ITEM 1. BUSINESS
Health-Chem Corporation is a Delaware corporation and conducts its business primarily through its wholly-owned subsidiaries, Herculite Products, Inc. ("Herculite") and Pacific Combining Corp. ("Pacific"), and through its subsidiaries Transderm Laboratories Corporation ("Transderm") and Hercon Environmental Corporation ("Hercon Environmental"), of which it owns 90% and 98.5%, respectively. Unless the context otherwise requires, the term "Company" includes Health-Chem Corporation and all its subsidiaries. The Company's executive offices are located in New York, New York.
The Company develops, manufactures and distributes products relying on or derived from laminated or coated films. The products fall into several categories - reinforced synthetic fabrics for industrial and health care use, controlled release dispensers for pharmaceuticals and controlled release dispensers for environmental chemicals.
Herculite and Pacific, which maintain facilities in Pennsylvania and California, manufacture and market multilayered synthetic fabrics which are sold domestically and internationally to health-care, industrial, military, automotive, marine and institutional markets. The manufacturing process of these products involves laminating and or coating layer(s) of vinyl, urethane or polyolefins to a synthetic textile. The result is a strong and durable fabric.
Fabrics for industrial use include heavy-duty, and high visibility fabrics, and a variety of custom engineered fabrics. Some of the applications for these fabrics include tension structures, commercial tents and awnings, livestock curtains for poultry, cattle and hogs, commercial wall covering, banners, inflatable bladders for air mattresses, tennis court wind screens, fabrics for use in motor homes, swimming pool and spa covers, gymnasium pads, mats and trampolines, long-term storage covers for military and commercial equipment and fabrics for use in nuclear power plants.
Herculite's Staph-Chek(R) products employ molecular migration technology to make them self-deodorizing and anti-bacterial. A wide variety of thicknesses and colors are sold to manufacturers of institutional mattresses, pillows, laundry carts, shower and cubicle curtains and many related products. Herculite's 'Lectrolite(R) fabric is engineered electrically conductive. By dissipating static electricity it helps reduce the hazard of explosion in flammable, gaseous atmospheres. It is sold to manufacturers of pads for various types of hospital equipment and operating room tables, and to manufacturers in the computer industry to reduce static problems. Herculite's latest health care innovation is a family of engineered Staph-Check(R) fabrics for low air loss and pressure relief applications. Herculite and Pacific are also actively engaged in development of product improvements and innovations to capture existing and new market opportunities for fabric reinforced composites. Pacific has recently installed new coating and lamination equipment to manufacture specialty fabrics for a variety of markets including some not currently served by the Company. These include the automotive and certain sporting goods markets.
The Company's fabric products are sold to more than 1,600 customers by a sales force consisting of several sales and marketing executives, 23 domestic manufacturers representatives, and sales agents in Europe and other parts of the world. The Company also distributes its fabric products through a network of 59 domestic and foreign distributors.
The Company also employs molecular migration technology to manufacture very different controlled release products.
Hercon Environmental manufactures and distributes controlled release dispensers and pheromone products for insect control and household use. Insecticide or insect pheromone products are contained in insoluble, vinyl dispensers to kill, trap or monitor insects as part of safer, more ecologically sound pest management programs. These products are sold to industry, farmers, the United States Department of Agriculture, and a variety of state agencies. Sales are effected primarily by a three person sales team. In an effort to decrease the seasonality and cyclical nature of Hercon Environmental's business, the Company plans to develop markets in the southern hemisphere. Additional new products are being developed through joint programs with governmental and private enterprises.
Transderm owns 98.5% of Hercon Laboratories Corporation ("Hercon Laboratories"), which develops and manufactures controlled release products for the pharmaceutical industry, at Transderm's Pennsylvania facility, to deliver a variety of drugs topically or transdermally. Many medications can be administered to or through a patient's skin at precise rates from small, adhesive patches. Some of the advantages of controlled release dispensers are steady dose rates and reduced dosage frequency. They also can be used for oral, buccal and subdermal delivery of medication.
Since 1986, Hercon Laboratories has manufactured a transdermal nitroglycerin patch which was the first such product introduced for the generic market in the U.S. This product is used for transdermal relief of vascular and cardiovascular symptoms related to angina pectoris. The Company sells the transdermal nitroglycerin patch to pharmaceutical companies who distribute it in the United States and in Europe. The Company is currently awaiting FDA approval of applications to market its improved transdermal nitroglycerin products which are thinner, smaller, more comfortable transparent patches. Some of these applications are the subject of a lawsuit instituted by Key Pharmaceuticals, Inc. (see Item 3. Legal Proceedings). In addition to its nitroglycerin transdermal products, the Company is also developing transdermal products for hormone replacement therapies. There can be no assurance that FDA filings for any additional products will be effected or that FDA approval for any additional products will be obtained.
The Company has additional products in early development and is conducting a number of feasibility studies on drugs to be developed independently or for client companies.
RESEARCH AND DEVELOPMENT
The Company's pharmaceutical research and development laboratory facilities are maintained at Transderm's York, Pennsylvania facilities. Independent laboratories are often engaged for special projects. Research and development for the Company's synthetic fabric operations are conducted at the Company's York and Los Angeles, California facilities. The York facilities also serve the Company's environmental product operations. The Company currently utilizes the skills of approximately 9 full-time employees with varying technical backgrounds, including pharmaceutics and pharmaceutical sciences, to conduct its research and development efforts. See the Consolidated Statements of Operations for the amount of research and development costs incurred during 1997, 1996 and 1995.
SUPPLIERS; RAW MATERIALS
Most of the products and materials used by the Company are purchased from a variety of suppliers and are readily available on the open market. Several materials used in the manufacture of the Company's products are available from single sources only. The Company has not experienced difficulty acquiring such materials which generally have been available to the Company and the industries in which the Company operates on commercially reasonable terms.
COMPETITION
Each of the businesses in which the Company is engaged is highly competitive. Many of its competitors are large national and international manufacturers and distributors, with considerably more financial, marketing and other resources than the Company. The Company believes that its principal competitive strength lies in its research, engineering and manufacturing capabilities.
PATENTS AND PROPRIETARY RIGHTS
The Company has obtained various U.S. and foreign patents and trademarks (which expire from time to time) for certain of its products and processes. While it is the Company's view that these patents and trademarks are a valuable asset, the Company does not consider any single patent or trademark to be of material importance to its business as a whole. The Company continues to seek patent and trademark protection for its proprietary technologies and products as it believes is appropriate in the U.S. and abroad.
ENVIRONMENTAL MATTERS
The Company does not believe that compliance by it with federal, state or local laws and regulations which have been enacted or adopted regulating the discharge of materials into the environment or otherwise relating to the protection of the environment has or will have any material effect upon the capital expenditures, earnings or competitive position of the Company. There can be no assurance, however, (i) that changes in federal, state or local laws or regulations, changes in regulatory policy or the discovery of unknown problems or conditions will not in the future require substantial expenditures, or (ii) as to the extent of the Company's liabilities, if any, for past failures, if any, to comply with laws, regulations and permits applicable to its operations.
BACKLOG; SEASONALITY
The Company's backlog orders usually do not exceed 60 days. Neither the backlog nor the Company's operations are subject to substantial seasonal variations, although its manufacturing operations typically are shut down for a one-week vacation period during the third quarter, which is reflected in results of operations for the period.
CUSTOMERS; GOVERNMENT CONTRACTS
There was no single customer nor, to the Company's knowledge, any group of affiliated customers to which sales during the fiscal year ended December 31, 1997 were in the aggregate equal to 10% or more of the Company's consolidated net sales. Government contracts are not material to the Company's consolidated net sales.
EMPLOYEES
The Company employs approximately 206 employees, of whom 83 are covered by collective bargaining agreements. Union employees of the Company are covered by three collective bargaining agreements, two with a local unit of the Retail Wholesale and Department Store Union, AFL-CIO ("R.W.D.S.U.") and one with the Stove, Furnace and Allied Appliance Workers International Union of North America ("S.F.A.A.W."). The R.W.D.S.U. agreements are for a three year period ending December 10, 1998 and a five year period ending December 18, 2002. The S.F.A.A.W. agreement is for a five year period ending March 2, 1999. All contracts are subject to annual renewal thereafter. The Company believes its relations with employees are good.
ITEM 2.
ITEM 2. PROPERTIES
The following table lists the principal facilities owned or leased by the Company as of December 31, 1997. In the opinion of management, the facilities are adequate for their purposes.
