UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For quarterly period ended July 31, 2005
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: 000-28307
NESCO INDUSTRIES, INC.
(Exact name of Registrant as specified in its charter)
Nevada 13-3709558
(State or other jurisdiction of (State or I.R.S. Employer
incorporation of organization) Identification Number)
305 Madison Avenue, Suite 4510
New York, New York
(Address of principal executive offices)
10165
(Zip Code)
(212) 986-0886
(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 and (2) has been subject to such filing requirements for
the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12B-2 of the Exchange Act). Yes [ ] No [X]
Class Outstanding at November 23, 2005
----- --------------------------------
Common Stock 20,136,225
NESCO INDUSTRIES, INC.
FORM 10-QSB
QUARTERLY REPORT
For the Three Months Ended July 31, 2005
TABLE OF CONTENTS
Part I - Financial Information
Item 1. Consolidated Financial Statements:
Consolidated Balance Sheet 1-2
Consolidated Statements of Operations 3
Consolidated Statements of Cash Flows 4-6
Notes to Unaudited Consolidated Financial Statements 7-16
Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations 17-21
Item 3. Controls and Procedures 22
Part II. - Other Information 23
Signatures 24
Exhibit 31
Exhibit 32
Item 1. Financial Statements
NESCO INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
- --------------------------------------------------------------------------------------------------------------------------------
July 31,
2005
(unaudited)
- --------------------------------------------------------------------------------------------------------------------------------
ASSETS
Current assets
Cash $ 18,679
Accounts receivable 224,042
Inventories 75,396
Prepaid expenses and other current assets 21,833
------------------
Total current assets 339,950
------------------
Property and equipment, net of accumulated depreciation of $1,708,470 371,383
------------------
Other assets
Deferred financing costs 167,528
Stock issuance costs 712,500
Investments 6,000
Other 16,455
------------------
Total other assets 902,483
------------------
$ 1,613,816
==================
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities
Note and interest payable $ 675,443
Convertible debentures and interest payable, related party, net of debt discount of $312,759 1,261,363
Convertible debentures and interest payable, other, net of debt discount of $692,118 2,427,817
Convertible debentures and interest payable, officers, net of debt discount of $23,999 855,264
Customer deposits 839,653
Accounts payable and accrued expenses 477,426
Stock to be issued 212,520
Common stock subject to redemption 330,000
Due to affiliates 246,879
------------------
Total current liabilities 7,326,365
------------------
Long-term liabilities, deferred sublease income 105,300
------------------
Commitments and contingencies
1
See accompanying notes to consolidated financial statements.
NESCO INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (CONTINUED)
- ------------------------------------------------------------------------------------------------------------------------------
July 31,
2005
(unaudited)
- ------------------------------------------------------------------------------------------------------------------------------
Stockholders' deficit
Series A convertible preferred stock, $.001 par value, authorized
850,000 shares, 67,000 issued and outstanding 67
Series B convertible preferred stock, $.001 par value, authorized
150,000 shares, 116,687 issued and outstanding 117
Common stock, $.001 par value, authorized 25,000,000 shares,
17,736,225 issued and outstanding 17,736
Additional paid-in-capital 14,004,266
Accumulated other comprehensive loss (69,000)
Accumulated deficit (19,771,035)
------------------
Total stockholders' deficit (5,817,849)
------------------
$ 1,613,816
==================
2
See accompanying notes to consolidated financial statements.
NESCO INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
- -------------------------------------------------------------------------------------------------------------------------------
Three Months Ended July 31,
-----------------------------------------
2005 2004
(unaudited) (unaudited)
- -------------------------------------------------------------------------------------------------------------------------------
Revenues $ 385,835 $ 188,114
Cost of revenues 245,612 210,466
-----------------------------------------
Gross profit (margin) 140,223 (22,352)
-----------------------------------------
Operating expenses
General and administrative 313,383 3,124,511
Amortization and other expenses 31,110
-----------------------------------------
313,383 3,155,621
-----------------------------------------
Loss from operations (173,160) (3,177,973)
-----------------------------------------
Other income (expenses)
Sublease income 11,700 11,700
Amortization of debt discount (701,585) (264,668)
Interest expense (78,397) (37,977)
Interest expense, related parties (42,573) (38,171)
Amortization of financing costs (126,332) (32,305)
Liquidated damages (91,800)
-----------------------------------------
(1,028,987) (361,421)
-----------------------------------------
Net loss $ (1,202,147) $ (3,539,394)
=========================================
Weighted average common shares outstanding
Basic and diluted 17,467,176 13,929,523
-----------------------------------------
Loss per common share
Basic and diluted $ (0.07) $ (0.25)
=========================================
3
See accompanying notes to consolidated financial statements.
NESCO INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
- ------------------------------------------------------------------------------------------------------------------------------
Three Months Ended July 31,
2005 2004
(unaudited) (unaudited)
- ------------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities
Net loss $ (1,202,147) $ (3,539,394)
Adjustments to reconcile net loss to net cash
used in operating activities:
Stock and warrants issued for services 34,800 1,099,053
Revaluation of warrants and options 1,793,555
Depreciation and amortization 41,563 69,837
Amortization of debt discount 701,585 264,668
Amortization of financing costs 126,332 32,305
Loss on write-off of fixed assets 4,940
Changes in operating assets and liabilities:
Accounts receivable (100,413) (36,035)
Inventories (10,270) 116
Prepaid expenses and other current assets 28,426 12,929
Other assets 209
Customer deposits (6,500)
Accounts payable and accrued expenses 173,183 (133,624)
Deferred sublease income (11,700) (11,700)
Due to affiliates 67,524 6,907
Interest payable 113,197 (8,805)
----------------------------------------
Net cash used in operating activities (32,980) (456,479)
----------------------------------------
Cash flows from investing activities
Net cash acquired from merger - 86,183
----------------------------------------
Net cash provided by investing activities - 86,183
----------------------------------------
Cash flows from financing activities
Proceeds from issuance of convertible debentures, other - 568,870
Payments on notes payable (20,500)
Payments on loan from officer (7,000)
Proceeds from (payments to) affiliate 30,000 (14,876)
----------------------------------------
Net cash provided by financing activities 30,000 526,494
----------------------------------------
Net increase (decrease) in cash (2,980) 156,198
Cash
Beginning of period 21,659 828
----------------------------------------
End of period $ 18,679 $ 157,026
========================================
4
See accompanying notes to consolidated financial statements.
NESCO INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
- ------------------------------------------------------------------------------------------------------------------------------
Three Months Ended July 31,
2005 2004
(unaudited) (unaudited)
- ------------------------------------------------------------------------------------------------------------------------------
Supplemental disclosure of cash flow information,
cash paid during the period for interest $ 516 $ 84,986
========================================
Supplemental disclosure of non-cash investing and financing,
activities:
Fair value of warrants issued to brokers for financing services $ - $ 298,262
========================================
Debt discount related to convertible debentures $ - $ 2,381,073
========================================
Stock issued for interest payment on convertible debentures $ 92,820 $ -
========================================
Reclassification of treasury stock to additional paid in capital $ - $ 42,500
========================================
Reclassification of note receivable, officer and interest receivable
against convertible debentures and interest payable, officer $ - $ 112,000
========================================
Reclassification of accrued expenses to convertible debentures
and interest payable, officer $ - $ 552,335
========================================
Reclassification of due to officer to convertible debentures and
interest payable, officer $ - $ 257,846
========================================
Reclassification of additional paid in capital to series A convertible
preferred stock $ - $ 513
========================================
Reclassification of additional paid in capital to series B convertible
preferred stock $ - $ 95
========================================
Conversion of series A convertible preferred stock to series B
convertible preferred stock $ - $ 446
========================================
Reclassification of additional paid in capital to common stock $ - $ 7,757
========================================
5
See accompanying notes to consolidated financial statements.
