 $30,910 $36,094 See notes to condensed consolidated financial statements. PENTECH INTERNATIONAL INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (000's omitted) (Unaudited) Three Months Ended December 31, 1999 1998 Net sales $10,285 $10,568 Cost of sales 7,060 7,297 Gross profit 3,225 3,271 Selling, general and administrative expenses 3,735 3,538 Plant move expense 213 - Interest expense 297 376 Interest (income) - (2) 4,245 3,912 (Loss) before taxes (1,020) (641) Income taxes - - Net (loss) $(1,020) $ (641) Net (loss) per share-basic and diluted (Note 1) $ (.08) $ (.05) See notes to condensed consolidated financial statements. PENTECH INTERNATIONAL INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (000's omitted) (Unaudited) Three Months Ended December 31, 1999 1998 Cash flows from operating activities: Net (loss) $(1,020) $ (641) Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 261 246 (Increase) decrease in: Accounts receivable 4,670 4,701 Joint venture receivable (217) - Inventories 658 713 Prepaid expenses and other (34) (106) Income taxes receivable/ payable - 448 Increase (decrease) in: Accounts payable (1,530) (696) Accrued expenses (1,396) (1,369) Deferred income from joint venture 171 - Settlement payable - (100) Total adjustments 2,583 3,837 Net cash provided by operating activities 1,563 3,196 Cash flows from investing activities: (Purchase) of furniture/equipment (91) (46) (Increase) Decrease in trademarks (13) 4 Net cash (used in) investing activities (104) (42) See notes to condensed consolidated financial statements. PENTECH INTERNATIONAL INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) (000's omitted) (Unaudited) Three Months Ended December 31, 1999 1998 Cash flows from financing activities: Net (decrease) in notes payable $(1,196) $(3,568) Net cash (used in) financing activities (1,196) (3,568) Net increase (decrease) in cash and cash equivalents 263 (414) Cash and cash equivalents, beginning of period - 759 Cash and cash equivalents, end of period $ 263 $ 345 Supplemental disclosures of cash flow information and non-cash financing activities: Cash paid during the period for: Interest $ 283 $ 456 See notes to condensed consolidated financial statements. PENTECH INTERNATIONAL INC. AND SUBSIDIARIES Notes to Condensed Consolidated Financial Statements (The information for the three months ended December 31, 1999 and 1998 is unaudited.) 1. Summary of significant accounting policies: Organization: Pentech International Inc. (the "Company") was formed in April 1984. A wholly-owned subsidiary, Sawdust Pencil Company ("Sawdust"), was formed in November 1989 and commenced operations in January 1991. The Company and its subsidiary are engaged in the production, design and marketing of writing and drawing instruments. The Company primarily operates in one business segment: the manufacture and marketing of pens, markers, pencils and other writing instruments and related products to major mass market retailers located in the United States, under the "Pentech" name or licensed trademark brand. The Company's fiscal year ends September 30. Principles of consolidation: The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated. Cash Equivalents: The Company considers all time deposits with a maturity of three months or less to be cash equivalents. Unaudited financial statements: All unaudited financial information includes all adjustments (consisting of normal recurring adjustments) which the Company considers necessary for a fair presentation of the financial position at December 31, 1999 and the results of operations and the statements of cash flows for the three month period ended December 31, 1999 and 1998. PENTECH INTERNATIONAL INC. AND SUBSIDIARIES Notes to Condensed Consolidated Financial Statements (The information for the three months ended December 31, 1999 and 1998 is unaudited.) 1. Summary of significant accounting policies (Cont'd): Inventory and Cost of Sales: Inventory is stated at the lower of cost or market (first-in, first-out). Interim inventories are based on an estimated gross profit percentage by product, calculated monthly. Cost of sales for imported products includes the invoice cost, duty, freight in, display and packaging costs. Cost of domestically manufactured products includes raw materials, labor, overhead and packaging costs. Equipment and depreciation: Equipment is stated at cost. Depreciation is provided by the straight-line method over the estimated useful lives of the assets, which range from five to ten years. Major improvements to existing equipment are capitalized. Expenditures for maintenance and repairs which do not extend the life of the assets are charged to expense as incurred. Trademarks: Costs related to trademarks are being amortized over a five year period on a straight-line basis. Revenue recognition: Revenue is recognized upon shipment of product to the customer. Fair Value of Financial Instruments: The fair value for cash and accounts receivable approximate carrying amounts due to the short maturity of these instruments. The fair value amounts for notes payable approximate carrying amounts due to the variable interest rates. 