Lease Approx. Expiration Location Sq. Ft. Date Use
New York, NY 7,000 3/99 Executive offices
York, PA 61,000 (owned) Pharmaceutical production, warehouse, research facility & office
York, PA 278,000 (1) (owned) Production, warehouse, & office
Los Angeles, CA 30,000 2/99 Production, office and warehouse; synthetic fabrics
Los Angeles, CA 25,000 6/98 Warehouse; synthetic fabrics
Los Angeles, CA 10,300 2/99 Warehouse; synthetic fabrics
(1) Non-affiliated tenants lease approximately 114,000 square feet under a lease expiring in August 1998. The monthly lease payment is approximately $31,000 which includes payment for a prorated share of utilities.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
(a) In August 1995, Key Pharmaceuticals, Inc., a subsidiary of Schering- Plough Corporation ("Key"), commenced an action against Hercon Laboratories in the United States District Court for the District of Delaware alleging that Hercon Laboratories' submission to the United States Food and Drug Administration ("FDA") of three Abbreviated New Drug Applications ("ANDAs") relating to some of Hercon Laboratories' transdermal nitroglycerin products, for which Hercon Laboratories is awaiting FDA approval, constitutes infringement of Key's patent for its Nitro-Dur(R) products. Key seeks certain injunctive relief, monetary damages if commercial manufacture, use or sale occurs, and a judgment that the effective date for FDA approval of the above- referenced ANDAs be not earlier than February 16, 2010, the expiration date of Key's patent. Hercon Laboratories denied the material allegations of the complaint, asserting, among other things, that the Key patent is invalid and unenforceable and that Hercon Laboratories has not infringed and does not infringe any claim of the patent. Hercon Laboratories has counterclaimed against Key for declaratory judgment of patent noninfringement, invalidity and unenforceability. A two-week, non-jury trial was completed on October 10, 1996. On September 30, 1997, the Delaware District Court ruled in favor of Key on its infringement claim and on Hercon's claim that Key's patent is invalid and unenforceable. On October 29, 1997, Hercon filed an appeal against the Delaware District Court's judgment to the United States District Court for the Federal Circuit in Washington, DC. On December 17, 1997, the Delaware District Court issued an injunction, enjoining Hercon, except as provided for by statute, from making, using, offering for sale, selling or importing any transdermal nitroglycerin patches that have been found to infringe claim 14 of Key's patent, before the expiration of Key's patent on February 16, 2010. Hercon has appealed to the United States Court of Appeals
for the Federal Circuit in Washington, D.C. from both the September 30, 1997 judgment and the December 17, 1997 injunction. The appeals were consolidated on January 23, 1998 and are now in the briefing stage. Management believes that Hercon has strong grounds for appeal.
(b) In October 1995, Gershon Yormack, a stockholder of the Company, initiated an action against the Company, its directors and Transderm in the Delaware Chancery Court (New Castle County) in which he sought injunctive and declaratory relief with respect to certain options to purchase Transderm common stock granted to each of Marvin M. Speiser, the Company's Chairman of the Board and President, and Robert D. Speiser, the Company's Executive Vice President. Pursuant to Employment Agreements entered into in April 1995, in November 1995 the Company caused Transderm to issue an option to purchase shares of Transderm's common stock at an exercise price of $.10 per share to each of Marvin M. Speiser and Robert D. Speiser. The plaintiff alleges that this exercise price, which is the same per share price as the subscription price for Transderm common stock offered by the Company to stockholders under a registered subscription rights offering (via a prospectus dated September 18, 1995) was substantially less than the fair market value of such Transderm common stock. In June 1997, the defendants filed an answer denying all material allegations and seeking dismissal of the complaint. Management believes that the claims are without merit and is defending the action vigorously. The action is in the discovery stage.
(c) In May 1996, Herman Rovner and Bruce Nicholl, two stockholders of the Company, commenced a class and derivative action against the Company, its directors, and a former director in the Delaware Chancery Court (New Castle County). The complaint alleged that the defendants breached their fiduciary duties insofar as the transactions under a Stock Purchase Agreement entered into between the Company and Marvin M. Speiser in March 1996 would unfairly benefit Mr. Speiser to the detriment of the other stockholders and violate the terms of a 1991 Chancery Court order under which a derivative action was settled.
Plaintiffs sought expedited proceedings and preliminary injunctive relief. In July 1996, after a hearing, the Vice Chancellor denied the plaintiffs' motion for a preliminary injunction on the basis that the plaintiffs failed to show irreparable harm or the likelihood of establishing that the 1991 Chancery Court order was violated. Later in July 1996, the Delaware Supreme Court denied the plaintiff's interlocutory appeal of the Vice Chancellor's decision.
In August 1996, in accordance with the Stock Purchase Agreement, as amended, the Company commenced a registered subscription rights offering (the "Rights Offering") of up to 1,320,000 shares of Common Stock to its record holders other than Marvin M. Speiser. A total of 952,520 shares of the Company's Common Stock were subscribed for in the Rights Offering prior to its expiration in September 1996. Under the Stock Purchase Agreement, Mr. Speiser provided shares of Common Stock for purchase by the Company in an amount equal to the number of shares issued to subscribers in the Rights Offering. The shares provided by Mr. Speiser had been subject to repurchase by the Company from Mr. Speiser pursuant to option agreements entered into in 1991 and 1994 (the "Options"). After expiration of the Rights Offering, 317,406 shares of Common Stock remain subject to the Options.
In July 1997, motions to dismiss the action were brought independently on behalf of the plaintiffs and the defendants, respectively. Common to both motions was the ground that the claims are moot. Plaintiffs' motion included a petition for an award of attorneys' fees and expenses. The defendants have vigorously opposed any award of attorneys' fees on several grounds, including the absence of any "benefit" conferred upon the Company by the bringing of the action. The Chancery Court heard oral argument on the issue of attorneys' fees on February 18, 1998. The Company is awaiting a decision from the Court.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.
FORM 10-K PART II
ITEM 5.
ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS
The Company's Common Stock is traded on the American Stock Exchange, Inc. under the symbol HCH.
The following information indicates the range of sale prices at which the Company's Common Stock traded on the American Stock Exchange, Inc. during the past two years:
1997 1996
QUARTER High Low High Low 1st 1 3/16 3/4 1 7/8 1 3/8 2nd 15/16 11/16 2 1/2 1 5/8 3rd 15/16 3/4 1 3/4 1 3/16 4th 1 1/2 1 3/8 7/8
There were approximately 1,472 holders of record of the Company's Common Stock as of February 28, 1998.
The Company has not paid cash dividends on its Common Stock during the five years ended December 31, 1997. See Note 4 to the Consolidated Financial Statements concerning restrictions on the payment of dividends.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA (In thousands, except per share data)
Year Ended December 31, 1997 1996 1995 1994 1993
Net sales $37,720 $47,565 $46,544 $46,930 $44,869
income before extraordinary gain $<3,275> $<1,327> $ <297> $ 1,415 $ 2,557
Extraordinary gain from repurchase of subordinated debentures 17 5 7 5 75
NET INCOME $<3,258> $<1,322> $ <290> $ 1,420 $ 2,632
Earnings per common share (basic & diluted):
income before extraordinary gain $ <.41> $ <.17> $ <.04> $ .18 $ .33
Extraordinary gain from repurchase of subordinated debentures .00 .00 .00 .00 .01
NET INCOME PER SHARE $ <.41> $ <.17> $ <.04> $ .18 $ .34
Dividends per share $ 0 $ 0 $ 0 $ 0 $ 0
Total assets $29,936 $32,413 $33,653 $32,177 $29,162
Long-term debt (including current portion) $17,765 $16,483 $17,616 $15,358 $14,625
See Item 8 herein for more detailed financial information.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Results of Operations
In connection with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the Company provides the following cautionary remarks regarding important factors which, among others, could cause future results to differ materially from the forward-looking statements, expectations and assumptions expressed or implied herein. The following discussion includes certain forward-looking statements. Such forward-looking statements are subject to a number of factors, including material risks and uncertainties, including those referred to herein and in the Company's Reports on Form 10-Q, which could cause actual results to differ materially from the forward-looking statements.
