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Immucor 10-Q 2007
FORM 10-Q
United
States Washington, D. C. 20549
(Mark One)
For the quarterly period ended: August 31, 2007
OR
Commission File Number: 0-14820
IMMUCOR, INC. (Exact name of registrant as specified in its charter)
Registrant’s telephone number: (770) 441-2051
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
As of September 30, 2007: Common Stock, $0.10 Par Value – 69,945,438
IMMUCOR, INC. AND SUBSIDIARIES
FORM 10-Q
INDEX
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FINANCIAL INFORMATION
IMMUCOR, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (Amounts in thousands, except share data)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
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IMMUCOR, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Amounts in thousands, except per share data) (Unaudited)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
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IMMUCOR, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (Unaudited, amounts in thousands)
*Accumulated Other Comprehensive Income balance primarily consists of foreign currency translation adjustments and has no tax effect.
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
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IMMUCOR, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited, amounts in thousands)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
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IMMUCOR, INC. AND SUBSIDIARIES Notes to Condensed Consolidated Financial Statements (Unaudited)
1. NATURE OF BUSINESS AND BASIS OF PRESENTATION
Nature of Business Immucor, Inc. (“Immucor” and, together with its wholly owned subsidiaries, the “Company”) is in the business of developing, manufacturing and marketing immunological diagnostic medical products. The Company operates facilities in the United States, Canada, Europe and Japan. The unaudited condensed consolidated financial statements include the accounts of the Company and all of its subsidiaries.
Basis of Presentation The accompanying condensed consolidated financial statements are unaudited and have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information, and the Securities and Exchange Commission’s (“SEC”) instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments, unless otherwise disclosed in a separate note, considered necessary for a fair presentation of the unaudited condensed consolidated financial statements have been recorded in the interim periods presented. These unaudited, condensed consolidated financial statements should be read in conjunction with the Company’s audited, consolidated financial statements and related notes for the year ended May 31, 2007, included in the Company’s Annual Report on Form 10-K.
The accompanying condensed consolidated financial statements present results of operations for the three months ended August 31, 2007. These results are not necessarily indicative of the results that may be achieved for the year ending May 31, 2008, or any other period.
Basis of Consolidation The condensed consolidated financial statements include the accounts of Immucor and all its subsidiaries. All significant inter-company balances and transactions have been eliminated in consolidation.
2. INVENTORIES
Inventories are stated at the lower of cost (first-in, first-out basis) or market (net realizable value):
3. SHAREHOLDERS’ EQUITY
During the quarter ended August 31, 2007, the Company either withheld from certain option exercises or reacquired from certain restricted stock holders an aggregate of 206,787 shares valued at $5.5 million in compliance with the statutory tax withholding requirements. The Company retired these shares and disclosed their value as ‘Stock repurchases and retirements’ in the condensed consolidated statement of shareholders’ equity and comprehensive income and as ‘Repurchase of common stock’ under financing activities in the condensed consolidated statements of cash flows.
The Company also withheld 18,609 shares valued at $0.5 million from an employee who exercised options and elected to pay the option exercise price by having shares withheld. These shares were also retired and their values were disclosed as ‘Stock repurchases and retirements’ in the condensed consolidated statement of
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shareholders’ equity and comprehensive income and as ‘Non-cash investing and financing activities’ in the condensed consolidated statements of cash flows.
The shares acquired in fiscal 2008 were returned to the status of authorized, but unissued shares.
4. STOCK REPURCHASE PROGRAM
The Company instituted a stock repurchase program in June 1998 for up to 6,075,000 shares of its common stock. On June 1, 2004, August 2, 2004 and December 13, 2005, the Board of Directors authorized the Company to repurchase up to an additional 675,000, 1,125,000 and 1.5 million shares, respectively.
During the quarter ended August 31, 2007, the Company did not make any repurchases in the open market under the 1998 repurchase program. During the quarter ended August 31, 2006, 281,969 shares were repurchased for $4.9 million. As of August 31, 2007, 8,232,944 shares had been repurchased under the program, leaving 1,142,056 shares available for repurchase.
The shares repurchased in fiscal 2007 were returned to the status of authorized, but unissued shares.