NESCO INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
- ------------------------------------------------------------------------------------------------------------------------------
Three Months Ended July 31,
2005 2004
(unaudited) (unaudited)
- ------------------------------------------------------------------------------------------------------------------------------
Supplemental disclosure of non-cash investing and financing,
activities (continued):
Balance sheet of Nesco Industries, Inc. at the date of the
Share Exchange (See Note 2):
Property and equipment $ - $ 4,939
----------------------------------------
Accounts payable and accrued expenses - 177,351
Deferred sublease income - 163,800
Stockholders' equity - 6,581
----------------------------------------
Total liabilities and stockholders' equity - 347,732
----------------------------------------
Elimination of intercompany bridge loan - (208,500)
----------------------------------------
Cash acquired from merger - 134,293
Expenditure of legal fees in connection with merger - (48,110)
----------------------------------------
Net cash acquired from merger $ - $ 86,183
----------------------------------------
6
See accompanying notes to consolidated financial statements.
NESCO INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Basis of Presentation
Organization
NESCO Industries, Inc. (hereinafter referred to as "Nesco"), a Nevada publicly
traded corporation, prior to ceasing business operations and becoming inactive
in May 2003, was a provider of asbestos abatement and indoor air quality
testing, monitoring and remediation services. In the fiscal year ended April 30,
2003, Nesco consolidated the operations of its various subsidiaries, through
which it provided services, into a single environmental services operating unit
organized under the banner of its wholly-owned subsidiary National Abatement
Corporation. Prior to consolidation, Nesco operated through its wholly-owned
subsidiaries, National Abatement Corporation ("NAC"), NAC/Indoor Air
Professionals, Inc. ("IAP") and NAC Environmental Services, Inc. ("NACE").
On April 29, 2004, Nesco entered into a share exchange agreement with Hydrogel
Design Systems, Inc. ("HDS"), a Delaware privately held corporation, whereby HDS
became a majority-owned subsidiary of Nesco and the holders of HDS common stock
and debt acquired a majority interest of Nesco. This exchange (the "Share
Exchange") was completed on May 25, 2004. The accounting for the transaction,
commonly called a reverse acquisition, resulted in a recapitalization of HDS,
which was treated as the accounting acquirer. The acquired assets and assumed
liabilities of Nesco were carried forward at their historical values which
approximates fair value (with the exception of deferred liabilities for which
there was no legal continuing obligation, which were not recorded). HDS'
historical financial statements were carried forward as those of the combined
entity (hereinafter referred to as the "Company"). HDS is engaged in the
manufacture, marketing, selling and distribution of aqueous polymer-based
radiation ionized gels ("gels" or "hydrogels") used in various medical and
cosmetic consumer products.
The Company's fiscal year ends on April 30 and, therefore, references to fiscal
2006 and fiscal 2005 refer to the fiscal years ending April 30, 2006 and April
30, 2005, respectively.
The accompanying condensed consolidated financial statements of the Company
reflect the historical results of the predecessor entity, HDS, prior to May 25,
2004 and the consolidated results of operations of the Company subsequent to the
acquisition date of May 25, 2004.
The common stock and per share information in the consolidated financial
information and related notes have been retroactively adjusted to give effect to
the reverse acquisition on May 25, 2004.
The accompanying interim consolidated financial statements and the accompanying
notes included herein have been prepared by the Company without audit, in
accordance with the instructions for Form 10-QSB pursuant to the rules and
regulations of the Securities and Exchange Commission ("SEC") and therefore do
not include all information and notes normally provided in the annual financial
statements and should be read in conjunction with the audited consolidated
financial statements and the notes thereto included in the Company's Form 10-KSB
for the year ended April 30, 2005. These statements reflect all adjustments
which are of a normal recurring nature and which, in the opinion of management,
are necessary for a fair statement of the results for the three month periods
ended July 31, 2005 and 2004. The results of operations for the three month
periods ended July 31, 2005 and 2004 are not necessarily indicative of the
results for the full year.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries on a consolidated basis. All
significant intercompany accounts and transactions have been eliminated.
7
Revenue Recognition
Revenues are generally recognized as product is shipped to a customer. In cases
where a customer requests a development project for a gel or a gel to be used as
a component of a new product, the Company will recognize revenue at the time the
project is completed.
Estimates
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and 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.
Reclassifications
Certain prior period items have been reclassified to conform to the current
period presentation.
Note 2. Exchange of Securities
On May 25, 2004, HDS consummated the Share Exchange with Nesco whereby HDS
became a majority-owned subsidiary of Nesco, and the holders of HDS common stock
and debt acquired a majority interest of Nesco. Because the former HDS
stockholders own a majority of the voting stock of Nesco (common stock and
Series B preferred stock convertible into common stock), HDS is considered for
accounting purposes to be the acquirer in the transaction. The accounting for
the transaction, commonly called a reverse acquisition, resulted in a
recapitalization of HDS.
The Company had intended to issue shares of its common stock in exchange for the
equity securities of HDS in certain ratios as provided for in the exchange
agreement. However, because the Company did not have the required number of
authorized shares of common stock to complete the exchange on this basis, it
agreed to issue shares of its newly designated Series B Preferred Stock instead
of common stock. Upon filing of a Certificate of Amendment to the Certificate of
Incorporation to increase the number of shares of common stock which the Company
is authorized to issue, each share of the Series B Preferred Stock will be
automatically converted into shares of common stock. On November 16, 2004 the
Company filed a preliminary information statement with the SEC. On December 16,
2004, the SEC responded with comments pertaining to the preliminary information
statement. On February 25, 2005, the Company responded to these comments and
received further additional comments from the SEC on March 15, 2005, May 19,
2005 and July 5, 2005. The Company has responded to the last comments received
(July 5, 2005) on August 5, 2005 and received final comments from the SEC on
August 23, 2005. The information statement can be completed once the 10-QSB for
the quarter ended July 31, 2005 is filed. Upon completion of this process, the
Company will file the Certificate of Amendment and issue the common stock.
As of July 31, 2005, approximately 97% of the HDS common and 90% of the HDS
preferred shareholders have exchanged their shares which has resulted in
approximately 54.1% of the Company's voting securities outstanding at the time
of the exchange owned by HDS stockholders. The Company anticipates that the
remaining HDS shareholders will exchange their shares in the near future, which
will result in 55.3% of the Company's voting securities outstanding at the time
of the exchange being owned by HDS stockholders. Upon completion of this
exchange, HDS common shareholders will exchange a total of 4,452,806 shares of
stock for 53,434 shares of the Company's Preferred B Stock, which will be
converted into 40,075,167 shares of the Company's common stock (a ratio of
approximately 9 shares of the Company's common stock for 1 share of HDS stock).
The HDS preferred shareholders will exchange a total of 522,487 shares of stock
for 25,079 shares of the Company's Preferred B Stock which will be converted
into 18,809,574 shares of the Company's common stock (a ratio of approximately
36 shares of the Company's common stock for 1 share of HDS stock). The HDS
stockholders, upon completion of the exchange of shares, will receive an
aggregate of 58,884,741 common shares or 55.3% of the total shares outstanding
at the time of the exchange which aggregated 106,386,847 equivalent common
shares on May 25, 2004, the exchange date.
8
Concurrent with the exchange, Nesco Series A Preferred shareholders agreed to
exchange 512,500 shares of stock for an aggregate of 20,500 shares of the
Company's Preferred B Stock, which will be converted into 15,375,000 shares of
the Company's common stock (a ratio of approximately 30 common shares for 1
share of Series A preferred stock). As of July 31, 2005, 445,500 shares of
Series A Preferred shares have been exchanged for 17,820 shares of Series B
Preferred shares. The Company anticipates that the majority of the remaining
Series A shareholders will exchange their shares in the near future.
As part of this transaction, Nesco conditionally transferred its three wholly
owned subsidiaries, NAC, IAP and NACE, to a consultant and interim officer of
Nesco who resigned his position as officer at the time of the transfer. The
transferee assumed all liabilities and obligations with respect to these
subsidiaries and agreed to indemnify the Company against any claims and, in
exchange therefore, received 3,000,000 shares of common stock of the Company and
certain related registration rights. As additional consideration for the
indemnification by the transferee, the Company agreed that if the transferee
cannot in good faith resell the shares of common stock in an arm's length
transaction during the twelve month period immediately following the closing for
a price equal to the lesser of (i) all liabilities resulting from the agreement
between NAC and its labor union plus legal fees or (ii) $330,000, then the
Company will repurchase from the transferee 2,400,000 of the common shares at
that amount upon written notice from the transferee requesting such. On May 25,
2005, the Company agreed to extend the put right granted to the transferee until
May 25, 2006 subject to the condition that the right may not be exercised until
after January 1, 2006. The repurchase of the 2,400,000 common shares, which are
subject to redemption by the transferee, are included in current liabilities at
an aggregate of $330,000, the maximum amount the Company would be required to
pay in the event of redemption.
