UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-QSB (Mark One) /X/ Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934 For the Quarterly Period Ended: SEPTEMBER 30, 2006 Or / / Transition Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934 For the Period from __________ to __________ Commission File Number: 0-6333 HYDRON TECHNOLOGIES, INC. ------------------------- (Exact name of Registrant as specified in its charter) New York 13-1574215 -------- ---------- (State or other jurisdiction of (I.R.S. Employer Incorporation or organization) Identification Number) 4400 34th Street N, Suite F Saint Petersburg, FL 33714 (727)342-5050 --------------------------- ------------- (Address of Principal Executive Offices) (Registrant's telephone number) 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. X Yes _ No. Number of shares of common stock outstanding as of November 10, 2006: 12,239,736 Transitional Small Business Disclosure Format (Check one): Yes [ ] No [X]. TABLE OF CONTENTS PAGE Part I. Financial Information Item 1. Financial Statements (Unaudited) Condensed Consolidated Balance Sheets -- September 30, 2006 and December 31, 2005 ............................................ 3 Condensed Consolidated Statement of Operations -- Three and nine months ended September 30, 2006 and 2005 ......................... 4 Condensed Consolidated Statements of Cash Flow -- Three and nine ended September 30, 2006 and 2005 ................................ 5 Notes to Condensed Consolidated Financial Statements ............. 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ........................................ 14 Item 3. Controls and Procedures .......................................... 22 Part II. Other Information Item 5. Other Information ................................................ 24 Item 6. Exhibits and reports on Form 8K .................................. 24 2 HYDRON TECHNOLOGIES, INC. Condensed Consolidated Balance Sheets (Unaudited) September December 30, 2006 31, 2005 ------------ ------------ ASSETS Current Assets Cash and cash equivalents ...................... $ 9,278 36,281 Trade accounts receivable, net ................. 58,153 147,130 Inventories, net ............................... 397,013 406,164 Prepaid expenses and other current assets ...... 7,024 31,193 ------------ ------------ Total current assets ........................ 471,468 620,768 Property and equipment, net ...................... 130,704 136,352 Deferred product costs, net ...................... 135,264 160,955 Intangible assets, net ........................... 195,796 222,634 Restricted cash .................................. 93,856 112,334 Deposits ......................................... 23,029 7,579 ------------ ------------ Total Assets ................................ $ 1,050,117 1,260,622 ============ ============ LIABILITIES AND SHAREHOLDERS' DEFICIT Current liabilities Accounts payable ............................... 377,047 333,398 Loans payable, net ............................. 152,865 146,700 Royalties payable .............................. 27,082 29,512 Deferred revenues .............................. 114,148 134,533 Accrued liabilities ............................ 268,626 254,727 Current portion of capital leases payable ...... 25,264 22,648 ------------ ------------ Total current liabilities ................... 965,032 921,518 Long tern liabilities Capital leases payable ......................... 31,287 50,576 Minority interest in consolidated partnership .. 228,759 249,863 Commitments and contingencies .................... - - Shareholders' deficit Preferred stock - $.01 par value 5,000,000 shares authorized; no shares issued or outstanding ................................... - - Common stock - $.01 par value 30,000,000 shares authorized; 12,239,736 and 11,926,836 shares, respectively issued and outstanding ................................... 122,397 119,268 Additional paid-in capital ..................... 21,238,241 21,126,925 Accumulated deficit ............................ (21,527,783) (21,199,712) Treasury stock, at cost 10,000 ................. (7,816) (7,816) ------------ ------------ Total Shareholders' deficit ................. (174,961) 38,665 ------------ ------------ Total liabilities and shareholders deficit .. $ 1,050,117 $ 1,260,622 ============ ============ See accompanying notes to condensed consolidated financial statements 3 HYDRON TECHNOLOGIES, INC. Condensed Consolidated Statements of Operations (Unaudited) Three months ended Nine months ended September 30, September 30, 2006 2005 2006 2005 ------------ ------------ ------------ ------------ Net sales ...................................... $ 458,145 $ 403,704 $ 1,180,475 $ 935,399 Cost of sales .................................. 101,927 163,507 338,744 393,157 ------------ ------------ ------------ ------------ Gross profit ................................... 356,218 240,197 841,731 542,242 Expenses Royalty expense .............................. 5,000 7,500 14,043 25,711 Research and development ..................... 4,516 9 11,483 54,737 Selling, general & administration ............ 321,038 382,718 1,028,844 874,388 Depreciation & amortization .................. 25,410 9,137 76,229 27,411 ------------ ------------ ------------ ------------ Total expenses ............................. 355,964 399,364 1,130,599 982,247 ------------ ------------ ------------ ------------ Operating income (loss) ........................ 254 (159,168) (288,869) (440,005) Interest expense - net ......................... (11,705) (6,515) (60,305) (5,829) ------------ ------------ ------------ ------------ Loss before income taxes and minority interest (11,452) (165,683) (349,174) (445,834) Income tax expense ............................. - - - - Minority interest in net loss of subsidiary .... 6,915 8,904 21,103 27,115 ------------ ------------ ------------ ------------ Net loss ................................... $ (4,537) $ (156,778) $ (328,071) $ (418,719) ============ ============ ============ ============ Basic and diluted loss per share Net loss per common share .................... $ (0.00) $ (0.01) $ (0.03) $ (0.04) ============ ============ ============ ============ Weighted average shares outstanding (basic and diluted) .............. 12,234,395 11,260,136 12,157,642 9,934,129 ============ ============ ============ ============ See accompanying notes to condensed consolidated financial statements. 4 HYDRON TECHNOLOGIES, INC. Condensed Consolidated Statements of Cash Flow (Unaudited) Nine Months ended September 30, 2006 2005 --------- --------- Operating activities Net loss ............................................. $(328,071) $(418,719) Adjustments to reconcile net loss to net cash used in operating activities Minority Interest ................................ (21,103) (27,115) Depreciation and amortization .................... 76,229 27,411 Compensation expense from stock option awards .... 