Year ended December 31, 1997 versus December 31, 1996
Net sales decreased $9.8 million, or 21% for the twelve months ended December 31, 1997 as compared to the same period for 1996. The decrease is due primarily to decreases in sales of transdermal nitroglycerin patches and synthetic fabrics of $6.8 million and $2.9 million, respectively. Sales of transdermal nitroglycerin patches, manufactured and marketed by Hercon Laboratories decreased due primarily to the absence of sales to a former domestic distributor and current competitor of the Company who accounted for approximately 10% of the Company's sales for the year ended December 31, 1996. Sales to both of the Company's current domestic distributors of nitroglycerin patches also decreased during 1997 as compared to 1996. During the first half of 1997, in anticipation of increased market pressures and delays in approvals from the United States Food and Drug Administration ("FDA") for the sale of new nitroglycerin patches, the Company undertook an organizational restructuring which is expected to reduce annual payroll-related expenses by approximately $1,600,000. While the Company hopes to receive approvals for its new nitroglycerin patches in 1998, no assurances can be made that any new nitroglycerin patches will be approved by the FDA. Moreover, the Company's ability to exploit its new nitroglycerin products may be limited in the absence of a favorable resolution to its litigation with Key. (See Note 8 of the Notes to Consolidated Financial Statements and discussion below.) The synthetic fabrics sales decrease is due primarily to lower sales of industrial fabrics, eliminating unprofitable business including certain government contracts and lower demand from certain customers.
Gross profit decreased $4.7 million, or 35%, for the twelve months ended December 31, 1997 as compared to the same period in 1996. Gross profit as a percent of sales was 24% for the twelve months ended December 31, 1997 and 29% for the same period in 1996. Gross profit for transdermal nitroglycerin patches and synthetic fabrics decreased $4.7 million and $149,000 respectively, while environmental products gross profit increased $113,000 as compared to the same period in 1996. Plant overhead decreased $1.2 million, including a $.6 million decrease for payroll-related expenses, for the twelve months ended December 31, 1997 as compared to the same period in 1996 reflecting, in part, the organizational restructuring and cost reduction program. Transdermal nitroglycerin patch gross profit decreased due primarily to decreased domestic sales volumes of higher margin products. Transdermal nitroglycerin patch plant overhead decreased $630,000, including a $450,000 decrease for payroll-related expenses, for the year ended December 31, 1997 as compared to the same period in 1996 reflecting, in part, the organizational restructuring. The synthetic fabrics gross profit decrease is due primarily to lower gross profit of $489,000 at Pacific Combining partially offset by higher gross profit of $340,000 at Herculite. Herculite's gross profit
increased $340,000 despite lower sales volumes of $1.5 million due primarily to utilizing the computerized inventory management system to improve the manufacturing process and implement cost reduction efforts and by identifying and eliminating unprofitable business including certain government contracts. In 1998, management will continue to apply manufacturing methods and cost reduction techniques proven at Herculite, to Pacific in efforts to improve gross profit results. Plant overhead for synthetic fabrics decreased $548,000, including a $205,000 decrease for payroll-related expenses, for the twelve months ended December 31, 1997 as compared to the same period in 1996 reflecting, in part, the organizational restructuring and cost reduction program. Environmental products gross profit increased $113,000 due primarily to decreased plant overhead expenses along with improved product mix.
Selling, general and administrative expenses decreased $.4 million for the twelve months ended December 31, 1997 as compared to the corresponding period in 1996. The decrease is due primarily to lower payroll-related expenses of $.2 million and $.1 million for consulting service expenses related to the Company's applications with the FDA to market improved transdermal nitroglycerin products.
Legal expenses decreased $2.2 million for the twelve months ended December 31, 1997 as compared to the same period in 1996. The decreased legal expenses are due primarily to reduced activity associated with the defense of the action brought by Key against Hercon Laboratories (See Note 8 of the Notes to Consolidated Financial Statements).
Research and development expense decreased $.2 million for the twelve months ended December 31, 1997 as compared to the same period in 1996. Payroll- related expenses decreased $.5 million reflecting the organizational restructuring while outside testing and clinical material expenses increased $.6 million. All other increases and decreases were not individually significant. The Company expects total research and development expenses related to pharmaceutical products in 1998 to be lower than 1997 levels.
Net interest expense increased $.4 million for the twelve months ended December 31, 1997 as compared to the same period in 1996 due primarily to higher average outstanding balances on borrowings.
Other income - net decreased $46,000 for the twelve months ended December 31, 1997 as compared to the same period in 1996. The decrease is due primarily to nonrecurring proceeds received in the third quarter of 1996 related to the settlement of a lawsuit.
Loss from operations before taxes and minority interest increased $2.3 million for the twelve month period ended December 31, 1997 as compared to the corresponding period in 1996 due primarily to the loss of sales and gross profits for transdermal nitroglycerin patches partially offset by a decrease in legal expenses related to the Key litigation.
The Company reported a $1.2 million tax benefit on a $4.5 million loss from operations for the twelve months ended December 31, 1997 as compared to a $.9 million tax benefit on a $2.2 million loss from operations in 1996. Income tax provision or benefit varies with the amount and nature of the components of income or loss from operations before income taxes. In 1997, the Company recorded a valuation allowance of $371,000 against current year tax assets. In 1996, a tax benefit was increased by adjustments to reserves for a settlement with a local taxing authority of disputed tax assessments pertaining to prior years of $69,000 and a reversal of a portion of the valuation allowance amounting to $25,000. Note 12 to the accompanying consolidated financial statements presents a reconciliation of taxes on income for 1997 and 1996.
Minority interest represents a 1.5% interest of a former Hercon Laboratories president in the equity of Hercon Environmental.
Year ended December 31, 1996 versus December 31, 1995
Net sales increased $1.0 million, or 2% for the twelve months ended December 31, 1996 as compared to the same period for 1995. The increase was due primarily to increases in sales of synthetic fabrics and environmental products of $.8 million and $.5 million, respectively, partially offset by a $.3 million decrease in sales of the Company's transdermal nitroglycerin patches. The synthetic fabrics sales increase was due principally to higher industrial fabrics sales which includes increased governmental and agricultural sales. Environmental products sales increased due primarily to several new insect mating disruptant products introduced in early 1996. Sales of transdermal nitroglycerin patches manufactured and marketed by Hercon Laboratories decreased due primarily to lower sales to a former domestic distributor of the Company, which obtained approval from the FDA for the manufacture and sale of its own nitroglycerin patches in August 1996. This former distributor, which currently competes with the Company in the nitroglycerin patch market, accounted for approximately 10% and 14% of the Company's sales for the years ended December 31, 1996 and December 31, 1995, respectively. Sales to all of the Company's other domestic distributors of nitroglycerin patches increased for the twelve months ended December 31, 1996 as compared to the same period in 1995.
Gross profit increased $.4 million, or 3%, for the twelve months ended December 31, 1996 as compared to the same period in 1995. Gross profit as a percent of sales was 29% for both of the twelve month periods ended December 31, 1996 and 1995. Gross profit for synthetic fabrics increased $.8 million while transdermal nitroglycerin patch gross profit decreased $.4 million as compared to the same period in 1995. The synthetic fabrics gross profit increase was primarily a result of greater sales volumes, improved manufacturing variances and lower raw material costs. Reducing manufacturing variances and lowering raw material costs were the primary focus of cost reduction efforts in 1996. Transdermal nitroglycerin patch gross profit decreased due primarily to decreased domestic and foreign sales volumes of higher margin products. Gross profit as a percent of sales for transdermal nitroglycerin patches was 58% for the twelve months ended December 31, 1996 as compared to 60% for the same period in 1995 reflecting decreased domestic sales volumes offset partially by domestic price increases and reduced operating costs.
Selling, general and administrative expenses increased $.7 million for the twelve months ended December 31, 1996 as compared to the corresponding period in 1995. The increase was due primarily to higher 1996 payroll-related expenses of $.3 million, including $.1 million related to pension accruals, and $.2 million for consulting costs primarily related to the Company's efforts of obtaining approval from the FDA for its new nitroglycerin patches. These and other increases were partially offset by decreased sales commissions and royalty expense.
Legal expenses increased $2.4 million for the twelve months ended December 31, 1996 as compared to the same period in 1995. In August 1995, Key commenced an action against Hercon Laboratories relating to some of Hercon Laboratories' improved transdermal nitroglycerin products. The increased legal expenses were primarily due to the costs related to the defense of this action, including preparing for and conducting a two-week trial which was completed on October 10, 1996 (See Note 8 of the Notes to Consolidated Financial Statements).
Research and development expense decreased $.7 million for the twelve months ended December 31, 1996. Lower outside testing and clinical material expenses related to pharmaceutical products research, along with lower product development costs related to synthetic fabrics research contributed to the decrease.
Net interest expense decreased $.1 million for the twelve months ended December 31, 1996 as compared to the same periods in 1995 due primarily to capitalized interest related to new equipment under construction.
Other income - net decreased $33,000 for the twelve months ended December 31, 1996 as compared to the same period in 1995. The decrease was due primarily to 1995 non-recurring income-producing items.
Loss from operations before taxes and minority interest increased $1.9 million for the twelve month period ended December 31, 1996 as compared to the corresponding period in 1995 due primarily to the increase in legal expenses related to the litigation described above.