Note 3. Going Concern and Liquidity
The accompanying consolidated financial statements have been prepared in
conformity with accounting principles generally accepted in the United States of
America, which contemplate continuation of the Company as a going concern. At
July 31, 2005, the Company has an accumulated deficit of approximately
$19,771,000, a working capital deficit of approximately $6,986,000, a
stockholders' deficit of approximately $5,818,000 and incurred a net loss of
approximately $1,202,000 for the three months then ended. The recoverability of
a major portion of the recorded asset amounts shown in the accompanying
consolidated balance sheet is dependent on the Company's ability to obtain
financing on an as needed basis. The Company's financial condition raises
substantial doubt about the Company's ability to continue as a going concern.
The Company has current debt obligations, including interest, of approximately
$6,249,000 which are due in December 2005. Although the Company is presently
trying to obtain debt extensions, there are currently no available resources for
the repayment of this debt. In addition, the current level of revenue being
generated is not sufficient to fund current operating costs. The consolidated
financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or amounts and
classification of liabilities that might be necessary should the Company be
unable to continue in existence.
Management recognizes that the Company must generate additional revenue to
achieve profitable operations. Management's plans to increase revenues include
the continued building of its customer base, especially in the medical and
cosmetic industries, through its ability to manufacture goods on a custom basis
or to the exacting standards required by medical customers (See Note 11).
Management also will seek to increase revenues through the development of
alternative uses of its equipment, such as irradiation and sterilization
services.
There can be no assurance that the Company will be able to obtain sufficient
debt or equity financing and extensions of current debt obligations on favorable
terms if at all, or that it will be successful in building its customer base or
developing alternative uses for its equipment. If the Company is unsuccessful in
building its customer base and developing alternative uses for its equipment or
is unable to obtain additional financing on terms favorable to the Company there
could be a material adverse effect on the financial position, results of
operations and cash flows of the Company. The accompanying consolidated
financial statements do not include any adjustments that might be necessary if
the Company is unable to continue as a going concern.
9
Note 4. Current Debt
Note Payable, Manufacturing Equipment
On January 24, 1997, HDS entered into a financing agreement with a customer for
the purchase of $600,000 of manufacturing equipment from a third party. The
agreement consisted of a promissory note in the amount of $600,000 bearing
interest at 8% per annum and principal and interest due between three (3) and
six (6) years from the anniversary date, depending upon the amount of product
the customer ordered from the Company. The funds were transferred directly from
the lender to the seller of the equipment. The note was collateralized by the
related equipment.
On January 23, 2001, the note was amended and restated in the amount of $793,053
which was the aggregate amount of the original note plus interest through the
date of the restated note. The amended note, with interest at 8%, payable
quarterly, was due on January 23, 2002. On December 9, 2001, the note was again
amended and restated in the amount of $793,053 which was originally due on
January 23, 2002. The amended note, with interest at 8%, payable quarterly,
called for a principal payment of $250,000 on January 23, 2002, and the balance
on January 23, 2003. The note was not paid when due.
On April 21, 2004, the lender agreed to amend and restate the note in the amount
of $793,053 upon the completion of the Share Exchange Agreement with Nesco which
occurred on April 29, 2004. The amended note matures on December 31, 2005 and
bears interest at 11% (the default rate) until such time that an aggregate
interest payment of $84,000 was made, interest from such date forward until the
maturity date provides for interest rate of 8%, payable at maturity. The Company
made the interest payment of $84,000 on July 27, 2004. In addition, the lender
agreed to release its security position on the collateral 90 days after receipt
of a payment of $200,000 against the principal balance. The Company made this
payment on August 13, 2004. The balance due on the note at July 31, 2005 is
approximately $675,000 consisting of approximately $555,000 in principal and
$120,000 of accrued interest. Interest expenses for the three months ended July
31, 2005 and July 31, 2004 approximated $11,000 and $22,000 respectively.
Convertible Debentures
Convertible Debentures - Related Party
As of April 30, 2004, a related party had loaned HDS an aggregate of $1,308,000.
HDS issued a series of convertible debentures in connection with these loans
between the period of October 12, 1999 and August 7, 2003. On April 19, 2004,
the related party agreed, upon consummation of the share exchange agreement, to
extend the due dates of these debentures until December 31, 2005 and to exchange
these debentures for 8% convertible debt of the Company based on the same ratios
in the share exchange agreement (a ratio of approximately 9 common shares for 1
common share of HDS stock and 36 common shares for 1 preferred share of HDS
stock). On May 25, 2004 the exchange was completed. This debt is convertible at
approximately $.08 per share into an aggregate of approximately 15,696,000
shares of the Company. The debt holder, was also granted, in consideration for
an extension and exchange of the debt, a warrant to acquire one share of common
stock at an exercise price of $.15 for a term of five years for each dollar of
HDS debt for an aggregate issuance of 1,308,000 warrants. Approximately $75,000
of the total debt exchanged was attributed to the fair value of the warrants and
$1,121,000 was attributed to the intrinsic value of the beneficial conversion
feature. These amounts were recorded as equity components. The remaining balance
of $112,000 was recorded as long-term debt. For the three months ended July 31,
2005 and July 31, 2004, the amortization of debt discount approximated $188,000
and $137,000, respectively. The balance due on the note at July 31, 2005 is
approximately $1,261,000 consisting of approximately $1,308,000 in principal,
approximately $266,000 of accrued interest, and unamortized debt discount of
approximately $313,000. Interest expense for the three months ended July 31,
2005 and July 31, 2004 approximated $26,000.
In addition, this party exchanged an aggregate of 331,500 options and warrants
of HDS for an aggregate of 10,566,000 warrants of the Company based on the same
ratios in the exchange agreement. These options/warrants are currently
exercisable at prices that range between $.08 -$.39 and expire between six and
seven years. Compensation expense approximating $889,000 was recorded on May 25,
2004 for the increase in the fair value of these vested HDS options/warrants as
a result of the exchange. The increase in the fair value was estimated on the
date of the share exchange using the Black-Scholes option pricing model with the
following assumptions: no dividend yield, expected volatility of 59%, risk-free
interest rate of 1.38% and two to three-year expected lives.
10
Convertible Debentures - Other - Including Bridge Loans and Investment Banking
Agreement
As of April 30, 2004, HDS had outstanding 8% convertible debentures in the
aggregate of $625,000, of which $325,000 were issued to a broker and $300,000
were issued to a series of investors in connection with a private placement in
2002. The debentures were due on October 31, 2003. On April 19, 2004, the
lenders agreed, upon consummation of the share exchange agreement, to extend the
due dates of this debenture until December 31, 2005 and to exchange these
debentures for 8% convertible debt of the Company based on the same ratios in
the share exchange agreement (a ratio of approximately 9 shares of the Company's
common stock for 1 common share of HDS stock and 36 shares of the Company's
common stock for 1 preferred share of HDS stock). On May 25, 2004 the exchange
was completed. This debt is convertible at approximately $.08 per share into an
aggregate of approximately 7,500,000 shares of the Company's common stock. The
debt holders, were also granted, in consideration for an extension and exchange
of the debt, a warrant to acquire one share of common stock at an exercise price
of $.15 for a term of five years for each dollar of HDS debt for an aggregate of
the issuance of 625,000 warrants. Approximately $36,000 of the total debt
exchanged was attributed to the fair value of the warrants and $536,000 was
attributed to the intrinsic value of the beneficial conversion feature. These
amounts were recorded as equity components. The remaining balance of $53,000 was
recorded as long-term debt. For the three months ended July 31, 2005 and July
31, 2004, the amortization of debt discount approximated $90,000 and $65,000
respectively. The balance due on the notes at July 31, 2005 is approximately
$645,000 consisting of approximately $625,000 in principal, approximately
$169,000 of accrued interest, and unamortized debt discount of approximately
$149,000. Interest expense for the three months ended July 31, 2005 and July 31,
2004 approximated $13,000.