18,880 4,261 Deferred financing costs ......................... 10,701 3,903 Interest expense ................................. 51,030 - Change in operating assets and liabilities Restricted cash .................................... 18,478 (118,894) Trade accounts receivable .......................... 88,977 (30,844) Inventories ........................................ 9,151 2,414 Prepaid expenses and other current assets .......... 24,169 43,986 Deposits ........................................... (15,450) 12,455 Accounts payable ................................... 43,648 53,310 Royalties payable .................................. (2,430) (1,620) Deferred revenues .................................. (20,385) 9,967 Accrued interest ................................... (4,536) 4,440 Accrued liabilities ................................ 13,899 (5,380) --------- --------- Net cash used in operating activities ................ (36,813) (440,425) Investing activities Cash acquired ..................................... - 6,977 Capital expenditures .............................. (18,052) - --------- --------- Net cash from investing activities ................. (18,052) 6,977 Financing activities Loan payable, proceeds ............................... - 149,250 Payments on capital leases ........................... (16,673) - Proceeds from exercise of stock options .............. 44,535 - --------- --------- Net cash provided by (used in) financing activities .. 27,862 149,250 Net decrease in cash and cash equivalents ............ (27,003) (284,198) Cash and cash equivalents at beginning of period ....... 36,281 339,679 --------- --------- Cash and cash equivalents at end of period ............. $ 9,278 $ 55,481 ========= ========= SUPPLEMENTAL CASH FLOW INFORMATION Stock issued to pay accrued interest ................. $ 51,030 - Stock issued in acquisition .......................... - 260,000 Warrants issued in connection with loans payable ..... - 24,000 See accompanying notes to condensed consolidated financial statements. 5 NOTE A - BASIS OF PRESENTATION AND GOING CONCERN The condensed consolidated financial statements included in this report have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission for interim reporting and include all adjustments (consisting only of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation. These financial statements have not been audited. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations for interim reporting. The Company believes that the disclosures contained herein are adequate to make the information presented not misleading. However, these financial statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report for the year ended December 31, 2005, which is included in the Company's Form 10-KSB for the year ended December 31, 2005. The financial data for the interim periods presented may not necessarily reflect the results to be anticipated for the complete year. The accompanying condensed financial statements were prepared assuming that the Company will continue as a going concern. This basis of accounting contemplates the recovery of the Company's assets and the satisfaction of its liabilities in the normal course of operations. The Company anticipates that present working capital balances and internally generated funds will be sufficient to meet our working capital needs for the next three months or longer based on management decisions and sales. The Company's independent accountants issued a "going concern" opinion on the Company's December 31, 2005 financial statements, since the Company has incurred significant losses over the past five years and generates a negative cash flow on a monthly basis. On July 1, 2005, the Company acquired Clinical Results, Inc. (CRI), a St. Petersburg, Florida-based company. CRI is a privately held product development laboratory and contract manufacturer of cosmeceutical and other personal care products. CRI's clients range from mass market retailers to marketers of high end brands, and certain health food store brands. Management believes that Hydron Technologies will benefit from lower manufacturing costs, and be better positioned to build its catalog and internet business, as well as expand the sale of its skin care treatments beyond its historical direct response TV and catalog operations, by utilizing CRI's broker network. The Company's ultimate ability to attain profitable operations is dependent upon obtaining additional financing or achieving a level of sales adequate to support its cost structure. Accordingly, there are no assurances that the Company will be successful in achieving the above objectives, or that such objectives, if realized, will enable the Company to obtain profitable operations or continue as a going concern. 6 NOTE B - ACCOUNTING POLICIES Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires Management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Principles of Consolidation The consolidated financial statements include the accounts of Hydron Technologies, Inc. and its wholly-owned subsidiary CRI purchased as of July 1, 2005, and its majority owned limited liability limited partnership, Hydron Royalty Partners, LLLP. All significant inter-company transactions have been eliminated. Cash and Cash Equivalents The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. The credit risk associated with cash equivalents is considered low due to the credit quality of the issuers of the financial instruments. The cash and cash equivalent balances at September 30, 2006 and December 31, 2005 are covered by the Federal Deposit Insurance Commission. Restricted cash At September 30, 2006, the Company had restricted cash of $93,856, all of which were covered by the Federal Deposit Insurance Commission, which represents funds from a consolidated entity, that are not available for use in the Company's normal operations. Concentration of Credit Risk Trade accounts receivable are due primarily from contract manufacturing customers and are usually paid to the Company within 45 days after receipt of goods. The Company performs ongoing evaluations of its significant customers and does not require collateral, although in some cases it requires deposits or advances. Inventories Inventories are valued at the lower of cost (first-in, first-out) or market, and include finished goods, components and raw materials. 