The Company reported a $.9 million tax benefit on a $2.2 million loss from operations for the twelve months ended December 31, 1996 as compared to less than a $.1 million tax benefit on a $.3 million loss from operations in 1995. In 1996, a tax benefit was increased by adjustments to reserves for a settlement with a local taxing authority of disputed tax assessments pertaining to prior years of $69,000 and a reversal of a portion of the valuation allowance amounting to $25,000. In 1995, the federal tax benefit resulting from this loss was partially offset by the provision for state taxes which was generated from income associated with the sale of transdermal nitroglycerin patches.
Liquidity and Capital Resources
The following measures of liquidity are drawn from the Company's Consolidated Financial Statements: December 31, 1997 1996
Working capital (current assets less current liabilities, in thousands) $5,698 $6,927 Current ratio (current assets/ current liabilities) 1.8 1.9 Quick ratio (cash and receivables/ current liabilities) .6 .7
Working capital decreased $1.2 million from December 31, 1996 to December 31, 1997 due to a $1.7 million decrease in current assets partially offset by a $.5 million decrease in current liabilities. Accounts receivable and accounts payable decreased $1.1 million and $.8 million, respectively, while accrued expenses and other current liabilities increased $.8 million. The accounts receivable decrease reflects lower sales volumes for transdermal nitroglycerin patches and synthetic fabrics. The accounts payable decrease reflects lower expenses related to cost reduction efforts and a reduction in amounts payable to raw material vendors. Accrued expenses and other current liabilities increased $.8 million due primarily to a $.6 million increase in the current portion of long-term debt (See Note 4 of the Notes to Consolidated Financial Statements.) Deferred taxes-current and income taxes payable-federal were reclassified to deferred taxes-non-current.
Cash used for operations for the twelve months ended December 31, 1997 was $1.8 million as compared to cash provided by operations of $2.4 million for the same period in 1996. The decrease is due primarily to increasing inventories of $.2 million and decreasing accounts payable of $.8 million in 1997 as compared to decreasing inventories of $1.7 million and increasing accounts payable of $1.3 million in 1996. Investing activities for the twelve months ended December 31, 1997 provided cash of $.5 million as compared to the same period in 1996 which used cash of $1.4 million. This increase is due primarily to lower additions to property, plant and equipment for 1997 which reflects the completion of the new production line for Pacific in early 1997. Financing activities for the twelve months ended December 31, 1997 provided $1.3 million of cash as compared to the same period in 1996 which consumed $1.1 million of cash. In 1997, financing activities provided cash for operations, compared to 1996 when cash from operations was used by financing activities to reduce outstanding debt.
The Company has not paid cash dividends and does not anticipate paying such dividends on its common stock in the foreseeable future.
On January 9, 1997, the Company replaced a $6,000,000 line of credit and a $1,750,000 term loan from The First National Bank of Maryland ("First National") with secured financing from IBJ Schroder Business Credit Corporation (formerly IBJ Schroder Bank & Trust Company) ("IBJS"). Pursuant to a Revolving Credit Term Loan and Security Agreement ("Loan Agreement") dated as of January 9, 1997, the Company was provided with up to $7,000,000 in term loans and up to $8,000,000 in revolving credit. Proceeds from borrowings under the Loan Agreement were used by the Company to repay outstanding indebtedness under the aggregate $7,750,000 facility with First National. The term loans were intended to be used to repurchase, repay and/or redeem up to $7,000,000 of the Company's 10 3/8% Convertible Subordinated Debentures due April 15, 1999, as market conditions warrant. Term loan advances were limited to $4,000,000 until the resolution of the litigation between Hercon Laboratories and Key in such a way as to be immaterial on the future operations of the Company.
Borrowings under the IBJS facility are collateralized by a pledge of substantially all of the assets of the Company. The Loan Agreement, which expires on January 9, 2002, was subject to various covenants which, among other things, required the Company to maintain specified ratios of net worth, current ratio, fixed charge coverage, minimum level of earnings before taxes, depreciation and amortization and limits capital expenditures. On January 21, 1998, the Company entered into a First Amendment ("Amendment") to the Loan Agreement with IBJS. The Amendment, among other things, amends the terms for drawing upon the term loan and amends certain financial covenants effective with the December 31, 1997 covenants. At December 31, 1997, the Company was in compliance with the covenants, as amended. Pursuant to the Amendment, the maximum term loan amount was reduced to $3,998,000 from $7,000,000 providing an aggregate of up to $11,998,000 in senior secured financing. The interest rates on the revolving credit line and term loans increased to IBJS's prime plus .50% and IBJS's prime plus .875%, respectively. These rates are subject to a .25% decrease upon IBJS's satisfactory review of the financial statements for the year ended December 31, 1998. The Company pays a facility fee of 3/8 of 1% on the amount of the unused available financing facility.
At December 31, 1997 the Company had borrowed $5.8 million on its revolving line of credit from IBJS and $2.7 million in term loans. A $1.1 million term loan increase in the second quarter of 1997 was used to purchase the Company's convertible subordinated debentures to meet the April 1997 sinking fund requirements. The $8,000,000 revolving credit line borrowing base is limited to the sum of 85% of eligible accounts receivable and 50% of eligible inventory. The eligible amount is evaluated monthly. For the twelve months ended December 31, 1997, the maximum eligible amount of the $8,000,000 revolving credit line, has ranged from $6,215,000 to $7,385,000, or from 78% to 92%.
The Company expects to meet $.5 million of debenture interest payments on its convertible subordinated debentures each April and October and other periodic interest payments out of working capital. The required $1.5 million sinking fund payment on the Company's subordinated debentures due on April 15, 1997 was satisfied by application of $.5 million debentures previously repurchased and by the Company's redemption of an additional $1.0 million of debentures. In market transactions throughout the twelve months of 1997, the Company purchased $.2 million principal amount of its subordinated debentures for $.2 million. Additional debentures may be repurchased and retired or if debentures are not available for purchase, the Company has an option to call for redemption the amount required to meet sinking fund requirements. The Company has elected to satisfy the 1998 sinking fund requirement by application of $.3 million of debentures previously repurchased or redeemed, of which $.1 million were purchased in 1996, and by calling for redemption of
the remaining $1.2 million. The Company intends to fund this redemption of $1.2 million in April 1998 through a term loan pursuant to the Loan Agreement, subject to IBJS's satisfactory review of the financial statements for the month ended March 31, 1998, including compliance with all financial covenants. The Company expects to be in compliance with all financial covenants at March 31, 1998.
The Company's debt to equity ratio increased to 7:1 at December 31, 1997 and was 4:1 at December 31, 1996. The Company's debt to equity ratio increased at December 31, 1997 reflecting a $3.3 million net loss for the twelve months ended.
Management believes anticipated expenditures in 1998 such as capital expenditures, research and development costs and other operating expenses will be financed by cash generated from operations and the utilization of the Company's credit facility from IBJS. The term loan portion of up to $3,998,000 of the overall $11,998,000 credit facility from IBJS will be used for the repurchasing of debentures. The Company anticipates capital expenditures for property, plant and equipment in 1998 not to exceed $1.3 million. These capital expenditures will primarily consist of manufacturing equipment. At December 31, 1997 the Company had expended $321,000 for capital expenditures for property, plan and equipment in 1997.
Inflation
The Company believes that inflation has not had a material effect upon its results of operations and liquidity and capital resources for any of the periods presented.
Impact of the Year 2000 Issue
The Year 2000 Issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities.
Based on a recent assessment, the Company determined that it will be required to modify or replace significant portions of its software so that its computer systems will properly utilize dates beyond December 31, 1999. The Company presently believes that with modifications to existing software and conversions to new software, the Year 2000 Issue can be resolved. However, if such modifications and conversions are not made, or are not completed on a timely basis, the Year 2000 Issue could have a material impact on the operations of the Company.
The Company will utilize both internal and external resources to reprogram or replace, and test the software for Year 2000 modifications. The Company plans to complete the Year 2000 project no later than June 30, 1999. The total cost of the Year 2000 project is estimated at $100,000 and is being funded through operating cash flows. The total project cost will be expensed as incurred over the next two years and is not expected to have a material effect on the results of operations. To date, the Company has not incurred any external costs related to the assessment of, and preliminary efforts in connection with, its Year 2000 project and the development of a remediation plan.
The costs of the project and the date on which the Company plans to complete the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, and similar uncertainties.
Implementation of New Financial Accounting Standards
In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 130 "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose financial statements. SFAS No. 130 requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in-capital in the equity section of a statement of financial position. SFAS 130 is effective for financial statements issued for periods beginning after December 15, 1997. The Company does not expect the implementation of SFAS 130 to have a material impact on the consolidated financial statements of the Company.
