Form 10-Q for HEALTH ENHANCEMENT PRODUCTS INC
20-May-2011
Quarterly Report
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
The Securities and Exchange Commission ("SEC") encourages companies to disclose forward-looking information so that investors can better understand future prospects and make informed investment decisions. This report contains these types of statements. Words such as "may," "will," "expect," "believe," "anticipate," "estimate," "project," or "continue" or comparable terminology used in connection with any discussion of future operating results or financial performance identify forward-looking statements. You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this report. All forward-looking statements reflect our present expectation of future events and are subject to a number of important factors and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements.
Critical Accounting Policies
The accompanying discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("US GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent assets and liabilities. These estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We base our estimates and judgments on historical experience and all available information. However, future events are subject to change, and the best estimates and judgments routinely require adjustment. US GAAP requires us to make estimates and judgments in several areas, including those related to recording various accruals, income taxes, the useful lives of long-lived assets, such as property and equipment and intangible assets, and potential losses from contingencies and litigation. We believe the policies discussed below are the most critical to our financial statements because they are affected significantly by management's judgments, assumptions and estimates.
Results of Operations for the three months ended March 31, 2011 and 2010.
Net Sales. Net sales for the three months ended March 31, 2011 were $32,579 as compared to $14,043 for the comparable prior period. These sales reflect principally revenues from the distribution of our ProAlgaZyme? product. The increase in our revenue for 2011 is due to our exclusive distributorship agreement with Ceptazyme, LLC to distribute our product. In the fourth quarter of 2010 we received an initial licensing fee payment of $255,000 under the terms of this exclusive distributorship agreement. We recognized $3,750 in revenue from this licensing fee during the first quarter of 2011.
Although we anticipate the realization of increasing revenues from our exclusive distributorship agreement with Ceptazyme, LLC, our ability to realize any such increased revenue is dependent upon the satisfaction of certain conditions, including the expansion of our production capacity to meet increased product demand and our product's meeting the FDA's GRAS standard or receiving New Diet Ingredient ("NDI") status form the FDA, neither of which conditions we have satisfied as of this date, though we are working on meeting the GRAS standard. In addition, we are currently working on expanding our production capacity .
However, we have encountered some difficulty in expanding our production capacity and meeting the GRAS standard, If we are unable to timely and sufficiently expand our production capacity and meet he GRAS standard (or NDI status), there will be a material adverse affect on our business, financial condition and results of operations.
Throughout 2010 and 2011, we were adversely impacted by a shortage of funds which has severely impeded our ability to market, test and expand the production of our ProAlgaZyme? product. Although we signed an exclusive distribution agreement in September of 2010, we intend to explore additional potential marketing opportunities, consistent with the limitations placed upon us by our exclusive distribution agreement with Ceptazyme, LLC. We believe that our ability to generate sales of the ProAlgaZyme? product will depend upon, among other things, expansion of our production capacity, further characterization of the product, identification of its method of action and further evidence of its efficacy, as well as advertising. The testing necessary to further characterize the product, identify its method of action and further substantiate its effectiveness is ongoing.
Cost of Sales. Cost of Sales was $39,529 for the three months ended March 31, 2011, as compared to $3,620 for the comparable prior period. Cost of Sales represents primarily costs related to raw materials, labor and the laboratory and controlled production environment necessary for the growing of the algae cultures that constitute the source of the biological activity of the ProAlgaZyme? product, and for conducting the necessary harvesting and production operations in preparing the product for sale. The increase in cost of sales for 2011 is due to an increase in overall production, combined with more efficient use of labor.
Research and Development Expenses. For the three months ended March 31, 2011, we incurred $106,911 on research and development expenses, as compared to $102,989 for the comparable period in 2010. These expenses are mainly comprised of costs associated with external research. Our research and development costs remain relatively stable as we work to complete the research begun in the first quarter of 2011. This research was initiated to further explore ProAlgaZyme?'s potential efficacy on the management of cholesterol levels. We have identified several potential bioactive compounds, but further research aimed at isolating the compound further is expected to be completed during the second half of 2011.
Selling and Marketing Expenses. Selling and marketing expenses were $5,112 for the three months ended March 31, 2011, as compared to $26,237 for the comparable prior period. The decrease in 2011 was due to the reclassification of wages paid to our Executive Vice President, combined with increased focus on research, resulting in our deemphacising marketing.
In the past we were only accustomed to nominal sales of our sole product, ProAlgaZyme. In September of 2010, we signed an exclusive distribution agreement to sell our product. This exclusive distribution agreement called for an initial licensing fee of $255,000 (received in October of 2010) and monthly orders which increase as our ability to produce product increases, subject to satisfaction of certain conditions, including satisfaction of the GRAS standard (or NDI status). An initial order of $51,100 was received in December of 2010.
Due to several delays in the design of new packaging, this order was shipped in full during the month of April, 2011. We anticipate delivering additional orders beginning towards the end of the second quarter of 2011, with monthly increases in the minimums each month as production will allow and subject to satisfaction of the FDA's GRAS standard. See Note 11 to the financial statements.
