10QSB 1 qsb083104.txt SECURITIES AND EXCHANGE COMMISSION Washington DC 20549 FORM 10-QSB Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 For Quarter Ended August 31, 2004 Commission File No. 0-5920 LANCER ORTHODONTICS, INC. (Exact Name of Small Business Issuer as Specified in its Charter) CALIFORNIA 95-2497155 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 253 Pawnee Street, San Marcos, California 92069 (Address of Principal Executive Offices) Issuer's telephone number, including area code: (760) 744-5585 Check whether the issuer: (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act 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. Yes X No State the number of shares outstanding of each of the issuer's classes of common equity, as of September 17, 2004: 2,768,820 Transitional small business disclosure format (check one): Yes X No LANCER ORTHODONTICS, INC. FORM 10-QSB QUARTERLY REPORT TABLE OF CONTENTS PART I - FINANCIAL INFORMATION Page(s) Item 1 Financial Statements (Unaudited) Consolidated Balance Sheet 3 Consolidated Statements of Operations 4 Consolidated Statements of Cash Flows 5 Notes to Consolidated Financial Statements 6-17 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 17-20 Item 3 Quantitative and Qualitative Disclosures about Market Risk 20-21 Item 4 Procedures and Controls 21 PART II - OTHER INFORMATION Item 1 Legal Proceedings 21 Item 2 Changes in Securities and Use of Proceeds 21 Item 3 Defaults Upon Senior Securities 21 Item 4 Submission of Matters to a Vote of Security Holders 21 Item 5 Other Information 21 Item 6 Exhibits and Reports on Form 8-K 21 Signature 22 PART I. FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS (UNAUDITED) LANCER ORTHODONTICS, INC. CONSOLIDATED BALANCE SHEET (UNAUDITED) 08/31/04 ASSETS CURRENT ASSETS: Cash $126,905 Accounts receivable, less allowances for sales returns and doubtful receivables of $97,829 1,275,954 Inventories, net of reserve of $144,135 2,006,068 Related party receivables 3,844 Prepaid expenses 59,638 Other receivables 50,728 Total current assets 3,523,137 PROPERTY AND EQUIPMENT, at cost 3,067,377 Less: Accumulated depreciation (2,458,888) 608,489 INTANGIBLE ASSETS: Marketing and distribution rights, net 4,150 OTHER ASSETS 48,821 Total assets $4,184,597 LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $505,477 Accrued payroll and related benefits 164,307 Accrued professional fees 31,881 Accrued royalties 34,289 Other current liabilities 40,938 Related party payable 200 Total current liabilities 777,092 COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY: Preferred stock, various series; 750,000 shares authorized; no shares issued and outstanding -- Common stock, no par value; 50,000,000 authorized; 2,768,820 shares issued and outstanding 5,162,095 Common stock subscribed, 51,041 shares subscribed 28,750 Accumulated deficit (1,783,340) Total stockholders' equity 3,407,505 Total liabilities and stockholders' equity $4,184,597 LANCER ORTHODONTICS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS UNAUDITED FOR THE THREE MONTHS ENDED 8/31/04 8/31/03 NET SALES $1,480,863 $1,318,107 COST OF SALES 1,072,427 975,267 Gross Profit 408,436 342,840 OPERATING EXPENSES: Selling 343,952 344,946 General & Administrative 118,594 111,019 Product Development 27,108 32,502 TOTAL OPERATING EXPENSES 489,654 488,467 LOSS FROM OPERATIONS (81,218) (145,627) OTHER INCOME: Interest Expense -- -- Other Income, net 17,868 5,412 TOTAL OTHER INCOME 17,868 5,412 LOSS BEFORE INCOME TAXES (63,350) (140,215) INCOME TAXES -- -- NET LOSS $(63,350) $(140,215) PER SHARE DATA: Basic $(.02) $(.06) Diluted $(.02) $(.06) WEIGHTED AVERAGE NUMBER OF COMMON AND COMMON EQUIVALENT SHARES: Basic 2,807,362 2,266,476 Diluted 2,807,362 2,266,476 LANCER ORTHODONTICS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) FOR THE THREE MONTHS ENDED 08/31/04 08/31/03 Cash flows from operating activities: Net loss $(63,350) $(140,215) Adjustments to reconcile net loss to net cash (used in) provided by operating activities: Depreciation and amortization 25,689 11,461 Provision for losses on accounts receivable (2,171) (5,142) Provision for losses on inventory 15,000 15,000 Common stock issued in lieu of salary 22,500 3,750 Net change in operating assets and liabilities: Accounts receivable (139,649) 202,926 Inventories (173,538) (39,531) Related party receivables 3,436 4,447 Prepaid expenses 64,539 (11,204) Other receivables (4,388) (1,497) Accounts payable 123,447 (126,562) Accrued payroll and related benefits 38,158 28,142 Other current liabilities (25,327) (13,818) Net cash used in operating activities (115,654) (72,243) Cash flows from investing activities: Purchases of property and equipment (61,586) (147,760) Other assets -- (3,651) Net cash used in investing activities (61,586) (151,411) Cash flows from financing activities: Net decrease in line of credit -- (5) Cash flows used in financing activities -- (5) Net change in cash (177,240) (223,659) Cash, beginning of period 304,145 511,407 Cash, end of period $126,905 $287,748 Supplemental disclosure of cash flow information: Cash paid for: Interest $-- $-- LANCER ORTHODONTICS, INC. Notes to Consolidated Financial Statements (A) Basis of Presentation The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10-QSB and therefore do not include all information and notes necessary for a fair presentation of consolidated financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. The unaudited consolidated financial statements include the accounts of Lancer Orthodontics, Inc. (the "Company" or "Lancer") and its wholly-owned subsidiary Lancer Orthodontics de Mexico. The consolidated operating results for interim periods are unaudited and are not necessarily an indication of the results to be expected for the full fiscal year. In the opinion of management, the results of operations as reported for the interim periods reflect all adjustments which are necessary for a fair presentation of operating results. Reference is made to Note 2 of the Notes to the Consolidated Financial Statements contained in Lancer's Annual Report on Form 10-KSB for the fiscal year ended May 31, 2004, for a summary of significant accounting policies