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 and PENTECH INTERNATIONAL INC. AND SUBSIDIARIES Notes to Condensed Consolidated Financial Statements (The information for the three months ended December 31, 1999 and 1998 is unaudited.) 1. Summary of significant accounting policies (Cont'd): 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. Stock Based Compensation: Statement of Financial Accounting Standards No. 123, "Accounting for Stock Based Compensation," encourages, but does not require companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related interpretations in accounting for its employee stock options. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. PENTECH INTERNATIONAL INC. AND SUBSIDIARIES Notes to Condensed Consolidated Financial Statements (The information for the three months ended December 31, 1999 and 1998 is unaudited.) 1. Summary of significant accounting policies (Cont'd): (Loss) per share: The following table sets forth the computation of basic and diluted (loss) per share: Three months ended December 31, 1999 1998 Numerator: Net (loss) $(1,020,000) $ (641,000) Numerator for basic and diluted (loss) per share $(1,020,000) $ (641,000) Denominator: Denominator for basic earnings per share - weighted average shares 12,571,258 12,570,258 Effect of dilutive securities: Employee stock options 0 0 Denominator for diluted earnings per share - adjusted weighted average shares and assumed conversions: 12,571,258 12,570,258 Basic and diluted (loss) per share $ (.08) $ (.05) PENTECH INTERNATIONAL INC. AND SUBSIDIARIES Notes to Condensed Consolidated Financial Statements (The information for the three months ended December 31, 1999 and 1998 is unaudited.) 1. Summary of significant accounting policies (Cont'd): Other Recently Issued Accounting Standard: In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 "Accounting for Derivative Instruments and Hedging Activities" which is effective for years beginning after June 15, 2000. The Company has completed its review of SFAS 133 and has concluded that the adoption of this statement would not have any effect on the Company and its reporting. PENTECH INTERNATIONAL INC. AND SUBSIDIARIES Notes to Condensed Consolidated Financial Statements (The information for the three months ended December 31, 1999 and 1998 is unaudited.) December 31, September 30, 1999 1999 2. Notes Payable bank: Revolving line of credit, interest payable monthly at prime plus .5% (9% at December 31, 1999 and 8.75% at September 30, 1999) $ 686,000 $ 1,882,000 Revolving line of credit, interest payable at maturity at libor plus 2.5% (ranging from 8.09% to 8.10% at December 31, 1999 and 7.76% to 7.87% at September 30, 1999) 12,000,000 12,000,000 $12,686,000 $13,882,000 In January 1997, the Company entered into a three year Revolving Credit Agreement with BankAmerica Business Credit, Inc. now known as Bank of America, N.A. (BABC) (the "Credit Agreement"). Borrowings under the Credit Agreement are subject to limitations based upon eligible inventory and accounts receivable as defined in the Credit Agreement. Borrowing under the Credit Agreement accrue interest, at the Company's option, at either prime plus .5% or libor plus 2.5%. In December 1999, the Company and BABC entered into an agreement to renew the Credit Agreement for an additional three years (the "Renewal"). The Renewal, among other things, waives compliance with certain financial covenants violated at September 30, 1999, modifies the financial covenants for the next three fiscal years, increases the maximum inventory advance and allows for a seasonal over-advance. The Renewal is collateralized by a security interest in substantially all of the assets of the Company. In connection with the Renewal, the Company has agreed to the maintenance of certain financial covenants and cannot declare a cash divided without the consent of BABC. PENTECH INTERNATIONAL INC. AND SUBSIDIARIES Notes to Condensed Consolidated Financial Statements (The information for the three months ended December 31, 1999 and 1998 is unaudited.) 3. Contingency: At December 31, 1999, the Company was contingently liable for outstanding letters of credit of $259,931. 4. Income taxes: Three Months Ended December 31 1999 1998 Federal: Current $ - $ - Deferred - - State: Current - - Deferred - - $ - $ - Income tax at Federal statutory rate applied to income before taxes $ (347,000) $ (218,000) Add: state income taxes (92,000) (58,000) Less: effect of deduction of state income taxes for Federal purposes (32,000) 32,000 Less: effect of increase in valuation allowance 407,000 244,000 Income taxes provided $ - $ - PENTECH INTERNATIONAL INC. AND SUBSIDIARIES Notes to Condensed Consolidated Financial Statements (The information for the three months ended December 31, 1999 and 1998 is unaudited.) 