-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Q9tjj1yz06+epKTlUuLtaXDuKrl50lmqEJFHQvmZK+qNnwMe4JnFO5Co5iCSH5fd rD+p9uqvEbo8E/dJ4PVxvQ== 0000950005-98-000323.txt : 19980401 0000950005-98-000323.hdr.sgml : 19980401 ACCESSION NUMBER: 0000950005-98-000323 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: EROX CORP CENTRAL INDEX KEY: 0000878616 STANDARD INDUSTRIAL CLASSIFICATION: PERFUMES, COSMETICS & OTHER TOILET PREPARATIONS [2844] IRS NUMBER: 943107202 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-23544 FILM NUMBER: 98580165 BUSINESS ADDRESS: STREET 1: 4034 CLIPPER CT CITY: FREMONT STATE: CA ZIP: 94538 BUSINESS PHONE: 5102266874 10-K405 1 FORM 10-K405 Washington, D.C. 20549 FORM 10-KSB (MARK ONE) [ X ] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (fee required) For the fiscal year ended December 31, 1997 [ ] TRANSITION REPORT UNDER SECTION 13 OR A5(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (no fee required) Commission file number 0-23544 EROX CORPORATION (Name of small business issuer in its charter)
California 94-3107202 - -------------------------------------------------------------- ------------------------------------ (State or other jurisdiction of incorporation or organization) (I.R.S. employee Identification No.) 4034 Clipper Court, Fremont, California 94538 - -------------------------------------------------------------- ------------------------------------ (Address of principal executive offices) (Zip code)
Issuer's telephone number: (510) 226-6874 Securities registered under Section 12(b) of the Exchange Act: None ---------------- (Title of class) Check whether the Issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 [ ] Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [ X ] State issuer's revenues for its most recent fiscal year. $17,169,616 State the aggregate market value of the voting stock held by non-affiliates computed by reference to the price at which the stock was sold, or the average bid and asked price of such stock, as of a specified date within the past 60 days. (See definition of affiliate in rule 12b-2 of the Exchange Act.) $10,088,442 (1) (1) Excludes 2,020,273 shares held by directors, officers and shareholders whose ownership exceeds 5% of the outstanding shares at March 19, 1998 based on a closing bid price on that day of $1.22 per share. Exclusion of such shares should not be construed as indicating that the holders thereof possess the power, direct or indirect, to direct the management or policies of the registrant or that such person is controlled by or under common control with the registrant. (APPLICABLE ONLY TO CORPORATE REGISTRANTS) State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date. 1,433,333 shares of convertible preferred stock, 10,289,488 shares of common stock. Transitional Small Business Disclosure Format (check one): Yes [ ] No [ X ] DOCUMENTS INCORPORATED BY REFERENCE Portions of the following document are incorporated by reference into Part III of this Form 10-KSB Report: the Proxy Statement for the Registrant's 1998 Annual Meeting of Shareholders (the "Proxy Statement"). Item 1. Description of Business Introduction This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Except for the historical information contained in this discussion of the business and the discussion and analysis of financial condition and results of operations, the matters discussed herein are forward looking statements. These forward looking statements include but are not limited to the Company's plans for sales growth and expansion into new channels of trade, expectations of gross margin, expenses, new product introduction, and the Company's liquidity and capital needs. These matters involve risks and uncertainties that could cause actual results to differ materially from the statements made. In addition to the risks and uncertainties described in "Risk Factors", below, these risks and uncertainties may include consumer trends, business cycles, scientific developments, changes in governmental policy and regulation, currency fluctuations, economic trends in the United States and inflation. These and other factors may cause actual results to differ materially from those anticipated in forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company, a California corporation, was founded in 1989 to develop and market a broad range of consumer products containing human pheromones as a component. The Company believes that human pheromone research funded by the Company presents an opportunity to create and market an entirely new category of pheromone-based fragrances and products. The Company believes that its related patents guarantee it a proprietary position in developing, licensing and marketing a new category of consumer products that could significantly change the consumer accepted standard for products containing a fragrance component and for cosmetic treatment products. Pheromones are chemical substances known to stimulate species-specific biological responses in animals. For eight years, scientists and advisors engaged by EROX have studied the functions and characteristics of human pheromones. EROX believes this research has resulted in findings that have disproved earlier theories that humans do not perceive and respond to pheromones. Specifically, the Company's sponsor research has focused on: * Identification, isolation and synthetic production of naturally occurring human pheromones; * Demonstration of the presence of the vomeronasal organ ("VNO") in the nasal passages of humans; and * Elucidation of its structure, function, and response to human pheromones. The human pheromones included as a component of and as a fixative for the Company's fragrance products have been manufactured for the Company by Pherin Corporation. The manufacturing process for human pheromones begins with hydrocarbon compounds commonly available from chemical supply houses, and involves the use of a synthetic chemistry process performed for the Company by Pherin at its laboratories in Salt Lake City, Utah. All the steps in the manufacturing process are standard chemical laboratory procedures. The manufacturing process for pheromones is similar to methods by which other naturally occurring substances (such as amino acids) are synthetically produced. The EROX Technology Pheromones. People have long known that insects and animals communicate with one another through subtle, biochemical cues recognized and understood by other members of the same species. These biochemical signals warn of danger, indicate the presence of food, mark territorial boundaries and display sexual maturation or readiness. The biochemical messengers that deliver these communications are pheromones. Pheromones trigger a nerve impulse to the hypothalamus when applied within or adjacent to the nasal passages. In humans, the hypothalamus functions as a control center, regulating physiological functions such as: * Sexual desire * Sexual maturation * The flight or flight response * Anxiety, fear and aggression * Appetite, and sugar and fat metabolism * Heart rate and blood pressure Scientists have observed that in higher species the influence of pheromones grows increasingly more subtle and complex. Not surprisingly, reactions to pheromones are the most subtle in human beings. While humans appear to have definite responses to pheromones, the research sponsored by EROX suggests that the highly developed human brain filters and masks those reactions. Rather than producing an isolated effect, as in lower level species, human pheromones act in concert with other sensory cues provided by odor, sight, taste, sound and touch to provide a cumulative influence. As a result of its sponsored research, the Company believes evidence has been developed that indicates that humans respond to human pheromones. EROX has also found that its human pheromones are sexually dimorphic: that is, some are more active in females while others show a higher level of activity in males. During the studies of human pheromones conducted by the Company, certain human subjects volunteered descriptions of their feelings. Women frequently described feeling comfortable or at ease, while a number of male subjects described a feeling of confidence and self-assurance. The Company continues to explore these naturally occurring substances in a variety of tests to increase its knowledge and understanding of their range of influence on human emotions and their application as components of fine fragrance products. Fragrances and Pheromones. Animal pheromones are well known in the fragrance industry. Natural and synthetic equivalents of mammalian pheromones such as musk, civet and castoreum are found in many perfumes today. However, since pheromonal cues can trigger a response only by members of the same species, these animal pheromones have no specific effect on humans; instead, they act only as fixatives or carriers for the fragrance or as a component of the scent. A scent binds to smell receptors in the nose and stimulates a specific region of the brain resulting in the sensation of smell. A pheromone binds to separate receptors that are physically and functionally distinct from smell receptors. These pheromone receptors stimulate a region of the brain different from that stimulated by smell receptors. Since it is widely believed that traditional perfumes allure and intrigue the senses, an alliance between fine fragrances and pheromones seems quite natural. For a perfume to create a true pheromonal effect in humans, however, it must contain human pheromones. Thus, a fragrance containing human pheromones may provide more allure than a traditional fragrance. The Vomeronasal Organ. The VNO consists of two tiny sensory organs -- one in each nasal passage. The VNO had been identified earlier in animal species, from reptiles to mammals, and has been known for some time to be a receptor for pheromones in animals. In humans, however, the VNO was assumed to be a non-functioning, vestigial remnant, rarely even present in modern-day men and women. Over the course of their work on human pheromones, scientists working on behalf of EROX believe they have made a further, important discovery concerning the VNO. Not only is the VNO present in all normal adults, it appears to be an active, functional receptor for human pheromones. This has allowed scientists engaged on behalf of EROX to track the activity of human pheromones by measuring the changes in the neuroelectric potential of the VNO's receptor cells caused by pheromones. To measure these changes in humans, a proprietary noninvasive method is utilized to measure the electrical response of the VNO in a way similar to how electrical responses of the heart are recorded by an electrocardiogram. The EROX Products Products. The Company is currently marketing three fragrances, REALM(R) Women, REALM(R) Men