5. SHARE-BASED COMPENSATION
Plan summary
The Immucor, Inc. 2005 Long-Term Incentive Plan (the “2005 Plan”) was the only active plan during the first quarter of fiscal 2008. Under the 2005 Plan, management is able to award stock options, stock appreciation rights, restricted stock, deferred stock, and other performance-based awards as incentive and compensation to employees. The maximum number of shares of the Company’s common stock as to which awards may be granted under the 2005 Plan is 3,600,000. The maximum number of shares that may be used for awards other than stock options is 1,800,000, and the maximum number of shares that may be used for grants of incentive stock options is 1,800,000. Options are granted at the closing market price on the date of the grant. Option awards generally vest equally over a four-year period and have a six-year contractual term. Restricted stock awards generally vest equally over a five-year period. The 2005 Plan provides for accelerated vesting of option and restricted stock awards if there is a change in control, as defined in the 2005 Plan.
Valuation method used and assumptions
The fair value of each option grant in the first quarter of fiscal years 2008 and 2007 was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
(1) Based on the U.S. Treasury yield curve in effect at the time of grant. (2) Expected stock price volatility is based on the average historical volatility of the Company’s shares during the period corresponding to the expected life of the options. (3) Represents the period of time options are expected to remain outstanding. The weighted average expected option term was determined using the “simplified method” as allowed by Staff Accounting Bulletin No. 107. The “simplified method” calculates the expected term as the average of the vesting term and original contractual term of the options. (4) The Company has not paid dividends on its common stock and does not expect to pay dividends on its common stock in the near future.
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Impact of adoption of SFAS 123R
On adoption of Statement of Financial Accounting Standard No. 123R, Share-Based Payment (“SFAS 123R”) as of June 1, 2006, the unrecognized compensation expense associated with the remaining portion of the unvested outstanding awards was $4.5 million ($2.9 million, net of taxes). This compensation expense is expected to be recognized through May 2010 on a straight-line basis over the weighted-average vesting period of approximately 1.75 years.
Total share-based compensation expense included in the condensed consolidated statements of income for the three-month periods ended August 31, 2007 and August 31, 2006 was $1.0 million ($0.7 million, net of taxes), and $0.7 million ($0.5 million, net of taxes), respectively. The impact on basic and diluted earnings per share was a reduction by $0.01 per share for each of the three-month periods ended August 31, 2007 and August 31, 2006.
Stock option activity
The options granted under the 2005 Plan during the first quarter ended August 31, 2007 have a six-year term with vesting of 25% at the end of each of the first four years; the restricted shares vest 20% at each anniversary of the issuance date. Compensation costs for stock options with tiered vesting terms are recognized evenly over the vesting periods.
The following is a summary of the changes in outstanding options for the first quarter of fiscal year 2008 ended August 31, 2007:
(1) The aggregate intrinsic value in the above table represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the quarter and the exercise price, multiplied by the number of options).
(2) The weighted-average grant-date fair value of share options granted during the first three months of fiscal years 2008 and 2007 was $11.59 and $7.08, respectively. The total intrinsic value of share options exercised during the first three months of fiscal years 2008 and 2007 was $28.4 million and $1.1 million, respectively.
Restricted stock activity
The Company awarded restricted shares for the first time on June 6, 2006. The following is a summary of the changes in nonvested restricted stock for the first quarter of fiscal year 2008 ended August 31, 2007:
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As of August 31, 2007, there was $9.8 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements. This compensation cost is expected to be recognized through June 8, 2012, based on existing vesting terms with the weighted average remaining expense recognition period being approximately 3.39 years from August 31, 2007.
6. COMPREHENSIVE INCOME
The components of comprehensive income for the three-month periods ended August 31, 2007 and 2006 are as follows (in thousands):
No tax effect is recorded for foreign currency translation adjustments as the foreign net assets translated are deemed permanently invested.