utilized by Lancer. (B) Organization Lancer Orthodontics, Inc. was incorporated on August 25, 1967, in the state of California, for the purpose of engaging in the design, manufacture, and distribution of orthodontic products. Lancer has a manufacturing facility in Mexico where a majority of its inventory is manufactured (Note G). The facility is incorporated and is a wholly-owned and consolidated subsidiary of Lancer. This subsidiary now also administers services previously provided by an independent manufacturing contractor. The conversion had no material effect on manufacturing operations. Lancer also purchases certain orthodontic and dental products for purposes of resale. Sales are made directly to orthodontists world-wide through Company representatives and independent distributors. Lancer also sells certain of its products on a private label basis. The Company is a partially owned and consolidated subsidiary of Biomerica, Inc. ("Biomerica"). Biomerica's direct ownership percentage of Lancer is 24.7% and its direct and indirect (via agreements with certain shareholders) voting control over Lancer is greater than 50% as of August 31, 2004. (C) Use of Estimates in the Preparation of Financial Statements The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP"), requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates made by Lancer's management include, but are not limited to, allowances for doubtful accounts, allowances for sales returns, valuation of inventories, realizeability of property and equipment through future operations, and realizeability of deferred tax assets. Actual results could materially differ from those estimates. LANCER ORTHODONTICS, INC. Notes to Consolidated Financial Statements - continued (D) Stock Based Compensation In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," which amended SFAS No. 123 "Accounting for Stock-Based Compensation." The new standard provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. Additionally, the statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in the annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This statement is effective for financial statements for fiscal years ending after December 15, 2002. In compliance with SFAS No. 148, the Company has elected to continue to follow the intrinsic value method in accounting for our stock- based employee compensation plan as defined by APB No. 25, "Accounting for Stock Issued to Employees". Pro forma information regarding net income and income per share is required by SFAS 148, and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS 148. The fair value for these options was estimated at the date of grant using the Black Scholes option pricing model with the following weighted average assumptions for the three months ended August 31, 2004 and 2003: risk free interest rates between 2% and 4%; dividend yield of 0%; expected life of the option of two to four years; and volatility factor of the expected market price of the Company's common stock of between 40% and 100%. 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. Because the Company's employee stock options have characteristics significantly different from 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 employee stock options. For purposes of pro forma disclosure, the estimated fair value of the options is amortized to expense over the options vesting period. Adjustments are made for options forfeited prior to vesting. The effect on compensation expense, net loss, and net loss per common share had compensation costs for the Company's stock option plans been determined based on a fair value at the date of grant consistent with the provisions of SFAS 148, for the three months ended August 31, 2004 and 2003 as follows: LANCER ORTHODONTICS, INC. Notes to Consolidated Financial Statements - continued (D) Stock Based Compensation - continued FOR THE THREE MONTHS ENDED 8/31/04 8/31/03 Net loss, as reported $(63,350) $(140,215) Add: Stock-based employee compensation expense -- -- Less: Stock-based employee compensation expense determined under fair value calculations (9,461) (14,218) Net loss pro forma $(72,811) $(154,433) Basic loss per share, as reported: $(0.02) $(0.06) Add: Stock-based employee compensation expense recorded -- -- Less: Stock-based employee compensation expense determined under fair value calculations (0.00) (0.01) Pro forma $(0.02) $(0.07) Diluted loss per share, as reported: $(0.02) $(0.06) Add: Stock-based employee compensation expense recorded -- -- Less: Stock-based employee compensation expense determined under fair value calculations (0.00) (0.01) Pro forma $(0.02) $(0.07) (E) Property and Equipment Costs in construction in progress consist of eight projects; five for new product lines and three for the replacement of existing equipment. Costs capitalized into the new product lines at August 31, 2004 are $52,834, with approximately $280,000 required for completion. Costs capitalized for the replacement equipment are $31,869, with approximately $47,000 required for completion. (F) Financing At August 31, 2004, Lancer has a $400,000 line of credit with Cuyamaca Bank, which expires January 8, 2005. Borrowings are made at prime plus 2.0%, (6.5% at August 31, 2004) and are limited to 80% of accounts receivable less than 90 days old. The outstanding balance at August 31, 2004, is $0 and the unused portion available is approximately $340,000. The Company requested that Cuyamaca Bank reserve $60,000 of Lancer's available credit line as a guarantee of credit with a European supplier. Lancer is in compliance with its debt covenants at August 31, 2004. The line of credit is collateralized by substantially all the assets of Lancer, including inventories, receivables, and equipment. The lending agreement for the line of credit requires, among other things, that Lancer maintain a balance sheet net worth of $2,700,000 and that a zero outstanding balance be maintained for 30 consecutive days during the term. Lancer also had a term loan for $100,000 with Cuyamaca Bank that was paid off in May 2004. This loan required monthly payments of approximately $2,300 (principal and interest) at an interest rate of prime plus 2% (6% at