In addition, these parties, inclusive of broker warrants, exchanged an aggregate
of 431,619 options and warrants of HDS for an aggregate of 11,015,820 warrants
of the Company based on the same ratios in the exchange agreement. These
options/warrants are currently exercisable at prices that range between $.08
- -$.39 and expire between six and seven years. Compensation expense approximating
$872,000 was recorded on May 25, 2004 for the increase in the fair value of
these vested HDS options/warrants as a result of the exchange.
The increase in the fair value of warrants and options in connection with the
above debentures was estimated on the date of the share exchange using the
Black-Scholes option pricing model with the following assumptions: no dividend
yield, expected volatility of 59%, risk-free interest rate of 1.38% and two to
three-year expected lives.
Convertible Debentures - Bridge Loans and Investment Banking Agreement
In June 2004 the Company borrowed $100,000 under bridge loans bearing interest
at 8%. The lenders were also granted warrants to acquire 666,667 common shares
at $.15 per share. These loans were converted into convertible debentures in
connection with an investment banking agreement entered into in July 2004. The
fair value of these warrants of approximately $40,000 was charged to debt
discount in the quarter ended July 31, 2004.
On July 1, 2004, the Company entered into an investment banking agreement with
Sloan Securities Corp. for the sale of up to $3,000,000 principal amount of the
Company's 8% senior secured convertible notes due December 1, 2005, with
interest payable on December 1 and June 1 semi-annually, either in cash or
common stock, and convertible into common stock at $.15 per share. The notes are
secured by the assets of the Company. Each note was issued with a five-year
warrant to purchase shares of the Company's common stock at $.25 per share or
666,667 warrants for each $100,000 of principal amount of notes purchased. As a
result of the agreement, which terminated on September 30, 2004, the Company
received $2,295,000 in gross proceeds in connection with this agreement and
issued warrants to purchase 15,300,000 shares. Under the terms of the private
placement the Company has agreed to undertake to register the common stock
issuable upon the conversion of the notes and the exercise of the warrants.
Approximately $1,108,000 of the proceeds was attributed to the fair value of the
warrants and $1,004,000 to the intrinsic value of the beneficial conversion
feature of the convertible debt. These amounts were recorded as equity
components. The remaining balance of $183,000 was recorded as long-term debt.
For the three months ended July 31, 2005 and July 31, 2004 the amortization of
debt discount was approximately $409,000 and $11,000, respectively . The balance
due on the notes at July 31, 2005 is approximately $1,783,000 consisting of
approximately $2,295,000 in principal, approximately $31,000 of accrued
interest, and unamortized debt discount of approximately $543,000. Interest
expense for the three months ended July 31, 2005 and July 31, 2004 was
approximately $47,000 and $2,000, respectively, of which approximately $31,000
is included in interest payable at July 31, 2005. On December 1, 2004, the
Company issued 390,305 shares of common stock as payment for the interest due in
the aggregate of approximately $59,000. On June 9, 2005, the Company issued
618,815 shares of common stock as payment for the interest due in the aggregate
of approximately $93,000.
11
Financing fees in connection with this agreement approximated $286,000 which are
being amortized over the term of the convertible notes. For the three months
ended July 31, 2005 and July 31, 2004, the amortization of financing costs
approximated $54,000 and $4,000 respectively. At July 31, 2005, the unamortized
balance approximated $72,000.
In connection with this agreement, the Company issued the broker warrants to
acquire 5,052,600 shares of common stock at an exercise price of $.15 per share.
The fair value of the warrants ($405,000) will be charged to operations over the
life of the underlying debt. For the three months ended July 31, 2005 and July
31, 2004, approximately $72,000 and $28,000 was charged to operations as
financing costs for these warrants, respectively. At July 31, 2005, the
unamortized balance approximated $95,000.
In connection with this agreement, under the terms of a related registration
rights agreement, the Company was required to file a registration statement to
effectively register the common stock issuable upon the conversion of the notes
and exercise of the warrants no later than 60 days after the termination of the
offering. As the Company did not file the required registration statement until
January 27, 2005, liquidated damages in the amount of 2% per month of the
aggregate purchase price were required to be paid in cash under the terms of the
agreement. The holders of the notes agreed to accept this payment in the
aggregate of $91,800 in common stock of the Company. The fair value of the
shares due ($91,800) was charged to operations in the prior fiscal year and this
expense is included in current liabilities as these shares have not been issued
at July 31, 2005. In addition, the Company was required to have the registration
statement declared effective no later than 270 days after the termination of the
offering which was June 27, 2005. As the registration statement has not been
declared effective, liquidated damages in the amount of 2% per month of the
aggregate purchase price were required to be paid in cash under the terms of the
agreement. At July 31, 2005, the amount of the damages ($91,800) was charged to
operations and is included in current liabilities.
Convertible Debentures - Officers
As of April 30, 2004, HDS had outstanding debt due to two officers in the
aggregate of $803,212, which was comprised or approximately $552,000 in payroll
and $251,000 in net notes receivable including accrued interest. On April 19,
2004, the officers agreed, upon consummation of the share exchange agreement, to
exchange this debt for 8% convertible debentures of the Company which are due on
December 31, 2005. On May 25, 2004 the exchange was completed. This debt is
convertible at approximately $.15 (the market price on the date of exchange) per
share into an aggregate of 5,354,747 shares of the Company's common stock. The
debt holders, were also granted, in consideration for an extension and exchange
of the debt, a warrant to acquire one share of common stock at an exercise price
of $.15 for a term of five years for each dollar of HDS debt for an aggregate
issuance of 803,212 warrants. Approximately $46,000 of the total debt exchanged
was attributed to the fair value of the warrants and $46,000 was attributed to
the intrinsic value of the beneficial conversion feature. These amounts were
recorded as equity components. The remaining balance of approximately $711,000
was recorded as long-term debt. For the three months ended July 31, 2005 and
July 31, 2004, the amortization of debt discount approximated $14,000 and
$11,000 respectively. The balance due on the notes at July 31, 2005 is
approximately $855,000 consisting of approximately $803,000 in principal,
approximately $76,000 of accrued interest, and unamortized debt discount of
approximately $24,000. Interest expenses for the three months ended July 31,
2005 and July 31, 2004 approximated $16,000 and $12,000, respectively.
In addition, one of the officers exchanged an aggregate of 133,334 options of
HDS for an aggregate of 1,200,000 warrants based on the same ratios in the
exchange agreement. These options are currently exercisable at $.39 and expire
in January 2006. Compensation expense approximating $23,000 was recorded on May
25, 2004 for the increase in the fair value of these vested HDS options/warrants
as a result of the exchange.
The increase in the fair value of warrants and options in connection with the
above debentures was estimated on the date of the share exchange using the
Black-Scholes option pricing model with the following assumptions: no dividend
yield, expected volatility of 59%, risk-free interest rate of 1.38% and two to
three-year expected lives.
Note 5. Standby Equity Distribution Agreement
On August 23, 2004, the Company entered into a Standby Equity Distribution
Agreement with Cornell Capital Partners, LP, an investment firm. Under the terms
12
of the agreement, the investment firm has committed to purchase up to
$10,000,000 of the Company's common stock at a purchase price equal to 98% of
the market price at the time of purchase. The investment firm is entitled to a
5% commission per transaction. The equity line can be drawn down upon a
registration statement covering the shares being declared effective by the SEC.
On November 16, 2004 the Company filed a preliminary information statement with
the SEC to allow the Company to increase the number of common shares it is
authorized to issue. This must be completed before the Company can have a
registration statement declared effective by the SEC. On December 16, 2004, the
SEC responded with comments pertaining to the preliminary information statement.