7 Long-Lived Assets The Company reviews long-lived assets and certain identifiable intangibles held and used for possible impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In evaluating the fair value and future benefits of its intangible assets, management performs an analysis of the anticipated undiscounted future net cash flows of the individual assets (or asset groups) over the remaining depreciation/amortization period. The Company recognizes an impairment loss if the carrying value of the asset exceeds the expected future cash flows. During the periods ended September 30, 2006 and 2005, there was no deemed impairment of long-lived assets. Property and Equipment Property and equipment, consisting primarily of furniture and equipment, is carried at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, ranging from four to six years. Deferred Product Costs Deferred product costs consist primarily of costs incurred for the purchase and development of patents and product rights. The deferred product costs are being amortized over their estimated useful lives of five to seventeen years using the straight-line method. Common Stock, Common Stock Options and Net Loss Per Share Prior to January 1, 2006, the Company accounted for employee stock-based compensation using the intrinsic value method supplemented by pro forma disclosures in accordance with APB 25 and SFAS 123 "Accounting for Stock-Based Compensation" ("SFAS 123"), as amended by SFAS No.148 "Accounting for Stock-Based Compensation--Transition and Disclosures." Under the intrinsic value method, the recorded stock-based compensation expense was related to the amortization of the intrinsic value of stock options issued and other equity-based awards issued by the Company. Options granted with exercise prices equal to the grant date fair value of the Company's stock have no intrinsic value and therefore no expense was recorded for these options under APB 25. Other equity-based awards for which stock-based compensation expense was recorded were generally grants of restricted stock awards which were measured at fair value on the date of grant based on the number of shares granted and the quoted price of the Company's common stock. Such value was recognized as an expense over the corresponding service period. Effective January 1, 2006 the Company adopted SFAS 123R using the modified prospective approach and accordingly prior periods have not been restated to reflect the impact of SFAS 123R. Under SFAS 123R, stock-based awards granted prior to its adoption will be expensed over the remaining portion of their vesting period. These awards will be expensed under the accelerated amortization method using the same fair value measurements which were used in calculating pro forma stock-based compensation expense under SFAS 123. 8 For stock-based awards granted on or after January 1, 2006, the Company will amortize stock-based compensation expense on a straight-line basis over the requisite service period, which is generally a four year vesting period. SFAS 123R requires that the deferred stock-based compensation on the condensed consolidated balance sheet on the date of adoption be netted against additional paid-in capital. For the nine months ended September 30, 2006, the Company recorded stock-based compensation expense of $18,880. For the nine months ended September 30, 2005, the Company recognized $0 of stock-based compensation expense under the intrinsic value method. The table below reflects the pro forma impact of valuing compensation expense of awards at fair value: NINE MONTHS ENDED SEPTEMBER 30, 2005 ------------------ Net loss, as reported ...................... $ (418,719) Pro Forma net loss ......................... $ (432,737) ============ Basic and diluted loss per share As reported .............. $ (0.04) ============ Pro forma ............... $ (0.04) ============ 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 Collectibility is reasonably assured. Subject to these criterion, the Company recognizes revenue at the time of shipment of the relevant merchandise. The Company offers its individual consumer customers a thirty-day warranty and estimates an allowance for sales returns based on historical experience with product returns. For the Company's formulation and contract manufacturing business revenue is recognized when the work is complete and the client approves the formula by written correspondence. 9 Shipping and Handling Fees The Company follows the provisions of Emerging Issues Task Force Issue No. 00-10, "Accounting for Shipping and Handling Fees and Costs." Any amounts billed to third-party customers for shipping and handling is included as a component of revenue. Shipping and handling costs incurred are included as a component of cost of sales. Recent accounting Pronouncements In June 2006, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes," which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In accordance with FIN 48, the Company must adjust its financial statements to reflect only those tax positions that are more-likely-than-not to be sustained as of the adoption date. The effective date of FIN 48 for the Company is January 1, 2007. The adoption of FIN 48 is not expected to have a material impact on the Company's condensed consolidated financial statements. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS 157"), which clarifies the definition of fair value, establishes guidelines for measuring fair value, and expands disclosures regarding fair value measurements. SFAS 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 will be effective for the Company on January 1, 2008. The Company is currently evaluating the impact of adopting SFAS 157 on its financial position, cash flows, and results of operations. In September 2006, the Securities and Exchange Commission ("SEC") released Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements" ("SAB 108"). SAB 108 provides interpretive guidance on the SEC's views on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The provisions of SAB 108 will be effective for the Company for the fiscal year ended December 31, 2006. The Company is currently evaluating the impact of applying SAB 108 but does not believe that the application of SAB 108 will have a material effect on its financial position, cash flows, and results of operations. 10 NOTE C - INVENTORIES Inventories consisted of the following at September 30, 2006: Finished Goods ............................... $ 79,516 Raw materials and components ................. 608,251 --------- 687,767 Less : inventory valuation allowance ......... (290,754) --------- Inventories, net ............................. $ 397,013 ========= NOTE D - ACCOUNTS RECEIVABLE Accounts receivable consisted of the following at September 30, 2006: Accounts Receivable ........................... $ 70,903 Less : Allowance for Doubtful accounts ........ (12,750) --------- Accounts Receivable, Net ...................... $ 58,153 ========= NOTE E - SHARE BASED COMPENSATION The Company recognized $18,880 in share based compensation expense for the nine month period ended September 30, 2006. Options to purchase 9,500 shares were granted to employees during the nine months ended September 30, 2006. For the stock-based awards granted on or after January 1, 2006, the Company is amortizing stock-based compensation expense on a straight-line basis over the requisite service period, which is generally a four year vesting period. The fair value for these options was estimated at the date of the grant using a Black-Scholes option pricing model with the following weighted-average assumptions for the period ended September 30, 2006: Risk-free interest rate .... 