UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF
THE EXCHANGE ACT
FOR THE TRANSITION PERIOD FROM _____________ TO _____________
COMMISSION FILE NO. 000-29245
HEALTH & NUTRITION SYSTEMS INTERNATIONAL, INC.
----------------------------------------------
(Exact name of small business issuer as specified in its charter)
FLORIDA
-------
(State or other jurisdiction of incorporation or organization)
65-0452156
----------
(I.R.S. Employer Identification Number)
3750 INVESTMENT LANE, SUITE 5, WEST PALM BEACH, FLORIDA 33407
-------------------------------------------------------------
(Address of principal executive offices)
(561) 863-8446
--------------
(Issuer's telephone number)
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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 [ ]
There were 3,832,813 shares of common stock, $0.001 par value, of the
registrant outstanding at March 31, 2004.
Transitional Small Business Disclosure Format: Yes [ ] No [X]
HEALTH AND NUTRITION SYSTEMS INTERNATIONAL, INC.
------------------------------------------------
INDEX
Page
---------------
Facing Sheet...................................................................... Cover Page
Index............................................................................. ii
Part I - Financial Information
Item 1. Financial Statements 1
Condensed Balance Sheet as of March 31, 2004 (Unaudited)................. 1
Condensed Statements of Operations for the three
months ended March 31, 2004 and 2003 (Unaudited)........................ 2
Condensed Statements of Cash Flows for the three months ended March 31,
2004 and 2003 (Unaudited)................................................ 3
Notes to Condensed Financial Statements.................................. 4-6
Item 2. Management's Discussion and Analysis or Plan of Operations...... 7
Item 3. Controls and Procedures......................................... 17
Part II - Other Information
Item 1. Legal Proceedings.................................................. 17
Item 2. Changes in Securities.............................................. 18
Item 3. Defaults Upon Senior Securities.................................... 18
Item 4. Submission of Matters to a Vote of Security Holders................ 18
Item 5. Other Information.................................................. 18
Item 6. Exhibits and Reports on Form 8-K................................... 19
Signature......................................................................... 20
ii
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
HEALTH & NUTRITION SYSTEMS INTERNATIONAL, INC.
CONDENSED BALANCE SHEET
(UNAUDITED)
ASSETS
------
MARCH 31, 2004
--------------
Current assets:
Cash $ 58,586
Accounts receivable, net 282,601
Inventory 1,001,254
Prepaid expenses 45,198
-----------
Total current assets 1,387,545
-----------
Property and equipment, net 67,431
-----------
Other assets:
Trademarks, net 986
Security deposits 6,425
-----------
Total other assets 7,411
-----------
Total assets $ 1,462,387
===========
LIABILITIES AND STOCKHOLDERS' DEFICIT
-------------------------------------
Current liabilities:
Accounts payable $ 657,164
Accrued expenses 281,411
Notes payable, current portion 504,671
-----------
Total current liabilities 1,443,246
-----------
Notes payable, less current portion 163,940
-----------
Total liabilities 1,607,186
-----------
Stockholders' deficit:
Common stock, $0.001 par value, authorized 30,000,000
shares; 3,832,813 shares issued and outstanding 3,830
Additional paid-in capital 858,612
Accumulated deficit (1,007,241)
-----------
Total stockholders' deficit (144,799)
-----------
Total liabilities and stockholders' deficit $ 1,462,387
===========
See accompanying notes to condensed financial statements.
-1-
HEALTH & NUTRITION SYSTEMS INTERNATIONAL, INC.
CONDENSED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31
2004 2003
----------- -----------
Net Revenue $ 1,489,377 $ 1,065,548
Cost of sales 639,936 451,418
----------- -----------
Gross profit 849,441 614,130
----------- -----------
Operating expense:
General and administrative expense 450,471 341,194
Advertising and promotion 473,814 162,411
Depreciation and amortization 5,897 7,443
----------- -----------
Total operating expense 930,182 511,048
----------- -----------
Income (loss) from operations (80,741) 103,082
----------- -----------
Other income (expense):
Interest expense (9,999) (10,829)
----------- -----------
Income (loss) before income taxes (90,740) 92,253
----------- -----------
Benefit (provision) for income taxes -- --
----------- -----------
Net income (loss) $ (90,740) $ 92,253
=========== ===========
Net income (loss) per share - basic $ (0.02) $ 0.03
=========== ===========
Net income (loss) per share - diluted $ (0.02) $ 0.03
=========== ===========
Weighted average number of shares - basic 3,832,813 3,629,813
=========== ===========
Weighted average number of shares - diluted 3,832,813 3,629,813
=========== ===========
See accompanying notes to condensed financial statements.
-2-
HEALTH & NUTRITION SYSTEMS INTERNATIONAL, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
2004 2003
--------- ---------
Net cash provided by operating activities $ 184,506 $ 189,106
--------- ---------
Cash flows from financing activities:
Repayments on notes payable (133,326) (101,500)
Repayments on capital leases -- (714)
--------- ---------
Net cash used in financing activities (133,326) (102,214)
--------- ---------
Net increase (decrease) in cash 51,180 86,892
Cash, beginning of period 7,406 14,778
--------- ---------
Cash, end of period $ 58,856 $ 101,670
========= =========
See accompanying notes to condensed financial statements.