On February 25, 2005, the Company responded to these comments and received
further additional comments from the SEC on March 15, 2005, May 19, 2005 and
July 5, 2005. The Company has responded to the last comments received (July 5,
2005) on August 5, 2005 and received final comments from the SEC on August 23,
2005. The information statement can be completed once the 10-QSB for the fiscal
quarter ended July 31, 2005 is filed. Upon completion of this process, the
Company will file the Certificate of Amendment and issue the common stock.
On January 27, 2005, a preliminary registration statement was filed. On March 1,
2005, the SEC responded with comments pertaining to the preliminary registration
statement. On November 4, 2005, the Company withdrew the Registration statement
as the restrictions imposed on the Company by having a Registration statement on
file, limits the Company's ability to obtain additional capital needed to carry
out its business activities. As consideration for entering into the Standby
Equity Distribution Agreement, we granted Cornell Capital Partners, LP 3,266.66
shares of the Company's Series B Preferred Stock (convertible into 2,450,000
shares of the Company's common stock) and paid a $70,000 cash consulting fee. In
addition, the Company granted the placement agent 66.66 shares of Series B
Preferred shares (convertible into 50,000 common shares). The fair value of the
shares ($625,000) as well as $17,500 in fees and the $70,000 cash consulting fee
associated with this agreement were recorded on the balance sheet as stock
issuance costs in the quarter ended October 31, 2004.
Note 6. Customer Deposits
At July 31, 2005, approximately $831,000 of the $839,653 of customer deposits
represents deposits from a customer to be applied against future purchase
orders. The deposits are non-refundable but applicable to future purchases from
the Company until December 31, 2009. To the extent that any portion of the
deposits is not used for purchases by the end of calendar year 2009, the
deposits will be forfeited.
Note 7. Due to Affiliates
Due to affiliates at July 31, 2005 of approximately $247,000 consists primarily
of temporary advances and unpaid rent and real estate taxes due to an entity
owned by a related party of the Company of approximately $224,000 and $23,000 of
unpaid rent due to an entity majority-owned by a director of the Company.
Note 8. Commitments and Contingencies
Employment Agreement
On May 19, 2004, the Company entered into a three-year employment agreement with
an officer. The agreement provides for annual compensation of $120,000 with a
10% increase each year on December 31 during the term of the agreement and
bonuses based on the Company's annual operating profit as defined in the
agreement. In addition, the officer was granted nonqualified options, effective
the date of the closing of the Share Exchange, to purchase 5,000,000 shares of
common stock for a period of 5 years. The option is immediately exercisable for
the purchase of 2,000,000 shares and exercisable as to an additional 1,000,000
shares commencing on each of the first, second, and third anniversaries of the
closing date, respectively, provided that optionee remains an employee of the
Company. The options are exercisable at the "Applicable Trading Price" in the
Share Exchange which is the lesser of (i) the average closing bid price per
share of the Company's common stock for 30 consecutive trading days prior to the
closing date or (ii) the average closing bid price per share of the Company's
common stock for 30 consecutive trading days commencing on the 31st day
following the effective date of the reverse split as defined in the share
exchange agreement; provided however, the exercise price shall be the price
determined under (i) at any time prior to the reverse split. The average bid
closing price for the 30 consecutive trading days prior to the closing was $.15.
On November 22, 2004, this employment agreement was amended and restated. The
amended and restated agreement provides for annual compensation of $200,000
effective January 1, 2005, with a 10% increase each year on December 31 during
13
the term of the agreement. Bonuses are to be paid as determined by the Board of
Directors. The agreement was also extended to December 31, 2009. All other terms
remained the same as defined in the original agreement.
Consulting Agreements
On May 25, 2004, the Company entered into a two-year consulting agreement with
an affiliate of an interim officer and consultant of Nesco which provided for
the issuance of 2,000,000 shares of common stock and a minimum monthly
consulting fee of $7,500 to be credited against any other cash fees earned under
the terms of the agreement. The agreement also provides for certain transaction
fees to be paid to the consultant based on sales and contracts with strategic
alliances. The fair value of the 2,000,000 shares of common stock ($300,000
based on the market price of $.15 on the date of the agreement) was charged to
operations in the quarter ended July 31, 2004. As of July 31, 2005, the Company
has prepaid approximately $2,000 in consulting fees associated with this
agreement.
On May 25, 2004, the Company entered into a one-year advisory services agreement
which provided for the issuance of 681,667 shares of common stock and a minimum
monthly consulting fee of $6,250 to be credited against any other cash fees
earned under the terms of the agreement. The agreement also provides for certain
transaction fees to be paid to the consultant based on sales and contracts with
strategic alliances. The fair value of the shares ($102,250 based on the market
price of $.15 on the date of the agreement) was charged to operations in the
quarter ended July 31, 2004. On December 17, 2004, the Company terminated the
agreement which was cancelable by either party after six months. On January 5,
2005, the Company issued an aggregate of 908.89 shares of Series B Preferred
shares (convertible into 681,667 common shares) as per the agreement.
On November 1, 2004, the Company entered into a one-year advisory services
agreement which provides for compensation of $10,000 per month, of which $1,800
shall by payable in cash and $8,200 shall be payable, at the Company's
discretion, in cash or in common stock of the Company. The common stock payment
shall be based each month on the closing bid price of the Company's common stock
on the first day of the month for which payment is due. The consultant shall
have customary piggyback registration rights with respect to any shares issued
under this agreement As of July 31, 2005, the Company has paid the monthly
minimum compensation of $1,800. The fair value of the shares due under the
agreement ($73,800) has been charged to operations and this expense is included
in current liabilities as these shares have not been issued at July 31, 2005.
On November 15, 2004, the Company entered into a one-year consulting agreement
for research and public relations services which provided for the issuance of
276,000 shares of restricted common stock and a one-time consulting fee of $500.
The fair value of the shares due under the agreement ($46,920 based on the
market price of $.17 on the date of the agreement) was charged to operations in
the prior fiscal year and this expense is included in current liabilities as
these shares have not been issued at July 31, 2005.
On December 20, 2004, the Company entered into a one-year advisory services
agreement which provides for compensation in the form of a five year warrant to
purchase 204,000 shares of the common stock of the Company at an exercise price
of $.15. The warrants vest at the rate of 1/3 immediately, 1/3 on the six month
anniversary of the agreement and 1/3 one year from the agreement date. The fair
value of the warrants vested as of July 31, 2005 ($20,400) were charged to
operations in the aggregate of $10,200 in the prior fiscal year and $10,200 in
the quarter ended July 31, 2005.
Litigation
Except for the claims against former subsidiaries of Nesco, as described in the
Nesco's April 30, 2004 10-KSB filing, the Company and its subsidiaries were not
involved in any other material legal proceedings during the three months ended
July 31, 2005.
The NAC entities, formerly subsidiaries of Nesco, are subject to a number of
claims and alleged violations. Pursuant to the stock purchase and assumption
agreement dated as of April 29, 2004, and completed as part of the terms of the
share exchange agreement with HDS on May 25, 2004, between Nesco and NAC
Calabria Acquisition Corporation (the "Purchaser"), the Purchaser became
responsible for all liabilities of our previous business conducted by the NAC
Entities.
14
Note 9. Stockholders' Equity
Loss Per Share
Basic loss per share excludes dilution and is calculated by dividing the net
loss attributable to common shareholders by the weighted average number of
common shares outstanding for the period. Diluted loss per share reflects the
potential dilution that could occur if securities or other contracts to issue
common stock were exercised or converted into common stock and resulted in the
issuance of common stock. Because the Company incurred a net loss, diluted net
loss per share was the same as basic net loss per share for the three months
ended July 31, 2005 and July 31, 2004, since the effect of any potentially
dilutive securities would be antidilutive.
The loss per common share at July 31, 2005 includes the current outstanding
common shares in the aggregate of 20,136,225 shares less the 2,400,000 shares
which are subject to redemption (see Note 2). It does not include 116,687 shares
of Series B preferred shares which will be converted into 87,515,132 common
shares, 67,000 shares of Series A preferred shares which will be converted into
2,010,000 common shares, and 2,916,308 common shares for the prior HDS common
and preferred holders who have not yet exchanged their shares. The loss per
common share at July 31, 2004 includes the outstanding common shares as of that
date in the aggregate of 19,127,106 shares. It does not include any Series B
preferred shares, Series A preferred shares or unexchanged shares as of that
date. Although the Series A and Series B preferred shares will be automatically
exchanged for common shares upon the filing of a Certificate of Amendment to the
Certificate of Incorporation to increase the number of shares of common stock
which the Company is authorized to issue, they have been excluded from loss per
common share, in accordance with the Emerging Issues Task Force ("EITF") 03-6 as
these securities have no contractual obligation to share in the losses of the
Company.