7. INCOME TAXES
The Company adopted the provisions of Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109” (“FIN 48”) on June 1, 2007. The cumulative effect of implementation of FIN 48 is a $0.2 million increase in the liability for unrecognized tax benefits, which will be accounted for as a decrease in the May 31, 2007 balance of retained earnings. As of the adoption date, we had gross unrecognized tax benefits of $5.1 million, which was accounted for as follows (in thousands):
The total balance of unrecognized tax benefits that would affect the effective tax rate, if recognized, is $3.4 million. We do not currently anticipate that the total amount of unrecognized tax benefits will significantly increase or decrease during the twelve month period ending August 31, 2008.
The Company recognizes interest and penalties accrued related to unrecognized tax benefits in income tax expense. Upon adoption of FIN 48 on June 1, 2007, the Company recognized $1.0 million of gross accrued interest expense. The company has not recognized any accrued penalties upon adoption of FIN 48.
The Company is subject to taxation in the U.S. and various states and foreign jurisdictions. The Company’s tax years for the fiscal years ended May 31, 2004, May 31, 2005, and May 31, 2006 are subject to examination by the tax authorities.
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With few exceptions, the Company is no longer subject to U.S. federal, state, local or foreign examinations by tax authorities for years before the fiscal year ended May 31, 2004.
8. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per share in accordance with Statement of Financial Accounting Standard No. 128, Earnings per Share.
Basic earnings per common share are calculated by dividing net income by weighted-average common shares outstanding during the period. Diluted earnings per common share are calculated by dividing net income by weighted-average common shares outstanding during the period plus dilutive potential common shares, which are determined as follows (in thousands, except per share data):
The effect of 45,423 and 377,546 out-of-the-money options for the quarter ended August 31, 2007 and August 31, 2006, respectively, was excluded from the above calculation as inclusion of these securities would be anti-dilutive.
9. SEGMENT AND GEOGRAPHIC INFORMATION
The Company’s operations and segments are organized around geographic areas. Immucor’s “Other” segment includes the operations of Belgium, Portugal and Spain. The foreign locations principally function as distributors of products developed and manufactured by the Company in the United States and Canada. The accounting policies applied in the preparation of the Company’s consolidated financial statements are applied consistently across the segments. Intersegment sales are recorded at market price and are eliminated in consolidation.
Segment information for the three-month periods ended August 31, 2007 and 2006 is summarized below (in thousands).
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The Company’s U.S. operations made net export sales to unaffiliated customers of approximately $1.4 million and $1.2 million for the three months ended August 31, 2007 and 2006, respectively. The Company’s German operations made net export sales to unaffiliated customers of approximately $1.3 million and $0.9 million for the three months ended August 31, 2007 and 2006, respectively. The Company’s Canadian operations made net export sales to unaffiliated customers of approximately $0.4 million for each of the three months ended August 31, 2007 and 2006.
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10. COMMITMENTS AND CONTINGENCIES
Italian subsidiary
As previously reported, the Company’s Italian subsidiary and Dr. Gioacchino De Chirico, the Company’s Chief Executive Officer and the former President of the subsidiary, have been the subjects of a criminal investigation in Milan, Italy centered on payments by several companies to certain Italian physicians allegedly in exchange for favorable contract awards by their hospitals. Dr. De Chirico was charged as the former President of the subsidiary with directing a €13,500 payment to one physician and payments totaling approximately $47,000 to another physician. The subsidiary was charged concerning the €13,500 payment under an Italian law holding the subsidiary responsible for actions allegedly taken by an officer, and it settled these charges in January 2007 on terms that were not material to the Company’s financial condition.
Dr. De Chirico has vigorously denied any wrongdoing, and is contesting the charges against him. The trial began in September 2007 and is expected to continue well into 2008, and appeals of an unfavorable verdict could take several years. The Company has continued to expense Dr. De Chirico’s legal fees under the terms of the standard indemnification agreement applicable to all the Company’s directors.
As previously reported, the Company and Dr. De Chirico have been subject to an SEC investigation concerning these charges in Italy. On September 27, 2007 the SEC agreed to a complete settlement of that investigation. Under the settlement, without admitting or denying any wrongdoing, the Company consented to the entry of an order that it cease and desist from future violations of Sections 13(b)(2)(A), 13(b)(2)(B) and 30A of the Securities Exchange Act of 1934. The SEC did not impose any monetary penalty against the Company or require the Company to take any further action. The SEC also approved a separate settlement with Dr. De Chirico related to the same investigation. Without admitting or denying any wrongdoing, Dr. De Chirico agreed to pay a $30,000 civil penalty and consented to the entry of an order that he cease and desist from causing future violations of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934.