and inner REALM(R). These "proof-of-concept" products include a full line of fragrance and bath and body products including eau de toilette, cologne, eau de parfume, lotion, bath and shower gel, after-shave balm, antiperspirant, talc, soap and body cream. The Company's fragrances were developed by Ann Gottlieb a leading consultant to the fragrance industry. All of the Company's products contain the Company's synthesized human pheromones as a component of the fragrance. In 1996, the Company introduced a unique refillable, dripless roll-on applicator containing REALM eau de toilette for women. In addition, development work commenced on a line of environmental products to be introduced in 1998. The first of these products will be REALM Women and REALM Men candles. Research. Pheromones are chemical substances known to stimulate species-specific biological responses in animals. The study of the uses, effects and advantages of human pheromones is in its infancy, but abstracts from presentations of two recent studies performed at leading research universities reveal new information regarding the beneficial effects of human pheromones. Most interestingly, these studies reveal new information regarding the biological pathways human pheromones traverse in the body. Publication of these findings is expected in the fall of 1998, and the Company expects increased interest in its patented technology as the result of these studies. Scientists working on behalf of EROX have identified and synthesized several naturally occurring human pheromones. One combination of pheromones shows a measurable response in women and another a comparable response in men. EROX has also developed the capability to manufacture commercial quantities of these naturally occurring substances. EROX intends to continue basic pheromone research as applied to fragrances and ancillary products. Since its inception through December 31, 1997, the Company has incurred $3,597,666 in research and development related expenses. Markets and Competition The Competitive Environment. The Company's current fragrance products contain what the Company believes are unique components: human pheromones. Consequently, EROX believes it will be able to differentiate its products from traditional products. If such differentiation is successful, the Company's products initially should have little direct competition in the marketplace, since the Company believes no other companies in the United States have the right to produce or distribute products containing human pheromones. While EROX current products are fragrances, the Company feels strongly that fine fragrances are only a "proof of concept". The Company's patented human pheromone technology has applications far beyond traditional fragrances and bath and body products. EROX hopes to position its technology as a desired "value added" ingredient for any product that contains a fragrance. Synthesized human pheromones provide the first patented technology of a component that could have broad applications and usage in cosmetic, treatment, cleansing, over-the-counter health supplements and home and vehicle environmental products. The Company does not feel that it has the resources to successfully exploit the potential market for such applications and is actively seeking licensing agreements with consumer product manufacturers. Marketing Strategy. EROX initial products are a line of fragrance and bath and body products containing the Company's patented human pheromones as a component. The first of these "proof of concept products" were developed in 1993 when the Company developed REALM Women and REALM Men. While new product launches in the fragrance industry frequently require considerable expenditures for promotional programs which attempt to establish product differentiation based upon imagery alone, EROX sought to develop a program in 1993 following a different approach -- one that relied on the human pheromone component in its fragrances for product differentiation. The Company's initial marketing program was intended to educate consumers and the trade about pheromones while suggesting the enhanced sensuality that the wearer of an EROX fragrance might feel. The Company also used packaging, pricing and distribution channels to communicate the uniqueness of their products and to differentiate them from traditional fragrance products. The Company launched its REALM products through direct marketing to ensure the quality and clarity of the EROX message and thereafter moved to more conventional fragrance channels based on criteria such as store location, image and promotional support. Distribution and Promotional Activities. During 1993, the Company developed two fragrances, REALM Women and REALM Men, each presented in 50Ml and 5Ml sizes. Initial promotion and distribution was in the form of a one half-hour infomercial, broadcast-tested in August 1994 and rolled-out nationally in the last four months of the year. Concurrent with the introduction of the infomercial, the Company changed its secondary packaging (cartons, carton inserts, etc.) to graphically portray its newly-developed print advertising message, Awaken your Sixth Sense!(R). In late 1994, the Company initiated retail distribution with a holiday season launch in I. Magnin Inc.'s twelve specialty-department stores in the Western United States and their Holiday catalogue. Although the I. Magnin stores were closed prior to Christmas as part of the consolidation of stores by its new parent, Federated Department Stores, the REALM products at I. Magnin sold out in all of the stores. During 1995, retail distribution in the United States accelerated and REALM products were introduced in Neiman Marcus and Bloomingdale's by Mail catalogs (supported by inserts containing scent-strips of both fragrances), Rich's/Lazarus divisions of Federated Department Stores, all divisions of Dillard Department Stores and several regional chains. Scented promotional pieces, store catalogs, the placement of in-store fragrance models and 30-second advertising spots that aired during "drive time" on local radio stations supported these retail introductions. Radio spots contained brief testimonial messages and invitations to consumers to purchase REALM at retailers in their area. The Company also began a full-scale program aimed at educating the retailers regarding the scientific differentiation of its REALM products. This education process included training attended by the local retail employees and hosted by the EROX sales force and Pherin research scientists. The Company feels these training sessions have been instrumental in providing the retailer's sales associates with the information to communicate the pheromone story to the retail customer. A considerable amount of interest was generated from local television news stations. When the Company launched a new retailer or division of a retailer, local television stations were provided with a short video new release that contained product and scientific information. A majority of local television markets provided news stories on the local REALM launches during their evening news broadcasts. In 1996, additional REALM products were introduced by the remaining divisions of Federated Department Stores (Macy's, Burdines and the Bon Marche), selected May Company units (Lord & Taylor, Famous Barr, Kaufmann's and Robinson May stores), the more upscale divisions of Dayton Hudson/Marshall Fields, Carson Pirie Scott, Proffitts, the Mercantile Group and selected regional department store chains. Again, promotional activities included scented pieces, catalogs, multifaceted spot radio advertising, educational symposia and television public relations efforts. In both 1995 and 1996, there were significant levels of product "pipeline fill" (initial launch quantities purchased by retailers, as contrasted with future ongoing lower volume replenishment orders). At the beginning of 1997, EROX was still a single product company, primarily involved in one class of trade -- better U.S. department stores. REALM fragrances and toiletries were available in more than 1,300 stores in the 48 contiguous states. While this is the largest channel of distribution for basic fragrances, the high level of retailer employee turnover required expensive ongoing training for continued success of differentiated, scientifically based products such as REALM fragrances. In addition, EROX provides significant in-store fragrance modeling to ensure that consumers driven to the stores by the Company's ongoing radio advertisements have the opportunity to actually experience REALM products once they reach the store. To lessen its dependence on a single class of trade and in an effort to leverage the expense of its radio advertising and promotion, the Company entered into agreements with distributors who focus on the fast growing perfumery and middle market department store classes of trade. These alternative channels provide additional exposure for the Company's products and human pheromone technology at a significantly lower cost than the better department stores. In mid-1997, the Company introduced a second women's fragrance line, inner REALM(R) initially to the department store class of trade. Results of this expensive product launch were disappointing. A decision was made to reposition this brand to the alternative channels of distribution in 1998, and results from the initial repositioning are encouraging. Repositioning will continue throughout 1998. To further reduce its dependence on a single market, the Company sought to increase its non-U.S. distribution. In 1995 and 1996, EROX entered into distribution agreements for the sale of REALM fragrances and toiletries in selected Middle East markets, including Saudi Arabia and the Gulf States as well as selected Duty Free markets in the Caribbean, South America and on the Mexican and Canadian borders. In 1997, additional South American markets were opened and discussions were undertaken for the profitable sale of REALM products in several European markets and the Far East. In early 1998, initial shipments were made under distribution agreements with distributors in Switzerland and the People's Republic of China. International expansion will continue to be a focus of EROX. The Company is very conscious of the fact that numerous brands of prestige fragrances have suffered immeasurable harm due to diversion by gray marketers. While realizing that certain levels of such diversion are inevitable, the Company hopes to curtail the risk of its REALM products being diverted back into the U.S. by gray market discounters by selecting duty free partners who purchase realistic quantities for sale in the regions they service. Such partnership agreements are subject to cancellation if significant diversion occurs. Patents and