-3-
HEALTH & NUTRITION SYSTEMS INTERNATIONAL, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
NOTE 1 - BASIS OF PRESENTATION
------------------------------
The accompanying unaudited condensed financial statements of Health & Nutrition
Systems International, Inc. (the "Company") have been prepared in accordance
with generally accepted accounting principles for interim financial information
and Regulation S-B. Accordingly, they do not include all of the information and
footnotes required for complete financial statements.
In the opinion of management, all adjustments (consisting of normal recurring
accruals) considered necessary for a fair presentation of the results for the
interim periods presented have been included.
These results have been determined on the basis of generally accepted accounting
principles and practices applied consistently with those used in the preparation
of the Company's Annual Financial Statements for the year ended December 31,
2003. Operating results for the three months ended March 31, 2004 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2004.
It is recommended that the accompanying condensed financial statements be read
in conjunction with the financial statements and notes for the year ended
December 31, 2003, found in the Company's Form 10-KSB.
NOTE 2 - REVENUE RECOGNITION
----------------------------
REVENUE RECOGNITION
The Company recognizes revenue when
o Persuasive evidence of an arrangement exists
o Shipment has occurred
o Price is fixed or determinable, and
o Collectability is reasonably assured
Subject to these criteria, except with respect to customers that buy our
products on "pay-on-scan terms," we recognize revenue at the time of shipment of
the relevant merchandise. "Pay-on-Scan" sales are treated as consignment sales
by the Company. In the case of these consignment sales, the Company records
revenues, and removes the items from inventory when the customer reports the
sales to the Company. Normally the Company is notified of the customer's sales
through periodic sales reports, payments, or when the customer reorders the
relevant product.
On March 31, 2004, the Company had approximately $232,000 of inventory on
consignment relating to its "pay-on-scan" sales. On March 31, 2003, the Company
had no outstanding consignment sales.
Included in the net sales in the accompanying financial statements are
reductions for returns and allowances, sales discounts, new store opening
discounts, and co-op advertising and promotions.
NOTE 3 - LEGAL MATTERS
----------------------
The Company from time to time is a party of various legal proceedings. In the
opinion of management, none of the proceedings are expected to have a material
impact on its financial position or results of operations.
-4-
NOTE 4 - MANAGEMENT'S PLANS AND ISSUES AFFECTING LIQUIDITY
----------------------------------------------------------
The Company's condensed financial statements have been prepared assuming that
the Company will continue as a going concern. In the first quarter of 2004, the
Company continued to control administrative costs and its cost of goods.
However, the Company created a reserve of $168,000 for one of its products,
because one of its major customers notified us that they intended to discontinue
selling the product, most likely within 90 days. The Company also increased its
advertising expenditures from approximately $163,000 in the first quarter of
2003, to approximately $455,000 in the first quarter of 2004. Primarily as a
result of the deduction of the reserve in computing net revenues and the
increased advertising expense, in the first quarter of 2004, the Company had a
net loss of $90,740, and cash flow from operations of $184,506. The increased
advertising expenditures were financed in part by profits generated in the third
and fourth quarter of 2003, and in part by a temporary increase in payment terms
by our supplier, Garden State Nutritional. At March 31, 2004, the Company has a
working capital deficit of $55,701 and adverse liquidity ratios.
Management intends to continue to attempt to control costs and monitor financial
capabilities. Management believes controlling costs and financial discipline are
critical to its ability to achieve sustained profitability.
There remains substantial doubt about the Company's ability to continue as a
going concern. The financial statements do not include any adjustments to
reflect the possible effects on the recoverability and classification of assets
or the amounts and classification of liabilities that may result from the
outcome of this uncertainty.
NOTE 5 - STOCK OPTIONS
----------------------
The non-qualified stock option plan adopted by the Company in May 1998
authorized the Company to grant 1,250,000 of its common shares.
The Company has adopted Statement of Financial Accounting Standards No. 123
("SFAS 123"), "Accounting for Stock-Based Compensation." SFAS 123 encourages the
use of a fair-value-based method of accounting for stock-based awards, under
which the fair value of stock options is determined on the date of grant and
expensed over the vesting period. Under SFAS 123, companies may, however,
measure compensation costs for those plans using the method prescribed by
Accounting Principles Board Opinion No. 25 ("APB No. 25"), "Accounting for Stock
Issued to Employees." Companies that apply APB No. 25 are required to include
pro forma disclosures of net earnings and earnings per share as if the
fair-value-based method of accounting had been applied. The Company elected to
account for such plans under the provisions of APB No. 25. The Company accounts
for stock options granted to consultants under SFAS 123.
During the three months ended March 31, 2004, no new options were granted to
officers, directors and employees of the Company. Subsequent to the close of the
quarter, as of April 8, 2004, in conjunction with the execution of a new
employment contract, Mr. Christopher Tisi, our Chief Executive Officer, was
granted options to purchase 50,000 shares of HNS stock at $.30. Those options
have a four-year term.
Had the compensation expense for the stock option plan been determined based on
the fair value of the options at the grant date consistent with the methodology
prescribed under Statement of Financial Standards No. 123, "Accounting for
Stock-Based Compensation," at March 31, the Company's net income and earnings
per share would have been reduced to the proforma amounts indicated below:
-5-
MARCH 31, 2004
--------------
Net income
As reported $ ($90,740)
=============
Pro forma $ ($90,740)
=============
Earnings per share
As reported $ ($0.02)
==============
Pro forma $ $0.02)
==============
The fair value of each option is estimated on the date of grant using the fair
market value option-pricing model with the following assumptions:
Risk-free interest rate 4.5% - 6.5%
Expected life (years) Various
Expected volatility 1.23
Expected dividends None
NOTE 6- NOTES PAYABLE
---------------------
In July 2003, the Company issued an amended promissory note to Garden State
Nutrition in the principal amount of $1,300,000 bearing interest at 4.5% per
annum. The balance of the note at March 31, 2004 was $645,687. The note is
payable in quarterly installments of $131,410.
