10KSB 1 p19731_10k.txt ANNUAL REPORT United States Securities and Exchange Commission 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 For the fiscal year ended December 31, 2005 ----------------- [ ] TRANSITION REPORT UNDER SECTION 13 OR A5(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission file number 0-23544 ------- HUMAN PHEROMONE SCIENCES, INC. ------------------------------ (Name of small business issuer in its charter) California 94-3107202 ---------- ---------- (State or other jurisdiction of (I.R.S. employee Identification No.) incorporation or organization) 84 W Santa Clara St. Suite 720, San Jose, California 95113 ------------------------------------------------------ ----- (Address of principal executive offices) (Zip code) Issuer's telephone number: (408) 938-3030 ----------------- Securities registered under Section 12(b) of the Exchange Act: None ---- (Title of class) Securities registered under Section 12(g) of the Exchange Act: Common ------ (Title of class) Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes [ X ] No [ ] Indicate by check mark 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 [ ] Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-B is not herein, and will not 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. Yes [ X ] No [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [ X ] State issuer's revenues for its most recent fiscal year. $ 414,000 The aggregate market value of the voting stock held by non-affiliates of the registrant was $ 1,642341 as of the last business day of the registrants most recently second fiscal quarter, based upon the closing sale price on the NASDAQ Bulletin Board reported for such date. Shares of common stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. There were 4,151,954 shares of the registrant's common stock issued and outstanding as of March 17, 2006. DOCUMENTS INCORPORATED BY REFERENCE Part III incorporates information by reference from the definitive proxy statement for the Annual Meeting of Shareholders to be held on June 21, 2006. 1 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. Item 1. Description of Business ----------------------- Introduction The Company, a California corporation, was founded in 1989 as EROX Corporation to develop and market a broad range of consumer products containing human pheromones as a component. On May 29, 1998, the shareholders of the Company voted to change the name of the Company to Human Pheromone Sciences, Inc. Human Pheromone Sciences, Inc. is alternatively referred to in this report as "we," "us," "our," "HPS" or the "Company". 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 toiletry products, as well as other types of consumer products that do not require FDA approval. The Company believes that its related patents provide it a proprietary position in developing, licensing and marketing this category of consumer products. Pheromones are chemical substances known to stimulate species-specific biological responses in animals. For sixteen years, scientists and advisors engaged by the Company have studied the functions and characteristics of human pheromones and other mood-enhancing compounds. The human pheromones included as a component of and as a fixative for the Company's current products are manufactured for the Company by contract vendors. The manufacturing process for these compounds begins with hydrocarbon compounds commonly available from chemical supply houses, and involves the use of a synthetic chemistry process. Since 2001 an independent laboratory has manufactured these compounds, androstadienone and estratetraenol (the "Initial Compounds"), under the direction of HPS' consulting scientists. 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 HPS Technology The Initial Compounds. 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 and other emotion-related centers of the brain when applied within or adjacent to the nasal passages. Scientists have observed that in higher species the influence of pheromones grows increasingly more subtle and complex. Not surprisingly, reactions to these mood-enhancing compounds are very subtle in human beings. While humans have definite responses to pheromones, the research sponsored by HPS and other scientists suggests that the highly developed human brain filters and masks those reactions. Rather than producing an isolated effect, as in lower level species, these mood-enhancing 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 research and the research of other scientists, the Company believes evidence has been developed that indicates that humans respond to these Initial Compounds. HPS has also found that they are sexually dimorphic; that is, some show more activity in females while others show a higher level of activity in males. During the studies of human pheromones conducted by the 2 Company, certain human subjects volunteered descriptions of their feelings. Women frequently described feeling comfortable or at ease or more positive, while a number of male subjects described a feeling of confidence and self-assurance. The Company continues to explore 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 consumer products. In 2005, the Company conducted studies on human volunteers with two additional naturally-occurring compounds which have shown initially promising results, and the Company will continue to invest in further development of these two additional compounds, ER 303 and ER 99, for broad-based inclusion in consumer products. While there can be no assurances that these two compounds will be commercially successful, the Company believes that the initial results warrant further study. Consumer Products and the Initial Compounds. Animal pheromones are well known in the consumer products industry. Natural and synthetic equivalents of mammalian pheromones such as musk, civet and castoreum are found in many fragrances 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 consumer product. A scent binds to smell receptors in the nose and stimulates a specific region of the brain resulting in the sensation of smell. These Initial Compounds bind 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 and toiletry products allure and intrigue the senses, an alliance between these products and the Company's compounds seems quite natural. For these products to create a true effect in humans, however, it must contain human pheromones. Thus, consumer products containing these mood enhancing components may provide more allure than any others currently available. The Current HPS Products and Research Products. The Company initially operated in one business segment and began by marketing three fragrances, REALM(R) Women, REALM(R) Men and inner REALM(R). These products were sold by the Company into U.S. department and specialty stores through a network of dedicated salespeople and through independent distributors in selected markets in the Middle East and South East Asia. In April 2000, the Company licensed the rights to sell these products in all parts of the world, excluding South East Asia, to Niche Marketing, Inc. (See "Markets and Competition"). On April 14, 2003 the Company sold to Niche Marketing Group, Inc. the assets and worldwide ownership rights to the REALM Women, REALM Men and innerREALM product lines, including the rights to all trademarks associated therewith. Niche Marketing, Inc was subsequently purchased by Five Star Fragrances, Inc. These "proof-of-concept" products included 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, deodorant, talc, soap and body cream. Subsequently, the Company developed a new line of fragrance and toiletry products containing these Initial Compounds for men and women under the trademark Natural Attraction(R). The Company introduced these products via a new website, naturalattraction.com, in 2000. Marketing of this line of products was through the web and other direct marketing channels in the United States. The Company primarily promoted the website by placing banner ads on other sites and by selling to selective small perfume retailers on the web. In 2003 the Company completed a licensing agreement which has expanded the Natural Attraction product line, and a distribution agreement for the new product line. Since then, the company has granted non-exclusive rights to the Natural Attraction products in Europe and Japan. The website was re-vamped and updated in 2005, and the product line was repackaged. The Company is now developing additional marketing tools to drive additional consumers to its website. In addition, the Company is in discussions with several distributors for the sale of the Natural