We intend to explore additional third party distribution channels for our product, consistent with the limitations placed upon us by our exclusive distribution agreement with Ceptazyme, LLC. The limit on our ability thus far to advertise our product (due in part to the need for additional testing) has had and, until we are able to advertise our product based upon the results of "class of compound" testing and identification of the bioactive ingredient, will continue to have, a material adverse effect on sales revenue and operating results. We intend to continue to pursue clinical study of our product and, subject to the results of such testing, increase advertising in 2011, subject to availability of sufficient funding, which we do not currently have.
General and Administrative Expenses. General and administrative expense was $312,663 for the three months ended March 31, 2011, as compared to $844,133 for the comparable prior period. The decrease in general and administrative expense during 2011 is due primarily to an approximate $531,000 decrease in fees paid to consultants for product and business development , of which approximately $500,000 was in the form of stock based compensation, a non-cash expense.
Liquidity and Capital Resources
The unaudited condensed consolidated financial statements contained in this Quarterly Report have been prepared on a "going concern" basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. We have an immediate and urgent need for additional capital. For the reasons discussed herein, there is a significant risk that we will be unable to continue as a going concern, in which case, you would suffer a total loss of your investment in our company.
As of May 11, 2011, we had a cash balance of approximately $3,000. We have had only limited revenue ($36,329 for the three months ended March 31, 2011) and have incurred significant net losses since inception, including a net loss of $467,281 for the quarter ended March 31, 2011. Subject to our expanding our production capacity to meet increased product demand (for which we do not currently have sufficient capital) and our product's meeting the FDA's GRAS standard or receiving New Diet Ingredient ("NDI") status form the FDA, the revenue guaranteed to us under the exclusive distribution agreement is expected to contribute significantly to funding our normal operations. However, we have, since inception, consistently incurred negative cash flow from operations. During the quarter ended March 31, 2011, we incurred negative cash flows from operations of $320,718. As of March 31, 2011, we had a working capital deficiency of $923,124 and a stockholders' deficiency of $1,043,755. Although we recently raised a limited amount of capital, we have an immediate and urgent need for additional capital.
During the three months ended March 31, 2011, our operating activities used $320,718 in cash, a decrease of $594,518 from the comparable prior period. The approximate $595,000 decrease in cash used by operating activities was primarily attributable to the following (all of which are approximated): a $5 million decrease in net loss, an 87,000 change (increase) in accrued payroll/ payroll taxes and an 89,000 change (increase) in accounts payable, partially offset by a $4.5 million decrease in fair value adjustment of derivative liability (a non-cash expense) and a $77,000 decrease in stocks and warrants issued for services (also a non-cash expense).
Our financing activities generated $308,910, a $819,831decrease from the comparable prior period. The decrease in cash provided by financing activities was due primarily to a decrease in proceeds from sales of securities.
Although we raised a limited amount of capital during 2010 and the first quarter of 2011, we continue to experience a shortage of capital, which is materially and adversely affecting our ability to run our business. As noted above, we have been largely dependent upon external sources for funding. We have in the past had great difficulty in raising capital from external sources. Subject to our ability to expand our production capacity (for which we do not currently have sufficient capital) and meet the FDA's GRAS standard, our exclusive distribution agreement should generate revenue to help cover at least a portion of our normal operating expenses; however we will still be reliant upon external financing for the continuation of our research program. With the leasing of our new manufacturing and office facilities, we anticipate being able to increase our production as necessary to meet the minimum requirements called for in our distribution agreement, subject to having sufficient capital, which we do not currently have.
We estimate that we will require approximately $1,500,000 in cash over the next 12 months in order to fund our normal operations. In addition, we are seeking additional funding in the range of $500,000 to $1,000,000 to fund our research initiatives. Based on this cash requirement, we have an immediate and urgent need for additional funding. Historically, we have had great difficulty raising funds from external sources; however, we recently were able to raise a limited amount of capital from outside sources.
In addition, we have only limited product liability insurance. If a product claim were successfully made against us, there could be a material adverse effect on our financial condition given our liquidity and cash limitations.
Significant elements of income or loss not arising from our continuing operations
Except as set forth below, we do not expect to experience any significant elements of income or loss other than those arising from our continuing operation. For the three months ended March 31, 2011, we recognized $4,464,607 in expense for financial statement purposes based on the change in fair value of derivative liabilities as of March 31, 2011. We may incur income or expense in future periods arising out of changes in the fair value of derivative liabilities. See the section above captioned Fair Value Adjustment of Derivative Liability for further information.
Seasonality
Our product is directed to the improvement of the health of our consumers, and we do not expect that operating results will be affected materially by seasonal factors. In addition, ProAlgaZyme? is cultivated in a climate-controlled laboratory environment, not subject to seasonal growing effects or influences
Staffing
We have conducted all of our activities since inception with a minimum level of qualified staff. We currently do not expect a significant increase in staff.
Off-Balance Sheet arrangements
We have no off-balance sheet arrangements that would create contingent or other forms of liability.