May 31, 2004). (G) Commitments and Contingencies In May 1990, Lancer entered into a manufacturing subcontractor agreement whereby the subcontractor agreed to provide manufacturing services to Lancer through its affiliated entities located in Mexicali, B.C., Mexico. Effective April 1, 1996, Lancer leased the Mexicali facility under a separate agreement. Since October 2000, the manufacturing agreement has operated on a month-to- month basis. During fiscal 2003, the facility in Mexico was incorporated as Lancer Orthodontics de Mexico, ("Lancer de Mexico"), a wholly-owned subsidiary of the Company. This subsidiary now administers services previously provided by an independent manufacturing contractor. A new lease was negotiated in the name of Lancer de Mexico, effective April 1, 2001, for the 16,000 square foot facility already in use for the Mexican operations. Mexican utilities and vendor obligations were also converted to the Lancer de Mexico name. This conversion eliminated the expense of an administrative fee and is expected to provide better control in meeting future obligations. The conversion had no material effect on manufacturing operations. Should Lancer discontinue operations in Mexico, it is responsible for accumulated employee seniority obligations as prescribed by Mexican law. At August 31, 2004, this obligation was approximately $338,000. Such obligation is contingent in nature and accordingly has not been accrued in Lancer's consolidated financial statements. Lancer has undergone no material change in the mode of conducting its business other than described above and it did not dispose of any material amount of its assets during the three months ended August 31, 2004 and 2003. Leases - Lancer leases its corporate facility under a non-cancelable operating lease expiring April 30, 2009, as extended, which requires monthly rentals that increase annually, from $6,688 per month in 2004 to $7,527 per month in 2009. The lease expense is being recognized on a straight-line basis over the term of the lease. The excess of the expense recognized over the cash paid aggregates $20,589 at August 31, 2004, and is included in accrued liabilities in the accompanying consolidated balance sheet. Total rental expense for this facility for the three months ended August 31, 2004, was approximately $20,000. LANCER ORTHODONTICS, INC. Notes to Consolidated Financial Statements - continued (G) Commitments and Contingencies - continued Effective December 1, 2002, Lancer Orthodontics de Mexico entered into a non- cancelable operating lease for its Mexico facility through March 31, 2009. The new lease encompasses the approximately 16,000 square feet of the previous lease, plus additional square footage of approximately 10,000 feet, for a total of approximately 26,000 square feet. Lancer Orthodontics de Mexico will provide sub-contracted manufacturing services to Biomerica, Inc., a related party, using a portion of the additional square footage. The new lease requires monthly payments of approximately $9,600 through March 2009. An agreement has been negotiated between Lancer Orthodontics de Mexico and Biomerica for lease reimbursement of approximately $2,000 per month. The remainder of approximately $7,600 monthly lease will be borne by Lancer. Total rental expense for this facility for the three months ended August 31, 2004, was approximately $26,000. The new Lancer Orthodontics de Mexico lease also requires an additional refundable security deposit of $26,550. Lancer Orthodontics, Inc. is paying half and Biomerica, Inc. the other half. This is in addition to the $31,146 refundable security deposit paid in fiscal 2003. At August 31, 2004, other assets on the consolidated balance sheet includes approximately $44,400 for security deposit paid on the Mexico location and approximately $4,400 paid on the San Marcos location previously. The Company entered into a non-cancelable operating lease for a copier in February 2003 that expires in February 2006, and requires monthly payments of $214. Total expense for the copier was approximately $674 and $662 during the three months ended August 31, 2004 and 2003, respectively. The Company entered into a non-cancelable operating lease for a postage machine in July 2003 that expires in September 2008, and requires monthly payments of $208. Total expense for the postage machine was approximately $691 and $208 in the three months ended August 2004 and 2003, respectively. The Company entered into a lease for a phone system in July 2003 that expires in June 2008, and requires monthly payments of $887. Total expense for the phone system was approximately $3,126 and $1,892 in the three months ended August 31, 2004 and 2003, respectively. At May 31, 2004, future aggregate minimum lease payments are as follows: Years ending May 31, 2005 223,000 2006 225,000 2007 228,000 2008 228,000 2009 191,000 Total $1,095,000 LANCER ORTHODONTICS, INC. Notes to Consolidated Financial Statements - continued (G) Commitments and Contingencies - continued A sub-lease agreement for approximately 459 square feet of Lancer's main facility was entered into in April 2003, effective through November 2003, and extended through November 2004, with an unrelated third party. The leased space is to be used for a machine shop and requires monthly payments of $344. Rental income for the three months ended August 31, 2004 and 2003 was $1,107 and $1,032, respectively. Employment Agreement - Pursuant to the terms of the employment agreement between the Company and Dan Castner, the Vice President of Sales and Marketing of the Company, dated as of May 20, 2003, the Company agreed to pay Mr. Castner an annual base salary of $135,000. In addition, the Company granted Mr. Castner stock options on June 2, 2003, to purchase an aggregate of 120,000 shares of the Company's common stock at an exercise price of $0.38 per share. The stock options have a term of five years and will vest over four years as follows: (i) 25% vesting on the first anniversary of the date of the grant; (ii) 25% vesting on the second anniversary of the date of the grant; (iii) the remaining 50% vesting as to one-twenty fourth (1/24th) per month each month thereafter for the