In January 2004, the Company purchased a vehicle for use by its salesperson, and
issued a note to a financial institution for $23,356. The balance of the note at
March 31, 2004 was $22,923.
-6-
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.
This quarterly report on Form 10-QSB contains forward-looking statements. Any
statements that are not statements of historical fact should be regarded as
forward-looking statements. For example, the words "intends," "believes,"
"anticipates," "plans," and "expects" are intended to identify forward-looking
statements. There are a number of important factors that could cause our actual
results to differ materially from those indicated by such forward-looking
statements. These factors include without limitation those factors contained in
our Form 10-KSB filed with the Securities and Exchange Commission. We do not
undertake any obligation to update any such factors or to publicly announce the
result of any revision to any of the forward looking statements contained herein
to reflect future events or developments.
The following discussion of our results of operations and financial condition
should be read together with our unaudited Financial Statements contained in
Part I, Item 1 and the related Notes in this Form 10-QSB and our audited
Financial Statements and the related Notes contained in our Form 10-KSB filed
with the Securities and Exchange Commission.
CRITICAL ACCOUNTING ESTIMATES
Financial Reporting Release No. 60, which was released by the U.S. Securities
and Exchange Commission, encourages all companies to include a discussion of
critical accounting policies or methods used in the preparation of financial
statements. Our financial statements include a summary of the significant
accounting policies and methods used in the preparation of our financial
statements.
Management believes the following critical accounting policies affect the
probable returns, significant judgments and estimates used in the preparation of
the financial statements.
REVENUE RECOGNITION
We recognize revenue when
o Persuasive evidence of an arrangement exists
o Shipment has occurred
o Price is fixed or determinable, and
o Collectability is reasonably assured
Subject to these criteria, except with respect to customers that buy our
products on "pay on scan terms," we recognize revenue at the time of shipment of
the relevant merchandise. "Pay on scan" sales are treated as consignment sales
by us. In the case of these consignment sales, we record revenues, and remove
the items from inventory when the customer reports the sales to us. Normally we
are notified of the customer's sales through periodic sales reports, payments or
when the customer reorders the relevant product.
On March 31, 2004, we had approximately $232,000 of inventory on consignment
relating to its "pay on scan" sales. At March 31, 2003, we had no inventory on
consignment.
Included in the net revenue in the accompanying financial statements for the
three months ended March 31, 2004 and 2003 are reductions for returns and
allowances, sales discounts, new store opening discounts and co-op advertising
and promotions in the aggregate amounts of $595,769 and $551,237 , respectively.
The larger reductions in the first quarter of 2004 were primarily due to
increases in sales returns and allowances, including the deduction of $168,000
as a reserve against a single product, which one of our major customers
indicated that they would stop selling.
-7-
USE OF ESTIMATES
Management's discussion and analysis of financial condition and results of
operations is based upon our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of
America. The preparation of these financial statements requires management to
make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues, and expenses, and related disclosure of contingent assets
and liabilities. On an ongoing basis, management evaluates these estimates,
including those related to valuation allowance for the deferred tax asset,
estimated useful life of fixed assets and the carrying value of long-lived
assets, intangible assets and allowances for sales returns, doubtful accounts,
and obsolete and slow moving inventory and reserve for customer liabilities.
Management bases these estimates on historical experience and on various other
assumptions that are believed to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying value of
assets and liabilities that are not readily apparent from other sources. Actual
results may differ from these estimates under different assumptions or
conditions.
CUSTOMER LIABILITY ESTIMATES
The Company estimates and accrues expenses and liabilities for co-op advertising
and promotions and expenses for discontinued products as a reduction of sales.
The liability is maintained until the customer takes the deduction against
payments due. This liability is netted against the accounts receivable account
on the balance sheet. The amount at March 31, 2004 was $875,255.
We may incur a liability to a customer in three ways:
o We and the customer may agree that if the customer includes an
advertisement for our products in the customer's advertising
circulars, we will discount our products to the customer
during the period of time surrounding the use of the
circulars;
o Some of our customers have a policy that require us to fund
cooperative advertising and promotions in an amount equal to
10% to 15% of the gross revenue generated within the year; and
o In some cases, if the dating of our product in inventory at
the customer's location expires, the customer may seek a
credit from us.
We record the liability when we determine that the customer is taking an action
that will result in an expense to the Company in the future. For example, when
we agree to fund an advertising promotion in a given month, we create a
liability for that promotion. We also establish reserves for returns we believe
likely. The actual payments to the customer are made when the customer makes a
deduction on its remittances for outstanding invoices. Typically, these
liabilities remain outstanding for three to six months.
RECENT DEVELOPMENTS
In July of 2003, the Board of Directions determined to consider strategic
alternatives to either enhance or replace our neutraceutical business. The Board
intends to continue to assess what steps can be taken to realize greater value
for our shareholders. These include the possibility of acquiring additional
businesses for stock and/or the sale of the Company or substantially all of its
assets, including the ongoing possibility of such a sale to our Chief Executive
Officer and President, Christopher Tisi, or an entity controlled by him.