With the settlement in January 2007 by the Company’s Italian subsidiary of the charges against it in Italy, and the settlement of the SEC investigation, the Company does not expect to become subject to any additional fines, penalties and/or other charges imposed by the SEC or any other governmental authority in connection with these circumstances.
Class-action lawsuits
Between August 31 and October 19, 2005, a series of ten class-action lawsuits were filed in the United States District Court for the Northern District of Georgia against the Company and certain of the Company’s current and former directors and officers alleging violations of the securities laws. The Court consolidated these cases for disposition under the caption In re Immucor, Inc. Securities Litigation, File No. 1:05-CV-2276-WSD, designated lead plaintiffs, and permitted the filing of an amended consolidated complaint. The consolidated complaint, brought on behalf of a putative class of shareholders who purchased Immucor stock between August 16, 2004 and August 29, 2005, alleges that the Company’s stock prices during that period were inflated as a result of material misrepresentations or omissions in the Company’s financial statements and other public announcements regarding the Company’s business. The Company denies liability and has vigorously defended the lawsuits.
On May 18, 2007, the Court granted preliminary approval of a proposed settlement of these lawsuits and directed that notice of the settlement be provided to all class members. On September 20, 2007, the Court conducted a hearing to inquire into the fairness, reasonableness and adequacy of the proposed settlement. On September 26, 2007, the Court entered an order granting final approval for the terms of the proposed settlement. Under the settlement, the Company’s insurance carrier agreed to pay $2.5 million to the plaintiff class in consideration of an unconditional release of all claims against the Company and the individual defendants. The Company’s only costs are certain legal defense expenses incurred by the Company, which have been expensed as incurred. The sole remaining open issue - the amount of attorneys’ fees and expenses of litigation the Court will permit plaintiffs’ counsel to recover from the agreed settlement proceeds - has no impact on the Company or its insurer. The Court’s order concludes the Company’s involvement in this litigation and terminates the claims asserted in this litigation as to all class members. Management believes this resolution of the litigation has no material adverse effect on the Company’s financial condition or results of operations.
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Other than as set forth above or as previously reported in the Company’s Annual Report on Form 10-K/A for the fiscal year ended May 31, 2007, as filed with the SEC on September 7, 2007, the Company is not currently subject to any material legal proceedings, nor, to the Company’s knowledge, is any material legal proceeding threatened against the Company. However, from time to time, the Company may become a party to certain legal proceedings in the ordinary course of business. Management does not believe any ongoing legal proceedings, including those summarized above, will have a material adverse effect on the Company’s consolidated financial position.
11. RECENT ACCOUNTING PRONOUNCEMENTS
Income taxes
On July 13, 2006, the FASB issued FIN 48. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes” and prescribes a recognition threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under FIN 48, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. Additionally, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The Company implemented FIN 48 effective June 1, 2007. A more detailed discussion of the effect of the adoption of FIN 48 is included in Note 7, “Income Taxes.”
Fair value measurements
In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 provides guidance for using fair value to measure assets and liabilities. This standard also responds to investors’ requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value and the effect of fair value measurements on earnings. SFAS No. 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances. SFAS No. 157 is effective for the Company in fiscal years beginning June 1, 2008. The Company does not believe SFAS No. 157 will have a material impact on the Company’s results from operations or financial position.
Fair value option for certain financial instruments
On February 15, 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” (“SFAS No.159”) which gives entities the option to measure eligible financial assets, financial liabilities and firm commitments at fair value (i.e., the fair value option), on an instrument-by-instrument basis, that are otherwise not permitted to be accounted for at fair value under other accounting standards. The election to use the fair value option is available when an entity first recognizes a financial asset or financial liability or upon entering into a firm commitment. Subsequent changes in fair value must be recorded in earnings. SFAS No. 159 is effective for the Company in fiscal years beginning June 1, 2008. The Company is currently assessing the effect of implementing this guidance, which is dependent upon the nature and extent of eligible items elected to be measured at fair value upon initial application of the standard. However, the Company does not expect the adoption of SFAS No. 159 to have a material impact on the Company’s results of operations and financial position.