next two years. Should the Company be purchased by an unaffiliated third party, the options shall vest 100%. Common Stock - Lancer's stock is traded on the OTC Bulletin Board. (H) Income Taxes At May 31, 2004, Lancer had net tax operating loss carryforwards of approximately $1,997,000 and business tax credits of approximately $63,000 available to offset future Federal taxable income and tax liabilities, respectively. The Federal carryforwards expire in varying amounts through the year 2021. As of May 31, 2004, Lancer had net tax operating loss carryforwards of approximately $70,000 and business tax credits of approximately $10,000 available to offset future state income tax liabilities. The state carryforwards expire through the year 2011. On September 11, 2002, California passed one of the budget trailer bills that implemented the state's 2002-2003 Budget Bill (A415). The law suspended the net operating loss ("NOL") carryover deduction for tax years 2002 and 2003. To compensate for the deduction suspension, the period of availability for these NOL deductions has been extended for two years. (I) Stockholders' Equity Common Stock During fiscal 2003, the Company issued 37,595 shares of its common stock valued at $8,271 to Biomerica for certain management and consulting services rendered in fiscal 2002. These shares were classified at May 31, 2002 as common stock subscribed. During fiscal 2003, the Company issued 25,000 shares of its common stock valued at $8,750 to its Chief Executive Officer for services rendered in fiscal 2002. These shares were classified at May 31, 2002 as common stock subscribed. LANCER ORTHODONTICS, INC. Notes to Consolidated Financial Statements - continued (I) Stockholders' Equity - continued During fiscal 2004, the Company issued 91,346 shares of its common stock valued at $29,000 to its Chief Executive Officer for services rendered. At May 31, 2003, 69,471 of these shares were reported as subscribed stock. During fiscal 2004, the Company agreed to issue 13,541 shares of its common stock to the Chairman of the Board for services rendered from January 2004 to May 2004 and 31,250 shares of common stock to the Chief Executive Officer for services rendered per agreement. At May 31, 2004, these shares are reported as subscribed stock. The Lancer Board of Directors approved a private offering of common stock, effective March 23, 2004, and ending April 12, 2004. The offering, to officers, board members, and key employees resulted in the sale of 450,000 new shares at $.60 per share with total proceeds received of $270,000. In addition, one warrant exercisable for each share purchased (450,000 warrants) was issued at $.85 per share. These warrants shall be exercisable until April 12, 2009. Stock Option Agreements and Warrants The Company has incentive stock option and non-qualified stock option plans for directors, officers, and key employees. The 1993 Stock Option Plan authorized 357,143 shares to be issued. Options granted under the 1993 plan were required to be granted at an option price not less than 85% of the fair market value for options granted to employees, or less than 100% of the fair market value for options granted to non-employees. The fair market value of the stock was the share price of the Company's common stock at the date the options were granted. Most options granted under this Plan had an expiration period of five years from the date of their respective grant and all were granted at fair market value at the date of grant. At August 31, 2004 there were 328,500 options outstanding under this plan. The 1993 Stock Option Plan expired in March 2004 and no new options could be granted under this Plan, but the outstanding options remain effective until exercised or forfeited. The 2000 Stock Incentive Plan authorized 450,000 initial shares to be issued, increasing by the lower of 1.5% of the total number of common shares outstanding or 225,000 shares, each year on January 1, beginning in 2001. The total shares authorized at August 31, 2004 were 581,023. Incentive stock options granted under the 2000 Plan are required to be granted at an option price not less than 100% of the fair market value of the Company's common stock on the date of grant, with an exercise period not exceeding ten years from grant date. The option price of non-statutory stock options granted under the 2000 Plan are required to be granted at an option price not less than 85% of the fair market value of the Company's common stock on the date of grant. Options granted to non-executive directors under the 2000 Plan are required to be granted at an option price not less than 100% of the fair market value determined by the Board of Directors, with an exercise period not exceeding ten years from grant date. The majority of options granted under this plan vest pro rata over a period of three years. At August 31, 2004 there were 300,500 options outstanding under this plan. LANCER ORTHODONTICS, INC. Notes to Consolidated Financial Statements - continued (I) Stockholders' Equity (continued) During the year ended May 31, 2003, the Company granted 70,000 options to purchase shares of the Company's common stock at an exercise price of $0.26 to certain employees of the Company for services rendered. The options vest over four years and have a term of five years. Management assigned a value of $0 to the options. During the year ended May 31, 2003, the Company granted 40,000 options to purchase shares of the Company's common stock at an exercise price of $0.28 to an employee of the Company for services rendered. The options vest over four years and have a term of five years. Management assigned a value of $0 to the options. During the year ended May 31, 2003, the Company granted 30,000 options to purchase shares of the Company's common stock at an exercise price of $0.28 to certain employees of the Company for services rendered. The options vest over four years and have a term of five years. Management assigned a value of $0 to the options. On June 2, 2003, the Company granted 120,000 stock options to purchase shares of the Company's common stock at an exercise price of $0.38 per share as pursuant to terms of the employment agreement