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RESPONSE BIOMEDICAL CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

May 14, 2014

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes. Unless otherwise specified, all dollar amounts are in Canadian dollars. OVERVIEW Response Biomedical develops manufactures and sells diagnostic tests for use with its proprietary RAMP® System, a portable fluorescence immunoassay-based diagnostic testing platform. Our RAMP® technology utilizes a unique method to account for sources of error inherent in conventional lateral flow immunoassay technologies, thereby providing the ability to quickly and accurately detect and quantify an analyte present in a liquid sample. Consequently, an end-user in a medical facility's central-lab or in a point-of-care diagnostic testing setting can rapidly obtain important diagnostic information. We currently have thirteen tests available for clinical and environmental testing applications and we have plans to commercialize additional tests. Our sales for any future periods are not predictable with a significant degree of certainty, and may depend on a number of factors outside of our control, including but not limited to the performance of our distributors including their inventory or timing considerations, their changing local competitive and/or reimbursement environments, and/or their failure to meet minimum purchase commitments. We generally operate with a limited order backlog because our products are typically shipped shortly after orders are received. Product sales in any quarter are generally dependent on orders booked and shipped in that quarter. As a result, any such revenue shortfall would negatively affect our operating results and financial condition. In addition, our sales may be adversely impacted by pricing pressure from competitors. Our ability to be consistently profitable will depend, in part, on our ability to increase the sales volumes of our products and to successfully compete with other competitors. We believe that period to period comparisons of our results of operations are not necessarily meaningful indicators of future results. During the three months ended March 31, 2014, we have incurred a net loss of $1.5 million and negative cash flows from operations of $327,000. As of March 31, 2014, we have a cash balance of $4.0 million, an accumulated deficit of $119.7 million, a shareholders' deficit of $2.7 million, and a negative working capital balance of $2.3 million. In addition, we have various operating leases, debt repayments and purchase commitments for inventory. Included in current liabilities is a warrant liability in the amount of $5.4 million that is required to be measured at fair value and is presented as a current liability in accordance with GAAP. Each warrant may only be exercised on a net cashless exercise basis meaning the potential settlement of any warrant does not require any cash disbursement by the holder of the warrant. Without taking into account the warrant liability mentioned above, current assets exceed current liabilities by $3.2 million. Our ability to continue as a going concern is uncertain and dependent on our ability to obtain additional financing and/or achieve profitable growth. Management has, thus far, financed the operations through a series of equity and debt financings. On February 11, 2014, we entered into a loan and security agreement with Silicon Valley Bank ("SVB") securing a US $2.5 million term loan. Under the terms of the loan agreement, the total proceeds of US $2.5 million will be made available in tranches of US$1.5 million upon closing and the remaining US$1.0 million at our discretion at any time prior to September 30, 2014 if certain revenue targets are met by July 31, 2014 and we remain in compliance with the terms of the loan and security agreement. We believe that, with the Private Placement completed in the fourth quarter of 2013 and the term loan noted above, based on our current level of operations, our cash and cash equivalents balances, including cash generated from operations, will be sufficient to meet the anticipated cash requirements through the next twelve months. However, due to the requirements to meet financial covenants related to revenue and liquidity as part of the term loan and our history of losses and negative cash flow, there is substantial doubt over our ability to continue as a going concern as it is dependent on meeting those covenants and ultimately achieving profitable operations, the outcome of which cannot be predicted at this time. RECENT DEVELOPMENTS



? On January 2, 2014, we announced that the distribution agreement with O&D

Biotech Co., Ltd. ("O&D") expired effective December 31, 2013 and that we were

discussing a new agreement with O&D. Ultimately, we were not able to agree on

mutually acceptable terms with O&D and we have now transitioned to two new

distributors, Beijing Clear Biotech Co., Ltd. and Shanghai Elite Biotech Co.,

Ltd who's collective territories encompass all of China.