Attraction products outside the United States. Licensing the use of the Company's Initial Compounds and related technology is currently the core business of the Company. These compounds are sold to licensed customers and included as components in their products. The Company also offers private label manufacturing services for licensed customers if that is desired. Research. Pheromones, in general, 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 studies conducted under the Company's sponsorship as well and several studies conducted by scientists at leading research universities around the world have revealed new information regarding the beneficial effects of the Company's compounds and the biological pathways these compounds traverse in the human body. 3 On July 13, 2004 the Company signed a Research Agreement with the University of Utah to conduct research and provide services. The five year agreement, which became effective July 15, 2004, provides that the University will provide professional research and services for specific research programs mutually initiated by the Company and accepted by the University. While the University shall own any inventions and improvements conceived or reduced to practice from the work performed, the Company retains the exclusive option to license any inventions or improvements conceived or reduced to practice and market the products developed from the research results. Scientists working on behalf of HPS have identified and synthesized several naturally occurring mood enhancing compounds during 2005. Various levels of testing on human volunteers has been completed. The initial results of testing on each of the two compounds, ER 202 and ER 99, are encouraging enough to warrant continued study and product development efforts. HPS intends to continue research and testing on several other compounds it has developed for application to applied to consumer products. For the years ended December 31, 2005 and 2004, research and development expense totaled $164,000 and $93,000, respectively. The Company expects increased expenditures for research and development in 2006, and will look to find development partners for compounds that appear promising. Since its inception through December 31, 2005, the Company has incurred $5,540,000 in direct research and development related expenses. Markets and Competition The Competitive Environment. The Company's current products contain what the Company believes are unique components: androstadienone and estratetraenol, synthesized mood-enhancing human pheromone compounds. With these components HPS is able to differentiate its products, and its licensee's products, from traditional consumer products. Other than its customers and licensees, the Company believes that no other companies in or outside the United States have the right to produce or distribute products that contain these compounds. However, even with this proprietary technology, the Company and its customers and licensees are competing against numerous companies in the fragrance industry, including Estee Lauder, Chanel and the fragrances subsidiaries of Proctor and Gamble and L'Oreal, and offerings from retailers such as Victoria's Secret Beauty and Bath and Body Works. While HPS's current products are fragrances and toiletries, the Company feels strongly that fine fragrances and related toiletries are only "proof of concept" products. The Company's patented technology has applications far beyond traditional fragrances and bath and body products. HPS 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 application 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 continues to actively seek licensing and supply relationships with consumer product manufacturers. Marketing Strategy. The Company's strategy has shifted from the initial need to educate the consumers and the trade about the company's unique compounds to its current focus on expanding the market for its existing patented pheromones to other consumer product and fragrance companies. In addition the Company continues to market its internally developed brand of pheromone-based products under the Natural Attraction brand. A joint venture with Demeter Fragrance Library for the marketing of mood based products under the licensed Demeter Natural Attraction label was terminated during 2005 because the sales and distribution generated by Demeter Fragrance Library were significantly below expected levels. The Company will seek to add to this group of products with new, patented compounds that may be developed through the research efforts that the Company is now directly managing. Historic Distribution and Promotional Activities through April 14, 2003. During 1993, the Company developed two fragrances, REALM Women and REALM Men. 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. The infomercial continued to be broadcast through mid-1995 while the Company commenced selling its products in the U.S. retail department stores on a limited basis in late 1994 and on an expanded basis during the next several years . By the beginning of 1997, HPS 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. 4 In mid-1997, the Company introduced a second women's fragrance line, innerREALM to alternative channels of distribution. The Company continued distributing its REALM Men and REALM Women's fragrances in leading U.S. department stores and into distribution agreements for the sale of REALM fragrances and toiletries in selected Middle East markets, including Saudi Arabia and the Gulf States, selected Duty Free markets in the Caribbean, South America and on the Mexican and Canadian borders, Switzerland, Spain/Portugal and China. During 1999, the Company reduced its presence in U.S. retailers whose business was not profitable to HPS. The Company believed that it was difficult for a company with a limited portfolio to profitably compete in the U.S. department store fragrance business. On April 24, 2000, HPS signed a multi-year licensing agreement for its REALM and innerREALM fragrance and toiletry products with Niche Marketing, Inc. ("Niche"), and on April 14, 2003 the Company sold to Niche the assets and worldwide ownership rights to the REALM Women, REALM Men and innerREALM product lines. Assets consisting of REALM and innerREALM product lines, resulting in a net gain of $1,170,000. Current Distribution and Promotional Activities ----------------------------------------------- The Company's strategic focus is now on expanding the market for its existing patented mood-enhancing pheromones to other consumer product companies and to the expansion of its internally developed brand of products under the Natural Attraction label. The Company is also engaged in a program to add distributors outside the United States for its Natural Attraction Brand, the sell, its Initial Compounds for use in cosmetics products marketed by other companies and to increase its private label manufacturing services for licensees who want a completed product delivered to them for further sale to the consumer. The Company will seek to add to these Initial Compounds be the development of additional compounds that have been identified as having mood altering or enhancing properties in laboratory and consumer studies.. Two such compounds are being aggressively tested at the present time and there are several other compounds waiting to undergo similar development efforts. Basic research on these compounds is not required. That has been done over the past eight years. Scientists working on behalf of the Company are now focused on the less-costly scale-up and testing of these additional compounds. Technology Licensing and Supply Agreements One of the strategic objectives of the Company is to expand the use of its patented human pheromone technology by working closely with consumer products companies who are leaders in their particular markets. In December 1998, HPS signed its first agreement to supply Avon Products, Inc. with its synthesized human pheromones. Revenues commenced in 1999 and have continued through 2005. Total revenues from this agreement and others aggregated $1,090,330 in 2005 and $858,790 in 2004, respectively. HPS is also in supply and /or licensing discussions with other companies in several consumer products fields and markets. During 2005, three companies represented 56%, 20% and 10% of the Company's net sales and revenues. During 2004, three companies comprised 74%, 11% and 6% of the Company's net sales and revenues. 