between the Company and Dan Castner, the Vice President of Sales and Marketing. The options vest over four years and have a term of five years. Management assigned a value of $0 to the options. On June 2, 2003, the Company granted its Chief Executive Officer 75,000 stock options to purchase shares of the Company's common stock at an exercise price of $.38. The options vest over 3 years and have a term of five years. Management assigned a value of $0 to the options. On June 2, 2003, the Company granted directors 52,500 stock options to purchase shares of the Company's common stock at an exercise price of $.38. The options vest over 2 years and have a term of five years. Management assigned a value of $0 to the options. On June 30, 2003, the Company granted 8,000 stock options to purchase shares of the Company's common stock at an exercise price of $.50 to an employee of the Company for services rendered. The options vest over 3 years beginning June 30, 2004 and have a term of five years. Management assigned a value of $0 to the options. On March 30, 2004, the Company granted 40,000 stock options to purchase shares of the Company's common stock at an exercise price of $.57 to an employee of the Company for services rendered. The options vest over four years and have a term of five years. Management assigned a value of $0 to the options. On April 12, 2004, the Company granted 17,500 stock options to purchase shares of the Company's common stock at an exercise price of $.60 to a new member of its Board of Directors for services to be rendered. The options vest over 2 years and have a term of five years. Management assigned a value of $0 to the options. LANCER ORTHODONTICS, INC. Notes to Consolidated Financial Statements - continued (I) Stockholders' Equity (continued) On April 12, 2004, the Company issued 450,000 warrants to officers, directors, and key employees who purchased 450,000 shares of the Company's common stock in a private placement. The warrants have an exercise price of $.85 and have a term of five years. The following summary presents the options and warrants granted, exercised, expired, and outstanding as of August 31, 2004: Weighted Number of Shares Average Employee Non- Exercise & Directors employee Total Price Outstanding, May 31, 2004 1,097,500 0 1,097,500 $0.60 Granted -- -- -- $-- Exercised -- -- -- -- Expired (18,500) 0 (18,500) $0.80 Outstanding, August 31, 2004 1,079,000 0 1,079,000 $0.59 (J) Net Loss per Common Share and Dividends Lancer calculates earnings per share in accordance with Statement of Financial Accounting Standards ("SFAS 128"). SFAS 128 replaces the presentation of primary and fully diluted earnings per share with the presentation of basic and diluted earnings per share. Basic earnings per share excludes dilution and is calculated by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. For all periods presented, no common stock equivalents have been included in the computation of diluted earnings per share as they were determined to be anti-dilutive. Basic and diluted net loss per share is computed using the weighted average number of common shares outstanding during the period. Potentially dilutive securities are excluded from the diluted net loss per share calculation, as the effect would be antidilutive. Potentially dilutive shares not included are 577,500 shares for outstanding employee stock options. LANCER ORTHODONTICS, INC. Notes to Consolidated Financial Statements - continued (K) Financial Information About Foreign and Domestic Operations and Export Sales FOR THE THREE MONTHS ENDED 8/31/04 8/31/03 Sales to unaffiliated customers: United States $830,690 $734,117 Europe 378,004 308,628 Central and South America 80,491 98,896 Middle East 67,041 56,781 Other Foreign 124,637 119,685 $1,480,863 $1,318,107 No other geographic concentrations exist where net sales exceed 10% of total net sales. 08/31/04 08/31/03 Sales or transfers between geographic areas None None Long-lived Assets: United States $498,040 $279,396 Mexico 110,449 86,435 $608,489 $365,831 (L) Related Party Transactions In April 2003, Lancer de Mexico entered into a manufacturing subcontractor agreement with Biomerica, Inc., to provide manufacturing services in Mexicali, Mexico. The agreement requires reimbursement from Biomerica for discrete expenses such as payroll, shipping, and customs fees; lease and security deposits of approximately $2,000 and $1,100 per month, respectively; and service fees of approximately $2,900 per month. There was no balance due from Biomerica at August 31, 2004. (M) Directors and Officers Insurance Under its bylaws, the Company has agreed to indemnify its officers and directors for certain events or occurrences arising as a result of the officer or director's serving in such capacity. The term of the indemnification period is for the officer's or director's lifetime. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. However, the Company has a directors and officer liability insurance policy that limits its exposure and enables it to recover a portion of any future amounts paid. LANCER ORTHODONTICS, INC. Notes to Consolidated Financial Statements - continued (M) Directors and Officers Insurance - continued As a result of its insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is minimal and has no liabilities recorded for these agreements as of August 31, 2004. The Company enters into indemnification provisions under (i) its agreements with other companies in its ordinary course of business, typically with business partners, contractors, and customers, landlords and (ii) its agreements with investors. Under these provisions the Company generally indemnifies and hold harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of the Company's activities or, in some cases, as a result of the indemnified party's activities under the agreement. These indemnification provisions often include indemnifications relating to representations made by the Company with regard to intellectual property rights. These indemnification provisions generally survive termination of the underlying agreement. In addition, in some cases, the Company has agreed to reimburse employees for certain expenses and to