The following supplemental pro forma information is presented to illustrate the
effects of the conversion of Series A and Series B preferred stock to common
stock for the three months ended July 31, 2005 and 2004:
July 31, 2005 July 31, 2004
------------- -------------
Net Loss $ (1,202,147) $ (3,539,394)
Weighed average common shares outstanding
Basic and diluted 109,908,584 94,935,188
Loss per common share, basic and diluted $ (.01) $ (.04)
The loss per common shares does not include an aggregate of 56,436,304 warrants
and options outstanding and 43,850,747 shares issuable under the terms of
convertible debt. The effect of these securities would be antidilutive.
Stock Based Compensation
The Company has a stock-based employee compensation plan. The Company uses the
intrinsic value method set forth in APB Opinion 25, "Accounting for Stock Issued
to Employees", and related Interpretations in accounting for its plans. The
following table illustrates the effect on net loss and loss per share for the
three months ended July 31, 2005 and 2004 as if the Company had applied the fair
value recognition provisions of FASB Statement 123, "Accounting for Stock-Based
Compensation".
15
Three Months Ended
July 31,
2005 2004
------------ --------------
Net loss as reported $ (1,202,147) $ (3,539,394)
Add: Total stock-based employee compensation expense determined
under fair value based method, net of related tax effects 15,001 151,311
-------------- ----------------
Pro-forma net loss $ (1,217,148) $ (3,690,705)
============== ================
Net loss per share as reported $ (.07) $ (.25)
============== ================
Pro-forma net loss per share $ (.07) $ (.26)
============== ================
10. Major Customers
Customers accounting for 10% or more of revenue for the three months ended July
31, 2005 and 2004 are as follows:
July 31,
2005 2004
---- ----
Customer A $174,000 $103,000
Customer B 94,000 -
Customer C - 23,000
---------- --------
$268,000 $126,000
========== ========
Accounts receivable from these customers aggregated approximately $168,000 at
July 31, 2005.
Note 11. Subsequent Events
Payroll Taxes
Subsequent to April 30, 2005, the Company became delinquent with regard to the
submission of certain federal payroll tax obligations due to cash flow
deficiencies. These liabilities approximated $104,000, exclusive of penalties
and interest assessed as of October 12, 2005. The total amount of the delinquent
payroll taxes due were paid on October 13, 2005 with funds advanced from a
related party. The penalties and interest assessed are currently being
contested.
Agreement
On October 3, 2005, the Company entered into an agreement with an entity
affiliated with a Director of the Company. The agreement grants the Company the
exclusive rights to manufacture patented hydrophilic urethane foam products,
polyurethane gels and moisture managed foam footwear inserts and to distribute,
along with the entity, these products in North America in consideration of a
7-10% royalty based on sales. The agreement also requires the Company to
purchase certain equipment from the entity and provides for a supply agreement
between the Company and the entity. Products to be manufactured under this
agreement will be sold for use in cosmetic, medical, and household markets
including the foot-care market under the brand name DRYZ, a registered
trademark.
16
Item. 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations
Forward Looking Statements
Information provided by Nesco Industries, Inc. in this report may contain,
"forward-looking" information, as that term is defined by the Private Securities
Litigation Reform Act of 1995 (the "Act"). In particular, the information
contained in "Management's Discussion and Analysis of Financial Condition and
Results of Operation - Liquidity and Capital Resources" contains information
concerning the ability of the Company to service its obligations and other
financial commitments as they become due. The forward looking statements are
qualified in their entirety by these cautionary statements, which are being made
pursuant to the provisions of the Act and with the intention of obtaining the
benefits of the "safe harbor" provisions of the Act.
The Company cautions investors that any forward-looking statements it makes are
not guarantees of future performance and that actual results may differ
materially from those in the forward-looking statements.
Share Exchange Agreement and Acquisition
NESCO Industries, Inc. (hereinafter referred to as "Nesco"), a Nevada publicly
traded corporation, prior to ceasing business operations and becoming inactive
in May 2003, was a provider of asbestos abatement and indoor air quality
testing, monitoring and remediation services.
On April 29, 2004, Nesco entered into a share exchange agreement with Hydrogel
Design Systems, Inc. ("HDS"), a Delaware privately held corporation, whereby HDS
became a majority-owned subsidiary of Nesco and the holders of HDS common stock
and debt acquired a majority interest of Nesco. This exchange (the "Share
Exchange") was completed on May 25, 2004. The accounting for the transaction,
commonly called a reverse acquisition, resulted in a recapitalization of HDS,
which was treated as the accounting acquirer. The acquired assets and assumed
liabilities of Nesco were carried forward at their historical values which
approximates fair value (with the exception of deferred liabilities for which
there was no legal continuing obligation, which were not recorded). HDS's
historical financial statements were carried forward as those of the combined
entity (hereinafter referred to as the "Company"). HDS is engaged in the
manufacture, marketing, selling and distribution of aqueous polymer-based
radiation ionized gels ("gels" or "hydrogels") used in various medical and
cosmetic consumer products.
The Company had intended to issue shares of its common stock in exchange for the
equity securities of HDS in certain ratios as provided for in the exchange
agreement. However, because the Company did not have the required number of
authorized shares of common stock to complete the exchange on this basis, it
agreed to issue shares of its newly designated Series B Preferred Stock instead
of common stock. Upon filing of a Certificate of Amendment to the Certificate of
Incorporation to increase the number of shares of common stock which the Company
is authorized to issue, each share of the Series B Preferred Stock will be
automatically converted into shares of common stock. On November 16, 2004 the
Company filed a preliminary information statement with the SEC. On December 16,
2004, the SEC responded with comments pertaining to the preliminary information
statement. On February 25, 2005, the Company responded to these comments and
received further additional comments from the SEC on March 15, 2005, May 19,
2005 and July 5, 2005. The Company has responded to the last comments received
(July 5, 2005) on August 5, 2005 and received final comments from the SEC on
August 23, 2005. The information statement can be completed once the 10-QSB for
the quarter ended July 31, 2005 is filed. Upon completion of this process, the
Company will file the Certificate of Amendment and issue the common stock.
As of July 31, 2005, approximately 97% of the HDS common and 90% of the HDS
preferred shareholders have exchanged their shares which has resulted in
approximately 54.1% of the Company's voting securities outstanding at the time
of the exchange owned by HDS stockholders. The Company anticipates that the
remaining HDS shareholders will exchange their shares in the near future, which
will result in 55.3% of the Company's voting securities outstanding at the time
of the exchange being owned by HDS stockholders. Upon completion of this
exchange, HDS common shareholders will exchange a total of 4,452,806 shares of
stock for 53,434 shares of the Company's Preferred B Stock, which will be
converted into 40,075,167 shares of the Company's common stock (a ratio of
approximately 9 shares of the Company's common stock for 1 share of HDS stock).
The HDS preferred shareholders will exchange a total of 522,487 shares of stock
for 25,079 shares of the Company's Preferred B Stock which will be converted
17
into 18,809,574 shares of the Company's common stock (a ratio of approximately
36 shares of the Company's common stock for 1 share of HDS stock). The HDS
stockholders, upon completion of the exchange of shares, will receive an
aggregate of 58,884,741 common shares or 55.3% of the total shares outstanding
at the time of the exchange which aggregated 106,386,847 equivalent common
shares on May 25, 2004, the exchange date.
Concurrent with the exchange, Nesco Series A Preferred shareholders agreed to
exchange 512,500 shares of stock for an aggregate of 20,500 shares of the
Company's Preferred B Stock, which will be converted into 15,375,000 shares of
the Company's common stock (a ratio of approximately 30 common shares for 1
share of Series A preferred stock). As of July 31, 2005, 445,500 shares of
Series A Preferred shares have been exchanged for 17,820 shares of Series B
Preferred shares. The Company anticipates that the majority of the remaining
Series A shareholders will exchange their shares in the near future.