4.3% Expected life .............. 5 years Expected volatility ........ 124% Expected dividend yield .... 0% 11 The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. As the Company's stock options have characteristics significantly different than those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in Management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock options. NOTE F - LOANS PAYABLE On June 14, 2005, the Company borrowed an aggregate of One Hundred Fifty Thousand Dollars ($150,000) (collectively, the "Loans") from three individual lenders (collectively, the "Lenders"), including individuals who are (i) the Chairman of the Board and Interim President, and (ii) a second director of the Company. In connection with the Loans, the Company issued to each of the Lenders a promissory note in the principal amount of Fifty Thousand Dollars ($50,000) (individually, a "Note" and collectively, the "Notes") providing for (a) quarterly payments of interest at ten percent (10%) per annum and (b) repayment of principal in a balloon payment on the second anniversary of the date of the Notes. Under the terms of the Notes, the Company may elect to pay quarterly interest to the holders of the Notes in shares of common stock, $.01 par value, of the Company (the "Common Stock"), in an amount calculated by dividing the amount of interest due and payable by ten cents ($.10). The Notes also provide that, in the event of a default by the Company under the Notes, the holders may elect to receive payment of principal and accrued and unpaid interest in shares of Common Stock, in an amount calculated by dividing the amount of principal and accrued and unpaid interest payable by the "Average Market Price" for a share of Common Stock. Under the terms of the Notes, "Average Market Price" means the average closing sale price for a share of Common Stock measured over the last ten trading days of the month preceding the interest payment date or, if no trading in the Common Stock has occurred during such period, the average closing sale price on the last date on which a share of Common Stock was sold in over-the-counter trading in the Common Stock. In the event that no shares of Common Stock have traded in the over-the-counter market for a period of six months or more, the Average Market Price shall be the fair market price for a share of Common Stock as determined in good faith by the Board of Directors of the Company. In October 2005, the Company elected to pay the accrued interest due on the Notes of $11,040 in stock of the Company and issued 44,000 shares at $.25 to the Note holders. In January 2006, the Company elected to pay the accrued interest due on the Notes of $13,230 in stock of the Company and issued 37,800 shares at $.35 to the Note holders. In March 2006, the Company elected to pay the accrued interest due on the notes of $21,546 in stock of the Company and issued 37,800 shares at $.57 to the Note holders. In July 2006, the Company elected to pay the accrued interest due on the notes of $16,254 in stock of the Company and issued 37,800 shares at $.43 to the Note holders. At September 30, 2006, the Company had accrued $8,694 of interest on the notes due to the Note holders. 12 In addition, in connection with the Loans, each Lender received a Common Stock Purchase Warrant (collectively, the "Warrants") entitling the holder to purchase One Hundred Thousand (100,000) shares of Common Stock at an exercise price of ten cents ($.10) per share for a five-year period. The warrants were valued using the Black Scholes model at $24,000, which is being amortized as interest expense over the life of the notes. The Notes and the Warrants each provide that in the event that the Company shall grant "piggy back" registration rights to any other party to cause the Company's Common Stock or any security exercisable or exchangeable for, or convertible into, shares of Common Stock to be included in a registration statement filed by the Company for sale by any selling shareholder or by the Company, the Company will grant the holders of the Notes and Warrants similar registration rights. Loans Payable consisted of the following at September 30, 2006: Loan Payable ............................ $ 150,000 Accrued interest ........................ 8,694 Less :Deferred financing costs .......... (5,829) --------- $ 152,865 ========= NOTE G - ACCRUED LIABILITIES Accrued liabilities represent expenses that apply to the reported period and have not been billed by the provider or paid by the Company. Accrued liabilities consisted of the following at September 30, 2006: Dividends payable ....................... $ 83,163 Director fees payable ................... 108,520 Professional fees ....................... 44,447 Other ................................... 32,496 -------- $268,626 ======== 13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS BUSINESS During early 2005, the Company returned its focus to the development and sales of its skin care products. For several years prior, the Company's research and development efforts were concentrated on products and medical applications utilizing its patented tissue oxygenation technology, and on accumulating data for a Food & Drug Administration (FDA) application related to this technology. On January 10, 2005, the Company attended a Pre-Investigational Device Exemption meeting with the FDA in the belief that a clear pathway for safety and clinical research requirements could be determined at that time; however, a defined methodology could not be agreed upon at that time. As a result of that meeting, and in consideration of the Company's limited working capital, management decided to refocus its efforts on non-medical technologies. The Company continues to believe that its tissue oxygenation technology has significant potential, and expects to re-institute research and development in that area when working capital allows. The Company's current focus is on furthering development and sales of its other proprietary products, including a newly patented evaporating emulsifier technology for use in cosmetic treatments and acne products, a number of patented polymer skin care formulas using a moisture-attracting ingredient (the "Hydron(R) polymer") that provide superior skin moisturization benefits and sunscreen delivery, and a patented formula for a wrinkle reduction serum. Currently, the Company markets a broad range of cosmetic and oral health care products using a moisture-attracting ingredient (the "Hydron(R) polymer") and a topical delivery system for active ingredients including pharmaceuticals. The Company holds U.S. and international patents on, what management believes is, the only known cosmetically acceptable method to suspend the Hydron polymer in a stable emulsion for use in personal care/cosmetic products. The Company is developing other personal care/cosmetic products for consumers using its patented technology and would, when appropriate, either seek licensing arrangements with third parties, or develop and market proprietary products through its own efforts. Management believes that because of their unique properties, products that utilize the Hydron polymer have the potential for wide acceptance in consumer and professional health care markets. On July 1, 2005, the Company purchased Clinical Results, Inc. ("CRI"), for two million (2,000,000) shares of the Company's common stock. Through the purchase of CRI the Company has entered the business of proprietary formulations and contract manufacturing for other consumer product companies. 