Item 2.
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Management's Discussion and Analysis of Financial Condition and Results of Operations
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FORWARD-LOOKING
STATEMENTS
Statements made in this Form 10-Q
which are not purely historical are forward-looking statements with respect to the goals, plans, objectives, intentions, expectations,
financial condition, results of operations, future performance and business of the Company. Forward-looking statements may be identified
by the use of such words as “believes”, “may”, “will”, “should”, “intends”,
“plans”, “estimates”, “anticipates”, or other similar expressions.
Forward-looking
statements involve inherent risks and uncertainties, and important factors (many of which are beyond our control) could cause actual
results to differ materially from those set forth in the forward-looking statements. In addition to those specific risks and uncertainties
set forth in the Company's reports currently on file with the SEC, some other factors that may affect the future results of operations
of the Company are: the development of products that may be superior to those of the Company; changes in the quality or composition
of the Company's products; lack of market acceptance of the Company's products; the Company's ability to develop new products;
general economic or industry conditions; changes in intellectual property rights; changes in interest rates; new legislation or
regulatory requirements; conditions of the securities markets; the Company's ability to raise capital; changes in accounting principles,
policies or guidelines; financial or political instability; acts of war or terrorism; and other economic, competitive, governmental,
regulatory and technical factors that may affect the Company's operations, products, services and prices.
Accordingly,
results actually achieved may differ materially from those anticipated as a result of such forward-looking statements, and those
statements speak only as of the date they are made.
The Company does not undertake, and specifically disclaims, any obligation to update any forward-looking statements to reflect events or circumstances occurring after the date of such statements.
OVERVIEW
The Company is a Delaware corporation
that, through its Guardian Laboratories Division, conducts research, product development, manufacturing and marketing of cosmetic
ingredients, personal and health care products, pharmaceuticals, medical products, and proprietary specialty industrial products.
All of the products that the Company manufactures, with the exception of
Renacidin
®
,
are produced at its facility in Hauppauge, New York, and are marketed through marketing partners, distributors, wholesalers, direct
advertising, mailings, and trade exhibitions. Its most important product line is its LUBRAJEL
®
line of water-based moisturizing and lubricating gels, which are used primarily as ingredients in cosmetic products. The Company’s
research and development department is actively working on the development of new products to expand the Company's line of personal
care products. Some of the Company’s products have patent protection, and others are produced using proprietary manufacturing
processes.
The Company’s personal care
products are marketed worldwide by five marketing partners, of which Ashland Specialty Ingredients ("ASI") purchases
the largest volume of products from the Company. Approximately 47% of the Company's products are sold, either directly or through
the Company’s marketing partners, to end users located outside of the United States.
The Company also sells two pharmaceutical
products for urological uses. Those products are sold mainly in the United States, with distribution handled primarily by the major
drug wholesalers, which in turn sell the products to pharmacies, hospitals, nursing homes and other long-term care facilities,
and to government agencies, primarily the U.S. Department of Veterans Affairs.
The Company’s non-pharmaceutical medical products (referred to hereinafter as “medical products”), such as its
catheter lubricants, as well as its specialty industrial products, are sold directly by the Company to the end users or to contract
manufacturers utilized by the end users, although they are available for sale on a non-exclusive basis by its marketing partners,
as well.
While the Company does have competition
in the marketplace for some of its products, particularly its cosmetic ingredients, some of its pharmaceutical and medical products
have some unique characteristics, and do not have direct competitors. However, these products may have indirect competition from
other products that are not marketed as direct competitors to the Company’s products but may have similar functions or properties
to the Company’s products.
The Company recognizes revenue
when products are shipped, title and risk of loss pass to the customers, persuasive evidence of a sales arrangement exists, and
collections are reasonably assured. An allowance for returns, based on historical experience, is taken as a reduction of sales
within the same period the revenue is recognized.
Over the years the Company
has been issued many patents and trademarks and intends, whenever possible, to make efforts to obtain patents in connection with
its product development program. Most of the patents that the Company has been issued have expired; however, the Company does not
believe that the expiration of those patents will have any material effect on its sales, since the Company’s most important
products rely on trade secrets and proprietary manufacturing methods rather than patent protection.
Critical
Accounting Policies
As
disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015, the discussion and analysis
of the Company’s financial condition and results of operations are based on its financial statements, which have been prepared
in conformity with GAAP. The preparation of those financial statements required the Company to make estimates and assumptions that
affect the carrying value of assets, liabilities, revenues and expenses reported in those financial statements. Those estimates
and assumptions can be subjective and complex, and consequently actual results could differ from those estimates and assumptions.