-8-
On November 26, 2003, we entered into an agreement with TeeZee, Inc., a company
wholly owned by Mr. Tisi, our chief executive officer and president, to sell
TeeZee, Inc. substantially all of our assets, subject to approval by our
shareholders, for $411,000 in cash and notes and the assumption of substantially
all of our liabilities. Prior to entering into the definitive agreement, the
Board of Directors considered strategic alternatives with particular attention
to the risks associated with our diet-related nutraceuticals business and the
increasingly challenging regulatory, legal and insurance environment for the
nutraceuticals industry, and weighed them against the offer from TeeZee, Inc.
and determined that, at that time, the proposed sale was in the best interests
of our shareholders. The Board also hired an investment advisory firm,
Capitalink, to render an opinion as to the fairness of the transaction, from a
financial point of view. Mr. Tisi subsequently informed us that based upon the
expiration of his employment agreement on December 31, 2003, if the sale was not
approved by our shareholders, he would terminate his employment with us. In
February 2004, we restated our earnings for the third quarter of 2003, which
lowered our reported earnings for the period. At that time, Mr. Tisi also told
the Board he was willing to continue to serve as our chief executive officer -
subject to the execution of a definitive agreement - even if the Board decided
not to accept his offer. Capitalink thereafter rescinded its fairness opinion
which was based in part on the third quarter results. As a result, on February
23, 2003, we terminated the agreement with Tee Zee, Inc. Tee Zee, Inc. has left
open its offer to purchase substantially all of our assets. The Board of
Directors continued to review TeeZee's offer in light of developments subsequent
to the termination of the agreement. On April 22, 2004, the Board rejected the
offer. The Board primarily based its decision as not in the current best
interest of the shareholders, the current market value of the Company's shares,
current operations, and Mr. Tisi's recent agreement to stay with the company
through December 31, 2005. In addition, the Board chose to afford itself more
time to consider strategic alternatives. The Board intends to continue to
consider strategic alternatives to increase shareholder value, which
alternatives may include the sale of our current business, a merger or other
combination with another enterprise, or both.
On April 9, 2004, Mr. Tisi entered into a new two-year employment contract,
effective as of January 1, 2004. The contract
o increases his base salary from $147,000 to $164,000;
o provides for a quarterly bonus of the sum of 5% of the
increase in net revenues compared to the comparable quarter
for the prior year and 10% of net income. One third of the
bonus is payable at the conclusion of the applicable quarter;
one third is payable on the conclusion of the following
quarter based on cumulative results for the year through the
end of such quarter compared to the prior year's year-to-date
results, and one third is payable at year-end based on a
comparison to the prior years results. Amounts paid in any
quarter are not subject to refund;
o provides for the payment of the unpaid portion of his 2003
bonus ($162,271) and the incremental increase in his annual
salary in 12 equal monthly installments beginning April 1,
2004;
o provides for an annual grant of options to purchase 50,000
shares of our common stock under the 1998 Stock Option Plan;
o provides for the payment of $275,000 in severance upon a
change in control of the Company if we terminate the agreement
other than for cause, unless we enter into an agreement
regarding his continued employment;
o provides that he will not compete with us for a one-year
period after the termination of the contract (other than
termination without cause) in the wholesale distribution of
sale in the United States to retailers or intermediaries of
products which directly or otherwise significantly compete
with products sold or distributed by the Company.
-9-
Mr. Tisi has developed relationships with our customers, vendors and other
industry participants that have enabled us to maintain our operations and, in
the last year, grow our business. The loss of his services would severely impair
our ability to function as we currently do. In addition to being our CEO, Mr.
Tisi is responsible for our product development, marketing, operations and
finance. We have reviewed, and continue to review, supplementing Mr. Tisi's
activities with additional executive capacity, but working capital limitations
limit our ability to identify and recruit appropriate candidates.
To partially mitigate our sole reliance on Mr. Tisi, the Board has expanded the
role of our Chairman, James Brown. Mr. Brown, who has to-date focused primarily
on opportunities that might strategically enhance shareholder value, will have
more day-to-day interaction in areas such as financial management and strategic
direction. For these services, Mr. Brown's compensation was increased in
February 2004 from $3,000 per month to $8,000 per month through July 31, 2004.
OVERVIEW
We believe that industry trends as well as factors specific to us will impact
our future results. Following are some key points that we believe are important
in understanding our position today, and our outlook for the future.
Trends in our industry
----------------------
According to the Nutrition Business Journal, revenues from the sale of dietary
supplements in year 2003 were up approximately two percent (2%) from those
reported in year 2002. No reliable statistics are yet available for the first
quarter of 2004. Particularly, because of their popularity, increased consumer
use of low carbohydrate diets will benefit products like ours. Our product
formulae are not proprietary. Similar formulations to our flagship product, Carb
Cutter(R), have been developed and have achieved full distribution at all of our
customers. Substantially all of our competitors have greater resources and name
recognition than we do. Many of our competitors sell, in addition to diet
products, a broad range of health and nutrition products. Many of our
competitors sell to the same customers as we do. In addition to our existing
competitors, we believe some of these potential competitors will begin to market
carbohydrate diet assisting products. In this respect, the very popularity of
the low carbohydrate diets may encourage additional stronger competitors to
compete with us. In addition, GSN, our sole manufacturer, sells similar products
to our competitors, often with similar formulations.