Advance payments for research and development activities
In June 2007, the Emerging Issues Task Force (“EITF”) issued EITF 07-3, “Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities” (“EITF 07-3”). EITF 07-3 addresses the diversity that exists with respect to the accounting for the non-refundable portion of a payment made by a research and development entity for future research and development activities. The EITF concluded that an entity must defer and capitalize non-refundable advance payments made for research and development activities until the related goods are delivered or the related services are performed.
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Entities should continue to evaluate whether they expect the goods to be delivered or services to be rendered. If an entity does not expect the goods to be delivered or services to be rendered, the capitalized advance payment should be charged to expense. EITF 07-3 is effective for the Company in fiscal years beginning June 1, 2008. The Company does not believe the adoption of EITF 07-3 will have a material impact on its results of operations or financial position.
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Certain statements that the Company may make from time to time, including all statements contained in this report that are not statements of historical fact, constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 and the safe harbor provisions set forth in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may be identified by words such as “plans,” “expects,” “believes,” “anticipates,” “estimates,” “projects,” “will,” “should” and other words of similar meaning used in conjunction with, among other things, discussions of future operations, financial performance, product development and new product launches, FDA and other regulatory applications and approvals, market position and expenditures. Factors that could cause actual results to differ materially from those expressed in any forward-looking statement made by, or on behalf of, the Company include the following, some of which are described in greater detail below: lower than expected market acceptance of the Company’s new Galieo Echo instrument; the decision of customers to defer capital spending; the inability of customers to efficiently integrate the Company’s instruments into their blood banking operations; increased competition in the sale of instruments and reagents, particularly in North America; product development or regulatory obstacles; the ability to hire and retain key managers; changes in interest rates; fluctuations in foreign currency conversion rates; the ability of the Company’s Japanese subsidiary to attain expected revenue, gross margin and net income levels; the outcome of any legal claims known or unknown; delays in regulatory approvals required to move Houston manufacturing to another Company facility; other currently unforeseen events that could delay the move; higher than expected Houston closure costs; higher than expected manufacturing consolidation costs; the unexpected application of different accounting rules; and general economic conditions. In addition, the strengthening of the US Dollar versus the Euro, Canadian Dollar and Japanese Yen would adversely impact reported results. Investors are cautioned not to place undue reliance on any forward-looking statements. The Company cautions that historical results should not be relied upon as indications of future performance. The Company assumes no obligation to update any forward-looking statements. Additional information concerning these and other factors which could cause differences between forward-looking statements and future actual results is discussed under the heading “Risk Factors” in the Company’s Annual Report on Form 10-K/A for the year ended May 31, 2007, as filed with the SEC on September 7, 2007.
Overview
Our Business
We develop, manufacture, and sell a complete line of reagents and automated systems used primarily by hospitals, clinical laboratories and blood banks in tests performed to detect and identify certain properties of human blood prior to blood transfusion. We have manufacturing facilities in the United States and Canada. We sell our products from these facilities and through our affiliates in Germany, Italy, Belgium, Spain, Portugal and Japan.
The FDA regulates all aspects of the immunohematology industry, including marketing of reagents and instruments used to detect and identify blood properties. Our industry has been very labor intensive but in recent years it has made noticeable advances in automating certain manual processes. We believe that companies that have successfully introduced new technologies and automated products have seen their profitability improve.
We have introduced several instruments in the past, and we continue to focus on developing new instruments and improving our existing instruments. In June 2007, we received FDA clearance to market our latest instrument, Echo™, which is a compact bench top, fully-automated walk-away instrument for small- and medium-sized hospitals, blood banks and transfusion laboratories. Echo™ uses Capture products, our proprietary reagents, and offers an extensive test menu and significant labor reduction while increasing productivity and patient safety. We expect to increase our market share and revenues from the sale of Echo™ and Galileo® instruments and the sale of Capture products in the near term. Instruments and Capture products currently account for approximately 27% of our revenues.