The Company’s most critical accounting policies relate to revenue recognition, concentration of credit risk, investments,
inventory, and income taxes. Since December 31, 2015, there have been no significant changes to the assumptions and estimates related
to those critical accounting policies.
The
following discussion and analysis covers material changes in the financial condition of the Company since the year ended December
31, 2015, and a comparison of the results of operations for the three and nine months ended September 30, 2016 and September 30,
2015. This discussion and analysis should be read in conjunction with "Management's Discussion and Analysis or Plan of Operation"
included in the Company's Annual Report on Form 10-K for the year ended December 31, 2015.
RESULTS
OF OPERATIONS
Net sales for the third quarter
of 2016 decreased by $162,732 (4.5%) compared with the third quarter of 2015. Net sales for the first nine months of 2016 decreased
by $4,257,475 (35.1%) as compared with the corresponding period in 2015. The changes in net sales for the three and nine months
ended September 30, 2016 were attributable to changes in sales of the following product lines:
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(a)
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Personal care products
: For the third quarter of 2016 the Company’s sales of personal
care products decreased by $887,108 (36.0%) when compared with the third quarter of 2015. For the nine-month period ended September
30, 2016 the Company’s sales of personal care products decreased by $5,432,102 (59.8%) when compared with the nine-month
period in 2015. The decrease in sales in both periods was due primarily to decreases in shipments of the Company's extensive line
of personal care products to ASI, the Company's largest marketing partner. Sales to ASI alone decreased by $963,470 (43.6%) and
$5,420,721 (67.8%)% for the three-month and nine-month periods, respectively, ended September 30, 2016, compared with the corresponding
periods in 2015. The Company has been informed by ASI that this decline in purchases was almost entirely the result of (1) overly
optimistic order forecasts by some of ASI’s customers in China, which resulted in ASI purchasing more of one of the Company’s
LUBRAJEL products than it needed; and (2) a regulatory issue in China unrelated to LUBRAJEL that resulted in the temporary suspension
of production of some products that contained an ingredient that was not approved for use in China, and which also happened to
contain LUBRAJEL as one of the ingredients. The companies that had been marketing those products are in the process of reformulating
them to comply with Chinese regulations. As a result of these two issues, ASI accumulated significant excess inventory that it
has been gradually working off since the fourth quarter of 2015 and continuing through most of the first nine months of 2016. That
excess inventory has now been reduced to the appropriate level for ASI to resume purchasing LUBRAJEL for sale in China. Accordingly,
shipments to ASI for sale in China resumed in September 2016. ASI has informed the Company that it anticipates that it will once
again be placing regular monthly orders for product intended for shipment to China.
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Sales of the Company’s
personal care products to its four marketing partners in Western Europe in the third quarter of 2016 increased by $23,636 (13.6%)
compared with the third quarter of 2015, with an increase in sales to the Company’s marketing partners in France and Switzerland
being partially offset by a decrease in sales to the Company’s marketing partners in the United Kingdom and Italy. For the
first nine months of 2016 sales to the Company’s marketing partners in Western Europe other than ASI increased by $160,466
(29.9%), with an increase in sales to the Company’s marketing partners in France and the United Kingdom being partially
offset by a decrease in sales to its marketing partners in Italy and Switzerland. Sales to the Company’s South Korean marketing
partner increased by $69,171 (131.1%) for the third quarter of 2016 compared with the third quarter of 2015, and decreased by
$142,712 (29.0%) for the first nine months of 2016 compared with the same period in 2015. That marketing partner experienced unusually
strong sales in the first nine months of 2015 that were not repeated in 2016.
The Company’s sales in
Western Europe continue to be negatively impacted by (a) the continuing economic problems in Europe; (b) the strong U.S. dollar
relative to the Euro, which has made the Company’s products less competitive in Europe, and (c) increased competition. For
the past few years the Company has been experiencing additional competition from Asian companies selling imitations of the Company’s
products at much lower prices, particularly Chinese and Korean companies, or other companies manufacturing competitive products
in China and Korea. This has resulted in a loss of some business to these competitive products. As a result, from time to time
it has been necessary, and will continue to be necessary, for the Company to lower its prices in specific cases in order to retain
or attract customers, and this has impacted its profit margins on those sales. The Company intends to continue to work with its
marketing partners to take whatever steps are necessary to try to recover the business it has lost to these lower-priced products,
including continuing to reduce prices on a case by case basis, as needed, in order to remain as competitive as possible.
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(b)
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Pharmaceuticals
: For the third quarter of 2016 sales of the Company’s pharmaceutical
products increased by $666,672 (130.8%) when compared with the third quarter of 2015. For the nine-month period ended September
30, 2016 sales of the Company’s pharmaceutical products increased by $1,025,858 (75.0%) when compared with the first nine
months of 2015. The increase in sales for the three-month and nine-month periods was primarily the result of an increase in sales
of RENACIDIN due to the introduction of the Company’s new 30mL single dose form of that product in April 2016.