14 HYDRON(R) BRANDED SKIN CARE PRODUCTS The Company has been developing various consumer products using Hydron polymers since 1986. The Company's products are designed to address concerns about the visible signs of aging, and include Hydron(R) skincare, hair care, bath and body and sun care lines. The Company currently has forty three individual branded products available in the following product categories: skin care (24 products), hair care (6 products), bath and body (11 products) and sun care (2 products). These products are also packaged into collections and sold at a more favorable value than the individual products sold separately. All of the products are available through the Hydron catalog and web site at www.hydron.com ("Catalog"). The Company also markets a number of customized formulations under private label and contract manufacturing for various outside brands. Management believes that the Company's moisturizers and skin treatments are unique and offer the following competitive benefits: they self-adjust to match the skin's optimal pH balance soon after they are applied to the skin; they become water-insoluble on the skin's surface, and unlike all other water-based cremes and lotions, are not removed by the skin's perspiration or plain water; they are oxygen-permeable, allowing the skin to breathe; they do not emulsify the skin's natural moisturizing agents, as do conventional cremes and lotions; and they attract and hold water, creating a cushion of moisture on the skin's surface that promotes penetration of other beneficial product ingredients, all while leaving no greasy after-feel. The Company's products are independently tested by dermatologists and, in their opinion, are considered to be safe, non-irritating and applicable to most skin types. Products for use around the eye area are also ophthalmologist tested and safe for contact lens wearers. Most of the Company's branded moisturizing products are based on the Company's patented emulsion system, which permits the product ingredients to deliver their intended benefits over an extended period of time and in a more efficient manner. Management believes that the Hydron(R) emulsion system can enhance the effectiveness of topical over-the-counter medications. The emulsion system is designed to deposit a polymer film on the skin's surface which has a number of advantages over traditional lotions: it promotes hydration of the outer layer of skin, improves penetration into the skin's pores, and has good tactility and flexibility. The Company expects to continue to focus research and development resources on proprietary technology-based products as determined by management's assessment of consumer demand. The Company discovered that the Hydron emulsion system also adjusts pH on the skin to match the pH of the stratum corneum, the skin's surface layer. The pH range of the emulsion system is ideal for promoting the skin's natural healing process and enzyme production responsible for rebuilding the skin's lipid barrier. In January 2006, the Company was granted U.S. Patent Number 6,984,391 for its Compositions and Method for Delivery of Skin Cosmeceuticals to cover this technology, which also applies to a new acne treatment system. 15 Catalog Sales - The Company offers personal care products for sale directly to consumers. Augmenting direct mail, the Company sells its products on the World Wide Web and regularly transmits E-mail broadcasts to its customer base. Catalog sales represented approximately 36% of Hydron's total sales for the nine months ended September 30, 2006 and 55% of sales the nine months ended September 30, 2005. The Company is continuing to explore new ways to enhance Catalog sales and operations. Private Label Contracting - Since March 1, 2001, the Company has been a supplier to Reliv International, Inc ("Reliv") to develop and manufacture a line of private label skin care products under their brand name, ReversAge(R). Reliv is a public company traded on NASDAQ (symbol RELV). Private label sales represented approximately 12% of Hydron's total sales for the nine months ended September 30, 2006 and 20% of sales for the nine months ended September 30, 2005. . Contract Manufacturing - Through its acquisition of CRI, the Company now manufactures consumer products for a number of companies. Products include proprietary formulations for skin and hair care. During the nine months of combined operations ending September 30, 2006, non-Hydron Technologies, Inc. related contract manufacturing revenue represented 42% of Hydron's total sales and 16% of sales for the nine months ended September 30, 2005. Formulation and Commission - The Company received a $60,000 payment for formulation services that its subsidiary Clinical Results, Inc had previously performed. Formulation sales represented 6% of sales and Commissions represented 2% of sales for the nine months ended September 30, 2006. When certain additional consulting services are completed, the Company expects to receive another milestone payment and may receive continuing royalties thereafter. RESULTS OF OPERATIONS RESULTS OF OPERATIONS - 2006 VERSUS 2005 Total net sales for the three months ended September 30, 2006 were $458,145, an increase of $54,441 or 14% from net sales of $403,704 for the three months ended September 30, 2005. Catalog Sales net sales for the three months ended September 30, 2006 were $128,592, a decrease of $27,113 or 17% from sales of the three months ended September 30, 2005 of $155,705. Private Label and Contract Manufacturing net sales for the three months ended September 30, 2006 were $309,892, an increase of $84,881 or 38% from sales the three months ended September 30, 2005 of $225,011. Formulation and commission net sales for the three months ended September 30, 2006 were $7,471, a 100% increase from the same period in 2005. Shipping and handling revenues for the three months ended September 30, 2006 were $12,190, a decrease of $10,798 or 47% from shipping and handling revenues for the three months ended September 30, 2005 of $22,988. 