We try to differentiate our products through the mixture of ingredients in our
products and the amounts of such ingredients contained in our products. We also
trademark our proprietary brand names. We believe that this helps us to maintain
consumer loyalty to our brand rather than to a specific ingredient or
combination of ingredients. We also strive to differentiate our products by
providing distinctive packaging. None of our efforts in differentiating
ourselves, however, will insure that existing or potential competitors will not
erode our market share.
Until and unless we develop additional products that are accepted by the market,
we remain largely dependent on the sales of one product, Carb Cutter(R). This
strategy is intended to minimize the impact of a shift in consumer preferences
with regard to any one of our products, a change in retailer attitude with
respect to any of our products, or any other cause of reduced sales either for a
particular product or in a particular geographical area.
-10-
The most significant barrier to entry within our industry is the difficulty of
establishing a new product. This involves significant commitment to advertise
the product, participate in trade shows, build inventory, and pay the cost of
entry with slotting fees and or free merchandise. Test marketing also requires a
significant commitment of time and capital. Those factors effect us as well as
our competition. Many of our competitors are significantly better capitalized
and have significantly more human resources than us.
NET REVENUE AND INCOME
----------------------
In the first three months of 2004, we have been able to increase net revenues
and maintain control over our administrative costs and cost of sales. The net
revenues for the three months ended March 31, 2004 were $1,489,377 compared to
$1,065,548 for the same period in 2003, an increase of $423,829, or 40%. General
and administrative expenses for the three months ended March 31, 2004 were
$450,471 compared to $341,194 for the same period in 2003, an increase of
$109,277, or 32%. While administrative costs rose, their rate of increase was
less than the rate of our rise in revenue. The cost of sales, as a percentage of
net sales, increased by only 0.6% for the three months ended March 31, 2004
compared to March 31, 2003. The gross profit for the three months ended March
31, 2004 was $849,441, or 57.0% of net revenue compared to the same period in
2003 of $614,130, or 58.6%, an increase of $235,311. The increase in net revenue
is largely attributable to sales of Carb Cutter(R) and Carb Cutter(R) Phase 2,
to two major customers. However, more competitors are introducing very similar
products and the higher level of competitor may adversely affect the sale of
these products.
We believe that increasing advertising expenditures by $311,403 during the three
months ended March 31, 2004 was a significant factor in the increase in net
revenues during the period. A substantial portion of the advertising
expenditures came from a temporary increase in payment terms granted to us by
our product supplier, Garden State Nutritional, and the profits generated in the
third and fourth quarter of 2003. We do not know whether Garden State will
continue to extend our payment terms. If they do not, we may have to curtail
advertising in subsequent periods.
We had a loss of ($90,740) for the three months ended March 31, 2004 compared to
net income of $92,253 in the first quarter of 2003, a decrease of $182,993. This
decrease was primarily because of
o a reserve of $168,000 for one of our products, which one of
our customers discontinued selling;
o increased advertising expenses; and
o increased insurance costs.
During the three months ended March 31, 2004, six companies accounted for
approximately 90% of our net revenues compared to 82% in the first quarter of
2003. Further, our two largest customers accounted for 81% of the net revenue in
the first quarter 2004 compared to 58% in the first quarter of 2003. Although we
are encouraged by the increase in net revenues generally, the increased
concentration of our business in fewer customers makes us more vulnerable to
changes in their purchasing practices or, in some cases, the customers'
reluctance to do business with a supplier where that customer's volume with that
supplier represents too large a part of the supplier's total sales.
INSURANCE
---------
Insurance for the products we sell has become significantly more expensive. The
policy became effective in March 2004 and carried a premium of $157,000, which
is over twenty times higher than our prior policy. Because it is written on a
"claims made" rather than an "occurrence" basis, it does not provide as much
continuity of coverage as we historically have enjoyed. We purchased $5,000,000
worth of coverage for 2004, as opposed to the $6,000,000 we had in 2003. While
we believe the level of coverage is adequate to meet the needs of our customers
and provide us with appropriate risk protection, there is no assurance that we
will be able to obtain coverage in the future. We do not believe that we will be
able to secure "claims made" coverage in the foreseeable future.
-11-
INCREASED COSTS
---------------
The increasing oversight mandated by the Sarbanes-Oxley Act coupled with changes
we have made in response to the occurrences, giving rise to the earnings
restatement for the third quarter of 2003, have led to the following.
o Our auditor, Daszkal Bolton, is spending more time in
assessing our internal controls and assisting us in
implementing other provisions of the Sarbanes-Oxley Act.
o The audit committee has expanded their review and interaction
with management.
o Our costs for legal and other professional services, including
the retention of professionals to consult on areas related to
Sarbanes-Oxley, have and will rise significantly.
ADEQUATE WORKING CAPITAL
------------------------
Our working capital situation improved in 2003, but deteriorated by
approximately $222,800 in the first quarter of 2004. At March 31, 2004, we had a
working capital deficit of ($55,701). Cash constraints continue to limit our
ability to grow. In addition, a change in our sole manufacturer's informal
financing arrangements with us, which occasionally enable us to exceed our
payment terms, could make it difficult or impossible to support our current
level of sales. The loss or reduction in sales to any of our key customers would
also negatively impact our working capital. Management and the Board of
Directors continue to explore alternative sources of capital to fund operations
and support potential growth, but we have not identified any financing sources
superior to or as good as that provided to us by our sole manufacturer.