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. In 1995, patents were granted in Taiwan, and in 1997, patents were granted in Mexico. In June 1998, the Company was granted a Notice of Allowance of its patents for the inclusion of synthesized human pheromones by the European Patent Office. Individual country patents were also granted. HPS is also the exclusive licensee for non-therapeutic uses of pheromones in consumer products under a royalty-free worldwide perpetual license to United States patents and patent applications covering pheromone technology owned by Pherin Pharmaceuticals, Inc. This technology is also the subject of other foreign patents and applications. The Company also relies on trade secrets protection for confidential and proprietary information. Other patent applications are currently anticipated as new compounds are developed. 5 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 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 and radio 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, 2006, the Company had two full-time employees and one part-time employee. In addition, the Company retains consultants to provide advice in the areas of research, sales and marketing, advertising, product safety testing, regulatory compliance, MIS and product development. 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 and its licensees are dependent on third parties to manufacture its products. The Company has selected several essential oil companies that provide fragrance products to the industry to supply such compounds to HPS in accordance with proprietary formulas developed for the Company and generic formulas developed by the essential oil companies. The Company has agreements in place with suppliers for its products and has been furnished with commercial quantities of the Company's and its licensees' products for sale to consumers. While the Company is responsible for blending the human pheromones with these products, final bottling and packaging of the products and ancillary product lines are performed by independent manufacturers. These manufacturers selected by HPS and its licensees have extensive experience in blending, filling and packaging fragrance, cosmetic and related products, and have the capacity to satisfy the Company's and its licensees' 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. The Company has qualified two manufacturers for the production of the synthesized human pheromones. Since 2002, the Company has utilized only one of these manufacturers to furnish all of the Company's human pheromone requirements. The Company does not believe that it would be economically feasible to establish its own manufacturing facilities since synthesized human pheromones are available from laboratories that now have experience in the preparation of these compounds. Available Information We make available free of charge on or through our Internet website our annual reports on Form 10-K, quarterly reports on Form 10-QSB, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission. Our Internet website address is "www.erox.com". 6 Risk Factors Our business is subject to various risks, including those described below. You should carefully consider the following risk factors and all other information contained in this Form 10-KSB. If any of the following events or outcomes actually occurs, our business, operating results, and financial condition would likely suffer. The Company's current cash position and projected results of operations for the year 2006 requires that additional funding be obtained. Unless the Company raises additional funding by debt or equity issuances, asset sales or a significant increase in product sales accompanied by reductions in corporate spending, the Company's current cash on hand is will be insufficient to cover its working capital requirements. The Company is actively working on securing the required funding but it cannot guarantee that it will be successful. The Company has not had sustained profitable operations since 1997. Since 1997, the Company has incurred losses from operations. In May 2000 the Company refocused its business model based on product licensing agreements. While the Company anticipated that this change in its business will result in profitable operations, it has not to date, and the Company's license based business model may not be successful in the future. To maintain the current operations the Company will require additional funding due to the continued operating losses sustained and projected. The Company's marketing strategy may not be successful. The Company may not be able to establish and maintain the necessary sales and distribution channels, even if funding is obtained. Consumer product companies may choose not to license or private label the Company's products. The Company may not be able to protect its technology or trade secrets from others who choose to violate the Company's patents. The Company may not be able to develop new patentable compounds. The Company's success substantially depends upon developing and obtaining patents for new mood and sensory enhancing compounds. The Company requires that its products be scientifically tested validating the human responses to the compounds. The Company may not be successful in validating that the desired human responses are obtained. The Company may not be able to recruit and retain key personnel. The Company's success substantially depends upon recruiting and retaining key employees and consultants with research, product development and marketing experience. The Company may not be successful in recruiting and retaining these key people. The Company relies upon other companies to manufacture its products. The Company and its distributors/licensees rely upon other companies to manufacture its pheromones, supply components, and to blend, fill and package its fragrance products. The Company and its distributors/licensees may not be able to obtain or retain pheromone manufacturers, fragrance suppliers, or component manufacturers on acceptable terms. This would adversely affect operating results. Item 2. Description of Property ----------------------- The Company presently occupies a 2,609 square feet of space for its headquarters offices in San Jose, California, pursuant to a lease extension signed on March 5, 2004 that expires March 31, 2007. The minimum annual rental is $48,997, with annual rent increases in accordance with the increase in the Consumer Price Index in the local area. Commencing in February 2001, the Company leases storage space in the local area on a month-to-month basis for approximately $0.75 per square foot. Our existing facilities are not yet being used at full capacity and management believes that these facilities are adequate and suitable for current and anticipated needs. During the year ended December 31, 2005, the Company incurred $60,000 in net rent expense and related charges for these facilities. Item 3. Legal Proceedings ----------------- We are not currently involved in any material legal proceedings. Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- None. 7 Item 5. Market for Common Equity, Related Stockholder Matters and Small -------------------------------------------------------------------- Business Issuer Purchases of Equity Securities ---------------------------------------------- The Company's Common Stock is quoted on the OTC Bulletin Board under the symbol EROX.OB. As of March 1, 2006, there were approximately 800 holders of record of the Company's Common Stock. Set forth below is the high and low bid information for the Company's Common Stock on the OTC Bulletin Board as reported during each of the four calendar quarters of 2005 and 2004. HIGH LOW ---- --- 2005 ---- First quarter $ 0.90 $ 0.45 Second quarter $ 0.85 $ 0.52 Third quarter $ 0.62 $ 0.40 Fourth quarter $ 0.51 $ 0.20 2004 First quarter $ 0.51 $ 0.22 Second quarter $ 0.85 $ 0.43 Third quarter $ 0.70 $ 0.38 Fourth quarter $ 0.70 $ 0.28 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 Operations -------------------------------------------------- The Company's strategic focus is now on expanding the use of its existing patented human pheromones to other consumer product companies on a worldwide basis, the development of its internally developed Natural Attraction and other proprietary lines of mood enhancing based products. In addition, the Company would like to add to this group of products new patented compounds that are being developed through the research efforts that the Company is now directly managing. Year ended December 31, 2005 compared with the year ended December 31, 2004 --------------------------------------------------------------------------- Net sales and revenues for the year ended December 31, 2005 were $414,000 compared to $1,140,000 for the prior