16 Total net sales for the nine months ended September 30, 2006 were $1,180,475, an increase of $245,076 or 26% from net sales of $935,399 for the nine months ended September 30, 2005. Catalog Sales net sales for the nine months ended September 30, 2006 were $419,612, a decrease of $95,249 or 19% from sales of the nine months ended September 30, 2005 of $514,861. Private Label and Contract Manufacturing net sales for the nine months ended September 30, 2006 were $635,582, an increase of $291,460 or 85% from sales for the nine months ended September 30, 2005 of $344,122. Formulation and commission net sales for the nine months ended September 30, 2006 were $86,521, a 100% increase from the same period in 2005. Shipping and handling revenues for the nine months ended September 30, 2006 were $38,759, a decrease of $37,658 or 49% from shipping and handling revenues for the nine months ended September 30, 2005 of $76,417. The decrease in catalog sales was the result of the attrition of the Company's customer base without marketing spending to replace those customers. Private Label and Contract Manufacturing sales increased due to the acquisition of Clinical Results, Inc. on July 1, 2005. Clinical Results is in the early stages of its manufacturing facility and has helped contribute to the overall revenue. Cost of sales was $101,927 for the three months ended September 30, 2006, a decrease of $61,580, or 38%, from cost of sales of $163,507 for the three months ended September 30, 2005. Cost of sales was 22% of total sales for the three months ended September 30, 2006, compared to 41% for the three months ended September 30, 2005. The decrease in the cost of sales percentage reflects the impact of higher margins on certain private label, commission and formulation sales. Cost increases are not material to catalog sales and the private label contracts provide for a pass through of any cost increases incurred in that segment. Shipping and handling costs for the third quarter of 2006 were $16,893, a decrease of $7,751, or 32%, from shipping and handling cost of $24,644 for the same period in 2005. This decrease reflects the decline in catalog sales plus savings realized by performing more of the shipping and handling tasks in-house and switching to more economical trucking company. For the nine months ended September 30, 2006 cost of sales was $338,744, a decrease of $54,412 or 14% from cost of sales of $393,156 for the nine months ended September 30, 2005. Cost of sales was 29% of total sales for the nine months ended September 30, 2006 compared to 42% for the nine months ended September 30, 2005. The decrease in cost of sales percentage reflects the impact of this year's formulation and commission net sales as stated above. Shipping and handling costs for the nine months were $54,276, a decrease of $30,646 or 36% from shipping and handling costs of $84,922 for the same period in 2005. This decrease reflects the 19% decline in catalog sales offset by savings realized by performing more of the shipping and handling tasks in house and switching to a new trucking company. 17 The Company's overall gross profit margin increased to 78% of net sales for the three months ended September 30, 2006 versus 59% for the three months ended September 30, 2005. This reflects the increase in formulation and commission sales as discussed above, less the relative mix of higher margin catalog sales versus lower margin private label sales. For the nine months ended September 30, 2006 the overall gross profit margin increased similarly to 71% of net sales versus 58% for the same period in 2005. Royalty expenses for the three months ended September 30, 2006 were $5,000 and $7,500 for the three months ended September 30, 2005. Royalty expenses for the nine months ended September 30, 2006 were $14,043 and $25,711 for the nine months ended September 30, 2005. An aggregate of $27,082 was accrued and unpaid as of September 30, 2006. This amount is adequate to cover any royalties that are payable through September 2006. Research and development ("R&D") expenses reflect the Company's efforts to identify new product opportunities, obtain regulatory approval, develop and package the products for commercial sale, perform appropriate efficacy and safety tests, and conduct consumer panel studies and focus groups. R&D expenses for the three months ended September 30, 2006 were $4,516 and $9 for the three months ended September 30, 2005, For the nine months ended September 30, 2006 R & D expenses were $11,483, a decrease of $43,254 or 79% from R & D expenses of $ $54,737 for the same period last year. This decrease was due principally to the Company eliminating the use of outside FDA consultants in association with its oxygenation technology during 2005 versus 2006. The amount of annual R&D expenses will vary year to year depending on the Company's research requirements. Selling, general and administrative ("SG&A") expenses for the three months ended September 30, 2006 were $321,038, representing an decrease of $61,680 or 16% from SG&A expenses of $382,718 for the three months ended September 30, 2005. Employment expense was $167,012 for the three months ended September 30, 2006, a decrease of $14,356, or 8%, from $181,368 for the three months ended September 30, 2005. This decrease was due primarily to the restructuring of operations and staff. Postage expense was $0 for the three months ended September 30, 2006, a decrease of $10,614, or 100%, from $10,614 for the three months ended September 30, 2005. This decrease resulted from marketing through emails instead of using mailings during this quarter. Advertising and promotional expenses was $18,499 for the three months ended September 30, 2006, an increase of $3,080, or 20% from $15,419 for the three months ended September 30, 2005. This increase is due to new advertising initiatives taken by the Company to increase sales and redesigning of the website. Warehousing expense was $287 for the three months ended September 30, 2006, a decrease of $8,223, or 97% from $8,510 for the three months ended September 30, 2006. This decrease is due to bringing all products to one location relieving the need for outside storage. Professional expenses (legal and audit) was $25,000 for the three months ended September 30, 2006, a decrease of $27,889 or 42% from $52,889 for the three months ended September 30, 2005. The decrease in professional fees involved additional costs associated with the use of an outside consultant instead of an in house CFO offset by decreases in 18 legal fees associated with the acquisition in the prior year during the quarter. Moving expenses was $0 for the three months ended September 30, 2006, a decrease of $12,625 or 100% from $12,625 for the three months ended September 30, 2005. The decrease was due to the movement of operations to St. Petersburg