DIVERSIFICATION
---------------
We intend to continue to implement our strategic plan of diversifying our
product line by developing and promoting new products. For example, in 2003, we
received initial orders for our new Carb Cutter(R) Phase 2 product, and, by
year's end, introduced Zoom(R). We will introduce two new products in the second
quarter of 2004. There is no assurance that these products will experience
widespread consumer acceptance. It is too early to determine whether customers
will accept Carb Cutter(R) Phase 2 on a long term basis, or whether our Zoom(R)
product or our other new products will be successful. Our strategy is intended
to minimize the impact of a shift in consumer preferences with regard to any one
of our products, a change in retailer attitude with respect to any of our
products, or any other cause of reduced sales either for a particular product or
in a particular geographical area. Despite the introduction of new products, we
remain significantly dependent on a single brand, the original Carb Cutter(R).
RESULTS OF OPERATIONS
We report our net revenue after deducting:
o co-op advertising and promotions given to the customers to
promote the product and improve sales;
-12-
o cash discounts;
o slotting fees and new store discounts; and
o returns and allowances.
In the first quarter of 2004, the aggregate amount of the deductions was
$595,769 compared to $551,237 in the first quarter 2003, an increase of 8%
compared to an increase in net revenue of 40%. The increase was less than the
amount of increase in net revenues despite the $168,000 reserve that we created
for the potential return of product from a key customer. Some of our new major
customers do not ask us to participate in co-op-advertising and other
promotions.
NET REVENUES
Net revenues, for the three months ended March 31, 2004 were $1,489,377 an
increase of $423,829, or 40%, compared to net revenues of $1,065,548 for the
three months ended March 31, 2003. Net revenues from two of our major customers
increased by $591,590 and accounted for 81% of our net revenue in 2004 compared
to 58% of our net revenue in 2003. We believe the increase was primarily driven
by increased sales of our Carb Cutter(R) products. Increases in our in-house
advertising by $311,403 significantly contributed to the increase in net
revenue. During the three months ended March 31, 2004, six customers accounted
for 90% of net revenue, compared to 82% in the same period of 2003.
NET INCOME (LOSS)
Our net loss for the three months ended March 31, 2004, was ($90,740), compared
to a profit of $92,253 for the three months ended March 31, 2003, a decrease of
$182,993. Net loss per share was ($0.02) for the three months ended March 31,
2004, as compared to a net profit of $0.03 per share for the three months ended
March 31, 2003. This decrease was primarily because of
o a reserve of $168,000 for one of our products, which one of
our customers discontinued selling;
o increased advertising expenses; and
o increased insurance costs.
COST OF SALES
Cost of sales for the three months ended March 31, 2004 was $639,936, or 43% of
net revenues, as compared to $451,418, or 42% of net revenues for the
corresponding period in 2003. The dollar amount is higher because of increased
sales during the period. While our cost of sales will always grow as an absolute
number as sales volume increases, we believe that our cost of sales will
maintain its current ratio to sales in the immediate future.
GROSS PROFIT
Gross profit for the three months ended March 31, 2004 was $849,411 an increase
of $235,311 or 38% compared to gross profit of $614,130 for the three months
ended March 31, 2003. As a percent of net sales, gross profit was 57% for the
three months ended March 31, 2004, compared to 58% for the three months ended
March 31, 2003. The increase in gross profit of $235,311 was primarily due to an
increase in net revenue, primarily from increased sales of Carb Cutter(R) and
Carb Cutter(R) Phase 2 products.
-13-
OPERATING EXPENSES
Operating expenses are made up of three expense classifications:
o Advertising;
o General and Administration; and
o Depreciation and Amortization.
Operating expenses were $930,182 for the three months ended March 31, 2004,
representing an increase of $419,134 compared to $511,048 for the three months
ended March 31, 2003. As a percent of net revenues, operating expenses were 62%
for the three months ended March 31, 2004, compared to 48% for the three months
ended March 31, 2003.
Advertising and promotion expenses for the three months ended March 31, 2004
were $473,814, representing an increase of $311,403, compared to $162,411 for
the three months ended March 31, 2003. The increase in advertising expenditures
has, in our opinion, been a significant factor in increasing sales.
General and administrative expenses were $450,471 for the three months ended
March 31, 2004, compared to $341,194 for the three months ended March 31, 2003,
an increase of $109,277; however as a percentage of net revenue, general and
administrative expenses were 30% in the first quarter of 2004 compared to 32% in
the first quarter of 2003, reflecting our continued efforts to control general
and administrative expenses.
INVENTORY
The inventory at December 31, 2003 was $1,159,470 compared to March 31, 2004 at
$1,001,160, a decrease of $158,310, or 14%. The decrease reflects normal
fluctuations in ordering new inventory. The reduction in depreciation
amortization expense from $7,443 in the three months ended March 31, 2003 to
$5,897 in the three months ended March 31, 2004, is primarily attributable to
the sale of the Acutrim(R) brand.
LIQUIDITY & CAPITAL RESOURCES
At March 31, 2004, the Company had a working capital deficit of $55,701,
compared to a $693,965 working capital deficit at March 31, 2003. At the end of
2003, the Company had positive working capital of $167,140.
Net cash provided by operating activities for the three months ended March 31,
2004 was $184,505 compared to $189,106 for the three months ended March 31,
2003. The primary activities providing the cash was the decrease in the accounts
receivables and a decrease in the inventory.
-14-
Net cash used in financing activities for the three months ended March 31, 2004
was $133,326 compared to net cash used by financing activities of $102,214 the
three months ended March 31, 2003. This is primarily attributable to the
repayment of a portion of the note to Garden State Nutritionals.