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Performance
In fiscal 2008, we continued to focus on increasing revenue and in improving gross margins, using the strategies we first implemented in fiscal 2005. We have also concentrated our efforts in successfully marketing the Echo™ after receiving the FDA clearance in June 2007. As part of this effort, in the first quarter of fiscal 2008 (the “2008 Quarter”), we critically examined and modified, where necessary, the changes in our organization structure we had previously made in fiscal 2007, including the hiring and training of additional sales and technical personnel to ensure the smooth introduction of the Echo™. We also continued to place Galileo® instruments in the market.
As of August 31, 2007, we had received purchase orders for a total of 504 Galileo® instruments worldwide (an increase of 23 instruments in the 2008 Quarter), including 292 in Europe, 210 in North America and 2 in Japan, and 456 of these instruments were generating reagent revenues, an increase of 33 instruments in the quarter. We began selling Echo™ in the 2008 Quarter. As of August 31, 2007, we had received purchase orders for a total of 30 Echo™ instruments worldwide.
Our overall gross margin increased to 72% during the 2008 Quarter from 68% achieved in the corresponding quarter of fiscal 2007 (the “2007 Quarter”). The 25% increase in revenue and 7% improvement in overall gross margin during the 2008 Quarter compared to the 2007 Quarter, were largely attributable to the price increases in our traditional reagents (reagents not using our patented Capture technology) introduced in fiscal 2006 and 2007, and to a lesser extent on volume increases in Capture products and sale of instruments.
In the 2008 Quarter, our operating expenses rose by 27% while gross profit increased by 33%, which translated into a 39% increase in net income compared to the 2007 Quarter. Expenses relating to the Echo™ launch and cost associated with the development of the next version of the Galileo® contributed to a higher percentage increase in operating expenses than what we have experienced in the recent past. However, in spite of these additional costs, increased revenues and improved gross margin enabled us to achieve a record quarter in terms of revenue and gross profit. This performance has translated into an increase in our cash resources from $113.6 million at May 31, 2007 to $124.8 million at August 31, 2007.
Business Outlook
For fiscal 2008, our primary focus will be in successfully introducing and marketing the new Echo™ to small- and medium-size customers. We will also continue to focus on placing Galileo® instruments with larger customers. Over the next few years, we expect our core business to shift gradually from being mainly a supplier of traditional reagents to being a major supplier of automated instruments that use our proprietary Capture technology and products. Simultaneously, we intend to increase our research and development efforts to introduce the next version of the Galileo® with additional and improved features.
Additionally, as a result of the planned closure of the Houston, Texas, manufacturing facility scheduled for December 2007 and the subsequent consolidation of production in Norcross, Georgia, and Halifax, Nova Scotia, the Company anticipates a significant reduction in costs, with the benefits expected to be partially realized in the 2008 fiscal year and fully realized in fiscal 2009 and subsequent years.
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Results of Operations
Improved sales and margins, along with a proportionately lower increase in operating expenses, resulted in an increase in net income for the 2008 Quarter of $5.0 million, 39% higher than the 2007 Quarter. Diluted earnings per share totaled $0.25 for the 2008 Quarter, as compared to diluted earnings per share of $0.18 for the 2007 Quarter, an increase of 39%.
United States operations continue to generate the majority of our revenue and operating income. U.S. operations generated 74% and 92%, respectively, of our revenue and operating income in the 2008 Quarter compared to 73% and 92%, respectively, in the 2007 Quarter.
Net Sales
Of the $12.6 million total increase in revenues, approximately $8.7 million came from price increases in the United States, approximately $1.5 million came from volume increases including instrument, warranty and service revenue in the United States, approximately $1.6 million came from sales increases including instrument revenues outside the United States, and the effect of the change in the Euro, Japanese Yen and Canadian Dollar exchange rates increased sales by approximately $0.8 million.
The 20% growth in traditional reagent revenue in the 2008 Quarter compared to the 2007 Quarter occurred mainly as a result of price increases in the United States. Traditional reagent sales have historically been our primary source of revenue and still constitute roughly 70% of our revenues. We expect the significance of this line of products to gradually decline as we place more instruments in the market that use our proprietary Capture products.