during 2005. Insurance expense was $3,014 for the three months ended September 30, 2006, a decrease of $13,651 or 82% from $16,665 for the three months ended September 30, 2005. The decrease was due to reducing certain insurance coverage's. Rent expense was $27,724 for the three months ended September 30, 2006, an increase of $19,001 or 217% from $8,723 for the three months ended September 30, 2005. The increase was due to consolidation of operations and the need for additional space due to manufacturing now done in house. All other expenses were $79,502 for the three months ended September 30, 2006, a decrease of 6,403 or 7% from $85,905 for the three months ended September 30, 2005. For the nine months ended September 30, 2006 selling, general and administrative expenses were $1,028,844, an increase of $154,456 or 18% from $874,388 for the same period last year. Depreciation and amortization expense was $25,410 for the three months ended September 30, 2006, an increase of $16,273 or 178% from $9,137 for the three months ended September 30, 2005. For the nine months ended September 30, 2006 depreciation and amortization were $76,229 an increase of $48,818 or 178% from $27,411 for the same period last year. The increase was due primarily to the amortization of the intangible of the purchase of CRI. Net interest (expense) was ($11,705) for the three months ended September 30, 2006 compared to net interest (expense) of ($6,515) for the three months ended September 30, 2005. For the nine months ended September 30, net interest (expense) was ($60,305) compared to net interest (expense) of ($5,829) for the same period last year. The increase in interest expense was due primarily to the interest on the loan payable and amortization of related debt discount. Minority interest in net loss for the three months ended September 30, 2006 was $6,915 compared to $8,904 for the three months ended September 30, 2005. Minority interest in net loss for the nine months ended September 30, 2006 was $21,103 compared to $27,115 for the nine months ended September 30, 2005. This minority interest is created from a consolidated limited liability partnership, Hydron Royalty Partners, LLLP, established by the Company in August 2004. The Company had a net loss of $4,537 for the three months ended September 30, 2006, representing a decrease of $152,241 or 97% from the net loss of $156,778 for the three months ended September 30, 2005. The Company had a net loss of $328,071 for the nine months ended September 30, 2006, representing a decrease of $90,648 or 22% from the net loss of $418,719 for the nine months ended September 30, 2005, primarily as a result of the factors discussed above. 19 LIQUIDITY AND FINANCIAL RESOURCES The Company anticipates that present working capital balances and internally generated funds will be sufficient to meet our working capital needs for the next three months and maybe longer based on management decisions and order flow. Beyond that point, it may be necessary to sell selected assets, or obtain an infusion of capital. The Company's independent accountants issued a "going concern" opinion on the Company's December 31, 2005 financial statements, since the Company has incurred significant losses over the past five years and generates a negative cash flow on a monthly basis. On July 1, 2005, the Company acquired CRI, a St. Petersburg, Florida-based company. CRI was a privately held product development laboratory and contract manufacturer of cosmeceuticals and other personal care products. CRI's clients range from mass-market retailers to marketers of high-end brands, and of certain health food store brands. Management believes that Hydron Technologies will benefit from lower manufacturing costs, and be better positioned to build its catalog and internet business, as well as expand the sale of its skin care treatments beyond its historical direct response TV and catalog operations, by utilizing CRI's broker network. The Company's ultimate ability to attain profitable operations is dependent upon obtaining additional financing or achieving a level of sales adequate to support its cost structure. The Company's working capital deficit was approximately ($500,000) at September 30, 2006, including cash and cash equivalents of approximately $9,278. Cash used by operating activities was $36,813 and cash used in investing activities was $18,052 during the nine months ended September 30, 2006. This was offset by proceeds from financing activities of $27,862. The Company does not have any material debt other than the loan payable of $150,000 borrowed from three shareholders in May 2005 (see Note F), and two capital leases for equipment purchases of $56,551. Effective August 5, 2005, the Company relocated its offices to St Petersburg, Fl. There are no capital expenditures under construction and no long-term commitments other than royalty payments under an agreement with Valera Pharmaceuticals, Inc. The Company does not have any lines of credit. There are no purchase order commitments that exceed 90 days. Management's plan includes implementing one or more of the following elements: o Emphasize and expand the marketing and manufacturing of private label products. o Implement new direct sales and networking initiatives. o Emphasize Catalog sales, including sales made over the Internet, since these sales have higher profit margins. 20 o Evaluate the possibilities of increasing direct marketing and direct response television exposure to build brand awareness and revenues. o Team with third parties to build the advertising and promotion of the Hydron(R) brand, as the Company does not have the financial resources to sustain a national advertising campaign to support distribution of its production into retail stores. o Develop and market new product lines based on the Company's proprietary technologies. o Continue to reduce overhead and operating costs. o Obtain an infusion of capital that will sustain the Company's operation until the newly established licensing arrangements can produce positive cash flow. There can be no assurances that management's plan will be successful and the Company's actual results could differ materially. No estimate has been made to the financial statements to account for the possibility that the plan may be unsuccessful. Recent accounting Pronouncements In June 2006, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes," which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In accordance with FIN 48, the Company must adjust its financial statements to reflect only those tax positions that are more-likely-than-not to be sustained as of the adoption date. The effective date of FIN 48 for the Company is January 1, 2007. The adoption of FIN 48 is not expected to have a material impact on the Company's condensed consolidated financial statements. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS 157"), which clarifies the definition of fair value, establishes guidelines for measuring fair value, and expands disclosures regarding fair value measurements. SFAS 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 will be effective for the Company on January 1, 2008. The Company is currently evaluating the impact of adopting SFAS 157 on its financial position, cash flows, and results of operations. In September 2006, the Securities and Exchange Commission ("SEC") released Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements" ("SAB 108"). SAB 108 provides interpretive guidance on the SEC's views on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. 21 The provisions of SAB 108 will be effective for the Company for the fiscal year ended December 31, 2006. The Company is currently evaluating the impact of applying SAB 108 but does not believe that the application of SAB 108 will have a material effect on its financial position, cash flows, and results of operations. CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS The following discussion and analysis of the Company's financial condition and results of operations should be read with the condensed consolidated financial statements and related notes contained in this quarterly report on Form 10-QSB ("Form 10-QSB"). All statements other than statements of historical fact included in this Form 10-QSB are, or may be deemed to be, forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements involve known and unknown risks, uncertainties and other factors that may cause the Company's actual results, levels of activity, performance or achievements to be materially different than any expressed or implied by these forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential," "continue," or the negative of these terms or other comparable terminology. Important factors that could cause actual results to differ materially from those discussed in such forward-looking statements include: 1. General economic factors including, but not limited to, changes in interest rates and trends in disposable income; 2. Information and technological advances; 3. Cost of products sold; 4. Competition; and 5. Success of marketing, advertising and promotional campaigns. The Company is subject to specific risks and uncertainties related to its business model, strategies, markets and legal and regulatory environment. You should carefully review the risks described in this Form 10-QSB and in other documents the Company files from time to time with the SEC. You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Form 10-QSB. The Company undertakes no obligation to publicly release any revisions to the forward-looking statements to reflect events or circumstances after the date of this document. ITEM 3. CONTROLS AND PROCEDURES As of the end of this period, the Company carried out an evaluation, under the supervision and with the participation of management, including its Chief Executive Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(e). Based upon that evaluation, the Chief Executive Officer concluded that the Company had material weaknesses associated with insufficient personnel resources with appropriate accounting experience and lack of controls relating to inventory valuation and segregation of inventory. Management is currently seeking personnel resources with appropriate accounting experience, as well as implementing a perpetual inventory system which should mitigate these material weaknesses in 2006. 22 Disclosure controls and procedures (as defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to management to allow timely decisions regarding required disclosure. The Certifying Officer has also indicated that there were no significant changes in our internal controls or other factors that could significantly affect such controls subsequent to the date of their evaluation, and there were no corrective actions with regard to significant deficiencies and material weaknesses. Our management, including the Certifying Officer, does not expect that our disclosure controls or our internal controls will prevent all error and fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. In addition, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the control. The design of any systems of controls also is based in part upon certain assumptions about the likelihood of future events, and their can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of these inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. 23 PART II. OTHER INFORMATION ITEM 5. OTHER INFORMATION The Company received a letter dated September 21, 2006 from the Division of Corporation Finance of the U.S. Securities and Exchange Commission with comments on the Company's Form 10-KSB for the fiscal year ended December 31, 2005 and Form 10-QSB for the fiscal quarter ended June 30, 2006. Among other comments, the staff requested that the Company either provide audited financial statements for Clinical Results, Inc. ("CRI"), the company acquired by the Company on July 1, 2005, or provide calculations of the tests of significance supporting the Company's determination that financial statements of CRI were not required. In response to the staff's comments, the Company submitted its calculations supporting its determination. By its letter dated November 13, 2006, the staff disagreed with the Company's manner of calculating significance and determined that the acquisition of CRI by the Company was significant. As a consequence, the staff required the Company to amend its Form 8-K filed on July 8, 2005 to include audited financial statements for CRI for the most recent fiscal year and the latest interim period preceding the acquisition, and the corresponding interim period of the preceding year to comply with Item 310(c) of Regulation S-B. In a letter dated November 16, 2006, the Company advised the staff that it was unable to provide audited financial statements for CRI because the financial records of CRI for the period prior to its acquisition by the Company are not sufficient to support an audit or, in the case of interim financial statements, financial statements prepared in accordance with generally accepted accounting principals. Discussions between the Company and the SEC are ongoing to resolve this matter. ITEM 6. EXHIBITS AND REPORTS ON FORM 8K (a) Exhibits: 31.1 Certification of Chief Executive Officer, Principal Financial and Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 and Item 307 of Regulation S-K (filed herewith) 32.1 Certification of Chief Executive Officer, Principal Financial and Accounting Officer Pursuant to 18 U.S.C., Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith) (b) Reports on Form 8-K: None 24 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HYDRON TECHNOLOGIES, INC. /s/: David Pollock ------------------ David Pollock Chief Executive Officer Principal Financial and Accounting Officer Dated: November 17, 2006 25