? On February 11, 2014, we entered into a loan and security agreement with

Silicon Valley Bank securing a US $2.5 million term loan. Under the terms of

the loan agreement, the total proceeds of US $2.5 million will be made

available in tranches of US$1.5 million at closing and the remaining US$1.0

million at our discretion at any time prior to September 30, 2014 if certain

revenue targets are met by July 31, 2014 and we remain in compliance with the terms of the agreement. 16

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RESULTS OF OPERATIONS



For the three month period ended March 31, 2014 and 2013:

REVENUES, COST OF GOODS SOLD AND GROSS MARGIN (IN THOUSANDS)

Revenue Three Months Ended March 31, Change 2013 to 2014 Increase / 2014 2013 (Decrease) Percent Change Product Sales 2,559 3,561 (1,002 ) (28 %) Cost of Sales 1,440 1,965 (525 ) (27 %) Gross profit on product sales $ 1,119$ 1,596$ (477 ) (30 %) Gross margin 43.7 % 44.8 % Revenues have decreased 28% or $1.0 million during the three month period ended March 31, 2014 as compared to March 31, 2013. The change in total revenue is due to the following:



? Cardiovascular sales have decreased 14%, or $0.4 million, primarily due

reduced sales in China as a result of the transition to new distribution

partners which began in the fourth quarter of 2013; and

? Infectious disease, West Nile Virus and Biodefense sales have decreased by

83%, or $0.6 million, primarily due to the seasonal increase in the demand for

Influenza tests during the first quarter of 2013 based on the severity of the

2012 - 2013 Influenza season in addition to the timing of shipments to our

distributors. Gross Margin Gross profit on product sales decreased 30%, or $0.5 million, during the three month period ended March 31, 2014 compared to March 31, 2013. The change in total gross profit is primarily due to the 28% decrease in product sales as our gross margin slightly decreased from 44.8% in 2013 to 43.7% in 2014. The relatively small decrease in gross margin, despite the decrease in product sales, was due to an ongoing reduction in unit manufacturing costs achieved through improvements in manufacturing efficiency during the 2013 fiscal year and continuing into the first quarter of 2014 along with a reduction in component material costs as a result of purchasing from more economical suppliers. This reduction in costs was offset by a change in product mix described above in Revenue and an increase in the amount of inventory written off related to scrapped, expired, obsolete or damaged inventory.



OPERATING EXPENSES (IN THOUSANDS)

Three Months Ended March 31, Change 2013 to 2014 Increase / 2014 2013 (Decrease) Percent Change Research and development 811 555 256 46 % General and administrative 811 825 (14 ) (2 %) Sales and marketing 646 484 162 33 % Total Operating Expenses $ 2,268$ 1,864$ 404 22 %



Research and Development Expenses

Research and development expenses increased by 46%, or $256,000, during the three month period ended March 31, 2014 in comparison to the same period ended March 31, 2013. The increase is primarily due to an $186,000 increase in professional fees and development costs associated with increased clinical and regulatory work and a $70,000 increase in salaries and wages as a result of the expiration of government funding support in 2013 which funded some of our salaries and wages in the prior year.



General and Administrative Expenses

General and administrative expenses decreased by 2%, or $14,000, during the three month period ended March 31, 2014 in comparison to the same period ended March 31, 2013. The decrease is primarily due to decreased legal and travel expenses.

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Sales and Marketing Expenses Sales and marketing expenses increased by 33%, or $162,000, during the three month period ended March 31, 2014 in comparison to the same period ended March 31, 2013 primarily due to salaries, recruiting, and travel expenses associated with increased staffing and expanded sales and marketing initiatives.



OTHER EXPENSES (INCOME), NET (IN THOUSANDS)

Three Months Ended March 31, Change 2013 to 2014 Increase / 2014 2013 (Decrease) Percent Change Interest expense and amortization of deferred financing costs and debt discount 197 177 20 11 % Interest income (5 ) (4 ) (1 ) 25 % Other income - (58 ) 58 100 % Income tax expense 17 - 17 100 % Foreign exchange loss 4 6 (2 ) (33 %) Unrealized loss on revaluation of warrant liability 161 9,575 (9,414 ) (98 %) Total Other Expenses $ 374 $ 9,696 $ (9,322 ) (96 %)



Interest Expense and Amortization of Deferred Financing Costs and Debt Discount

Interest expenses and amortization of deferred financing costs and debt discount increased by 11%, or $20,000, during the three month period ended March 31, 2014 compared to the same period ended March 31, 2013. The increase is primarily due to the interest and amortization costs related to the SVB debt offset by a decrease in interest paid on the repayable leasehold improvement allowance as a result of a decrease in principal in 2014 versus 2013. Other Income Other income decreased by $58,000 during the three month period ended March 31, 2014 compared to the same period ended March 31, 2013 due to a non-recurring payment received in 2013 as a result of the demutualization of our insurance provider. Income Tax Expense The income tax expense is the result of the establishment of our representative office in Shanghai, China. Income tax is owed based on a percentage of operating expenses incurred.