year, a decrease of $726,000, or 64%. Decreased revenues for 2005 were the result of a primary customer altering their buying pattern in 2004 with accelerated orders in the fourth quarter of 2004. Revenues from this customer decreased 73% in 2005 after a 48% increase in 2004 from the 2003 revenues and accounted for 84% of the 2005 revenue decline. The revenues from the Demeter Natural Attraction line which was launched in 2004 did not met expectations accounting for 5% of the decline in revenues. Although the company was able to expand its customer base during the year and reworked its Natural Attraction fragrances in the fourth quarter of 2005 revenues from these other sources decreased by 8%. The Company has licensed additional fragrance distributors late in the year and is continuing to seek new licensees and expand discussions with potential licensees in both the fragrance and consumer product markets. Gross margin in 2005 was 79% of sales as compared with 81% in the prior year. The slight decrease is primarily attributable to different sales mix of products and more aggressive pricing for international distributors. Research and development costs increased by $71,000 in 2005 to $164,000 from the $93,000 incurred in the prior year. The increase of the research expenditures was the result of the Company inaugurating operations at the University of Utah under the Research Agreement signed July 13, 2004 and initiating preliminary testing of new compounds at another facility. The Company is now directly managing all research and development efforts from this facility as it continues additional testing based on the initial favorable test results. 8 Selling, general and administrative expenses decreased $306,000 to $1,113,000 for the year ending December 31, 2005 from $1,419,000 for year ending December 31, 2004. Sales, marketing and distribution expenses decreased $174,000, while other administrative expenses increased by $132,000. The decrease in sales and marketing expenses was due to curtailing spending in 2005 on the Demeter Natural Attraction line which was launched in 2004 and reduced fees associated with licensing activities. Administrative costs decreases were primarily due to reduced investor relations program costs and head count reduction. Total other income and expense, including interest remained at $17,000 in 2005. Net interest income for 2005 was $17,000 with no significant other income or expense. In 2004 the net interest income was $18,000 with no significant other income or expense. The reduction in net interest income was due to the reduced cash balances. In 2005 the Company has not recorded a tax provision due to the net operating losses generated, or the utilization of net losses carried forward from prior years. In 2004 a $21,000 tax benefit was recorded as a gain from sale of assets as the actual tax liability was less than anticipated. As of December 31, 2005 the Company's gross deferred tax asset, which relates primarily to net operating losses carried forward, was approximately $7,137,000. However, a full valuation allowance was provided for the gross deferred tax asset as management could not determine whether its realization was more likely than not. Liquidity and Capital Resources ------------------------------- At December 31, 2005, the Company had cash and cash-equivalents of $452,000, working capital of $411,000, and no bank borrowings outstanding. These balances at December 31, 2004 were $1,201,000 and $1,336,000, respectively with no bank borrowings outstanding. Net cash used by operating activities was $748,000 for the year ended 2005 as compared with $733,000 for the year ended December 31, 2004. The cash used from operations for 2005 increased by $15,000 and is primarily attributed to operating spending reductions slightly less than the 2005 revenue and gross profit reductions. The Company did not renew its Business Loan Agreement with Mid-Peninsula Bank of Palo Alto, California which had been providing for a revolving line of credit, secured by the Company's trade receivable and inventories. The Business Loan Agreement which expired May 3, 2005 was never drawn upon by the Company. The Company's current cash position and projected results of operations for the year 2006 requires that additional sources of funding be obtained. Unless the Company raises additional funding by debt or equity issuances, asset sales or a significant increase in product sales accompanied by reductions in corporate spending, the Company's current cash on hand will be insufficient to cover its working capital requirements. The Company is actively working on securing the required funding and it is not know how successful those efforts might be. If our capital resources are unable to meet our capital requirements, we will have to raise additional funds. We may be unable to raise sufficient additional capital when we need it or to raise capital on favorable terms. The sale of equity or convertible debt securities in the future may be dilutive to our stockholders, and debt financing arrangements may require us to pledge certain assets and enter into covenants that could restrict certain business activities or our ability to incur further indebtedness and may contain other terms that are not favorable to us or our stockholders. If we are unable to obtain adequate funds on reasonable terms, we may be required to curtail operations significantly or to obtain funds by entering into financing agreements on unattractive terms. New Accounting Pronouncements ----------------------------- In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment". SFAS 123(R) amends SFAS No. 123, " Accounting for Stock-Based Compensation", and APB Opinion No. 25, "Accounting for Stock Issued to Employees". SFAS No.123(R) requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements. SFAS No. 123(R) applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments (except for those held by an ESOP) or by incurring liabilities (1) in amounts based (even in part) on the price of the company's shares or other equity instruments, or (2) that require (or may require) settlement by the issuance of a company's shares or other equity instruments. This statement is effective (1) for public companies qualifying as SEC small business issuers, as of the first interim period or fiscal year beginning after December 15, 2005, or (2) for all other public companies, as of the first interim period or fiscal year beginning after June 15, 2005, or (3) for all nonpublic entities, as of the first fiscal year beginning after December 15, 2005. Management will comply with this statement beginning in 2006. 9 In May 2005, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 154, "Accounting Changes and Error Corrections" ("SFAS No. 154"), an amendment to Accounting Principles Bulletin Opinion No. 20, "Accounting Changes" ("APB No. 20"), and SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements". Though SFAS No. 154 carries forward the guidance in APB No.20 and SFAS No.3 with respect to accounting for changes in estimates, changes in reporting entity, and the correction of errors, SFAS No. 154 establishes new standards on accounting for changes in accounting principles, whereby all such changes must be accounted for by retrospective application to the financial statements of prior periods unless it is impracticable to do so. SFAS No. 154 is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005, with early adoption permitted for changes and corrections made in years beginning after May 2005. The Company will implement SFAS No. 154 in its fiscal year beginning January 1, 2006. We are currently evaluating the impact of this new standard but believe that it will not have a material impact on the Company's financial position, results of operations, or cash flows. In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments", which amends SFAS No. 133, "Accounting for Derivatives Instruments and Hedging Activities" and SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities". SFAS No. 155 amends SFAS No. 133 to narrow the scope exception for interest-only and principal-only strips on debt instruments to include only such strips representing rights to receive a specified portion of the contractual interest or principle cash flows. SFAS No. 155 also amends SFAS No. 140 to allow qualifying special-purpose entities to hold a passive derivative financial instrument pertaining to beneficial interests that itself is a derivative instrument. The Company is currently evaluating the impact this new Standard but believes that it will not have a material impact on the Company's financial