In June 1997, the FASB issued Statement of Financial Accounting Standards No. 131 "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"). SFAS 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. SFAS 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. SFAS 131 is effective for financial statements for periods beginning after December 15, 1997. In the initial year of application, comparative information for earlier years is to be restated. The Company is still evaluating the impact of SFAS 131 on segment disclosures.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS
Index to Consolidated Financial Statements.
PAGE
Report of Independent Accountants 17
Consolidated Balance Sheets - December 31, 1997 and 1996 18-19
Consolidated Statements of Operations Years Ended December 31, 1997, 1996 and 1995 20
Consolidated Cash Flow Statements Years Ended December 31, 1997, 1996 and 1995 21-22
Consolidated Statements of Stockholders' Equity Years Ended December 31, 1997, 1996 and 1995 23
Notes to Consolidated Financial Statements 24-41
REPORT OF INDEPENDENT ACCOUNTANTS
The Board of Directors and Stockholders of Health-Chem Corporation:
We have audited the accompanying consolidated financial statements and the financial statement schedules of Health-Chem Corporation and Subsidiary Companies as of December 31, 1997 and 1996 and for each of the three years in the period ended December 31, 1997, listed in Item 14(a) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Health-Chem Corporation and Subsidiary Companies as of December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein.
COOPERS & LYBRAND L.L.P.
One South Market Square Harrisburg, Pennsylvania March 25, 1998
i. Fair Value of Financial Instruments
In 1995, the Company adopted Statement of Financial Accounting Standards #107, "Disclosures about Fair Value of Financial Instruments," which requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet. The carrying amount reported in the consolidated balance sheets at December 31, 1997 for cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities approximate fair value due to the short-term nature of these instruments. The carrying amount of the Company's notes receivable and long-term debt approximate fair value because the underlying instruments reprice frequently. The fair value of the Company's convertible subordinated debentures is based on quoted market prices and at December 31, 1997 was approximately $7 million.
j. Use of Estimates in the Preparation of Financial Statements
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 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.
k. Implementation of New Financial Accounting Standards
In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 130 "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose financial statements. SFAS 130 requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in-capital in the equity section of a statement of financial position. SFAS 130 is effective for financial statements issued for periods beginning after December 15, 1997. The Company does not expect the implementation of SFAS 130 to have a material impact on the consolidated financial statements of the Company.
l. Reclassifications
Certain amounts included in the Consolidated Financial Statements and Notes thereto relating to prior periods have been reclassified to conform to the current presentation.
2. Inventories (In thousands) December 31, 1997 1996
Raw materials $3,590 $3,979 Finished goods and work in process 3,947 3,364 Total $7,537 $7,343
3. Accrued Expenses and Other Current Liabilities (In thousands)
December 31, 1997 1996
Allowance for litigation contingencies $ 201 $ 201 Current portion of long-term debt 1,495 901 Accrued interest on debt 37 57 Accrued legal and audit fees 197 112 Accrued payroll and related liabilities 551 400 Financed insurance premiums 119 192 Other 284 269 Total accrued expenses and other current liabilities $2,884 $2,132
4. Long-Term Debt
The Company's long-term debt balances are as follows (in thousands):
December 31, 1997 1996
10.375% convertible subordinated debentures, due April 15, 1991 through April 15, 1999 $ 9,500 $11,000 Less debentures purchased to meet sinking fund requirements 310 599 Subtotal 10.375% convertible subordinated debentures 9,190 10,401 Less current portion 1,190 901 Total 10.375% convertible subordinated debentures $ 8,000 $ 9,500
Long-term line of credit payable $ 5,834 $ 4,582 Long-term bank debt term loan 2,741 1,500 Subtotal other long-term debt 8,575 6,082 Less current portion 305 0 Total other long-term debt $ 8,270 $ 6,082
From January 1996 throughout January 1997 the Company had a $6.0 million long- term line of credit and a $1,750,000 term loan from The First National Bank of Maryland ("First National") which had been scheduled to expire October 15, 1997 and November 15, 2000, respectively. Borrowings under the line of credit and term loan were collateralized by a pledge of substantially all of the assets of the Company and its subsidiaries with the exception of real estate. They were subject to various financial covenants which, among other things, required the Company to maintain specified ratios of debt to tangible net worth and fixed charge coverage, and minimum levels of tangible net worth and limits capital additions. At December 31, 1996, the Company was not in compliance with certain covenants. The borrowing base was limited to the sum of 80% of eligible accounts receivable and 35% of eligible inventory. At the Company's option, borrowings under the line would bear interest at the lender's prime rate or the London Inter-Bank Offer Rate, as amended. The weighted average interest rate was 7.4% at December 31, 1996. In addition, the Company paid a facility fee of 1/4 of 1% on the amount of the unused credit facility. Borrowings under the term loan would bear interest at the lender's prime rate plus .375%, unless Pacific elected otherwise in accordance with the loan documents. The interest rate was 8.1% at December 31, 1996. The term loan required quarterly principal payments of $62,500 in 1996 which would have increased to $87,500 in 1997 and $95,833 from 1998 through November 2000 had the loan not been replaced in January of 1997.
On January 9, 1997, the Company replaced the line of credit and term loan from First National with secured financing from IBJ Schroder Business Credit Corporation (formerly IBJ Schroder Bank & Trust Company) ("IBJS"). Pursuant to a Revolving Credit Term Loan and Security Agreement ("Loan Agreement') dated as of January 9, 1997, the Company was provided with up to $7,000,000 in term loans and up to $8,000,000 in revolving credit. Proceeds from borrowings under the Loan Agreement were used by the Company to repay outstanding indebtedness under the aggregate $7,750,000 facility with First National. The term loans were intended to be used to repurchase, repay and/or redeem up to $7,000,000 of the Company's 10 3/8% Convertible Subordinated Debentures due April 15, 1999, as market conditions warrant. Term loan advances were limited to $4,000,000 until the resolution of the litigation between Hercon Laboratories and Key in such a way as to be immaterial on the future operations of the Company.
Borrowings under the IBJS facility are collateralized by a pledge of substantially all of the assets of the Company. The Loan Agreement, which expires on January 9, 2002, was subject to various covenants which, among other things, required the Company to maintain specified ratios of net worth, current ratio, fixed charge coverage, minimum level of earnings before taxes, depreciation and amortization and limits capital expenditures. On January 21, 1998, the Company entered into a First Amendment ("Amendment") to the Loan Agreement with IBJS. The Amendment, among other things, amends the terms for drawing upon the term loan and amends certain financial covenants effective with the December 31, 1997 covenants. At December 31, 1997, the Company was in compliance with the covenants, as amended. Pursuant to the Amendment, the maximum term loan amount was reduced to $3,998,000 from $7,000,000 providing an aggregate of up to $11,998,000 in senior secured financing. The interest rates on the revolving credit line and term loans increased to IBJS's prime plus .50% and IBJS's prime plus .875%, respectively. These rates are subject to a .25% decrease upon IBJS's satisfactory review of the financial statements for the year ended December 31, 1998. The Company pays a facility fee of 3/8 of 1% on the amount of the unused available financing facility.
At December 31, 1997 the Company had borrowed $5.8 million on its revolving line of credit from IBJS and $2.7 million in term loans. A $1.1 million term loan increase in the second quarter of 1997 was used to purchase the Company's convertible subordinated debentures to meet the April 1997 sinking fund requirements. The $8,000,000 revolving credit line borrowing base is limited to the sum of 85% of eligible accounts receivable and 50% of eligible inventory. The eligible amount is evaluated monthly. For the twelve months ended December 31, 1997, the maximum eligible amount of the $8,000,000 revolving credit line, has ranged from $6,215,000 to $7,385,000, or from 78% to 92%.
Interest on the debentures is payable semi-annually. The debentures are subject to redemption through a sinking fund whereby the Company is required to redeem at face value $1,500,000 of the debentures each April 15, from 1991 through 1998. The balance is due on April 15, 1999. The debentures are convertible into shares of the Company's common stock at $19.52 per share and are redeemable in whole or in part at par. During 1997, 1996 and 1995, the Company repurchased debentures with a face amount of $1.1 million in market transactions and called for redemption $3.1 million to meet sinking fund requirements. The Company satisfied the 1997 sinking fund requirement by application of $.5 million of debentures previously repurchased and by the Company's redemption of an additional $1.0 million of debentures. In market transactions throughout the twelve months of 1997, the Company purchased $.2 million principal amount of its subordinated debentures for $.2 million. The Company has elected to satisfy the 1998 sinking fund requirement by application of $.3 million of debentures previously repurchased or redeemed, of which $.1 million were purchased in 1996, and by calling for redemption of the remaining $1.2 million. The Company intends to fund this redemption of $1.2 million in April 1998 through a term loan pursuant to the Loan Agreement, subject to IBJS's satisfactory review of the financial statements for the month ended March 31, 1998, including compliance with all financial covenants. The Company expects to be in compliance with all financial covenants at March 31, 1998.