Mr. Tisi's bonus is based on a formula contained in his employment agreement
dated April 7, 2004, as follows:
o 5% of the increase in net revenues for the period as measured
against the corresponding period the year before, plus
o 10% of net income for the period.
With respect to actual payment of the bonus, 33.3% of it is paid when we file
our first quarter 10-QSB. The second 33.3% will be paid after the second
quarter, and is contingent upon operating performance. The final third is
payable after filing our 2004 annual report (Form 10-KSB), and is also
contingent on operating performance. Mr. Tisi is not required to return any
amounts paid to him in prior quarters. We accrued the full amount of the bonus
in the first quarter.
In early April 2002, we entered into an agreement with GSN, our sole
manufacturer, pursuant to which we agreed to repay to GSN amounts owed to them
as of the date of the agreement. The amount was represented by a promissory note
of approximately $700,000. Our repayment schedule required equal monthly
payments over the next twenty-four months, without interest. In connection with
this agreement, we granted a blanket lien on our assets to GSN. The occurrence
of any of the following events constitute a default under this promissory note:
o the failure of the Company to pay when due any payment of
principal and such failure continues for fifteen (15) days
after Lender notifies the Company in writing;
o the Company files for or is granted certain relief pursuant to
or within the meaning of the United States Bankruptcy Code, or
any other federal or state law relating to insolvency or
relief of debtors; and
o Christopher Tisi ceases to be the President and Chief
Executive Officer of the Company (unless a replacement
reasonably acceptable to Lender is obtained within thirty
days).
In July 2003, the Company issued an amended promissory note to Garden State
Nutrition in the principal amount of $1,300,000.
The new note provided for $300,000 to be paid before December 31, 2003, with the
balance due in quarterly installments of $131,410 commencing November 1, 2003 at
4.5% per annum. At March 31, 2004, the balance owed to GSN for the note is
$645,687.
In early April 2002, we entered into an exclusive manufacturing agreement with
GSN that provided us with a $450,000 line of credit on current invoices, with
60-day terms. GSN has allowed us to have as much as $1,000,000 outstanding at
certain times under the line of credit. At March 31, 2003, the balance owed to
GSN under this line of credit was $746,130. Under our line of credit, the
balance owed on March 31, 2004 was $467,397. GSN allows us to periodically
exceed our payment terms. There is no assurance that GSN will continue to allow
us to exceed its payment terms in the future.
-15-
Our working capital constraints make it difficult to grow our business, and any
reduction in informal arrangements allowing us to exceed our credit limits or to
increase our payment terms with Garden State Nutritional would have a materially
adverse impact on us. Management and the Board are seeking additional sources to
finance our business. While our cash flow from operations continues to be
positive, we believe that greater capital availability is required to facilitate
future growth and to cover additional expenses.
COMMITMENTS AND CONTINGENCIES
GOVERNMENT REGULATIONS
The processing, formulation, packaging, labeling and advertising of our products
are subject to regulation by one or more federal agencies, including the FDA,
the FTC, the Consumer Product Safety Commission, the United States Department of
Agriculture and the United States Environmental Protection Agency. These
activities are also regulated by various agencies of the states, localities, and
countries in which its products are sold.
Although we cannot predict what new legislation or regulations governing our
activities will be enacted by legislative bodies or promulgated by agencies
regulating our activities. We do know that our industry has come under increased
scrutiny principally due to the FDA's investigation of the use of ephedra. We
believe we will become subject to additional laws or regulations administered by
the FDA or other federal, state, or foreign regulatory authorities. We also
believe the laws or regulations which we consider favorable may be repealed or
more stringent interpretations of current laws or regulations will be
implemented in the future. Any or all of such requirements could be a burden and
costly, to us. Future regulations could:
o require us to change the way we conduct business;
o require us to change the contents of our products;
o make us keep additional records;
o make us increase the available documentation of the properties
of our products; or
o make us increase or use different labeling and scientific
proof of product ingredients, safety or usefulness.
PRODUCT LIABILITY
-----------------
The Company, like other marketers of products that are intended to be ingested,
faces the inherent risk of exposure to product liability claims in the event
that the use of our products results in injury. The Company maintains product
liability insurance coverage of $5,000,000. Because of the increased scrutiny of
our industry, it has become increasingly difficult to obtain and maintain
product liability insurance coverage for products. We applied for coverage with
over 40 different companies, and very few provided us a quote. The cost for
coverage rose in excess of 2,500%, and we procured 16% less coverage than one
year ago.
-16-
GOING CONCERN QUALIFICATION
The Company's accountants have issued a going concern opinion due to the lack of
capital. Because of the uncertainties in our ability to satisfy its future
capital needs, our independent auditors' report on our financial statements for
the year ended December 31, 2003 contains an explanatory paragraph about our
ability to continue as a going concern.
If Garden State Nutritionals, our sole manufacturer, fails to supply our
products in sufficient quantities and in a timely fashion, our business may
suffer. We currently obtain 100% of our manufactured product from a single
source of supply, Garden State Nutritionals. In 2002, we entered into a two year
contract with GSN to manufacture all of our products. In the event that GSN is
unable or unwilling to provide us with the products in accordance with the terms
of our contract, delays in securing alternative sources of supply would result
in a material adverse effect upon our operations.
The Company's continuation is dependent upon its ability to control costs and
attain a satisfactory level of profitability with sufficient financing
capabilities or equity investment.