Unrealized Loss on Revaluation of Warrant Liability

The unrealized loss on revaluation of the warrant liability is solely due to the mark-to-market revaluation each reporting period of the outstanding warrants, issued during our 2011 rights offering. The fair market value increased from December 31, 2013 resulting in an unrealized loss of $161,000. The fair market value is calculated using a Black-Scholes model with inputs for volatility, risk free interest rate, and expected life of the warrants. The primary reason for the increase in the value of the liability is the increase in the fair market value of the shares of the Company in relation to December 31, 2013. A small change in the estimates used in the Black-Scholes pricing model may have a relatively large change in the estimated valuation of the common stock warrants.



LIQUIDITY AND CAPITAL RESOURCES

Total cash and cash equivalents and working capital at March 31, 2014, and December 31, 2013 were as follows (in thousands):

December 31, As at, March 31, 2014 2014 Cash and cash equivalents $ 4,049 $ 2,958 Percentage of total assets 27 % 21 % Working capital $ (2,256 )$ (2,232 ) Warrant liability $ 5,412 $ 5,251 Working capital, excluding Warrant liability $ 3,156 $ 3,019 As at March 31, 2014, the Company had a negative working capital balance. Included in current liabilities is a warrant liability that is required to be measured at fair value and is presented as a current liability in accordance with ASC 815. Each warrant may only be exercised on a net cashless exercise basis and no warrant may be exercised at a time when the exercise price equals or exceeds the current market price meaning the potential settlement of any warrant does not require any cash disbursement. Without taking into account the warrant liability mentioned above, the Company's working capital as at March 31, 2014 is $3.2 million (December 31, 2013 - $3.0 million). The increase of $0.2 million during the three months ended March 31, 2014 is primarily due to the cash provided by the debt financing received during the quarter offset by the cash used in operating activities as described below. 18 --------------------------------------------------------------------------------

FINANCIAL CONDITION We have financed our operations primarily through equity and debt financings. As of March 31, 2014, the Company has raised approximately $107.2 million from the sale and issuance of equity securities and debt, net of issue costs. We have sustained continuing losses since our formation and as of March 31, 2014, had a deficit of $119.7 million and historically, have incurred negative cash flows from operations. We completed a private placement in the fourth quarter of 2013 for net proceeds of $2.8 million and on February 11, 2014, we secured a $2.5 Million USD term loan. Cash flows from operations are generally impacted by our level of quarterly sales and our ability to manage operating expenses. However, increased quarter over quarter growth also requires additional working capital in the form of higher accounts receivable and greater inventory balances to meet the increased demand. We expect that we will have net negative cash flow from operations over the next several quarters until our growth initiatives provide sustained cash flow positive income (net income (loss) excluding items not involving cash) and sufficient cash flow to offset the additional working capital required to support the growth. In addition, we continue to require cash for our contractual obligations outlined below. We believe that with our current level of financing and our expected level of operations, our cash and cash equivalents balances, including cash generated from operations, will be sufficient to meet the anticipated cash requirements through the next twelve months. However, due to the requirements to meet certain financial covenants as part of the term loan and our history of losses and negative cash flow, there is substantial doubt over our ability to continue as a going concern as it is dependent on meeting those covenants and ultimately achieving profitable operations, the outcome of which cannot be predicted at this time.