position, results of operations, or cash flows. CRITICAL ACCOUNTING POLICIES The discussion and analysis of our financial conditions and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses and disclosures on the date of the financial statements. On an on-going basis, we evaluate our estimates, including, but not limited to, those related to revenue recognition and license fees. We use authoritative pronouncements, historical experience and other assumptions as the basis for making judgments. Actual results could differ from those estimates. We believe that the following critical accounting policies affect our more significant judgments and estimates in the preparation of our financial statements. Revenue Recognition Revenue is recorded at the time of merchandise shipment, net of provisions for returns. The Company records revenues from sales, initiated by sales agents, net of the sales commissions earned following the interpretative guidance provided by FASB Emerging Issue Task Force (EITF) EITF No. 99-19 Reporting Revenue Gross as a Principal versus Net as an Agent. License fees are earned over the license period according to the terms of the license agreement and interpretative guidance provided by Staff Accounting Bulletin (SAB) No. 101 and No. 104. The majority of the Company's sales are to distributors and licensees, and these distributors and licensees have no right to return products. Off-Balance-Sheet Arrangements As of December 31, 2005, the Company did not have any off-balance-sheet arrangements as defined in Item 303(c)(2) of SEC Regulation S-B. Item 7. Financial Statements -------------------- See the Financial Statements set forth in Item 13(a), which are incorporated herein by reference. Itemv 8. Changes In and Disagreements with Accountants on Accounting and -------------------------------------------------------------------- Financial Disclosure -------------------- None. 10 Item 8A. Controls and Procedures ----------------------- The Company carried out an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15(e) of the Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that as of December 31, 2005, the end of the period covered by this report, our disclosure controls and procedures were effective at the reasonable assurance level to timely alerting them to material information relating to the Company required to be in our Exchange Act filings. Changes in internal control over financial reporting During the quarter ended December 31, 2005, there have been no significant changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Item 8B. Other Information ----------------- None. 11 PART III Item 9. Directors and Executive Officers of the Registrant -------------------------------------------------- The executive officers of the Company and their ages as of March 1, 2006 are as follows: Name Age Position ---- --- -------- William P. Horgan 58 Chairman, Chief Executive Officer and Director Gregory S. Fredrick 51 Chief Financial Officer 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 to 1988, he held various executive and management positions with CooperVision, Inc. and several affiliated companies, including President of its Revo, Inc. subsidiary. Gregory S. Fredrick joined the Company in October 1998 as Vice President, Controller. Prior to joining the Company Mr. Fredrick spent nearly eight years in the Entertainment industry. From February 1997 to June 1998, he was the Vice President, Controller for a start-up record label / internet company 911 Entertainment. Mr. Fredrick served in various finance and operations capacities while with Windham Hill Records / BMG Entertainment from April 1990, leaving as Director of Operations in December 1996. Code of Ethics The Company has adopted a Code of Ethics that applies to all of our directors, officers and employees. The Code of Ethics is posted on our website at erox.com under the caption Company. The Company intends to satisfy the disclosure requirement under Item 10 of Form 8-K regarding an amendment to, or waiver from, a provision of the Code of Ethics by posting such information on our website, at the address and location specified above. The remainder of this item is incorporated by reference to the Company's definitive Proxy Statement relating to its 2004 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 and -------------------------------------------------------------------- Related Shareholder Matters --------------------------- Incorporated by reference to the Proxy Statement. Item 12. Certain Relationships and Related Transactions ---------------------------------------------- Incorporated by reference to the Proxy Statement. 12 Item 13. Exhibits -------- Financial Statements. The following are filed as a part of this report: --------------------- Page ---- Report of Singer Lewak Greenbaum & Goldstein LLP, Independent Registered Public Accounting Firm 16 Balance Sheets - December 31, 2005 and 2004 17 Statements of Operations - Years ended December 31, 2005 and 2004 18 Statements of Shareholders' Equity -Years ended December 31, 2005 and 2004 19 Statements of Cash Flows - Years ended December 31, 2005 and 2004 20 Notes to Financial Statements 21 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) 3.2 Copy of Registrant's By-laws (1) 10.1 Registrant's Stock Plan * (1) 10.2 Technology Transfer Agreement between Registrant and Pherin dated August 23, 1991 (1) 10.3 Supply Agreement with Avon Products, Inc.((2)) 10.4 Lease Agreement between Registrant and Ernest E. Pestana and Irene Pestana, dated March 5, 2001 for the Registrant's California offices ((3)). 10.5 Amendment to License and Purchase Agreement with Niche Marketing, Inc. dated March 8, 2002. ((4)) 10.6 Business Loan Agreement dated April 19, 2002. ((5)) 10.7 Business Loan Agreement dated May 2, 2003((6)) 10.8 2003 Nonemployee Directors Stock Option Plan of Human Pheromone Sciences, Inc((6)) 10.9 Lease Agreement between Registrant and Ernest E. Pestana and Irene Pestana, dated March 5, 2004 for the Registrant's California offices ((7)). 10.10 Promissory Note with Mid-Peninsula Bank dated April 26, 2004 ((8)). 10.11 Research Agreement with University of Utah effective July 15, 2004 (8). 23.1 Consent of Independent Certified Public Accountants Singer Lewak Greenbaum & Goldstein LLP 31.1 Certification of Chief Executive Officer pursuant to Rules 13a - 15(e) 31.2 Certification of Chief Financial Officer pursuant to Rules 13a - 15(e) 32. Certification of Chief Executive Officer and Chief Financial Officer pursuant to U.S.C. 1350 Item 13. Exhibits and Reports on Form 8-K (continued) -------------------------------------------- (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, 1998. (3) Filed as an exhibit with corresponding exhibit no. To Registrant's Annual Report on Form 10-KSB for the year ended December 31, 2001. (4) Filed as an exhibit with corresponding exhibit no. to Registrant's Quarterly Report on Form 10-QSB for the three month ended March 31, 2002. (5) Filed as an exhibit with corresponding exhibit no. to Registrant's Quarterly Report on Form 10-QSB for the three month ended June 30, 2002. (6) Filed as an exhibit with corresponding exhibit no. to Registrant's Quarterly Report on From 10-QSB for the three month ended June 30, 2003. 13 (7) Filed as an exhibit with corresponding exhibit no. to Registrant's Quarterly Report on From 10-QSB for the three month ended March 31, 2004. (8) Filed as an exhibit with corresponding exhibit no. to Registrant's Quarterly Report on From 10-QSB for the three month ended June 30, 2004. * Management contract or compensatory plan Item 14. Principal Accountant Fees and Services -------------------------------------- Incorporated by reference to the Proxy Statement. 14 SIGNATURES ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, Human Pheromone Sciences, Inc. Corporation has duly caused this Annual Report on Form 10-KSB to be signed on its behalf by the undersigned, thereunto duly authorized, in San Jose, California, on March 27, 2006. HUMAN PHEROMONE SCIENCES, INC. By: /s/ William P. Horgan ------------------------- Name: William P. Horgan ----------------------- Title: Chief Executive Officer and Chairman of the Board -------------------------------------------------- POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENT, that each person whose signature appears below constitutes and appoints William P. Horgan and Gregory S. Fredrick, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-KSB and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed on behalf of Human Pheromone Sciences, Inc. by the following persons in the capacities and on the dates indicated.