As part of this transaction, Nesco conditionally transferred its three wholly
owned subsidiaries, NAC, IAP and NACE, to a consultant and interim officer of
Nesco who resigned his position as officer at the time of the transfer. The
transferee assumed all liabilities and obligations with respect to these
subsidiaries and agreed to indemnify the Company against any claims and, in
exchange therefore, received 3,000,000 shares of common stock of the Company and
certain related registration rights. As additional consideration for the
indemnification by the transferee, the Company agreed that if the transferee
cannot in good faith resell the shares of common stock in an arm's length
transaction during the twelve month period immediately following the closing for
a price equal to the lesser of (i) all liabilities resulting from the agreement
between NAC and its labor union plus legal fees or (ii) $330,000, then the
Company will repurchase from the transferee 2,400,000 of the common shares at
that amount upon written notice from the transferee requesting such. On May 25,
2005, the Company agreed to extend the put right granted to the transferee until
May 25, 2006 subject to the condition that the right may not be exercised until
after January 1, 2006. The repurchase of the 2,400,000 common shares, which are
subject to redemption by the transferee, are included in current liabilities at
an aggregate of $330,000, the maximum amount the Company would be required to
pay in the event of redemption.
The Company's fiscal year ends on April 30 and, therefore, references to fiscal
2006 and fiscal 2005 refer to the fiscal years ending April 30, 2006 and April
30, 2005, respectively.
The accompanying condensed consolidated financial statements of the Company
reflect the historical results of the predecessor entity, HDS, prior to May 25,
2004 and the consolidated results of operations of the Company subsequent to the
acquisition date of May 25, 2004.
Results of Operations
Revenues for the three months ended July 31, 2005 were $386,000 as compared to
$188,000 for the three months ended July 31, 2004. The increase of $198,000 is
primarily attributable to one new customer which had revenues of $94,000 in the
current period and another customer who had increased revenues of $71,000 from
the prior period due to developmental work on a new product. Cost of revenues
for the three months ended July 31, 2005 increased by $34,000 from $211,000 to
$246,000. Cost of revenues consists primarily of direct labor and other
manufacturing fixed costs. The increase relates primarily to the costs of
materials associated with the increase in revenues. Material costs generally
range between 10% and 20% of revenues. The gross margin for the three months
ended July 31, 2005 was $140,000 and compared with ($22,000) for the three
months ended July 31, 2004. The negative gross margin of in the prior period is
attributable to the amount of direct fixed costs such as rent, equipment
depreciation and manufacturing overhead (primarily labor) which approximate
$180,000 quarterly. In the current quarter, the increased revenue was able to
cover these fixed costs and generate a positive gross margin. If the Company is
able to generate additional revenue in the future to cover these fixed costs,
the margin should improve as increased revenue will result in little, if any,
corresponding increase to these fixed costs.
General and administrative expenses for the three months ended July 31, 2005
decreased to $313,000 from $3,125,000 for the three months ended July 31 2004.
This decrease of $2,812,000 includes a charge of approximately $1,099,000 for
stock issued for consulting and other services and a charge of approximately
$1,794,000 for the revaluation of the HDS outstanding warrants which were
exchanged for the Company's warrants at the time of the merger in the prior
period as compared to a charge of $35,000 in the current period for the issuance
of stock and warrants to consultants . The offsetting increase of $46,000 is
primarily due to ongoing consulting fees, increased utility costs, and executive
salaries from agreements entered into as a result of the merger and
subsequently.
18
The net loss for the three months ended July 31, 2005 decreased to $1,202,000
from $3,539,000 for the three months ended July 31, 2004. This decrease of
$2,337,000 includes a non-cash debt discount charge and amortization of debt
financing costs of $828,000, an increase of $531,000 from the three months ended
July 31, 2004. This increase is primarily due to greater amortization of these
costs in the current period as a significant amount of debt was incurred after
July 31, 2004. The decrease in the net loss also includes a charge of
approximately $92,000 for liquidated damages accrued for not having the required
registration statement declared effective timely as per the terms of an
investment banking agreement. This increase of approximately $623,000 is offset
by the decrease in general and administrative expenses as described above and
the increase in gross margin as described above which aggregated $2,974,000.
Liquidity, Capital Resources and Going Concern
The Company's cash at July 31, 2005 decreased to approximately $19,000 as
compared to approximately $157,000 in the prior fiscal period. This decrease is
primarily attributable to the use of cash to fund current operations.
Net cash used in operating activities in the three months ended July 31, 2005
was approximately $33,000 as compared with approximately $456,000 in the prior
fiscal period ended July 31, 2004. In the three months ended July 31, 2004, the
Company used approximately $134,000 to pay down accounts payable which were
required to be paid in order for the Company to continue to be able to operate.
The balance of the cash used to fund operations was used to fund increased
general and administrative costs and to cover fixed manufacturing costs as
previously discussed above in results of operations which were not covered by
revenues. In the period ending July 31, 2005, the Company used approximately
$33,000 to fund current operations as funds were not available to pay down
accounts payable and other liabilities which were due. The increase in revenues
allowed the Company to cover its manufacturing costs and some of its general and
administrative costs.
Net cash provided by investing activities in the three months ended July 31,
2005 was $-0- as compared with $86,000 in the three months ended July 31, 2004.
The net cash provided by investing activities in the prior period was due to the
cash received from Nesco at the closing of the Share Exchange, net of closing
costs. The net cash provided by financing activities in the three months ended
July 31, 2005 was $30,000 as compared with $526,000 in the three months ended
July 31, 2004. The net cash provided by financing activities was primarily
provided by the issuance of convertible debentures in the prior period. In the
current period, a related party advanced the Company $30,000 for operating
expenses.
On July 1, 2004, the Company entered into an investment banking agreement with
Sloan Securities Corp. for the sale of up to $3,000,000 principal amount of the
Company's 8% senior secured convertible notes due December 1, 2005, with
interest payable on December 1 and June 1 semi-annually, either in cash or
common stock, and convertible into common stock at $.15 per share. The notes are
secured by the assets of the Company. Each note was issued with a five-year
warrant to purchase shares of the Company's common stock at $.25 per share or
666,667 warrants for each $100,000 of principal amount of notes purchased. As a
result of the agreement, which terminated on September 30, 2004, the Company
received $2,295,000 in gross proceeds in connection with this agreement and
issued warrants to purchase 15,300,000 shares. Under the terms of the private
placement the Company has agreed to undertake to register the common stock
issuable upon the conversion of the notes and the exercise of the warrants.
Approximately $1,108,000 of the proceeds was attributed to the fair value of the
warrants and $1,004,000 to the intrinsic value of the beneficial conversion
feature of the convertible debt. These amounts were recorded as equity
components. The remaining balance of $183,000 was recorded as long-term debt.
For the three months ended July 31, 2005 and July 31, 2004 the amortization of
debt discount was approximately $409,000 and $11,000, respectively . The balance
due on the notes at July 31, 2005 is approximately $1,783,000 consisting of
approximately $2,295,000 in principal, approximately $31,000 of accrued
interest, and unamortized debt discount of approximately $543,000. Interest
expense for the three months ended July 31, 2005 and July 31, 2004 was
approximately $47,000 and $2,000, respectively, of which approximately $31,000
is included in interest payable at July 31, 2005. On December 1, 2004, the
Company issued 390,305 shares of common stock as payment for the interest due in
the aggregate of approximately $59,000. On June 9, 2005, the Company issued
618,815 shares of common stock as payment for the interest due in the aggregate
of approximately $93,000.
Financing fees in connection with this agreement approximated $286,000 which are
being amortized over the term of the convertible notes. For the three months
ended July 31, 2005 and July 31, 2004, the amortization of financing costs
approximated $54,000 and $4,000 respectively. At July 31, 2005, the unamortized
balance approximated $72,000.
In connection with this agreement, the Company issued the broker warrants to
acquire 5,052,600 shares of common stock at an exercise price of $.15 per share.