4. Income taxes (Cont'd): Significant components of the Company's deferred tax assets and liability as of December 31, 1999 and September 30, 1999 are as follows: December 31, September 30, 1999 1999 Current deferred tax asset (liability): State taxes on deferred federal items $ 160,314 $ (51,957) Current deferred tax assets: Bad debts 24,360 15,331 Inventory reserve 385,710 475,580 Reserve for returns and allowances 135,588 267,018 Unicap 8,364 8,364 Total current deferred tax assets 554,022 766,293 Valuation allowance on current deferred tax assets (714,336) (714,336) (160,314) 51,957 Net current deferred tax assets $ - $ - Long-term deferred tax liabilities: Depreciation $ (853,163) $ (853,163) Long-term deferred tax assets: Reserve for litigation 817,000 817,000 State net operating loss carryforwards 644,210 552,210 Federal net operating loss carry forward 1,755,331 1,440,331 Total long-term deferred tax assets 3,216,541 2,809,541 Valuation allowance on long-term deferred tax assets (2,363,378) (1,956,378) 853,163 853,163 Net long-term deferred tax assets $ - $ - PENTECH INTERNATIONAL INC. AND SUBSIDIARIES Notes to Condensed Consolidated Financial Statements (The information for the three months ended December 31, 1999 and 1998 is unaudited.) 5. Paradise Settlement In Fiscal 1997, the Company entered into a settlement agreement with Leon Hayduchok, All-Mark Corporation and Paradise Creations, Inc., (collectively, "Paradise") providing, among other things, for Pentech to pay $500,000, deliver a $3,000,000 promissory note plus interest at the rate of 7% per annum (the "Note") and enter into a five year non-exclusive license to sell such products for a 10% royalty, with an aggregate minimum royalty of $500,000 (the "Paradise Settlement"). The Company paid $500,000 at the date of signing in January 1997 and a required payment against the Note of 400,000 in February 1997. In addition, the Note required $100,000 quarterly principal payments commencing January 1, 1998. Quarterly principal payments have been made through January 2000. The Company also paid $400,000 against the minimum royalty. 6. Available-for-Sale Security The value of Fun Cosmetics, Inc. stock (based on quoted market prices) as of December 31, 1999 was $.275 a share. The Company has the right to begin selling its shares in Fun. However, due to the historically low level of trading activity, the number of shares the Company owns and the fact that the shares are unregistered, there is no assurance the Company will realize the current market value. Accumulated Other Comprehensive Income Beginning balance $181,400 Less: Net unrealized loss (126,400) Ending balance $ 55,000 7. Joint Venture During the quarter ended December 31, 1999, the Company formed a strategic partnership with a manufacturer in Shanghai, China with the purpose of developing and manufacturing both existing products and many of the Company's new products in development. The terms PENTECH INTERNATIONAL INC. AND SUBSIDIARIES Notes to Condensed Consolidated Financial Statements (The information for the three months ended December 31, 1999 and 1998 is unaudited.) 7. Joint Venture (cont'd): of the joint venture provide for Pentech to receive cash for some of its manufacturing equipment and obtain a 50% ownership in the new entity being formed in China. In addition, once the transaction is complete, there will be costs associated with the relocation of the Company's domestic manufacturing facility. As of December 31, 1999, the Company has shipped approximately $217,000 worth of equipment and inventory and incurred relocating costs of approximately $213,000. The Company is in the process of finalizing this transaction. There is no assurance it will be finalized, or if finalized, it will not be on terms different than set forth above. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. (1) Material Changes in Results of Operations Net sales decreased in the three months ended December 31, 1999 2.7% from the same period a year ago primarily due to a decrease in sales of licensed products. This was offset by an increase in the children's activity product line. Gross profit as a percentage of net sales increased for the three months ended December 31, 1999 to 31.3% from 30.9% in the same period a year ago. A higher percentage of sales this quarter came from the children's activity line which generate higher gross profit margins. Selling, general and administrative ("SG&A") expenses as a percentage of sales for the three months ended December 31, 1999 increased to 36.3% from 33.5% in the same period a year ago. This was primarily due to an increase in our sales force. In addition, a similar level of fixed costs were incurred over a lower sales volume. For the three months ended December 31, 1999, interest expense decreased as compared to the same period a year ago. This was due to a higher outstanding loan balance in the prior year. For the three months ended December 31, 1999, the net loss was $1,020,000 or $.08 per share as compared to a net loss of $641,000 or $.05 for the same prior period. The decrease in income was primarily due to the lower sales volume as well as the plant move expenses. (2) Material Changes in Financial