SIGNATURE CAPACITY DATE --------- -------- ---- /s/ William P. Horgan Chief Executive Officer March 27, 2006 ---------------------- and Chairman William P. Horgan (Principal Executive Officer) /s/ Gregory S. Fredrick Chief Financial Officer March 27, 2006 ---------------------- (Principal Financial and Gregory S. Fredrick Accounting Officer) /s/ Bernard I. Grosser Director March 27, 2006 ---------------------- Bernard I. Grosser, MD /s/ Helen C. Leong Director March 27, 2006 ---------------------- Helen C. Leong /s/ Robert Marx Director March 27, 2006 ---------------------- Robert Marx
15 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors Human Pheromone Sciences, Inc. San Jose, California We have audited the accompanying balance sheets of Human Pheromone Sciences, Inc. (the "Company") as of December 31, 2005 and 2004, and the related statements of operations, stockholders' equity (deficit) and cash flows for the years then ended. 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 standards of the Public Company Accounting Oversight Board (United States). 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 Human Pheromone Sciences, Inc. as of December 31, 2005 and 2004, and the results of its operations and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has suffered recurring losses from operations and has an accumulated deficit of $20,390,000 as of December 31, 2005. The available cash as of December 31, 2005 might not be sufficient for year 2006 operations. This raises substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ SINGER LEWAK GREENBAUM & GOLDSTEIN LLP Los Angeles, California February 23, 2006 16 Human Pheromone Sciences, Inc. Balance Sheets
December 31, December 31, (in thousands except share data) 2005 2004 -------- -------- Assets Current assets: Cash and cash equivalents $ 452 $ 1,201 Accounts receivable, net of $5,000 allowance in 2004 only 11 259 Inventory, net 70 63 Other current assets 18 8 -------- -------- Total current assets 551 1,531 Property and equipment, net 8 17 -------- -------- $ 559 $ 1,548 ======== ======== Liabilities and Shareholders' Equity Current liabilities: Accounts payable $ 21 $ 41 Accrued professional fees 63 58 Accrued employee benefits 27 35 Accrued sales returns 15 40 Accrued income taxes 2 3 Other accrued expenses 12 18 -------- -------- Total current liabilities 140 195 -------- -------- Total liabilities 140 195 Commitments and Contingencies Shareholders' equity: Common stock, no par value, 13,333,333 shares authorized, 4,151,954 shares issued and outstanding at each date 20,809 20,809 Accumulated deficit (20,390) (19,456) -------- -------- Total shareholders' equity 419 1,353 -------- -------- $ 559 $ 1,548 ======== ========
See accompanying notes to financial statements. 17 Human Pheromone Sciences, Inc. Statements of Operations
Years ended December 31, (in thousands except per share data) 2005 2004 ----------------------------------------------------------------------- ------- ------- Net revenue $ 414 $ 1,140 Cost of goods sold 88 215 ------- ------- Gross profit 326 925 ------- ------- Operating expenses: Research and development 164 93 Selling, general and administrative 1,113 1,419 ------- ------- Total operating expenses 1,277 1,512 ------- ------- Loss from operations (951) (587) Other (expense) income Interest income (net) 17 18 Other expense -- (1) ------- ------- Total other income 17 17 ------- ------- Loss from on-going operations (934) (570) Net gain from sale of assets -- 28 ------- ------- Net loss $ (934) $ (542) ======= ======= Net income (loss) per common share-basic and fully diluted From on-going operations $ (0.22) $ (0.14) From assets sold 0.00 0.01 Net income (loss) (0.22) (0.13) Weighted average common shares outstanding - basic and fully diluted 4,152 4,129 ======= =======
See accompanying notes to financial statements. 18 Human Pheromone Sciences, Inc. Statements of Shareholders' Equity
(in thousands) Common Stock ----------------------- Total Shareholders' Shares Amount Accumulated Deficit Equity ------ ------ ------------------- ------------------- Balances, at December 31, 2003 4,105 $ 20,659 $(18,914) $ 1,745 Conversion of Series AA preferred stock 47 150 -- 150 Net loss -- -- (542) (542) -------- -------- -------- -------- Balances, at December 31, 2004 4,152 20,809 (19,456) 1,353 Net loss -- -- (934) (934) -------- -------- -------- -------- Balances, at December 31, 2005 4,152 $ 20,809 $(20,390) $ 419 ======== ======== ======== ========
See accompanying notes to financial statements. 19 Human Pheromone Sciences, Inc. Statements of Cash Flows
Years ended December 31, (in thousands) 2005 2004 -------------------------------------------------------- ------- ------- Cash flows from operating activities: Net loss from on-going operations $ (934) $ (570) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 9 8 Changes in operating assets and liabilities: Accounts receivable, net 248 (221) Inventories, net (7) (11) Other current assets (9) 10 Accounts payable and accruals (55) 43 ------- ------- Net cash used in on-going activities (748) (741) Net cash provided by operations sold -- 8 ------- ------- Net cash used in operating activities (748) (733) Cash flows used in investing activities: Purchase of property and equipment (1) (16) ------- ------- Net cash used in investing activities (1) (16) Cash flows used in financing activities ------- ------- Net cash used in financing activities -- -- ------- ------- Net increase (decrease) in cash and cash equivalents (749) (749) Cash and cash equivalents at beginning of the year 1,201 1,950 ------- ------- Cash and cash equivalents at end of the year $ 452 $ 1,201 ======= ======= (in dollars) ------------ Cash disbursement for income taxes $ -- $ -- ======= ======= Cash disbursement for interest $ 2,000 $ 1,000 ======= =======
See accompanying notes to financial statements. 20 Human Pheromone Sciences, Inc. Notes to Financial Statements December 31, 2005 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization, Nature of Operations and Basis of Presentation Human Pheromone Sciences, Inc. (the "Company") was incorporated in the State of California in 1989 under the name of EROX Corporation. The Company changed its name to Human Pheromone Sciences, Inc. in May 1998. The Company is engaged in the research, development, manufacturing and marketing of consumer products containing synthetic human pheromones and other mood enhancing compounds. The Company initiated commercial operations in late 1994 with a line of fine fragrances and toiletries. In April 2000, the Company licensed the sale of its REALM fragrance products through department and specialty stores across the United States and selected international markets to Niche Marketing, Inc. On April 14, 2003 the Company sold to Niche Marking Group, Inc. the assets and worldwide ownership rights to the REALM Women, REALM Men and innerREALM product lines. Assets consisting of the REALM and innerREALM trademarks, inventory and product licenses were sold. Licensing of the Company's technology is currently the core business of the Company. The Company's patented compounds are sold to licensed customers and included as components in their fragrance products. The Company also offers private label manufacturing services for third party consumer product licensees. Going