Other Intellectual Property In December 1993 and January 1994, the Company received two United States patents for non-therapeutic compositions of fragrances and human pheromones for use as components in perfumes and personal care products and consumer and industrial products such as clothing, air fresheners and paper products. European patents regarding these compositions have been filed and are pending. In 1995, patents were granted in Taiwan, and in 1992 patents were granted in Mexico. EROX is also the exclusive licensee for non-therapeutic uses of pheromones in consumer products under a royalty-free world-wide perpetual license to five United States patent applications covering pheromone technology owned by Pherin Corporation. This technology is also the subject of foreign patent applications. The Company also relies on trade secrets protection for confidential and proprietary information. Regulation Unless the FDA extends its regulatory authority, regulation by governmental authorities in the United States and other countries is not expected to be a significant consideration in the sale of the Company's fragrance products and in its ongoing research and development activities. Under current regulations, the market introduction of the majority of non-medicated cosmetics products does not require prior formal registration or approval by the FDA, although this could change in the future. The cosmetic industry has established self-regulating procedures and most companies perform their own toxicity and consumer tests. Voluntary filings related to manufacturing facilities are made with the FDA. The Cosmetics Division of the FDA, however, does monitor closely problems of safety, adulteration and labeling. In addition, if the FDA should determine that claims made by the Company for its fragrances involve the cure, mitigation or treatment of disease, the FDA could take regulatory action against the Company and its products. In addition, the United States Federal Trade Commission ("FTC") monitors product claims made in television commercials and print advertising to ensure that any claim can be substantiated. If the FTC believes that any advertising claim made by the Company with regard to the effect or benefit of its products is not substantiated by adequate data or research and the Company cannot support such claim, the FTC could also take regulatory action against the Company and its products. Employees At March 1, 1998, the Company had twenty-four full-time employees. In addition, the Company retains consultants to provide advice in the areas of sales and marketing, public relations, product safety testing, regulatory compliance, MIS, product development and advertising. The Company also has access to scientific and professional consultants, who are retained directly by Pherin Corporation, and who undertake projects for the Company by virtue of the Company's agreement with Pherin. None of the Company's employees is represented by a labor union. The Company considers its relations with its employees and consultants to be good. Manufacturing The Company is dependent on third parties to manufacture its fragrance products. The Company has selected two essential oil companies, which provide fragrance products to the industry generally to supply such compounds to EROX in accordance with proprietary formulas developed for the Company. The Company has agreements in place with suppliers for its fragrances and has been supplied with commercial quantities of the Company's products for sale to consumers. While the Company is responsible for blending the human pheromones with these fragrances, final bottling and packaging of the fragrance and ancillary product lines are performed by independent manufacturers. These manufacturers selected by EROX have extensive experience in blending, filling and packaging fragrance, cosmetic and related products, and have the capacity to satisfy the Company's manufacturing needs, at least for the foreseeable future. The Company believes that such manufacturing services are widely available to the fragrance industry at competitive prices and has identified additional contract manufacturing companies. In addition, commercial scale production has taken place for the Company's fragrance bottles and other components as well as tubes for the Company's ancillary products. The Company and Pherin are parties to an agreement under which Pherin will supply EROX with its reasonable requirements of human pheromones and will make available to EROX the basic manufacturing technology. At any time after January 31, 1996, rather than supply human pheromones to EROX, Pherin may instead elect to provide to the Company all manufacturing technology in its possession that it has not previously supplied to EROX. Because only small quantities of human pheromones, which can be produced in a laboratory environment, are required for its fragrance and ancillary products, the Company believes that the cost of establishing its own human pheromone manufacturing facility would not be material. Risk Factors The Company's future results may be affected to a greater or lesser degree by the following factors among others: Competition: The prestige fragrance market is volatile and extremely competitive. Consumer preferences and demands can shift dramatically reflecting changes in fashion and current fads. There are numerous fragrance products that are better known than the products marketed by the Company. There are also many companies which have substantially greater resources than EROX and which have the ability to invest heavily in new product development and introduction. The Company can expect that its competitors will attempt to compete with the Company through the introduction of new products and promotion of existing products. In addition, the product life cycle of fragrances is shortening. Traditional fragrance companies now introduce a new fragrance every one to two years compared to every four to five years as in the past. This increase in competing fragrances makes it difficult for any one fragrance to hold the consumer's attention on a long-term basis. Although the Company believes the inclusion of human pheromones as a component clearly differentiates its products, other fragrances are competing for space with the Company's products at both the store level and in print and media advertising. Marketing: The failure to establish and maintain the necessary sales or distribution channels could have a material adverse effect on the Company's business. Although the Company believes its marketing strategy is the most cost-effective way to introduce its products, there can be no assurance that broader-scale retail launches will be successful. The Company cannot guarantee that retail outlets or catalogs will continue to carry the EROX products. If the current strategy is unsuccessful, marketing of the Company's products would require a new strategy and may require a significantly more expensive sales effort for which the Company may not have sufficient funds. Retail environment: Continued consolidation in the retail trade has led to the emergence of four major retail players who control the major share of the market. Federated Department Stores, The May Company, Dayton Hudson/Marshall Fields and Dillard Department Stores now comprise the majority of US upper end department stores. This consolidation could lead to price and promotional pressure and increased credit risk for the Company. The retail environment in better department stores is increasingly challenging. Retailers have aggressively cut inventories across the board. Promotional support in the form of co-op advertising dollars is being cut back and retailers are feeling pressure to become more promotional in order to compete with price conscious chains appealing to bargain hunters. Fragrances and cosmetics are increasingly being sold in secondary markets such as discount perfumeries, drug chains and lower priced department stores. It is not anticipated that the department store class of trade in the U.S. will become more profitable in the near future. Seasonality: Sales in the fragrance industry are generally seasonal, with generally higher sales in the second half of the calendar year as a result of increased demand for fragrance products in anticipation of and during the Christmas holiday season. The anticipated seasonality of the Company's sales could cause a significant variation in its quarterly operating results. Patent protection: There can be no assurance that any patent or patent application owned or controlled by the Company will continue to provide commercially significant protection of the Company's technology or ensure that the Company may not be determined to infringe valid patents of others. No assurance can be given that others will not independently develop substantially equivalent proprietary information or otherwise gain access to the Company's trade secrets or that the Company can meaningfully protect its technology, proprietary information or trade secrets. Attraction and retention of key employees: The success of the Company's future operations depends in large part on the Company's ability to recruit and retain key employees and consultants with research, product development and marketing experience, as well as other professionals who are in considerable demand. There can be no assurance that the Company will be successful in retaining or recruiting such key personnel. Dependence on third parties for manufacturing: The Company does not have facilities to manufacture its products and relies on Pherin to manufacture its pheromones and third parties to supply components and to blend, fill and package its fragrance products. The Company believes that such manufacturing services are the most effective method of producing its products. The majority of the fragrance industry uses contract fillers, and the Company has no current plans to set up its own filling facilities. However, as with any business that is not vertically integrated, if the Company is unable to obtain or retain fragrance suppliers, component manufacturers or third party manufacturing on acceptable terms, it may not be able to obtain commercial quantities of its products, which would adversely affect results. Item 2. Description of Property The Company presently occupies approximately 8,780 square feet of office and warehousing space for its headquarters in Fremont, California, pursuant to a lease which expires on October 31, 1998, and which is currently cancelable by the Company on 90 days written notice and by paying a $15,000 cancellation fee which may be waived under certain circumstances. The annual base rent was approximately $75,336 for the 12 months ended December 31, 1997 and will be $62,780 in 1998. Total rent expense may be increased by the Company's