Sales of Capture products increased by 30% in the 2008 Quarter compared to the 2007 Quarter mainly due to volume increases. Sales of Capture products are largely dependent on the number of installed instruments requiring the use of Capture reagents. As we succeed in placing more instruments in the market, we expect revenue from Capture products to increase.
Revenue from instruments increased by 56% in the 2008 Quarter compared to the 2007 Quarter. In the 2008 Quarter, $1.6 million of deferred revenue was recognized from previously placed instruments compared to $0.9 million recognized in the 2007 Quarter. Most instrument sales in the United States are recognized over the life of the underlying reagent contract, which is normally five years. In the 2008 Quarter, approximately $2.9
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million of instrument sales and associated service revenues were deferred in this manner, compared to $1.7 million in the 2007 Quarter. As of August 31, 2007 and August 31, 2006, deferred instrument and service revenues totaled $21.4 million and $19.7 million, respectively. In the 2008 Quarter, we received orders for 23 Galileo® instruments compared to 19 orders received for Galileo® instruments in the 2007 Quarter. We expect to place more instruments in the market and increase revenue from this sector of our business.
Human collagen forms a very small part of our business, and we expect to discontinue this product in fiscal 2009 when our manufacturing commitment expires.
Gross Margins
Overall gross margin improved during the 2008 Quarter to 72%, up from 68% in the 2007 Quarter, due to improvement in margins in all three main categories of our business. Gross margin on traditional reagents improved by 6% in the 2008 Quarter as compared to the 2007 Quarter primarily due to price increases.
In the 2007 Quarter, we paid $0.2 million royalties under an agreement which expired in fiscal 2007 for certain Capture products; we did not incur any royalty expenses for these products in the 2008 Quarter. The reduction in royalty expenses largely improved the gross margin on Capture products by 5% in the 2008 Quarter as compared to the 2007 Quarter.
In the case of instruments, comparing gross margin from period to period can be misleading due to the method of accounting used for revenue and cost for certain types of instrument sales. Where sales contracts have price guarantee clauses, instrument costs are expensed when the sale is made, but the related revenue is deferred and recorded as income over the term of the contract. For the 2008 Quarter, the gross margin on instruments was negative 4% and, for the 2007 Quarter, it was negative 31%.
Operating Expenses
Research and development expenses increased by $0.8 million to $2.1 million in the 2008 Quarter. Expenses relating to development of the second generation Galileo® ($0.6 million) accounted for most of the increase.
Selling and marketing expenses increased by approximately $2.0 million to $7.6 million for the 2008 Quarter compared to the 2007 Quarter; impacted primarily by new hires, annual salary increases and other salary related expenses ($0.7 million) and an increase in sales meetings, conventions and travel expenses ($0.5 million). A significant amount of these expenses related to the launch of the Echo™ instrument in June 2007.
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General and administrative expenses increased by $0.7 million as compared to the 2007 Quarter to $5.9 million in the 2008 Quarter. Major variations were an increase in salary, share-based compensation and bonus expenses ($1.4 million) and a reduction in professional services attributable primarily to the reduction in outsourcing of Sarbanes-Oxley compliance work ($1.0 million).
Income Taxes
The provision for income taxes increased $2.8 million to $10.2 million in the 2008 Quarter compared to the tax charge of $7.4 million in the 2007 Quarter, primarily due to higher pre-tax income.
As a result of utilizing compensation cost deductions arising from the exercise of nonqualified employee stock options granted prior to June 1, 2006 for federal and state income tax purposes, we realized income tax benefits of approximately $4.3 million and $0.4 million in the 2008 Quarter and the 2007 Quarter, respectively. As required by U.S. generally accepted accounting principles, these income tax benefits are recognized in our financial statements as additions to additional paid-in capital rather than as reductions of the respective income tax provisions in the consolidated financial statements because the related compensation deductions are not recognized as compensation expense for financial reporting purposes. Our income tax liability is reduced by these amounts.
Non-Operating Income (Expenses):
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