Concern The accompanying financial statements have been prepared in conformity with the accounting principles generally accepted in the United States of America, which contemplate continuation of the Company as a going concern. During the years ending December 31, 2005 and 2004 from the company's inception to December 31, 2005, the Company has incurred net losses available to shareholders of $934,000, $542,000 and $20,390,000, respectively, and has had negative cash flows from operations in 2005 and 2004 for $748,000 and $733,000, respectively, and the cash balance on had at December 31, 2005 is $452,000. These factors raise substantial doubt about the Company's ability to continue as a going concern. The Company is actively working on securing the required funding to continue operations. Unless the Company raises additional funds, either by debt, equity issuances or asset sales, managements believes that its current cash on hand in addition to the on-going collections from sales, and expense reductions, will be insufficient to cover its working capital needs as the year progresses. Use of Estimates The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Concentration of Credit Risk Since the Company has refocused its business based on a product licensing model, its concentration of credit risk consists principally of cash, cash equivalents and accounts receivable. The Company places its cash and cash equivalents with high quality institutions. As of December 31, 2005 and 2004, the Company had deposits at one financial institution which aggregated $441,000 and $1,219,000, respectively. Such funds are insured by the Federal Deposit Insurance Corporation up to $100,000. Concentration of credit risk with respect to accounts receivable has increased because the Company's customer base consists of several large customers in the United States and distributors in several international markets. On-going credit evaluations of customers' financial condition are performed and, generally, no collateral is required. However, until the credit worthiness of these international customers is acceptable to the Company, the customer generally pays in advance of shipment. The Company maintains an allowance for potential losses based upon management analysis of possible uncollectible accounts. 21 Human Pheromone Sciences. Inc. Notes to Financial Statements December 31, 2005 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Customer Concentration During 2005, three customers comprised 56%, 20% and 10% of the Company's net sales. Accounts receivable from these customers at December 31, 2005 account for 0%, 0% and 3%, respectively, of the net receivables. During 2004, three customers comprised 74%, 11% and 6% of the Company's net revenues. Supplier Concentration The Company is dependent on third parties to manufacture its fragrance products, as well as the synthesized human pheromones used in these products. Capacity limitations at these essential suppliers, or any other occurrences leading to an interruption of supply could have a material adverse effect on the Company. During the year three suppliers comprised 88% of the cost of goods sold. During 2004 three suppliers comprised 99% of the cost of goods sold. Revenue Recognition Revenue is recorded at the time of merchandise shipment, net of provisions for returns. The Company records revenues from sales, initiated by sales agents, net of the sales commissions earned following the interpretative guidance provided by FASB Emerging Issue Task Force (EITF) EITF No. 99-19 Reporting Revenue Gross as a Principal versus Net as an Agent. License fees are earned over the license period according to the terms of the license agreement and interpretative guidance provided by Staff Accounting Bulletin (SAB) No. 101 and No. 104. The majority of the Company's sales are to distributors and licensees, and these distributors and licensees have no right to return products. Advertising Costs The cost of advertising is expensed as incurred. Advertising costs were $17,000 and $44,000 in 2005 and 2004, respectively. Research and Development Research and development costs are charged to expense when incurred. Research and development costs were $164,000 and $93,000 in 2005 and 2004, respectively. Fair Value of Financial Instruments The Company believes that the book value of financial instruments, including cash and cash equivalents, accounts receivable, inventory, accounts payable and accrued expenses, approximate their fair value. Income Taxes The Company accounts for income taxes under SFAS No. 109 Accounting for Income Taxes. In accordance with SFAS No. 109, deferred tax assets and liabilities are established for the temporary differences between the financial reporting basis and tax basis of the Company's assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. The Company provides a valuation allowance against net deferred tax assets unless, based upon available evidence, it is more likely than not that the deferred tax asset will be realized. 22 Human Pheromone Sciences, Inc. Notes to Financial Statements December 31, 2005 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Stock Options SFAS No. 123(R), "Share-Based Payment", which amends SFAS No. 123, " Accounting for Stock-Based Compensation", and APB Opinion No. 25, "Accounting for Stock Issued to Employees" defines a fair value based method of accounting for stock-based compensation. However, SFAS No. 123(R) allows an entity to continue to measure compensation cost related to stock and stock options issued to employees using the intrinsic method of accounting prescribed by Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" until its effective date. Entities electing to remain with the accounting method of APB No. 25 must make pro forma disclosures of net income and earnings per share as if the fair value method of accounting defined in SFAS No. 123(R) had been applied. The Company has elected to account for its stock-based compensation to employees using the intrinsic value method under APB No. 25. New Accounting Pronouncements In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment". SFAS 123(R) amends SFAS No. 123, " Accounting for Stock-Based Compensation", and APB Opinion No. 25, "Accounting for Stock Issued to Employees". SFAS No.123(R) requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements. SFAS No. 123(R) applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments (except for those held by an ESOP) or by incurring liabilities (1) in amounts based (even in part) on the price of the company's shares or other equity instruments, or (2) that require (or may require) settlement by the issuance of a company's shares or other equity instruments. This statement is effective (1) for public companies qualifying as SEC small business issuers, as of the first interim period or fiscal year beginning after December 15, 2005, or (2) for all other public companies, as of the first interim period or fiscal year beginning after June 15, 2005, or (3) for all nonpublic entities, as of the first fiscal year beginning after December 15, 2005. Management will comply with this statement beginning in 2006. In May 2005, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 154, "Accounting Changes and Error Corrections" ("SFAS No. 154"), an amendment to Accounting