proportional share of any escalation related to taxes, common area charges and outside maintenance incurred by the complex in which the facility is located. During the year ended December 31, 1997, the Company incurred $101,023 in rent expense and related charges for this facility. Item 3. Legal Proceedings On February 3, 1997, a purported class action lawsuit was filed against the Company in the Superior Court of Contra Costa County, California. The suit alleged that the Company's packaging is constructed to facilitate the perpetration of deception and fraud in that the outer container has substantial empty spaces in it. The complaint sought unspecified damages and attorney's fees as well as other relief. The Company considered this action to be entirely without merit. On October 8, 1997, a request for dismissal of the purported class action lawsuit was filed by the plaintiff in Contra Costa County Superior Court. The dismissal was entered as requested. The Company knows of no other pending legal action. Item 4. Submission of Matters to a Vote of Security Holders Not applicable. PART II Item 5. Market for Common Equity and Related Stockholder Matters The Company's Common Stock is quoted on the NASDAQ Small-Cap Market under the symbol EROX. As of March 1, 1998, there were approximately 325 holders of record of the Company's Common Stock. The Company believes that there are a significant number of beneficial owners of its Common Stock whose shares are held by nominees in "Street Name". Set forth below is the high and low bid information for the Company's Common Stock on the NASDAQ Small-Cap Market as reported in the Wall Street Journal during each of the four calendar quarters of 1996 and 1997. HIGH LOW ---- --- 1996 First quarter $ 4.13 $ 2.50 Second quarter $ 8.78 $ 3.25 Third quarter $ 10.13 $ 4.63 Fourth quarter $ 6.75 $ 3.44 1997 First quarter $ 4.88 $ 2.94 Second quarter $ 3.63 $ 1.19 Third quarter $ 2.69 $ 1.00 Fourth quarter $ 1.94 $ .66 These quotations reflect interdealer prices, without retail mark-up, markdown or commissions and may not represent actual sales. The Company has never paid cash dividends on its Common Stock. The Company currently intends to retain future earnings, if any, to fund the development and growth of its business and does not plan to pay any cash dividends in the foreseeable future. Item 6. Management's Discussion and Analysis of Financial Condition and Results of Operations Year ended December 31, 1997 compared with the year ended December 31, 1996 Net sales for the year ended December 31, 1997 were $17,169,616 compared to $20,323,028 for the prior year. This 15.5% decrease was attributed to decreases in purchases by U.S. department stores. In 1997, U.S. department store retailers began the year with significantly higher in-store fragrance inventories than planned. These retailers began an industry wide program to significantly reduce retail stock levels and increase inventory turns from three turns per year to six. This negatively impacted the Company's sales to this important class of trade. While the Company's sales to this class of trade were off 27% overall for the year, sell-through at the retail level increased from the prior year. During the last six months of 1997, consumer purchases of REALM fragrances at the Company's U.S. department store customers exceeded the prior year by over 2% compared to flat fragrance industry growth. This comparison indicates that the Company's customer base expanded while the overall category reflected lower consumer demand. During 1997, the Company launched its second fragrance inner REALM(R). Sales for this product line did not meet expectations. The Company plans to continue to distribute inner REALM on a more limited basis in specialty stores and selected markets. The Company also developed several secondary markets during 1997. These sales are handled through an authorized distributor to perfumeries and mid-priced department stores. Net sales for the years 1997 and 1996 were as follows: Markets: 1997 Net Sales 1996 Net Sales -------- -------------- -------------- U.S. markets $15,723,331 $18,807,594 Foreign markets 1,446,285 1,515,434 ----------- ----------- Total Net Sales $17,169,616 $20,323,028 =========== =========== Gross margin for the year ended 1997 was 76% compared to 73% in 1996. Costs for the Company's new fragrance, inner REALM, were significantly lower than the component costs for the original REALM line of products. In the last quarter of 1997, the Company decreased the number of lower margin fragrance value sets made available for sale. These factors were offset by the increase in sales to lower margin classes of trade. The Company increased sales to secondary markets and duty free distributors in 1997. This move was made to increase overall operating profits as these classes of trade do not demand the same level of co-operative advertising expenditures for store sponsored vehicles. In the future, increasing sales to these secondary classes of trade may lower gross margin, but should increase operating profits. Research and development costs in 1997 decreased to $332,389 from $473,420 in 1996. Expenses in 1997 were mainly for payments to Pherin Corporation under the Company's ongoing R&D agreement. These expenses totaled $276,000 and $270,000 in 1997 and 1996, respectively. Total research and development costs in 1996 were higher than in 1997 due to costs for development of inner REALM (introduced in 1997) and for line extensions of the Company's REALM Men and REALM Women fragrances (introduced in the prior year). Selling, general and administrative expenses increased in 1997 to $16,034,659 from $13,088,248 in 1996 mainly due to advertising expenditures of $3,421,018 primarily related to the launch of inner REALM. Selling and advertising expenditures of $12,382,012 in 1997 compared to $9,639,617 in 1996. Advertising agreements to promote the launch of inner REALM were entered into early in 1997. The Company was unable to cancel these advertising agreements when it became apparent that inner REALM sales were not approaching the Company's internal sales plan. In the second half of 1997, the Company reduced the level of commitments for co-operative programs and focused expenditures on radio programs and in-store fragrance modeling. General and administrative expenses increased in 1997. Distribution and facilities costs increased as the Company added inner REALM to its line of products. Additional warehouse space was required and additional personnel were required for shipping. In 1996, the Company had employed mainly temporary workers in its warehouse operations. In 1997, the Company installed new shipping hardware and software required of all vendors by U.S. department stores. The level of accuracy required by these systems demands a higher level of skilled worker, and the Company has found it necessary to train full-time permanent employees for these jobs. Interest expense increased to $75,989 in 1997 from $7,879 in 1996 due to higher short term borrowings under the Company's line of credit. The Company recorded no income tax provision in 1997 due to the current year's net operating loss. In 1996, the Company recorded a provision equal to 5% of pretax income. This represented the federal and state alternative minimum taxes after utilizing the allowable amount of net operating loss carryforward for that year. Year ended December 31, 1996, compared with the year ended December 31, 1995. For the year ended December 31, 1996, the Company reported net sales of $20,323,028. This was a 126% increase over the prior year's net sales of $8,973,313. During 1996, the Company continued to expand its retail distribution and product line offerings. At the end of 1996, the Company's products were available in more than 1,350 US department store locations. This compared to 479 locations at the end of 1995. The additional doors opened during 1996 provided the Company with distribution into new metropolitan areas and expanded its customer base from three major chains in 1995 (Federated, Dillard Department Stores and Dayton Hudson Fields) to include May Company, Mercantile Stores, Younkers, Elder Berman, Carson Pirie Scott, McRaes, Proffitts, ZCMI, Jacobsons and Parisian. In addition to increasing distribution in upscale department stores in the United States, the Company also expanded into duty free and a limited number of international markets. In the spring of 1996, the Company began shipping to distributors in the Middle East. Several months later, REALM(R) products were introduced in 32 doors of Eaton Department Stores in Canada. The Company added duty free stores in Mexico and selected border stores in the U.S. and Canada. Overall, the Company increased its duty free and international business by 210% over 1995. Net sales for the years 1997 and 1996 were as follows: Markets: 1996 Net Sales 1995 Net Sales ------- -------------- -------------- U.S. markets $18,807,594 $ 8,496,183 Foreign markets 1,515,434 477,130 ----------- ------------ Total Net Sales $20,323,028 $ 8,973,313 =========== ============ Gross margin increased two percentage points in 1996 to 73% from 71% in 1995 as the Company began to reap the benefits of several major cost cutting projects. First of these was the development of a new subcontractor to apply the red lacquer to the Company's signature 50ml bottles. For the first time, the automated application of colored lacquers to oblique angles of a bottle was successfully completed in commercial quantities. Following extensive testing and development work, the Company moved a major portion of its bottle decorating to this new subcontractor in early 1996, thereby increasing production capacity and reducing unit costs. In addition, the Company redesigned the most expensive component of the women's 50ml package reducing costs significantly without changing the aesthetic feel or the function. These changes, coupled with a move to a one-piece pump, lowered costs on the Company's red lacquered bottles by more than 30%. These cost savings made it possible to develop attractively priced sets of fragrance products while maintaining competitive gross margin levels. Due to different pricing structures, gross margins vary considerably between the Company's major classes of customers. Gross margins for duty free and international sales are significantly below those of department store sales. The Company does not consider this to be detrimental to overall profitability since additional selling and marketing dollars are not needed to support these non-U.S. sales. All promotional expenditures are the contractual responsibility of the distributor. Research and development costs in 1996 increased to $473,420 from $288,051 in 1995 as the Company developed new fragrance items under its REALM Women and REALM Men fragrance