The terms of the indenture relating to the debentures restrict the Company's ability to pay cash dividends and/or repurchase its capital stock pursuant to a formula based upon the consolidated net income of the Company and other factors. Under the formula, at December 31, 1997, no amount was available for the payment of dividends and/or the repurchase of capital stock.
Annual maturities of long-term debt for each of the five years following December 31, 1997 are as follows:
Convertible Line of Subordinated Credit Term Year Debentures(1) Payable Loan (2)
1998 $ 1,190 $ 0 $ 305 1999 8,000 0 457 2000 0 0 457 2001 0 0 457 2002 0 5,834 1,065 Subtotal 9,190 5,834 2,741
Less: Current portion 1,190 0 305 Total $ 8,000 $5,834 $2,436
Note: (1) Amounts shown are net of face value of repurchased debentures and assume application of such debentures to meet, in part, sinking fund requirements for 1998.
(2) The term loans require monthly payments commencing with $38,080 in May 1998. The sum of all term loans made during the borrowing period will be amortized on the basis of a seventy-two (72) month amortization schedule (with the monthly amortization amount being adjusted upon each term loan being advanced).
5. Supplemental Pension Agreements
In April 1995, Health-Chem entered into five-year Employment Agreements with each of Marvin M. Speiser and Robert D. Speiser which entitle them to receive upon retirement on or after January 1, 2000, in the case of Marvin M. Speiser, and on or after January 1, 2010, in the case of Robert D. Speiser, an annual supplemental pension benefit equal to 60% of such executive's final base salary, which for this purpose will be the highest nominal annual salary paid to him during his employment. The supplemental pension will be payable for a period of ten (10) years beginning on the retirement date, or if later, January 1, following termination of employment. In the event of termination of employment prior to the retirement date, the amount of the supplemental pension payable on that date will be prorated based on the period of employment from December 31, 1994 to the date of termination. No proration will be applied, however, if the executive's employment is involuntarily terminated. An actuarially reduced supplemental pension benefit may be paid if the benefit is commenced upon termination of employment prior to the retirement date. For the year ended December 31, 1997 and 1996 the related pension accrual in the amount of $1,474,000 and $930,000 has been recorded in other long-term liabilities on the Consolidated Balance Sheets.
Net pension cost included in the operating results for fiscal year ended December 31, 1997, 1996 and 1995 consisted of the following components:
1997 1996 1995
Service costs $ 81 $ 76 $ 50 Interest costs 147 134 107 Net amortization 316 321 242 Net pension cost $544 $531 $399
The supplemental pension agreements currently are not funded. The status of these plans at December 31, 1997 and 1996 is as follows:
1997 1996
Accumulated benefit obligations $1,932 $1,758 Projected benefit obligation 2,243 2,120 Projected obligation of plan assets in excess 2,243 2,120 Unrecognized prior service cost <769> <1,190> Accrued pension cost $1,474 $ 930
The assumed discount rate used in determining the accumulated benefit obligation was 7% for 1997 and 1996.
6. Employee Benefit Plan
All permanent, full-time non-union employees of the Company are eligible to participate in Health-Chem's 401(k) Plan (the "Plan") following six months of employment. The Plan allows eligible employees to defer up to 20% of their income on a pre-tax basis through contributions to the Plan. The Company may contribute for each participant a matching contribution equal to a percentage of the elective contributions made by the participants. The decision to make matching contributions and the amount of such contributions will be made each year by the Company. These Company matching contributions were $59,000, $64,000, and $59,000 in 1997, 1996 and 1995, respectively.
7. Commitments
The Company leases office space in New York City and three production/warehouse facilities in Los Angeles. Minimum rental commitments required under non-cancelable operating leases having a term of more than one year as of December 31, 1997 were as follows (in thousands):
Year Amount 1998 $ 421 1999 80 Total $ 501
Rent expense was $541,000, $511,000 and $502,000 in 1997, 1996 and 1995, respectively.
At December 31, 1997, commitments under employment arrangements aggregated $1,816,000 through 2002. Certain employees were provided bonuses, based upon defined earnings or the attainment of certain sales levels, which amounted to $251,000 and $201,000 in 1997 and 1996, respectively. Based on these criteria, no bonuses were earned in 1995.
8. Litigation
(a) In August 1995, Key Pharmaceuticals, Inc., a subsidiary of Schering- Plough Corporation ("Key"), commenced an action against Hercon Laboratories in the United States District Court for the District of Delaware alleging that Hercon Laboratories' submission to the United States Food and Drug Administration ("FDA") of three Abbreviated New Drug Applications ("ANDAs") relating to some of Hercon Laboratories' transdermal nitroglycerin products, for which Hercon Laboratories is awaiting FDA approval, constitutes infringement of Key's patent for its Nitro-Dur(R) products. Key seeks certain injunctive relief, monetary damages if commercial manufacture, use or sale occurs, and a judgment that the effective date for FDA approval of the above- referenced ANDAs be not earlier than February 16, 2010, the expiration date of Key's patent. Hercon Laboratories denied the material allegations of the complaint, asserting, among other things, that the Key patent is invalid and
unenforceable and that Hercon Laboratories has not infringed and does not infringe any claim of the patent. Hercon Laboratories has counterclaimed against Key for declaratory judgment of patent noninfringement, invalidity and unenforceability. A two-week non-jury trial was completed on October 10, 1996. On September 30, 1997, the Delaware District Court ruled in favor of Key on its infringement claim and on Hercon's claim that Key's patent is invalid and unenforceable. On October 29, 1997, Hercon filed an appeal against the Delaware District Court's judgment to the United States Court of Appeals for the Federal Circuit in Washington, DC. On December 17, 1997, the Delaware District Court issued an injunction, enjoining Hercon, except as provided for by statute, from making, using, offering for sale, selling or importing any transdermal nitroglycerin patches that have been found to infringe claim 14 of Key's patent, before the expiration of Key's patent on February 16, 2010. Hercon has appealed to the United States District Court for the Federal Circuit in Washington, D.C. from both the September 30, 1997 judgment and the December 17, 1997 injunction. The appeals were consolidated on January 23, 1998 and are now in the briefing stage. Management believes that Hercon has strong grounds for appeal.
(b) In October 1995, Gershon Yormack, a stockholder of the Company, initiated an action against the Company, its directors and Transderm in the Delaware Chancery Court (New Castle County) in which he sought injunctive and declaratory relief with respect to certain options to purchase Transderm common stock granted to each of Marvin M. Speiser, the Company's Chairman of the Board and President, and Robert D. Speiser, the Company's Executive Vice President. Pursuant to Employment Agreements entered into in April 1995, in November 1995 the Company caused Transderm to issue an option to purchase shares of Transderm's common stock at an exercise price of $.10 per share to each of Marvin M. Speiser and Robert D. Speiser. The plaintiff alleges that this exercise price, which is the same per share price as the subscription price for Transderm common stock offered by the Company to stockholders under a registered subscription rights offering (via a prospectus dated September 18, 1995) was substantially less than the fair market value of such Transderm common stock. In June 1997, the defendants filed an answer denying all material allegations and seeking dismissal of the complaint. Management believes that the claims are without merit and is defending the action vigorously. The action is in the discovery stage.
(c) In May 1996, Herman Rovner and Bruce Nicholl, two stockholders of the Company, commenced a class and derivative action against the Company, its directors, and a former director in the Delaware Chancery Court (New Castle County). The complaint alleged that the defendants breached their fiduciary duties insofar as the transactions under a Stock Purchase Agreement entered into between the Company and Marvin M. Speiser in March 1996 would unfairly benefit Mr. Speiser to the detriment of the other stockholders and violate the terms of a 1991 Chancery Court order under which a derivative action was settled.
Plaintiffs sought expedited proceedings and preliminary injunctive relief. In July 1996, after a hearing, the Vice Chancellor denied the plaintiffs' motion for a preliminary injunction on the basis that the plaintiffs failed to show irreparable harm or the likelihood of establishing that the 1991 Chancery Court order was violated. Later in July 1996, the Delaware Supreme Court denied the plaintiff's interlocutory appeal of the Vice Chancellor's decision.