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(c)
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Medical (non-pharmaceutical) products:
Sales of the Company’s medical products increased
by $93,376 (13.8%) for the third quarter of 2016 and by $221,193 (12.8%) for the nine-month period ended September 30, 2016 compared
with the comparable periods in 2015. The increase in medical product sales was primarily attributable to an increase in sales to
a major multinational medical products company due to the addition of one of the Company’s products to a new product line.
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(d)
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Industrial and other products
: Sales of the Company's industrial products, as well as other
miscellaneous products, increased by $9,968 for the third quarter of 2016, and by $2,403 for the nine-month period ended September
30, 2016 compared with the comparable periods in 2015.
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In addition to the above changes
in sales, net sales allowances increased by $45,923 and $76,293 for the three and nine month periods, respectively, ended September
30, 2016, when compared with the corresponding periods in 2015. This increase was primarily due to increases in allowances for
distribution fees and outdated material returns attributable to the Company’s pharmaceuticals.
Cost of Sales
For the third quarter of 2016,
cost of sales as a percentage of sales increased to 46.1%, from 36.8% in the third quarter of 2015, and to 44.5% for the nine-months
ended September 30, 2016 compared with 36.4% for the comparable period in 2015. The increases for the third quarter of 2016
as compared to third quarter of 2015 and for the first nine months of 2016 as compared with the comparable period in 2015 were
primarily due to the substantial increase in the sales of the Company’s RENACIDIN, which is manufactured for the Company
by a third party and therefore has a lower profit margin than many of the Company’s other products.
Operating Expenses
Operating expenses consist
of selling, general and administrative expenses. Operating expenses increased by $48,782 (11.9%) for the third quarter of 2016
compared with the comparable quarter in 2015, and by $76,749 (5.8%) for the nine months ended September 30, 2016 compared with
the nine months ended September 30, 2015. The increase for the third quarter and the first nine months of 2016 were primarily attributable
to increases in payroll and payroll related expenses and consulting fees. Operating expenses are expected to remain relatively
constant.
Research and Development
Expenses
Research and development expenses
decreased by $25,507 (13.9%) for the third quarter of 2016, and $12,895 (2.5%) for the first nine months of 2016, which related
to decreases in payroll and payroll-related expenses.
Investment Income
Investment income decreased
by $9,489 for the third quarter of 2016 compared with the comparable quarter of 2015, and by $9,619 for the nine months of 2016
compared with the nine months of 2015. These decreases were mainly due to decreases in investment income from both stock and bond
mutual funds.
Provision for income
taxes
The Company's effective income
tax rate remained approximately 31.0% for all periods presented, and is expected to remain consistent for the current fiscal year.
LIQUIDITY
AND CAPITAL RESOURCES
Working
capital increased from $13,529,593 at December 31, 2015 to $14,125,558 at September 30, 2016, an increase of $595,965. The current
ratio decreased from 14.7 to 1 at December 31, 2015 to 10.7 to 1 at September 30, 2016. The increase in working capital was primarily
due to increases in receivables and marketable securities, partially offset by an increase in income taxes payable. The decrease
in the current ratio was primarily due to increases in accruals for expenses and income taxes.
The
Company believes that its working capital is, and will continue to be, sufficient to support its operating requirements for at
least the next twelve months. The Company does not expect to incur any significant capital expenditures for the remainder of 2016.
The
Company generated cash from operations of $1,666,481 and $4,106,921 for the nine months ended September 30, 2016 and September
30, 2015, respectively. The decrease in cash from operations was primarily due to a decrease in net income.
Cash used in investing activities for the nine-month period ended September 30, 2016 and September 30, 2015 was $116,090 and $2,611,715, respectively. This decrease was primarily due to a decrease in cash used for the purchase of marketable securities in the nine months ended September 30, 2016 compared with the nine months ended September 30, 2015.
Cash
used in financing activities was $1,603,871 and $2,298,219 for the nine months ended September 30, 2016 and September 30, 2015,
respectively. This decrease was due to a decrease in the dividend paid per share from $0.50 per share in 2015 to $0.35 per share
in 2016.
The Company expects to continue to use its cash to make dividend payments, to purchase marketable securities, and to take advantage of other opportunities that are in the best interest of the Company and its shareholders, should they arise.
OFF BALANCE SHEET ARRANGEMENTS
The Company has no off balance sheet transactions that have, or are reasonably likely to have, a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
CONTRACTUAL
OBLIGATIONS AND COMMITMENTS
The information to be reported under this item is not required of smaller reporting companies.