ONGOING SOURCES AND USES OF CASH

CHANGES IN CASH FLOWS



Changes in cash flows were as follows (in thousands):

For the Three Months Ended March 31, 2014 2013



Cash generated from (used in) operating activities (272 ) 126 Cash used in investing activities

(94 ) (35 )



Cash provided by/(used in) financing activities 1,457 (89 ) Increase in cash during the period

$ 1,091$ 2 As at March 31, 2014, our cash and cash equivalents balance was $4.0 million. The increase in our cash and cash equivalents during the three months ended March 31, 2014 was primarily the result of $1.4 million of cash provided by in financing activities offset by cash used in operating and investing activities as described below:



Cash Generated from (Used in) Operating Activities

Cash used in operating activities during the three month period ended March 31, 2014 was $272,000 versus the $126,000 of cash generated by operating activities in the prior year. The net cash used in operating activities in 2014 was primarily the result of $996,000 of cash used in operations because our cash expenses exceeded our gross profit earned on product sales. This was offset by the net change in non-cash working capital of $723,000 related to operations consisting of the following (in thousands):



For the Three Months Ended March 31, 2014 2013 Trade receivables

472 (318 ) Other receivables 62 (111 ) Inventories (114 ) (73 ) Prepaid expenses and other (49 ) (45 )



Accounts payable and accrued liabilities 248 666 Deferred revenue

104 29



Total change in non-cash working capital $ 723$ 148

Explanations of the more significant net changes in working capital during the three month period ended March 31, 2014 are as follows:

? Trade receivable balances decreased from $875,000 to $403,000 as a result of

an increase in prepayments from customers and the decrease in sales during Q1

2014; 19

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? Accounts payable and accrued liabilities increased from $2.7 million to $3.0

million as a result of the timing of payments made to certain vendors for

working capital management purposes;

? Inventory balances increased from $2.3 million to $2.4 million primarily due

to the stocking of inventory for sales to be made in the second quarter;

? Deferred revenue increased from $90,000 to $194,000 due to an increase in

prepayments made for future sales; and

? Other receivables decreased from $112,000 to $50,000 as a result of the timing

of receipt of government refunds.



Cash Used in Investing Activities

Net cash used in investing activities for the three month period ended March 31, 2014 and 2013 was $94,000 and $35,000 respectively which represents cash that was used primarily for the purchase of manufacturing, demonstration, and computer equipment in the first quarter of 2014.



Cash Provided by (Used in) Financing Activities

Net cash provided by financing activities was $1.5 million in the first quarter of 2014 versus $89,000 of cash used in financing activities in the comparative period last year. The cash provided by financing activities in 2014 was the result of $1.6 million of debt proceeds received from Silicon Valley Bank offset by $105,000 of deferred financing costs related to this debt and $99,000 of principal payments for the repayable leasehold improvement allowance. The prior year only consisted of principal repayments of the leasehold improvement allowance.



OFF-BALANCE-SHEET ARRANGEMENTS

The Company does not have any off-balance sheet financing arrangements at March 31, 2014.

TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS

The following table summarizes our contractual commitments as of March 31, 2014 and the effect those commitments are expected to have on liquidity and cash flow in future periods (in thousands). Payments due by Period Less than More than Contractual Obligations Total 1 Year 1-3 years 3 - 5 years 5 years Long-term debt obligations (1) 11,037 1,354 3,379 2,234 4,070 Operating lease obligations (2) 9,717 993 2,065 2,172 4,487 Purchase obligations (3) 1,612 902 214 353 143 Total $ 22,366$ 3,249$ 5,658$ 4,759$ 8,700



(1) Long-term debt obligations consist of the principle and interest payments of

our long term debt with SVB and repayable leasehold improvement allowance.

The term of the SVB debt is 3 years with principal payments made over 32

months starting October 1, 2014. The term of repayable leasehold improvement

allowance coincides with the term of the lease mention in note (2).

(2) Operating lease obligations consist of leases of the facilities and property,

plant, and equipment. These lease obligations expire on various dates between

2014 and 2023. The lease for the facility, which commenced in 2008, has a term of 15 years.



(3) Purchase obligations consist of obligations to purchase raw materials,

equipment, and other supplies from suppliers.