There is substantial doubt about the Company's ability to continue as a going
concern. The financial statements do not include any adjustments to reflect the
possible effects on the recoverability and classification of assets or the
amounts and classification of liabilities that may result from the outcome of
this uncertainty.
ITEM 3. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures
------------------------------------------------
As of the end of the period, the Company carried out an evaluation of the
effectiveness of the design and operation of its disclosure controls and
procedures pursuant to Exchange Act Rule 13a-14. This evaluation was done under
the supervision and with the participation of the Company's President and its
Controller. Based upon that evaluation, they concluded that the Company's
disclosure controls and procedures are effective in gathering, analyzing, and
disclosing information needed to satisfy the Company's disclosure obligations
under the Exchange Act.
Change in internal controls
---------------------------
There were no significant changes in the Company's internal controls or in other
factors that could significantly affect those controls since the most recent
evaluation of such controls.
PART II - OTHER INFORMATION
---------------------------
ITEM 1. LEGAL PROCEEDINGS.
The Company was involved in litigation with J.C. Herbert Bryant, III, a former
officer, director and one of our shareholders, and KMS-Thin Tab 100, Inc., which
was settled in September 2002. The settlement agreement generally provided for
Bryant and KMS to transfer the registration and ownership of the domain names
Thintab.com, Thintab.CC, and Carbcutter.cc to HNS, and to take other action to
eliminate confusion over the ownership of the Thin Tab(R) name. Additionally,
each of the adverse parties generally released the others. As part of the
settlement, HNS entered into a distribution agreement with Bryant, beginning on
September 26, 2002 and ending on September 25, 2007, permitting Bryant to
purchase certain of its products from HNS and to exclusively distribute those
-17-
products in Florida from Orlando south. HNS also transferred its rights to the
Carbolizer(TM) product to KMS. Carbolizer(TM) contained ephedra and in our
judgment would have required a considerable investment of corporate attention
and money to remanufacture, repackage, and promote, to significantly increase
its revenue share. The value of Carbolizer(TM) in facilitating settlement of the
law suit, and recovering control over more valued HNS trademarks, was deemed of
greater benefit to the Company.
In October 2003, HNS terminated the distribution agreement with KMS based on KMS
breach of material terms of the Agreement. HNS filed suit against KMS-Thin Tab
100, Inc. on December 1, 2003 for breach of contract, trademark infringement and
for a declaration of rights that the Distribution Agreement is terminated and of
no further force and effect. KMS has answered the complaint and filed its own
counterclaim for fraud in the inducement, trademark infringement, dilution and
fraudulent misrepresentation. HNS has scheduled a Motion for Summary Judgment in
this matter for June 9, 2004.
Twenty-two (22) cases have been filed alleging that our Acutrim(R) products
contain Phenylpropanolamine ("PPA") and that those products have caused damage
to the plaintiffs. Many of these cases have been consolidated in class action
suits pending in the U.S. District Court for the Western District of Washington
in Seattle, the Philadelphia County Court of Common Pleas or the Louisiana State
Court. None of the Company's Acutrim(R) products have ever contained, or
currently contains, PPA. Based on that defense, to date, all but one case have
been voluntarily dismissed after delivery to plaintiff's counsel information
substantiating the fact that HNS's products do not presently contain, and have
not contained, PPA, or involuntarily dismissed by court order. The remaining
case, being litigated pro se, remains pending, subject to HNS's filed motion for
summary judgment. No opposition to the pending Motion for Summary Judgment has
been filed.
ITEM 2. CHANGES IN SECURITIES AND SMALL BUSINESS ISSUER PURCHASES OF
EQUITY SECURITIES.
As provided for in his new employment contract, we granted our Chief Executive
Officer, Christopher Tisi, options to purchase 50,000 shares of our common stock
at an exercise price of $.30 per share, the closing price of our stock on April
8, 2004, when we entered into the contract. Mr. Tisi is entitled to the same
grant on each anniversary date of the employment agreement. The options vest
immediately, have a four-year term from the date of grant, and are exercisable
at the fair marked value on the date of grant.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.
None.
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS.
None.
ITEM 5. OTHER INFORMATION.
None
-18-
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits
Exhibit 31.1 Certification Pursuant to Item 601(b)(31) of Regulation
S-B, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.
Exhibit 31.2 Certification Pursuant to Item 601(b)(31) of Regulation
S-B, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.
Exhibit 32.1 Certification Pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(furnished pursuant to Item 601(b)(32) of Regulation S-B).
Exhibit 32.2 Certification Pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(furnished pursuant to Item 601(b)(32) of Regulation S-B).
(b) Reports on Form 8-K during the fiscal quarter ended March 31, 2004.
The registrant filed a report dated February 19, 2004 on Form 8-K on
February 24, 2004, reporting an Item 5 Event.
-19-
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
Date: May 17, 2004 Health & Nutrition Systems International, Inc.
(The "Registrant")
By: /s/Christopher Tisi
----------------------------------
Christopher Tisi
Chief Executive Officer, President,
and Secretary
(Principal executive officer and duly
authorized officer)
-20-
Exhibit Index
EXHIBIT
NUMBER DESCRIPTION
------ -----------
31.1 Certification Pursuant to Item 601(b)(31) of Regulation S-B,
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002.
31.2 Certification Pursuant to Item 601(b)(31) of Regulation S-B,
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(furnished pursuant to Item 601(b)(32) of Regulation S-B).
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(furnished pursuant to Item 601(b)(32) of Regulation S-B).