lines and its new women's fragrance, inner REALM. In addition to payments to Pherin of $270,000 in 1996, the Company made expenditures for fragrance and primary and secondary packaging design and development and consumer and product testing. In 1996, four new items were introduced a women's body cream and an after bath body talc, a men's antiperspirant/deodorant and the REALM Roulette. Included in R&D expenditures in 1996 are testing and development costs for these products. During 1996, the Company and scientists at Pherin developed a program of training and public relations to convey the scientific findings that differentiate this new fragrance. Payments to Pherin in 1995 under the Company's ongoing R&D agreement were $240,000. Selling, general and administrative expenses increased to $13,088,248 in 1996 from $7,178,882 in 1995 mainly due to greater advertising, public relations and salary expenses as the Company continued to expand its retail presence and product lines. Despite the absolute increase in these expenses, at 64% of sales, SG&A expenses as a percentage of sales for 1996 were significantly lower than the 80% of sales reported for 1995. During 1996, the Company increased its marketing and advertising spending and added additional regional sales personnel to support the increased number of stores selling REALM fragrances. Advertising expenditures increased as the Company developed regional and national radio campaigns to promote existing products and introduce new line items. In 1996, the Company expended funds on fragrance modeling, sampling and promotional materials in over 1,350 retail doors compared to less than 500 in 1995. In 1996, the Company's distribution, materials and warehousing functions expanded to accommodate the growth of its retail sales. Additional warehousing capability and new employees were added to handle the increased workload. By the end of the year, the Company had successfully installed 90% of its retail department store customers on EDI (Electronic Data Interface) for all purchase orders. This has made it possible for the Company to process the increased volume of orders without adding proportional customer service staff. The basic growth in the volume of retail orders resulted in increased employee and supply expenses in 1996 as compared with the prior year. Interest income decreased to $20,612 in 1996 from $113,142 in 1995 due to lower cash and investment balances. The Company recorded a provision for income taxes in 1996 equal to 5% of pretax income. This represents federal and state alternative minimum taxes after utilizing the allowable amount of net operating loss carryforwards for the current year. There was no provision for income taxes in 1995 since the Company incurred a net operating loss in that year. Liquidity At December 31, 1997, the Company had cash and cash-equivalents equal to $248,617 and working capital of $4,329,799. These balances at December 31, 1996 were $2,059,084 and $5,258,089, respectively. Net cash used in operating activities was $4,204,364, $589,788 and $2,334,656 for the years ended December 31, 1997, 1996 and 1995, respectively. Issuance of convertible preferred stock to a long-term investor in the amount of $2,145,535 partially offset cash usage in 1997. Other cash infusions were from bank borrowings, the issuance of common stock and maturity of investments in the amounts of $340,290, $550,816 and $4,091,788 for 1997, 1996 and 1995, respectively. At December 31, 1997, borrowings against the Company's $3,000,000 line of credit were $548,000. Assuming the Company's activities proceed substantially as planned, the Company's current cash, line of credit and anticipated revenues from product sales should be adequate to meet its working capital needs over the next twelve months. Working capital requirements will primarily be for the supply of inventory, accounts receivable financing and staffing. Additional working capital may be required should the Company fail to generate anticipated increased consumer response levels. Furthermore, additional working capital may be required should the Company experience a greater than planned success with its current products and expanded product lines and geographical territories. Funds would be needed for inventory build, accounts receivable financing and staffing purposes. If the Company fails to achieve significant revenues from its 1998 marketing efforts or if expansion proves to be more capital intensive than planned, the Company may require additional funding. In March 1997, the Company renegotiated its Business Loan Agreement with Mid-Peninsula Bank of Palo Alto, California ("the Bank"). On March 23, 1998, the Company signed a commitment letter with the Bank providing for a renewal of the line of credit. The Company may borrow up to $3,000,000 million at an interest rate equal to the Bank's prime rate plus .75 % with borrowings secured primarily by the Company's trade receivables and inventory. The agreement, which expires on April 1, 1999, contains certain debt-to-equity and working capital covenants. Item 7. Financial Statements See the Financial Statements listed in Item 13(a), which are incorporated herein by reference. Item 8. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable PART III Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act The executive officers of the Company and their ages as of March 1, 1998 are as follows:
Name Age Position ---- --- -------- William P. Horgan 50 Chairman, Chief Executive Officer and Director Michael V. Stern 39 President and Director Maxine C. Harmatta 47 Vice President, Finance and Administration
William P. Horgan was appointed to the newly created post of Chairman of the Board in November 1996 after serving as President, Chief Executive Officer and Director since January 1994, when he joined the Company. From May 1992 to January 1994, he served as Chief Financial and Administrative Officer of Geobiotics, Inc., a biotechnology-based development stage company, and from January 1990 to May 1992, was employed by E.S. Jacobs and Company as Senior Vice President of Worlds of Wonder, Inc. From March 1988 to January 1990, he was Chief Financial Officer of Advanced Polymer Systems, Inc., a manufacturer and supplier of polymer based delivery systems for the ethical dermatology, OTC skin care and personal care markets. Prior thereto, he held various executive and management positions with CooperVision, Inc. and several affiliated companies, including President of its Revo, Inc. subsidiary. Michael V. Stern was named President in November 1996. He had served as a Director since March 1993, and was appointed Vice President Sales and Marketing in February 1994. Prior to that, from February 1993 until February 1994 he was Director of Marketing and Sales for McGuire Company, a division of Kohler Company. He also served as a management consultant for Carter, Hawley, Hale, a department store operation, from May 1992 until February 1993. From prior to 1989 until May 1992, Mr. Stern held various management positions with R.H. Macy in its California Division. Maxine C. Harmatta was appointed Vice President, Finance and Administration in December 1996. She joined the Company in March 1994 and served as Vice President, Controller until January 1996 when she assumed responsibility for operations as Vice President, Finance and Operations. From July 1992 until February 1994, she was Controller for Revo, Inc., a manufacturer of performance and fashion eyewear. Ms. Harmatta was Controller of Easton Aluminum, Inc., a manufacturer and distributor of sporting goods and consumer products, from June 1986 until July 1992. The remainder of this item is incorporated by reference to the Company's definitive Proxy Statement relating to its 1998 Annual Meeting of Shareholders (the "Proxy Statement"). Item 10. Executive Compensation Incorporated by reference to the Proxy Statement. Item 11. Security Ownership of Certain Beneficial Owners and Management Incorporated by reference to the Proxy Statement. Item 12. Certain Relationships and Related Transactions Incorporated by reference to the Proxy Statement. Item 13. Exhibits and Reports on Form 8-K
(a) Financial Statements. The following are filed as a part of this report: Page ----- Report of Independent Auditors F-1 Balance Sheets -- December 31, 1997 and 1996 F-2 Statements of Operations -- Years ended December 31, 1997, 1996 and 1995 F-3 Statements of Shareholders' Equity - Three Years ended December 31, 1997 F-4 Statements of Cash Flows -- Years ended December 31, 1997, 1996 and 1995 F-5 Notes to Financial Statements F-6
(b) Reports on form 8-K. None (c) Exhibits. The following exhibits are filed as part of this report:
EXHIBIT NUMBER EXHIBIT TITLE ------ ------------- 3.1 Copy of the Registrant's Articles of Incorporation (1) 3.1.1 Certificate of Determination of Preferences of Series AA Preferred Stock of Registrant 3.2 Copy of Registrant's By-laws (1) 10.1 Registrant's Stock Plan* (1) 10.2 Research and Development Agreement between Registrant and Pherin dated July 1, 1992 (1) 10.7 Technology Transfer Agreement between Registrant and Pherin dated August 23, 1991 (1) 10.10 Registrant's Non-employee Directors Stock Option Plan* (2) 10.12 Standard Industrial Lease - Net between Registrant and SCI Limited Partnership-I dated September 29, 1995 for the Registrant's California facility (3) 10.13 Amendment to Research and Development Agreement between Registrant and Pherin dated February 29, 1996 (3) 10.14 Business Loan Agreement dated July 1, 1997 (4) 23.1 Consent of Ernst & Young LLP, independent auditors E-27 27.01 Financial Data Schedule E-28 (1) Filed as an exhibit with corresponding exhibit no. to Registrant's Registration Statement on Form SB-2 (Registration No. 33-52340) and incorporated herein by reference. (2) Filed as an exhibit with corresponding exhibit no. to Registrant's Annual Report on Form 10-KSB for the Year Ended December 31, 1993. (3) Filed as an exhibit with corresponding exhibit no. to Registrant's Annual Report on Form 10-KSB for the Year Ended December 31, 1996. (4) Filed as an exhibit with corresponding exhibit no. to Registrant's Quarterly Report on Form 10-QSB for the Three Months ended June 30, 1997. * Management contract or compensatory plan
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, EROX Corporation has duly caused this Annual Report on Form 10-KSB to be signed on its behalf by the undersigned, thereunto duly authorized, in Fremont, California, on March 26, 1998. EROX CORPORATION By: /s/ William P. Horgan -------------------------------- Name: William P. Horgan ----------------------------- Title: Chairman of the Board ---------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed on behalf of EROX Corporation by the following persons in the capacities and on the dates indicated.