CRITICAL ACCOUNTING POLICIES AND ESTIMATES

A summary of the significant accounting policies is as follows:

USE OF ESTIMATES Our consolidated financial statements are prepared in accordance with U.S. GAAP. In the application of U.S. GAAP we are required to make estimates that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities in our consolidated financial statements. Changes in the accounting estimates from period to period are reasonably likely to occur. Accordingly, actual results could differ significantly from the estimates made by management. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation of our financial condition or results of operations may be affected. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, valuation of stock based compensation, valuation of long-lived assets, tax related contingencies, recoverability of receivables, valuation of inventories, and warranty accruals. We base our estimates on historical experience and on various other assumptions, including expected trends that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. 20 -------------------------------------------------------------------------------- In addition to making critical accounting estimates, we must ensure that our financial statements are properly stated in accordance with U.S. GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. GAAP and does not require a high degree of management judgment in its application, while in other cases, management's judgment is required in selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. Our significant accounting policies are discussed in Note 3, "Significant Accounting Policies," to the consolidated financial statements included in Item 8 of our Annual Report on Form 10-K that we filed with the SEC on March 17, 2014. We believe that the following are our most critical accounting policies and estimates, each of which is critical to the portrayal of our financial condition and results of operations and requires our most difficult, subjective and complex judgments. Our management has reviewed our critical accounting policies and the related disclosures with the Audit Committee of our Board of Directors. INVENTORIES Raw material inventory is carried at the lower of actual cost, determined on a first-in first-out basis, and market value. Finished goods and work in process inventories are carried at the lower of weighted average cost and market value. Cost of finished goods and work in process inventories includes direct materials, direct labor and applicable overhead. We write down our inventory balances for estimates of excess and obsolete amounts. These write-downs are recorded as a component of cost of sales. At the point of the write-down, a new, lower-cost basis for that inventory is established, and any subsequent improvements in facts and circumstances do not result in the restoration or increase in that newly established cost basis. LONG LIVED ASSET IMPAIRMENT Long-lived assets to be held and used are periodically reviewed to determine whether any events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. For long-lived assets to be held and used, we base our evaluation on such impairment indicators such as the nature of the assets, the future economic benefit of the assets, any historical or future profitability measurements, as well as other external market conditions or factors that may be present. In the event that facts and circumstances indicate that the carrying amount of an asset may not be recoverable and an estimate of future undiscounted cash flows is less than the carrying amount of the asset, an impairment loss will be recognized for the difference between the carrying value and the fair value. REVENUE RECOGNITION



Product sales are recognized when legal title passes to distributors or customers, the sales price is fixed and determinable, collection of the resulting receivables is reasonably assured and no uncertainties with regard to customer acceptance exist. Sales are recorded net of discounts and sales returns.

WARRANT LIABILITY We account for warrants, issued in the 2011 rights offering, pursuant to the authoritative guidance on accounting for derivative financial instruments indexed to, and potentially settled in, a company's own stock. We have classified the warrants on the consolidated balance sheet as a liability that is revalued at each balance sheet date subsequent to the initial issuance. Determining the appropriate fair-value model and calculating the fair value of warrants requires considerable judgment, including estimating stock price volatility and expected warrant life. The computation of expected volatility was based on the historical volatility of shares of our common stock for a period that coincides with the expected life of the warrants. A small change in the estimates used may have a relatively large change in the estimated valuation. We use the Black-Scholes pricing model to value the warrants. STOCK-BASED COMPENSATION The Company uses the fair value method of accounting for all stock-based awards for non-employees and for all stock-based awards to employees that were granted, modified or settled since January 1, 2003. The fair value of stock options is determined using the Black-Scholes option-pricing model, which requires certain assumptions, including future stock price volatility, estimated forfeiture rates and expected time to exercise. Stock-based compensation expense is recorded net of estimated forfeitures such that expense is recorded only for those stock-based awards that are expected to vest. A forfeiture rate is estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from initial estimates. Changes to any of these assumptions could produce different fair values for stock-based compensation. The expense is amortized on a straight-line basis over the graded vesting period. The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures. We have discussed those estimates that we believe are critical and require the use of complex judgment in their application in our 2013 Form 10-K filed with the SEC on March 17, 2014. Since the date of our 2013 Form 10-K, there have been no material changes to our critical accounting policies or the methodologies or assumptions we apply under them. See note 3, "Recent Accounting Pronouncements," of the consolidated financial statements in Item 1 for information related to the adoption of new accounting standards in 2014, none of which had a material impact on our financial statements. 21



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