The fair value of the warrants ($405,000) will be charged to operations over the
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life of the underlying debt. For the three months ended July 31, 2005 and July
31, 2004, approximately $72,000 and $28,000 was charged to operations as
financing costs for these warrants, respectively. At July 31, 2005, the
unamortized balance approximated $95,000.
In connection with this agreement, under the terms of a related registration
rights agreement, the Company was required to file a registration statement to
effectively register the common stock issuable upon the conversion of the notes
and exercise of the warrants no later than 60 days after the termination of the
offering. As the Company did not file the required registration statement until
January 27, 2005, liquidated damages in the amount of 2% per month of the
aggregate purchase price were required to be paid in cash under the terms of the
agreement. The holders of the notes agreed to accept this payment in the
aggregate of $91,800 in common stock of the Company. The fair value of the
shares due ($91,800) was charged to operations in the prior fiscal year and this
expense is included in current liabilities as these shares have not been issued
at July 31, 2005. In addition, the Company was required to have the registration
statement declared effective no later than 270 days after the termination of the
offering which was June 27, 2005. As the registration statement has not been
declared effective, liquidated damages in the amount of 2% per month of the
aggregate purchase price were required to be paid in cash under the terms of the
agreement. At July 31, 2005, the amount of the damages ($91,800) was charged to
operations and is included in current liabilities.
On August 23, 2004, the Company entered into a Standby Equity Distribution
Agreement with Cornell Capital Partners, LP, an investment firm. Under the terms
of the agreement, the investment firm has committed to purchase up to
$10,000,000 of the Company's common stock at a purchase price equal to 98% of
the market price at the time of purchase. The investment firm is entitled to a
5% commission per transaction. The equity line can be drawn down upon a
registration statement covering the shares being declared effective by the SEC.
On November 16, 2004 the Company filed a preliminary information statement with
the SEC to allow the Company to increase the number of common shares it is
authorized to issue. This must be completed before the Company can have a
registration statement declared effective by the SEC. On December 16, 2004, the
SEC responded with comments pertaining to the preliminary information statement.
On February 25, 2005, the Company responded to these comments and received
further additional comments from the SEC on March 15, 2005, May 19, 2005 and
July 5, 2005. The Company has responded to the last comments received (July 5,
2005) on August 5, 2005 and received final comments from the SEC on August 23,
2005. The information statement can be completed once the 10-QSB for the fiscal
quarter ended July 31, 2005 is filed. Upon completion of this process, the
Company will file the Certificate of Amendment and issue the common stock.
On January 27, 2005, a preliminary registration statement was filed. On March 1,
2005, the SEC responded with comments pertaining to the preliminary registration
statement. On November 4, 2005, the Company withdrew the Registration statement
as the restrictions imposed on the Company by having a Registration statement on
file, limits the Company's ability to obtain additional capital needed to carry
out its business activities. As consideration for entering into the Standby
Equity Distribution Agreement, we granted Cornell Capital Partners, LP 3,266.66
shares of the Company's Series B Preferred Stock (convertible into 2,450,000
shares of the Company's common stock) and paid a $70,000 cash consulting fee. In
addition, the Company granted the placement agent 66.66 shares of Series B
Preferred shares (convertible into 50,000 common shares). The fair value of the
shares ($625,000) as well as $17,500 in fees and the $70,000 cash consulting fee
associated with this agreement were recorded on the balance sheet as stock
issuance costs in the quarter ended October 31, 2004.
At July 31, 2005, the Company has an accumulated deficit of approximately
$19,771,000, a working capital deficit of approximately $6,986,000, a
stockholders' deficit of approximately $5,818,000 and incurred a net loss of
approximately $1,202,000 for the three months then ended. The recoverability of
a major portion of the recorded asset amounts shown in the accompanying
consolidated balance sheet is dependent on the Company's ability to obtain
financing on an as needed basis. The Company's financial condition raises
substantial doubt about the Company's ability to continue as a going concern.
The Company has current debt obligations, including interest, of approximately
$6,249,000 which are due in December 2005. Although the Company is presently
trying to obtain debt extensions, there are currently no available resources for
the repayment of this debt. In addition, the current level of revenue being
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generated is not sufficient to fund current operating costs. The consolidated
financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or amounts and
classification of liabilities that might be necessary should the Company be
unable to continue in existence. The additional funds which were received in the
prior fiscal year from the financing described above have been substantially
depleted to repay indebtedness, pay fees associated with the share exchange and
for product development which has not yet materialized into current revenue.
Management intends to focus its efforts in the next twelve months on building
the business of the Company but realizes that additional debt or equity
financing will be needed. There can be no assurance that the Company will be
able to obtain this financing or that current debt obligations will be extended.
The consolidated financial statements do not include any adjustments relating to
the recoverability and classification of recorded asset amounts or amounts and
classification of liabilities that might be necessary should the Company be
unable to continue in existence.
The Company's current primary sources of revenues are the development,
manufacture and sale of hydrogel related products to the original equipment
manufacturer market and developers and distributors of skin care preparations
and other cosmetics as well as prescription and OTC medications. The Company has
expanded its business to include the sales of finished product including its
branded wound care products, Aquamatrix(R), to wound care providers and other
potential users and plans to expand this business by: (i) Increasing the number
of distributors who carry Aquamatrix(R); (ii) Identifying potential private
label opportunities; (iii) Incorporating novel active ingredients for wound
healing into the gels as product extensions; and (iv) Expanding the
Aquamatrix(R) product line to include complimentary products.
In addition, on October 3, 2005, the Company entered into an agreement with a
subsidiary of HH Brown Shoe Company, HH Brown Shoe Technologies Inc. d/b/a Dicon
Technologies ("Dicon"), an entity affiliated with a Director of the Company. The
agreement grants the Company the exclusive rights to manufacture patented
hydrophilic urethane foam products, polyurethane gels and moisture managed foam
footwear inserts and to distribute, along with the entity, these products in
North America in consideration of a 7-10% royalty based on sales. The agreement
also requires that we purchase certain equipment from the entity, for which the
Company has obtained a tentative commitment for financing from a related party,
and provides for a supply agreement between the Company and the entity. Products
to be manufactured under this agreement will be sold for use in cosmetic,
medical, and household markets including the foot-care market under the brand
name DRYZ, a registered trademark. Management believes that this agreement will
result in an increase in revenues within the next 12 months.
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Item 3. Controls and Procedures
Disclosure Controls and Procedures. We carried out an evaluation, under the
supervision and with the participation of the our management, including our
Chief Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Exchange Act of 1934, as amended (the
"Exchange Act")). Based on such evaluation, our Chief Executive Officer and
Chief Financial Officer concluded that, as of the end of the period, our
disclosure controls and procedures were effective in recording, processing,
summarizing and reporting on a timely basis, information required to be
disclosed by us in the reports that we file or submit under the Exchange Act.
Internal Controls over Financial Reporting. There have not been any changes in
our internal control over financial reporting (as defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act) that during the fiscal quarter to which this
report relates, have materially affected, or are reasonably likely to affect,
our internal control over financial reporting.
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PART II- OTHER INFORMATION
Item 6. - Exhibits And Reports on Form 8-K.
(A) Exhibits:
Exhibit 31 - Certification of Principal Executive and Financial Officer pursuant
to Section 302 of the Sarbanes- Oxley Act of 2002
Exhibit 32 - Certification of Principal Executive and Financial Officer pursuant
to Section 906 of the Sarbanes- Oxley Act of 2002
(B) Reports on Form 8-K:
Current Reports on Form 8-K filed during the quarter ended July 31, 2005
are as follows:
- -- Report on Form 8-K/A (Amendment #2) filed with the SEC on May 17,2005 to
report additional information about the acquisition of HDS under Item 2.01
and to revise the required proforma financial information under Item 9.01.
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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 there unto duly authorized.
NESCO INDUSTRIES, INC.
By: /s/ Matthew L. Harriton
Matthew L. Harriton
President and Chief
Executive Officer
By: /s/ Karen Nazzareno
Karen Nazzareno
Chief Financial Officer
Dated: November 23, 2005
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