provide salary continuation during short-term disability. The maximum potential amount of future payments the Company could be required to make under these indemnification provisions is unlimited. The Company has not incurred material costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of August 31, 2004. (N) Risks and Uncertainties License Agreements - Certain of the Company's sales of products are governed by license agreements with outside third parties. All of such license agreements to which the Company currently is a party, are for fixed terms which will expire after ten years from the commencement of the agreement or upon the expiration of the underlying patents. After the expiration of the agreements or the patents, the Company is free to use the technology that had been licensed. There can be no assurance that the Company will be able to obtain future license agreements as deemed necessary by management. The loss of some of the current licenses or the inability to obtain future licenses could have an adverse affect on the Company's financial position and operations. Historically, the Company has successfully obtained all the licenses it believed necessary to conduct its business. Distribution - The Company has entered into various exclusive and non- exclusive distribution agreements (the "Agreements") which generally specify territories of distribution. The Agreements range in term from one to five years. The Company may be dependent upon such distributors for the marketing and selling of its products worldwide during the terms of these agreements. Such distributors are generally not obligated to sell any specified minimum quantities of the Company's product. There can be no assurance of the volume of product sales that may be achieved by such distributors. LANCER ORTHODONTICS, INC. Notes to Consolidated Financial Statements - continued (N) Risks and Uncertainties - continued Government Regulations - The Company's products are subject to regulation by the FDA under the Medical Device Amendments of 1976 (the "Amendments"). The Company has registered with the FDA as required by the Amendments. There can be no assurance that the Company will be able to obtain regulatory clearances for its current or any future products in the United States or in foreign markets. European Community - The Company is required to obtain certification in the European community to sell products in those countries. The certification requires the Company to maintain certain quality standards. The Company has been granted certification. However, there is no assurance that the Company will be able to retain its certification in the future. Risk of Product Liability - Testing, manufacturing and marketing of the Company's products entail risk of product liability. The Company currently has product liability insurance. There can be no assurance, however, that the Company will be able to maintain such insurance at a reasonable cost or in sufficient amounts to protect the Company against losses due to product liability. An inability could prevent or inhibit the commercialization of the Company's products. In addition, a product liability claim or recall could have a material adverse effect on the business or financial condition of the Company. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain information contained herein (as well as information included in oral statements or other written statements made or to be made by Lancer) contains statements that are forward-looking, such as statements relating to anticipated future revenues of the Company and success or current product offerings. Such forward-looking information involves important risks and uncertainties that could significantly affect anticipated results in the future, and accordingly, such results may differ materially from those expressed in any forward-looking statements made by or on behalf of Lancer. The potential risks and uncertainties include, among others, fluctuations in the Company's operating results. These risks and uncertainties also include the success of the Company in raising needed capital, the continual demand for the Company's products, competitive and economic factors of the marketplace, availability of raw materials, and the state of the economy. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof, and the Company undertakes no obligation to update these forward-looking statements. CRITICAL ACCOUNTING POLICIES The discussion and analysis of our financial condition and results of operations are based on the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires estimates and assumptions that affect the reported amounts and disclosures. We believe the following to be critical accounting policies as they require more significant judgments and estimates used in the preparation of our consolidated financial statements. Although we believe that our judgments and estimates are appropriate and correct, actual future results may differ from our estimates. In general, the critical accounting policies that may require judgments or estimates relate specifically to the recognition of revenue, the Allowance for Doubtful Accounts, Inventory Reserves for Obsolescence and Declines in Market Value, Impairment of Long-Lived Assets, Stock Based Compensation, and Deferred Income Tax Valuation and Allowances. We recognize product revenues when an arrangement exists, delivery has occurred, the price is determinable and collection is reasonably assured. The Allowance for Doubtful Accounts is established for estimated losses resulting from the inability of our customers to make required payments. The assessment of specific receivable balances and required reserves is performed by management and discussed with the audit committee. We have identified specific customers where collection is probable and have established specific reserves, but to the extent collection is made, the allowance will be released. Additionally, if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Reserves are provided for excess and obsolete inventory, which are estimated based on a comparison of the quantity and cost of inventory on hand to management's forecast of customer demand. Customer demand