SIGNATURE CAPACITY DATE --------- -------- ---- /s/ William P. Horgan Chief Executive Officer March 26, 1998 - -------------------------------------------- and Director William P. Horgan /s/ Michael V. Stern President and Director March 30, 1998 - -------------------------------------------- Michael V. Stern /s/ Maxine C. Harmatta Vice President, March 26, 1998 - --------------------------------------------- Principal Financial and Maxine C. Harmatta Accounting Officer /s/ Bernard I. Grosser Director March 30, 1998 - -------------------------------------------- Bernard I. Grosser, MD /s/ Michael D. Kaufman Director March 30, 1998 - -------------------------------------------- Michael D. Kaufman /s/ Helen C. Leong Director March 30, 1998 - -------------------------------------------- Helen C. Leong /s/ Robert Marx Director March 30, 1998 - ------------------------------------------- Robert Marx
Report of Ernst & Young LLP, Independent Auditors The Board of Directors and Shareholders EROX Corporation We have audited the accompanying balance sheets of EROX Corporation as of December 31, 1997 and 1996, and the related statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of EROX Corporation at December 31, 1997 and 1996, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. Ernst & Young LLP Palo Alto, California February 6, 1998 EROX Corporation Balance Sheets
December 31, December 31, 1997 1996 ------------ ------------ Assets Current assets: Cash and cash equivalents $ 248,617 $ 2,059,084 Accounts receivable, net of allowances of $822,813 and $501,677 in 1997 and 1996, respectively 3,084,784 2,813,135 Inventory 3,421,298 2,906,517 Other current assets 128,817 74,414 ------------ ------------ Total current assets 6,883,516 7,853,150 Property and equipment, net 99,491 71,516 ------------ ------------ $ 6,983,007 $ 7,924,666 ============ ============ Liabilities and shareholders' equity Current liabilities: Loan payable, bank $ 548,000 $ 500,000 Accounts payable 800,648 1,218,741 Accrued advertising 743,900 218,249 Accrued compensation 38,733 176,038 Other accrued expenses 422,436 482,033 ------------ ------------ Total current liabilities 2,553,717 2,595,061 Commitments -- -- Shareholders' equity: Convertible preferred stock, issuable in series, no par value, 10,000,000 shares authorized, 1,433,333, and -0- shares issued and outstanding at December 31, 1997 and December 31, 1996, respectively 2,145,535 -- Common stock, no par value, 40,000,000 shares authorized, 10,289,488 shares issued and outstanding at December 31, 1997 and 10,156,905 shares at December 31, 1996 17,667,024 17,374,734 Accumulated deficit (15,383,269) (12,045,129) ------------ ------------ Total shareholders' equity 4,429,290 5,329,605 ------------ ------------ $ 6,983,007 $ 7,924,666 ============ ============ See accompanying notes.
EROX Corporation Statements of Operations
Years ended December 31, --------------------------------------------------------- 1997 1996 1995 ------------ ------------ ------------ Net sales $ 17,169,616 $ 20,323,028 $ 8,973,313 Cost of goods sold 4,079,555 5,487,801 2,602,549 ------------ ------------ ------------ Gross profit 13,090,061 14,835,227 6,370,764 Expenses: Research and development 332,389 473,420 288,051 Selling, general and administrative 16,034,659 13,088,248 7,178,882 ------------ ------------ ------------ Total expenses 16,367,048 13,561,668 7,466,933 ------------ ------------ ------------ Income (loss) from operations (3,276,987) 1,273,559 (1,096,169) Interest income 12,621 20,612 113,142 Interest (expense) (75,989) (7,879) -- Other (expense) 2,215 (4,651) -- ------------ ------------ ------------ Income (loss) before income taxes (3,338,140) 1,281,641 (983,027) Income taxes -- 64,082 -- ------------ ------------ ------------ Net income (loss) $ (3,338,140) $ 1,217,559 $ (983,027) ============ ============ ============ Net income (loss) per common share-basic $ (0.32) $ 0.12 $ (0.10) ============ ============ ============ Net income (loss) per common share- assuming dilution $ (0.32) $ 0.12 $ (0.10) ============ ============ ============ Weighted average shares used in calculation of earnings per share 10,271,377 9,998,770 9,866,260 ============ ============ ============ Weighted average shares and equivalents, if dilutive, used in calculation of net income (loss) per common share 10,271,377 10,508,680 9,866,260 ============ ============ ============ See accompanying notes.
EROX Corporation Statements of Shareholders' Equity
Three Years ended December 31, 1997 ------------------------------------------------------------------------- Convertible Preferred Total Stock Common Accumulated Shareholders' Series AA Stock Deficit Equity ----------------- --------------- ---------------- ---------------- Balances at December 31, 1994 - 16,693,918 (12,279,661) 4,414,257 Exercise of stock options for 60,000 shares for cash 130,000 130,000 Net loss (983,027) (983,027) ----------------- --------------- ---------------- ---------------- Balances at December 31, 1995 - 16,823,918 (13,262,688) 3,561,230 Exercise of stock options for 234,933 shares for cash 530,816 530,816 Exercise of warrants for 10,000 shares for cash 20,000 20,000 Net income 1,217,559 1,217,559 ----------------- --------------- ---------------- ---------------- Balances at December 31, 1996 - 17,374,734 (12,045,129) 5,329,605 Exercise of stock options for 132,583 shares for cash 292,290 292,290 Issuance of 1,433,333 shares of AA convertible preferred stock for cash, net of issuance costs 2,145,535 2,145,535 Net loss (3,338,140) (3,338,140) ----------------- --------------- ---------------- ---------------- Balances at December 31, 1997 $ 2,145,535 $ 17,667,024 $ (15,383,269) $ 4,429,290 ================= =============== ================ ================ See accompanying notes.
EROX Corporation Statements of Cash Flows
Years ended December 31, ------------------------------------------------------ 1997 1996 1995 ----------- ----------- ----------- Cash flows from operating activities Net income (loss) $(3,338,140) $ 1,217,559 $ (983,027) Adjustments to reconcile net income (loss) to net cash used in operating activities: Depreciation and amortization 63,953 95,470 171,242 Amortization of premium/discount on securities, net -- -- (53) Changes in operating assets and liabilities: Accounts receivable (271,649) (858,627) (1,813,108) Inventory (514,781) (1,106,789) (993,585) Other current assets (54,403) 94,371 (49,902) Accounts payable (418,093) 486,964 392,857 Accrued advertising 525,651 (344,391) 562,640 Accrued compensation and other accrued expenses (196,902) (174,345) 378,280 ----------- ----------- ----------- Net cash used in operating activities (4,204,364) (589,788) (2,334,656) Cash flows from investing activities Proceeds from maturity of held-to-maturity investments -- -- 3,461,788 Purchase of property and equipment (91,928) (88,772) (90,485) ----------- ----------- ----------- Net cash provided by (used in) investing activities (91,928) (88,772) 3,371,303 Cash flows from financing activities Proceeds from bank borrowings 48,000 -- 500,000 Proceeds from issuance of common stock 292,290 550,816 130,000 Proceeds from issuance of convertible preferred stock 2,145,535 -- -- ----------- ----------- ----------- Net cash provided by financing activities 2,485,825 550,816 630,000 Net increase/(decrease) in cash and cash equivalents (1,810,467) (127,744) 1,666,647 Cash and cash equivalents at beginning of the year 2,059,084 2,186,828 520,181 ----------- ----------- ----------- Cash and cash equivalents at end of the year $ 248,617 $ 2,059,084 $ 2,186,828 =========== =========== =========== See accompanying notes.