For a description of the transactions effected pursuant to the Stock Purchase Agreement, see Note 9 below. In July 1997, motions to dismiss the action were brought independently on behalf of the plaintiffs and the defendants, respectively. Common to both motions was the ground that the claims are moot. Plaintiffs' motion included a petition for an award of attorneys' fees and expenses. The defendants have vigorously opposed any award of attorneys' fees on several grounds, including the absence of any "benefit" conferred upon the Company by the bringing of the action. The Chancery Court heard oral argument on the issue of attorneys' fees on February 18, 1998. The Company is awaiting a decision from the Court.
9. Redeemable Common Stock and Stock Purchase Agreement/Rights Offering
On July 15, 1994, the Company exercised its option to purchase 525,000 shares of the Company's Common Stock, par value $.01 per share, at $2.00 per share, from National Union Fire Insurance Company of Pittsburgh, PA. These shares are included in treasury stock and had previously been classified as Redeemable Common Stock.
In compliance with certain restrictive covenants under the indenture governing the Company's 10.375% convertible subordinated debentures due April 15, 1999, the Company paid for the 525,000 shares from the proceeds of the substantially concurrent sale of 575,000 shares of the Company's treasury stock at $2.00 per share, to Marvin M. Speiser pursuant to a stock purchase and option agreement ("1994 Option Agreement")
In September 1996, the Company issued 952,520 shares of its Common Stock, at $1.10 per share, pursuant to a subscription rights offering of up to 1,320,000 shares registered under the Securities Act (the "Rights Offering"). The Rights Offering was effected in accordance with the Stock Purchase Agreement referenced in Note 8(c). Substantially all of the proceeds of this Rights Offering were used to pay the exercise price (at $1.0816 per share) of an equal number of shares acquired from Marvin M. Speiser upon the exercise of the Company's repurchase rights under the 1994 Option Agreement and an option agreement entered into in 1991. Of the total of 1,782,689 shares subject to repurchase by the Company, 952,520 shares were purchased, 512,763 shares were retained by Mr. Speiser free of the Company's repurchase rights, as the deemed exercise of his pro rata subscription rights, and 317,406 remain subject to the Company's repurchase rights under the option agreements.
10. Stockholders' Equity
a. A summary of the shares of common and treasury stock is as follows:
Treasury Stock Common Convertible Common Stock Special Stock Stock
Balance at 12/31/96 7,982,424 738,667 6,490,632
Balance at 12/31/97 7,982,424 738,667 6,490,632
b. Convertible special stock
The convertible special stock has the same rights as common stock except that it is nonvoting. Each share is convertible into 1 1/3 shares of the Company's common stock. The conversion rate is subject to change under certain circumstances. No shares of convertible special stock are outstanding.
c. Reserved shares Number of Purpose of Reservation Shares
Conversion of convertible special stock 984,889 Stock option plans 902,500 Conversion of 10.375% convertible subordinated debentures 470,799 Total reserved shares 2,358,188
d. Stock rights plan
On February 28, 1989, the Company adopted a stock rights plan which was amended November 7, 1990. Pursuant to such plan, the Board of Directors declared a dividend of one right ("Right") for each share of common stock of the Company outstanding on March 21, 1989. In the event that a person or affiliated group, other than any present officer or director, acquires, obtains the right to acquire, or tenders for 30% or more of the Company's outstanding common stock (other than through certain permissibly structured tender offers), then each holder of a Right, other than the 30% stockholder or tender offeror, shall be entitled to receive upon exercise of each Right, common shares of the Company which have a market value equal to two times the exercise price of the Right, or capital stock of the acquiring company which has a market value of two times the exercise price of the Right.
The Company may redeem the Rights for a nominal amount at any time prior to 10 days (subject to extension by the Board of Directors) after a person or group acquires or tenders for 30% or more of the Company's common stock. Unless redeemed earlier, all Rights expire on February 27, 1999.
11. Stock Options
Health-Chem Corporation
Options granted under various stock option plans are exercisable in installments commencing one year from the date of grant and expire five to ten years from the grant date.
In March 1995, the Company adopted the 1995 Performance Equity Plan ("1995 Plan") which was designed to attract and retain employees of the highest caliber, to provide increased incentive for officers and key employees and to continue to promote the well-being of the Company. Pursuant to the 1995 Plan, up to an aggregate of 600,000 shares of the Company's Common Stock are available for the granting of stock or stock related incentive awards.
The Company has adopted Statement of Financial Accounting Standards No. 123, "Accounting for Stock Based Compensation" (SFAS 123). As permitted by SFAS 123, the Company has chosen to apply APB Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations in accounting for its stock option plans. Accordingly, no compensation cost has been recognized for options granted under the plans. The Company did not award any option grants during the years ended December 31, 1997, 1996 and 1995.
A summary of the status of the Company's plans as of December 31, 1997, 1996 and 1995 and changes during the years ended on those dates is presented below:
1997 1996 1995 Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price
Outstanding at beginning of year 557,500 $4.53 615,000 $4.53 697,600 $4.97
Granted 0 0 0
Exercised 0 0 <2,000> $2.50
Forfeited Price @ $9.125-$11.125 <88,000> $10.25 0 <69,600> $9.14 Price @ $4.38-$5.25 <91,000> $5.25 <3,000> $5.25 0 Price @ $3.25-$3.75 <66,000> $3.48 <44,500> $3.48 <11,000> $3.52 Price @ $2.50 <10,000> $2.50 <10,000> $2.50 0 Total Forfeited <255,000> <57,500> <80,600>
Outstanding at end of year 302,500 $3.16 557,500 $4.65 615,000 $4.53
Options exercisable at year-end 238,900 397,600 343,800
The following table summarizes information about the Plan's stock options outstanding at December 31, 1997:
Options Outstanding Options Exercisable
Weighted- Average Weighted- Weighted- Range of Number Remaining Average Number Average Exercise Outstanding Contractual Exercise Exercisable Exercise Prices at 12/31/97 Life Price at 12/31/97 Price
$ 2.50 98,000 4.3 years $ 2.50 98,000 $ 2.50 $ 3.25 113,500 6.3 years $ 3.25 68,100 $ 3.25 $ 3.75 91,000 5.3 years $ 3.75 72,800 $ 3.75
Total 302,500 238,900
Transderm Laboratories Corporation
Pursuant to the five-year Employment Agreements referred to in Note 5, on November 13, 1995, the Company caused Transderm to enter into stock option agreements with Robert D. Speiser and Marvin M. Speiser allowing each of them to purchase 5,000,000 shares of Transderm's common stock at $.10 per share, which was the per share subscription exercise price in Transderm's initial public offering effected pursuant to the Plan of Reorganization and Asset Exchange Agreement referred to in Note 1a. The options, which have been exercisable in full since November 13, 1996, each represent ten percent (10%) of the outstanding common stock of Transderm on a diluted basis.
In April 1996, Transderm adopted the 1996 Performance Equity Plan ("Transderm Plan") which was designed to attract and retain employees of the highest caliber, to provide increased incentive for officers and key employees and to continue to promote the well-being of Transderm. Pursuant to the Transderm Plan, up to an aggregate of 2,000,000 shares of Transderm's Common Stock were made available for the granting of stock or stock related incentive awards. During 1996 the Company entered into stock option agreements with three officers and key employees allowing them to purchase up to an aggregate of 1,400,000 shares under the Transderm Plan. The Company has reserved 1,400,000 shares of Common Stock pursuant to these stock option agreements.
In accordance with the Company's adoption of SFAS 123, no compensation cost has been recognized for options granted under the Transderm Plan. Had compensation cost for the Transderm Plan been determined based on the fair value at the grant dates for awards under the Transderm Plan consistent with the method of SFAS 123, the Company's net loss and net loss per share would have been increased to the pro forma amounts indicated below. Transderm did not award any option grants during the year ended December 31, 1997.
1997 1996 1995
Net loss As reported $<3,258,000> $<1,322,000> $<290,000> Pro forma $<3,288,000> $<2,033,000> $<432,000>
Basic and diluted As reported $<0.41> $<0.17> $<0.04> loss per share Pro forma $<0.41> $<0.25> $<0.05>
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1996 and 1995, respectively; no dividend yield for both years; expected volatility of 100% for both years; risk-free interest rates of 6.11% and 5.86%; and expected lives of seven years for both the 1996 and 1995 option grants.