is dependent on many factors and requires us to use significant judgment in our forecasting process. We must also make assumptions regarding the rate at which new products will be accepted in the marketplace and at which customers will transition from older products to newer products. Once a reserve is established, it is maintained until the product to which it relates is sold or otherwise disposed of, even if in subsequent periods we forecast demand for the product. In general, we are in a loss position for tax purposes, and have established a valuation allowance against deferred tax assets, as we do not believe it is likely that we will generate sufficient taxable income in future periods to realize the benefit of our deferred tax assets. Predicting future taxable income is difficult, and requires the use of significant judgment. At August 31, 2004, all of our deferred tax assets were reserved. Accruals are made for specific tax exposures and are generally not material to our operating results or financial position, nor do we anticipate material changes to these reserves in the near future. We have provided a full valuation reserve related to our substantial deferred tax assets. In the future, if sufficient evidence of our ability to generate sufficient future taxable income in certain tax jurisdictions becomes apparent, we may be required to reduce our valuation allowances, resulting in income tax benefits in our consolidated statement of operations. We evaluate the realizability of the deferred tax assets and assess the need for valuation allowance quarterly. The utilization of the net operating loss carryforwards could be substantially limited due to restrictions imposed under federal and state laws upon a change in ownership. We have adopted SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," which amended SFAS No. 123. Under SFAS No. 148, we continue to measure compensation expense for our stock-based employee compensation plan using the intrinsic value method prescribed in Accounting Principles Board ("APB") No. 25, "Accounting for Stock Issued to Employees" and its related interpretations. We provide pro forma disclosure of the effect on net income or loss as if the fair value based method had been applied in measuring compensation expense. RESULTS OF OPERATIONS For the three months ended August 31, 2004, net loss decreased $76,865 as compared to the three months ended August 31, 2003. The decrease in net loss is primarily attributable to the increase in sales. For the three months ended August 31, 2004, net sales increased $162,756 (12.4%) as compared to the three months ended August 31, 2003. International net sales increased $66,183 primarily in Europe and the Middle East. Domestic net sales increased $96,573, primarily due to a price increase. For the three months ended August 31, 2004, cost of sales as a percentage of sales totaled 72.4%, a decrease of 1.6% as compared to the three months ended August 31, 2003, which totaled 74.0%. This decrease is primarily attributable to the domestic selling price increase. For the three months ended August 31, 2004, selling expenses decreased $994 (.3%) as compared to the three months ended August 31, 2003. The decrease is primarily attributable to a decrease in commissions, offset by an increase in professional fees and brochure costs. For the three months ended August 31, 2004, general and administrative expenses increased $7,575 (6.8%) as compared to the three months ended August 31, 2003. The increase is primarily attributable to the cost of stock issued to officers in lieu of salary. For the three months ended August 31, 2004, product development expenses decreased $5,394 as compared to the three months ended August 31, 2003. The decrease is attributable to 2003 development projects starting production in 2004. For the three months ended August 31, 2004 and 2003 there was no interest expense. For the three months ended August 31, 2004, other income increased $12,456 as compared to the three months ended August 31, 2003. The increase is due to a refund of insurance premiums paid in prior years due to an audit by the carrier and a decrease in financing costs. For the three months ended August 31, 2004 and 2003, rental income of $1,107 and $1,032, respectively, was realized. FINANCIAL CONDITION, LIQUIDITY, AND CAPITAL RESOURCES Lancer's financial condition at August 31, 2004 (unaudited) and its previous two fiscal year ends was as follows: 08/31/04 05/31/04 05/31/03 Current Assets $3,523,137 $3,463,606 $3,448,770 Current Liabilities 777,092 640,814 635,098 Working Capital 2,746,045 2,822,792 2,813,672 Line of Credit 0 0 426 Shareholder Equity 3,407,505 3,448,355 3,115,654 Total Assets 4,184,597 4,089,169 3,750,752 Cash decreased $177,240 during the three months ended August 31, 2004 primarily due to the purchase of new equipment and increases in inventories and accounts receivable. Working capital decreased $76,747 during the three months ended August 31, 2004, primarily attributable to the decrease in cash. Lancer's management believes that it will be able to finance Lancer's operations through cash flow and available borrowings through the current fiscal year and ensuing fiscal years. This assumption is based upon a reasonable level of demand for our products. At August 31, 2004, Lancer has a $400,000 line of credit with Cuyamaca Bank, which expires January 8, 2005. Borrowings are made at prime plus 2.0%, (6.5% at August 31, 2004) and are limited to 80% of accounts receivable less than 90 days old. The outstanding balance at August 31, 2004, is $0 and the unused portion available is approximately $340,000. The Company requested that Cuyamaca Bank reserve $60,000 of Lancer's available credit line as a guarantee of credit with a European supplier. Lancer is in compliance with its debt covenants at August 31, 2004. The line of credit is collateralized by substantially all the assets of Lancer, including inventories, receivables, and equipment. The lending agreement for the line of credit requires, among other things, that Lancer maintain a balance sheet net worth of $2,700,000 and that a zero outstanding balance be maintained for 30 consecutive days during the term. Lancer also has a term loan for $100,000 with Cuyamaca Bank that was paid off in May 2004. This loan required monthly payments of approximately $2,300 (principal and interest) at an interest rate of prime plus 2% (6% at May 31, 2004). Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Factors That May Affect Future Results You should read the following factors in conjunction with the factors discussed elsewhere in this and our other filings with the SEC and in materials incorporated by reference in these filings. The following is intended to highlight certain factors that may affect the financial condition and results of operations of Lancer and are not meant to be an exhaustive discussion of risks that apply to companies such as Lancer. Like other businesses, Lancer is susceptible to macroeconomic downturns in the United States or abroad, that may affect the general economic climate and performance of Lancer or its customers. Aside from general macroeconomic downturns, the additional material factors that could affect future financial results include, but are not limited to: terrorist attacks and the impact of such events; diminished access to raw materials that directly enter into our manufacturing process; shipping; labor disruption or other major degradation of the ability to ship our products to end users; inability to successfully control our margins which are affected by many factors including competition and product mix; protracted shutdown of the US border due to an escalation of terrorist or counter terrorist activity; the operating and financial covenants contained in our credit line which could limit our operating flexibility, any changes in our business relationships with international distributors or the economic client they operate in; any event that has a material adverse impact on our foreign manufacturing operations may adversely affect our operations as a whole, failure to manage the future expansion of our business could have a material adverse effect on our revenues and profitability; possible costs in complying with government regulations and the delays in receiving required regulatory approvals or the enactment of new adverse regulations or regulatory requirements; numerous competitors, some of which have substantially greater financial and other resources than we do; potential claims and litigation brought by patients or dental professionals alleging harm caused by the use of or exposure to our products; quarterly variations in operating results caused by a number of factors, including business and industry conditions and other factors beyond our control. All of these factors make it difficult to predict operating results for any particular period. Item 4. PROCEDURES AND CONTROLS Within the 90 days prior to the date of this report, Lancer carried out an evaluation, under the supervision and with the participation of Lancer's management, including the Company's Chief Executive Officer and Director of Financial Planning, of the effectiveness of the design and operation of Lancer's disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer and Director of Financial Planning concluded that Lancer's disclosure controls and procedures are effective. There were no significant changes in Lancer's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. PART II. OTHER INFORMATION Item 1. LEGAL PROCEEDINGS Not Applicable. Item 2. CHANGES IN SECURITIOES AND USE OF PROCEEDS Not Applicable. Item 3. DEFAULTS UPON SENIOR SECURITIES Not Applicable. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. Item 5. OTHER INFORMATION Not Applicable. Item 6. EXHIBITS AND REPORTS ON FORM 8-K A report on Form 8-K was filed on June 8, 2004 as amended, for the change in accountants. Subsequent to the quarter ended August 31, 2004 a Form 8-K was filed on September 24, 2004 regarding the departure of Dr. Robert Orlando from the Lancer Board of Directors. 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. LANCER ORTHODONTICS, INC. Registrant Date October 15, 2004 By /s/ Allen Barbieri Allen Barbieri, Chief Executive Officer CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 I, Allen Barbieri, certify that the Quarterly Report on Form 10-QSB for the quarter ended August 31,2004 fully complies with the requirements in Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, and that the information contained in such Quarterly Report fairly presents, in all material respects, the financial condition and results of operations of Lancer Orthodontics, Inc. for the periods being presented. /s/ Allen Barbieri Allen Barbieri Chief Executive Officer Date: October 15, 2004 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Allen Barbieri, certify that: 1. I have reviewed this Quarterly Report on Form 10-QSB of Lancer Orthodontics, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects, the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of our internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or other persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: October 15, 2004 /s/Allen Barbieri Chief Executive Officer CERTIFICATION OF DIRECTOR OF FINANCIAL PLANNING PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 I, John Dodge, certify that the Quarterly Report on Form 10-QSB for the quarter ended August 31,2004 fully complies with the requirements in Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, and that the information contained in such Quarterly Report fairly presents, in all material respects, the financial condition and results of operations of Lancer Orthodontics, Inc. for the periods being presented. /s/ John Dodge John Dodge Director of Financial Planning Date: October 15, 2004 CERTIFICATION OF DIRECTOR OF FINANCIAL PLANNING PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, John Dodge, certify that: 1. I have reviewed this Quarterly Report on Form 10-QSB of Lancer Orthodontics, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects, the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of our internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or other persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: October 15, 2004 /s/John Dodge Director of Financial Planning