EROX Corporation Notes to Financial Statements December 31, 1997 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization and Nature of Operations EROX Corporation (the "Company") was incorporated in the State of California in 1989. The Company is engaged in the research, development, manufacturing and marketing of consumer products containing synthetic human pheromones as a component. The Company initiated commercial operations in late 1994 with a line of fine fragrances and toiletries. The Company currently sells its REALM fragrance products through department and specialty stores across the United States and selected International markets. Revenue Recognition Revenue is recorded at the time of merchandise shipment, net of provisions for returns. The majority of the Company's sales are to large department store chains. During 1997 three customers comprised 30%, 21% and 15% of the Company's total sales. The Company's foreign sales approximated 3.2% and 4.4% of net sales during fiscal 1997 and 1996, respectively. Foreign currency transaction gains and losses are included in the results of operations and were immaterial for all periods presented. Advertising Expense The cost of advertising is expensed as incurred. The Company incurred $5,912,176, $4,447,061, and $2,716,997 in advertising costs during 1997, 1996, and 1995, respectively. Stock Based Compensation The Company grants stock options to employees and consultants for a fixed number of shares with an exercise price equal to the fair value of the shares at the date of grant. Net Income/Loss Per Share In 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128 (SFAS 128), Earnings per Share. Statement 128 replaced the previously reported primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is similar to the previously reported fully diluted earnings per share. All per share amounts for all periods have been presented and where necessary, restated to conform to Statement 128 requirements. Basic net income/(loss) per share is computed using the weighted-average number of common shares outstanding. Diluted net income/(loss) per share is computed using the weighted-average number of common shares and dilutive common equivalent shares outstanding during the period. Dilutive common share equivalents consist of employee stock options using the treasury stock method and dilutive convertible securities using the if-converted method. Diluted loss per share is computed using the weighted-average number of common shares outstanding during the period. Common stock equivalents are excluded from the diluted loss per share computation as their effect in antidilutive. The following table sets forth the computation for basic and diluted earnings/(loss) per share:
December 31, December 31, December 31, 1997 1996 1995 ------------ ------------ ------------ Numerator: Net income (loss) from operations $ (3,338,140) $ 1,217,559 $ (983,027) Denominator: Denominator for basic earnings per share-data 10,271,377 9,998,770 9,866,260 Effect of dilutive securities: Employee stock options -- 509,910 -- ------------ ------------ ------------ Denominator for diluted earnings per share-data 10,271,377 10,508,680 9,866,260 Basic net income (loss) per share $ (0.32) $ 0.12 $ (0.10) ------------ ------------ ------------ Diluted net income (loss) per share $ (0.32) $ 0.12 $ (0.10) ------------ ------------ ------------
EROX Corporation Notes to Financial Statements December 31, 1997 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Cash and Cash Equivalents The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Inventories Inventories are stated at the lower of cost (first-in, first-out method) or market. The inventory at December 31, 1997 consists of finished goods inventory valued at $1,665,393, work in process of $151,143 and raw materials of $1,604,762. At December 31, 1996, these balances were $1,188,882, $154,347 and $1,563,288, respectively. Property and Equipment The Company's property and equipment, which consists of molds, computer hardware and software, and furniture and fixtures, are being depreciated on a straight-line basis over their estimated useful lives of up to three years. Use of Estimates The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. 2. PROPERTY AND EQUIPMENT Property and equipment consist of the following: Years ended December 31, --------------------------- 1997 1996 ---------- ---------- Molds $477,769 $477,769 Computer hardware 93,487 62,204 Computer software 128,647 87,394 Furniture and other office equipment 90,563 71,171 --------- --------- 790,466 698,538 --------- --------- Less: Accumulated depreciation (690,975) (627,022) --------- --------- $ 99,491 $ 71,516 ========= ========= 3. LOAN PAYABLE, BANK At December 31, 1997, there was a loan payable of $548,000 under the Company's Line of Credit with Mid-Peninsula Bank. Under the terms of this agreement the Company may borrow up to 75% of allowable accounts receivable as defined. The interest rate on borrowings is the bank's prime rate plus 0.75%. Borrowings are primarily secured by the Company's accounts receivable and inventories. The agreement will expire April 1, 1998. See Note 8. 4. COMMITMENTS Effective September 29, 1995, the Company entered into a lease arrangement for office space in Fremont, California until October 31, 1998. The annual base rent will be approximately $75,336 and $62,780 for the years ended December 31, 1997 and 1998, respectively. The lease also provides for payments related to taxes, common area charges and outside maintenance. Total rental expense was $138,540, $88,776 and $68,168 for the years ended December 31, 1997, 1996 and 1995, respectively. 5. SHAREHOLDERS' EQUITY Convertible Preferred Stock On August 25, 1997, the Company obtained additional equity capital from affiliates of a current shareholder by issuing 1,433,333 shares of convertible preferred stock. This investment provided the Company with $2,145,535, net of issuance costs, in equity capital that was used to reduce bank borrowings and finance accounts receivable. EROX Corporation Notes to Financial Statements December 31, 1997 5. SHAREHOLDERS' EQUITY (continued) Holders of shares of convertible preferred stock shall be entitled to the number of votes equal to the number of shares of common stock into which such shares could be converted. Reserved for the future conversion of this preferred stock are 1,433,333 shares of common stock. No dividends are payable in connection with these preferred shares. Each share of preferred stock shall be convertible at $1.50 per share of common stock. Such initial conversion price shall be increased quarterly beginning October 1, 1997 by $.0225 such that the original issue price shall increase by $.09 per share each year. In addition, each preferred share shall automatically convert in the event of any of the following: 1. Immediately after the closing bid price of the common stock on the NASDAQ Stock Market exceeds $5.00 per share for a period of twelve consecutive weeks. 2. Immediately after the Company reports earnings per common share for any fiscal year of $.50 or greater. 3. Upon the written request for such conversion by sixty-six and two-thirds percent (66 2/3%) of the then outstanding preferred stockholders. 4. At the time that sixty-six and two-thirds percent (66 2/3%) of the preferred stock ever outstanding have converted to common stock. Stock Plan In 1990, the Company adopted a stock option plan (the "Plan"), which is administered by the Compensation and Stock Option Committee of the Board of Directors. The maximum number of shares that may be issued under the Plan is 2,125,000. Terms and conditions of stock options are set by the Board of Directors. Options may be granted at the fair value at the date of the grant as determined by the Board of Directors. Options for a holder of more than 10% of the voting stock of the Company may be granted at not less than 110% of fair market value. Options have a maximum term of ten years or a shorter period as set forth in the option agreement, and generally vest over a four-year period unless otherwise specified. Options granted to a shareholder with 10% or more of the voting stock of the Company have a maximum term of five years. A summary of the option activity under the Plan is as follows:
WEIGHTED WEIGHTED SHARES AVERAGE UNDER OPTION PRICE EXERCISE OPTION PER SHARE PRICE ------ ----------- ------- Balance, December 31, 1994 637,000 $1.53 - $2.25 $1.98 Options granted 219,000 $1.38 - $3.72 $2.02 Options exercised (60,000) $2.00 - $2.25 $2.17 ---------- Balance, December 31, 1995 796,000 $1.38 - $3.72 $1.97 Options granted 498,600 $2.94 - $7.91 $4.95 Options exercised (234,933) $1.56 - $4.00 $2.26 Options canceled (8,167) $1.53 - $3.72 $3.54 ------------ Balance, December 31, 1996 1,051,500 $1.38 - $7.91 $3.16 Options granted 100,000 $1.58 $1.58 Options exercised (102,583) $1.53 - $2.13 $2.05 Options canceled (12,500) $1.60 - $3.72 $3.30 ----------- Balance, December 31, 1997 1,036,417 $1.38 - $7.91 $3.11 =========