Condition In January 1997, the Company entered into a three year $30,000,000 (subsequently amended to $25,000,000) revolving credit facility with BankAmerica Business Credit Inc., now known as Bank of America, N.A. ("BABC") (the "Credit Agreement"). The amount of drawings under the facility is subject to limitations based upon eligible inventory and accounts receivable as described in the Credit Agreement. The Credit Agreement is collateralized by a security interest in substantially all of the assets of the Company. In addition, in accordance with the Credit Agreement, the Company has agreed, among other things, to the maintenance of certain financial covenants. In December 1999, the Company and BABC entered into an agreement to renew the Credit Agreement for an additional three years (the "Renewal"). The Renewal, among other things, waives compliance with certain financial covenants violated at September 30, 1999, modifies the financial covenants for the next three fiscal years, increases the maximum inventory advance and allows for a seasonal over-advance. The $3,000,000 note (the "Note") issued in connection with the Paradise Settlement requires $100,000 quarterly principal payments that commenced January 1, 1998 thru April 1, 2004. Quarterly principal payments were made through January 2000. The Company does not anticipate any difficulty meeting this payment schedule. During the quarter ended December 31, 1999, the Company formed a strategic partnership with a manufacturer in Shanghai, China with the purpose of developing and manufacturing both existing products and many of the Company's new products in development. The terms of the joint venture provide for Pentech to receive cash for some of its manufacturing equipment and obtain a 50% ownership in the new entity being formed in China. In addition, once the transaction is complete, there will be costs associated with the relocation of the Company's domestic manufacturing facility. As of December 31, 1999, the Company has shipped approximately $217,000 worth of equipment and inventory and incurred relocating costs of approximately $213,000. The Company is in the process of finalizing this transaction. There is no assurance it will be finalized, or if finalized, it will not be on terms different than set forth above. The Company continued several actions to increase its liquidity. It continued a policy of obtaining thirty to sixty day open credit to finance a majority of its purchases that historically have been financed pursuant to letters of credit. It continues to reduce the number of items held in inventory and has reduced the level of capital expenditures. Working capital decreased $902,000 to $11,068,000 at December 31, 1998. As a result of the seasonal nature of the Company's business, the Company's use of its credit facility increases significantly in the months of May, June, July and August as the Company finances its inventory and receivables, and declines in September and October after the collections of receivables from its Back-to-School sales. The change in financial position during the quarter ended December 31, 1999 reflects primarily this seasonality due to the decrease in receivables from the collection of its Back- to-School sales and a decline in inventory. The Company anticipates that its revolving credit line under the Credit Agreement together with anticipated revenues from operations, will be sufficient to provide liquidity on both a short-term and long-term basis to finance its future operations. The Company believes these resources are sufficient to support its operating expenses. (3) Safe Harbor Statement Statements which are not historical facts, including statements about the Company's confidence and strategies and its expectations about new and existing products, technologies and opportunities, market and industry segment growth, demand and acceptance of new and existing products are forward looking statements that involve risks and uncertainties. there include, but are not limited to, product demand and market acceptance risks; the impact of competitive products and pricing; the results of financing efforts; the loss of any significant customers of any business; the effect of the Company's accounting policies; the effects of economic conditions and trade, legal, social, and economic risks, such as import, licensing, and trade restrictions; the results of the Company's business plan and the impact on the Company of its relationship with its lenders. PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits. 3.1 Certificate of Incorporation of the Company, as amended, incorporated by reference to Exhibit 3.1 to Registration Statement. Statement No. 2-95102-NY of the Company. 3.2 The Company's By-Laws incorporated by reference to Exhibit 3.2 to Form S-18. 27 Financial Data Schedule. (b) Reports on Form 8-K. None. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PENTECH INTERNATIONAL, INC. Dated: February 22, 2000 By:/s/ William Visone William Visone, Treasurer and Chief Financial Officer N:\RSKLAW\PTK\10Q-DEC.99