A summary of the status of the Transderm Plan as of December 31, 1997, 1996 and 1995 and changes during the years ended on those dates is presented below (in thousands, except per share amounts):
1997 1996 1995 Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price
Outstanding at beginning of year 11,400 $0.103 10,000 $0.10 0 $0
Granted 0 0 1,400 0.125 10,000 0.10
Exercised 0 0 0 0 0 0
Forfeited 0 0 0 0 0 0
Outstanding at end of year 11,400 0.103 11,400 0.103 10,000 0.10
Options exercisable at year-end 10,280 10,000
Weighted-average fair value of options granted during the year $0 $0.106 $0.085
The following table summarizes information about the Transderm Plan stock options outstanding at December 31, 1997:
Options Outstanding Options Exercisable
Weighted- Average Weighted- Weighted- Range of Number Remaining Average Number Average Exercise Outstanding Contractual Exercise Exercisable Exercise Prices at 12/31/97 Life Price at 12/31/97 Price
$0.10- 11,400,000 8.0 years $0.103 10,280,000 $0.101 $0.125
12. Taxes on Income (In thousands) Year Ended December 31, 1997 1996 1995 Taxes on income include provision for: Federal income taxes $<1,136> $ <767> $ <105> State and local income taxes <85> <128> 63 Total $<1,221> $ <895> $ <42>
Taxes on income are comprised of: Currently payable $ <116> $ <55> $ 236 Deferred <1,105> <840> <278> Total $<1,221> $ <895> $ <42>
Charged to: Income before extraordinary gain $<1,230> $ <898> $ <45> Extraordinary gain on repurchase of debentures 9 3 3 Total $<1,221> $ <895> $ <42>
A reconciliation of taxes on income to the federal statutory rate is as follows:
Year Ended December 31, 1997 1996 1995
Tax at statutory rate $<1,523> $ <755> $ <107> Increase resulting from: State and local taxes, net of federal tax benefit <85> <36> 13 Recognition of tax loss and tax credit carryforwards (not previously recognized) <84> <51> 0 Intangibles and officers' life insurance premiums 79 15 20 Settlement of state tax assessments 0 <69> 0 Valuation allowance 371 <25> 0 Other 21 26 32 Tax $<1,221> $ <895> $ <42>
At December 31, 1997 and 1996, the deferred tax assets and liabilities result from the following temporary differences and carryforwards:
1997 1996
Deferred tax assets: Net operating and other tax loss carryforwards $10,047 $ 8,733 Tax credit carryforwards 631 693 Provision for litigation contingencies 101 99 Allowances for bad debts 282 303 Inventory reserves 126 158 Capitalization of overhead costs as inventory in accordance with tax laws 169 150 Retirement benefits 690 435 Other 215 29 Total deferred tax assets 12,261 10,600
Deferred tax liabilities: Accelerated depreciation <881> <902> Other 0 0 Total deferred tax liabilities <881> <902> Net deferred tax asset before valuation allowance 11,380 9,698 Valuation Allowance <9,488> <8,469> Total deferred tax assets and liabilities net $ 1,892 $ 1,229
At December 31, 1997, the net deferred tax asset was comprised of a non- current asset of $1,892,000. The net deferred tax asset at December 31, 1996 was comprised of a current asset of $554,000 and a non-current asset of $675,000. For the year ended December 31, 1997 the valuation allowance increased by $1,019,000 and total assets and liabilities net of the valuation allowance increased $663,000 primarily as a result of generating a federal net operating loss for the current year and changes in temporary differences.
At December 31, 1997, the Company had approximately $18 million of net operating loss carryforwards for federal income tax purposes which expire in various years from 2000 through 2012 and tax credit carryforwards that expire in various years from 1998 through 2008. The Company also had net operating loss carryforwards in various states in which the Company and its subsidiaries operate which are available to absorb allocated portions of future taxable income for state tax purposes. The state operating loss carryforwards expire from 1998 through 2012. Realization is dependent on generating sufficient taxable income prior to expiration of the loss carryforwards. Although realization is not assured, management believes the deferred tax asset net of a valuation allowance is an amount that is more likely than not to be realized. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced.
13. Interest Expense - Net (In thousands)
Year ended December 31, 1997 1996 1995 Interest expense $1,775 $1,700 $ 1,646 Interest income <162> <181> <175> Capitalized interest 0 <256> <120>
Total interest expense - net $1,613 $1,263 $ 1,351
14. Extraordinary Gain
The Company's Board of Directors has authorized the repurchase (subject to certain bank credit facility restrictions) of up to $12 million in principal amount of the Company's 10.375% convertible subordinated debentures to be used to satisfy redemption requirements which began in April 1991. As of December 31, 1997, $7,697,000 principal amount of debentures had been repurchased in market transactions and $3,113,000 were called for redemption. Extraordinary gains on the repurchase of debentures during 1997, 1996 and 1995 have been recognized as follows (in thousands):
1997 1996 1995
Extraordinary gain from repurchase of subordinated debentures before taxes $ 26 $ 8 $ 10 Tax provision (See Note 12) <9> <3> <3> Extraordinary gain from repurchase of subordinated debentures $ 17 $ 5 $ 7
15. Segment Information and Foreign Sales
The Company's operations consist of a single dominant segment which manufactures and distributes several products. These products are related mainly by manufacturing processes requiring lamination of materials and usually involve common technological features such as the slow timed release of various substances. Most products are wholesaled through distributors or to other manufacturers.
Foreign sales, consisting primarily of sales to European countries, were $2.1 million or 5.5% of sales in 1997. In each of 1997, 1996 and 1995, foreign sales were less than 10% of total revenues.
In 1997, there was no single customer nor, to the Company's knowledge, any group of affiliated customers to which sales during the fiscal year ended December 31, 1997 were in the aggregate equal to 10% or more of the Company's consolidated net sales. In 1996 and 1995 sales of transdermal nitroglycerin patches to Mylan Laboratories, Inc. accounted for approximately 10% and 14% of consolidated net sales, respectively.
In June 1997, the FASB issued Statement of Financial Accounting Standards No. 131 "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"). SFAS 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. SFAS 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. SFAS 131 is effective for financial statements for periods beginning after December 15, 1997. In the initial year of application, comparative information for earlier years is to be restated. The Company is still evaluating the impact of SFAS 131 on segment disclosures.
16. Related Party Transactions
The consolidated financial statements include the following items applicable to related parties (in thousands): December 31, Balance Sheets: 1997 1996
Receivable from director and executive officer $337 $311
10.375% convertible subordinated debentures held by directors and executive officers 465 427
Stockholder notes receivable arising from exercise of stock options 148 148
Year ended December 31, Income Statements: 1997 1996 1995
Management fees - charged to selling, general and administrative expense $ 0 $ 0 $ 20
Interest expense - net 22 14 36
17. Minority Interest
A former president of Hercon Laboratories maintains a 1.5% interest in Hercon Laboratories and Hercon Environmental. Equity in Hercon Environmental has generated a $11,000 minority interest.
18. Management Plans
The Company has incurred net losses of $3,258,000, $1,322,000 and $290,000 for the years ended December 31, 1997, 1996 and 1995, respectively, and, as a result has a retained deficit of $6,721,000 as of December 31, 1997. Management developed a plan of action during 1997 which included cost containment measures and the penetration of new markets. Cost containment measures include an organizational restructuring whereby plant overhead, research and development and selling, general and administrative expenses have been reduced. The penetration of new markets includes sales of certain products outside the United States and seeking contract manufacturing opportunities and collaborative partnerships for the development of new transdermal and topical products. Additionally, with respect to its synthetic fabrics products, the Company has restructured the sales department, redefined product lines, introduced new products to the market and focused its efforts on traditionally high margin products. Management intends to continue to refine and enhance this plan during 1998.
The Company is currently developing strategies which will enable it to retire or refinance the remaining $8 million in debentures by April 15, 1999.
SIGNATURES
Pursuant to the requirements of Sections 13 or 15(d) 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.
HEALTH-CHEM CORPORATION
Date: March 26, 1998
/s/ Marvin M. Speiser /s/ Paul R. Moeller By: Marvin M. Speiser By: Paul R. Moeller Chairman of the Board and Vice President-Finance President (Principal (Principal Financial Officer) Executive Officer) (Principal Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following Directors on behalf of the Registrant on the dates indicated:
/s/ Martin Benis /s/ Bruce M. Schloss Martin Benis March 26, 1998 Bruce M. Schloss March 26, 1998
/s/ Steven Bernstein /s/ Marvin M. Speiser Steven Bernstein March 26, 1998 Marvin M. Speiser March 26, 1998
/s/ Matthew Goldstein /s/ Robert D. Speiser Matthew Goldstein March 26, 1998 Robert D. Speiser March 26, 1998
/s/ Paul R. Moeller /s/ Milton Y. Zussman Paul R. Moeller March 26, 1998 Milton Y. Zussman March 26, 1998
/s/ Eugene Roshwalb Eugene Roshwalb March 26, 1998