At December 31, 1997, a total of 263,067 shares of the Company's common stock was reserved for future grants under the Plan, and options to purchase 549,787 shares were exercisable. In June 1993, the Company's Board of Directors adopted a Non-Employee Directors' Stock Option Plan covering a total of 275,000 shares of common stock, which provides for a one-time automatic grant of options to purchase 25,000 shares of common stock and annual grants thereafter of options to purchase 10,000 shares of common stock to each non-employee director at an exercise price equal to the fair market value of the stock on the date of grant. EROX Corporation Notes to Financial Statements December 31, 1997 5. SHAREHOLDERS' EQUITY (Continued) The stock option activity under the Plan was as follows:
WEIGHTED SHARES AVERAGE UNDER OPTION PRICE EXERCISE OPTION PER SHARE PRICE ------ --------- ----- Balance, December 31, 1994 115,000 $1.64 - $4.00 $2.97 Options granted 40,000 $2.20 $2.20 ---------- Balance, December 31, 1995 155,000 $1.64 - $4.00 $2.77 Options granted 40,000 $7.88 $7.88 ---------- Balance, December 31, 1996 195,000 $1.64 - $7.88 $3.82 Options granted 55,000 $1.58 $1.58 Options exercised (30,000) $2.00 - $4.00 $2.73 ---------- Balance, December 31, 1997 220,000 $1.64 - $7.88 $3.45 ==========
At December 31, 1997, a total of 25,000 shares of the Company's common stock was reserved for future grants under the Plan, and options to purchase 188,330 shares were exercisable. Stock Compensation The Company has elected to follow APB 25 and related Interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under SFAS 123, "Accounting for Stock-Based Compensation," requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company's stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. Pro forma information regarding net income and earnings per share is required by SFAS 123, which also requires that the information be determined as if the Company had accounted for its employee stock options granted subsequent to December 31, 1994 under the fair value method of the Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes multiple option pricing model with the following weighted average assumptions:
Option Grants Option Grants Option Grants 1997 1996 1995 ---- ---- ---- Risk-Free Interest Rates 5.91% to 6.44% 4.95% to 6.50% 5.82% to 7.09% Dividend Yield -0- -0- -0- Volatility factor of the Company's common stock .99 .88 .88 Weighted average expected life beyond each respective vesting period 1 year 1 year 1 year
The weighted average fair value of options granted during 1995, 1996 and 1997 was $.87, $2.60 and $.90, respectively. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option 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 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. Had compensation cost for the Company's employee stock option plan been determined based on the fair value at the grant dates for awards under those plans consistent with the methodology of SFAS 123, the Company's net income (loss) and earnings (loss) per share would have been reduced (increased) to the pro forma amounts indicated:
1997 1996 1995 ----- ---- ---- Pro forma net income (loss) $(4,081,816) $ 719,981 $(1,146,808) Pro forma income (loss) per share $ (.40) $ .07 $ (.12)
Because SFAS 123 is applicable only to options granted subsequent to December 31, 1994, its pro forma effect will EROX Corporation Notes to Financial Statements December 31, 1997 5. SHAREHOLDERS' EQUITY (continued) not be fully reflected until 1998. The following table summarizes information about stock options outstanding at December 31, 1997:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ---------------------------------------------------------- ----------------------------- WEIGHTED AVERAGE WEIGHTED WEIGHTED RANGE OF NUMBER REMAINING AVERAGE NUMBER AVERAGE EXERCISE OUTSTANDING CONTRACTUAL EXERCISE EXERCISABLE EXERCISE PRICES AT 12/31/97 LIFE PRICE AT 12/31/97 PRICE - -------------- ------------- ----------- -------- ------------ ---------- $0.79 to $1.58 375,000 3.3 $1.52 239,373 $1.51 $1.58 to $2.37 344,317 4.6 $1.96 278,562 $2.00 $2.37 to $4.74 167,600 4.3 $3.32 95,310 $3.55 $4.74 to $7.91 379,500 5.1 $5.81 124,875 $6.31 --------- --- ----- ------- ----- $0.79 to $7.91 1,256,417 4.3 $3.17 738,120 $2.77 ========= =======
6. RELATED PARTY TRANSACTIONS On February 29, 1996, the Company renewed a research and development agreement with Pherin Corporation ("Pherin"), a company related by common shareholders, whereby Pherin supplies EROX with its required synthesized human pheromones and also provides to EROX research and development and scientific public relations services. This renewal expires on March 1, 1998. The total expense incurred pursuant to the Company's research and development agreement with Pherin Corporation during the fiscal years ended December 31, 1997, 1996, and 1995 was $280,000, $270,000 and $240,000, respectively. See Note 8. 7. INCOME TAXES There was no provision for income taxes for the year ended December 31, 1997 as the Company incurred a net operating loss. For the year ended December 31, 1996, the provision for income taxes consists of the following: Current: Federal $24,903 State 39,179 --------- $64,082 ========= The Company's effective income tax provision for the year ended December 31, 1996 differs from the statutory federal income tax rate of 34% due to the following: Expected tax provision at federal statutory rate $423,345 State taxes 39,179 Benefit of net operating loss carryforward (398,442) -------- Provision for income taxes $ 64,082 ======== At December 31, 1997, the Company had net operating loss carryforwards of approximately $12,940,000. The Company also had federal research and development tax carryforwards of approximately $140,000. The net operating loss and credit carryforwards will expire between 2004 and 2012. Utilization of the net operating losses and credits may be subject to a substantial annual limitation due to the "change in ownership" provisions of the Internal Revenue Code of 1986 and similar state provisions. The annual limitations may result in the expiration of net operating losses and credits before utilization. Significant components of the Company's deferred tax assets and liabilities for federal and state income taxes are as follows:
Deferred tax asset: 1997 1996 ----- ---- Net operating loss carryforward $4,590,000 $3,030,000 Research credit carryforward 180,000 170,000 Returns Reserve 330,000 201,000 Other, net 360,000 309,000 Valuation allowance for deferred tax assets (5,460,000) (3,710,000) ---------- ---------- Net deferred tax assets $ - $ - ========== ==========
EROX Corporation Notes to Financial Statements December 31, 1997 7. INCOME TAXES (continued) Because of the Company's lack of earnings history, the deferred tax asset has been fully offset by a valuation allowance. The net valuation allowance increased in 1997 by $1,750,000 and decreased by $390,000 in 1996. 8. SUBSEQUENT EVENT (unaudited) On February 10, 1998, the Company renewed its research and development agreement with Pherin Corporation. The term of the agreement is a minimum of one year and the stipulated payments are $23,000 per month. On March 23, 1998, the Company renegotiated its Business Loan Agreement with Mid-Peninsula Bank of Palo Alto, California. The Company may borrow up to $3.0 million at an interest rate equal to the bank's prime rate plus .75% with borrowings secured primarily by the Company's trade receivables and inventory. The agreement, which expires on April 1, 1999, contains certain debt-to-equity and working capital covenants. EX-23.1 2 CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS Exhibit 23.1 CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 33-98836) pertaining to the Stock Plan and the Non-Employee Directors' Stock Option Plan of EROX Corporation of our report dated February 6, 1998, with respect to the financial statements of EROX Corporation included in the Annual Report (Form 10-KSB) for the year ended December 31, 1997. ERNST & YOUNG LLP Palo Alto, California March 26, 1998 EX-27 3 FINANCIAL DATA SCHEDULE
5 The Schedule Contains Summary Financial Information Extracted From Balance Sheets and Statements of Income 0000878616 EROX Corporation 1 12-MOS Dec-31-1997 Jan-1-1997 Dec-31-1997 248,617 0 3,907,597 (822,813) 3,421,298 6,883,516 790,466 (690,975) 6,983,007 2,553,717 0 0 2,145,535 17,667,024 (15,383,269) 4,429,290 17,169,616 17,169,616 4,079,555 4,079,555 332,389 0 75,989 (3,338,140) 0 (3,338,140) 0 0 0 (3,338,140) (0.32) (0.32)
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