Principles Bulletin Opinion No. 20, "Accounting Changes" ("APB No. 20"), and SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements". Though SFAS No. 154 carries forward the guidance in APB No.20 and SFAS No.3 with respect to accounting for changes in estimates, changes in reporting entity, and the correction of errors, SFAS No. 154 establishes new standards on accounting for changes in accounting principles, whereby all such changes must be accounted for by retrospective application to the financial statements of prior periods unless it is impracticable to do so. SFAS No. 154 is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005, with early adoption permitted for changes and corrections made in years beginning after May 2005. The Company will implement SFAS No. 154 in its fiscal year beginning January 1, 2006. We are currently evaluating the impact of this new standard but believe that it will not have a material impact on the Company's financial position, results of operations, or cash flows. In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments", which amends SFAS No. 133, "Accounting for Derivatives Instruments and Hedging Activities" and SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities". SFAS No. 155 amends SFAS No. 133 to narrow the scope exception for interest-only and principal-only strips on debt instruments to include only such strips representing rights to receive a specified portion of the contractual interest or principle cash flows. SFAS No. 155 also amends SFAS No. 140 to allow qualifying special-purpose entities to hold a passive derivative financial instrument pertaining to beneficial interests that itself is a derivative instrument. The Company is currently evaluating the impact this new Standard but believes that it will not have a material impact on the Company's financial position, results of operations, or cash flows. 23 Human Pheromone Sciences, Inc. Notes to Financial Statements December 31, 2005 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Net Income (Loss) Per Common Share The Company follows the provisions of SFAS No. 128, Earnings Per Share. SFAS No. 128 provides for the calculation of "Basic" and "Diluted" earnings per share. Basic earnings (loss) per share is computed using the weighted-average number of common shares outstanding. Diluted earnings (loss) per share is computed using the weighted-average number of common shares and dilutive common shares outstanding during the period. For the year ended December 31, 2005, options to purchase 438,000 shares of common stock were excluded from the computation of diluted earnings per share since their effect would be antidilutive. Cash and Cash Equivalents The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Accounts Receivable and Sales Returns Allowances The Company records accounts receivable upon the shipment of goods and records an offsetting estimate for future sales returns or other allowances that the Company anticipates. The Company estimates the required reserves based on historical sales activity, contractual obligations with the customers, current sell-through of inventory at the customer locations, customer credit worthiness and general economic and consumer trends. Significant judgment is required to estimate our allowance for doubtful accounts in any accounting period. Therefore, our estimates could differ materially from actual results. Inventories Inventories are stated at the lower of cost (first-in, first-out method) or market. The Company records an inventory reserve for inventory shrinkage and obsolescence. The Company estimates the required reserves based on historical sales and projected sales, historical inventory shrinkage, marketing plans, packaging modifications required, minimum production runs, economic viability and general economic environment. Property and Equipment The Company's property and equipment are stated at cost, net of accumulated depreciation. Depreciation is provided on a straight-line basis over three years for all categories. 2. INVENTORIES A summary of inventories follows (in thousands): December 31, -------------- 2005 2004 ---- ---- Components (raw materials) $ 56 $ 62 Finished goods 39 18 Reserve for shrinkage and obsolescence (25) (17) ---- ---- $ 70 $ 63 ==== ==== 24 Human Pheromone Sciences, Inc. Notes to Financial Statements December 31, 2005 3. PROPERTY AND EQUIPMENT Property and equipment consist of the following (in thousands): December 31, --------------- 2005 2004 ---- ---- Computer hardware $ 62 $ 62 Computer software 52 52 Furniture and other office equipment 26 26 ----- ----- 140 140 Accumulated depreciation (132) (123) ----- ----- $ 8 $ 17 ===== ===== Depreciation expense for the years ended December 31, 2005 and 2004 were $9,000 and $8,000, respectively. 4. BANK BORROWING The Company did not renew its Business Loan Agreement with Mid-Peninsula Bank of Palo Alto, California which had been providing for a revolving line of credit, secured primarily by the Company's trade receivables and inventory. The agreement which expired on May 3, 2005 was never drawn upon by the Company. 5. COMMITMENTS AND CONTINGENCIES The Company presently occupies a 2,609 square feet of space for its headquarters offices in San Jose, California, pursuant to a lease extension signed on March 5, 2004 that expires March 31, 2007. The minimum annual rental is $49,774, with annual rent increases in accordance with the increase in the Consumer Price Index in the local area. Future minimum lease payments under this non-cancelable lease as of December 31, 2005 are as follows: Year Ending Minimum December 31, Lease Payment ------------ ------------- 2006 $49,774 2007 16,591 ------- Total $66,365 ======= Since February 2001, the Company has leased storage space in the local area on a month-to-month basis for approximately $0.75 per square foot. Total rent expense was $60,000 and $65,000 for the years ended December 31, 2005 and 2004, respectively. 6. SHAREHOLDERS' EQUITY Stock Option 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. This Plan expired on August 29, 2000 and a new plan has not been established. The maximum number of shares that were issuable under the Plan was 708,333. The Board of Directors had set terms and conditions of stock options. Options were 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 could have been granted at not less than 110% of fair market value. Options had 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 had a maximum term of five years. 25 Human Pheromone Sciences, Inc. Notes to Financial Statements December 31, 2005 6. SHAREHOLDERS' EQUITY (continued) A summary of the option activity under the Plan is as follows (in thousands except per share data): WEIGHTED AVERAGE SHARES EXERCISE PRICE ------ -------------- Outstanding, January 1, 2004 294 $0.98 Canceled or Expired (45) $1.09 ------ Outstanding, December 31, 2004 249 $1.01 Canceled or Expired (61) $0.95 ------ Outstanding, December 31, 2005 188 $1.03 ====== At December 31, 2005, no shares of the Company's common stock were reserved for future grants since the Plan has expired, and options to purchase 188,000 shares were exercisable at a weighted average exercise price of $1.03 per share. In June 1993, the Company's Board of Directors adopted a Non-Employee Directors' Stock Option Plan (Directors' Plan) covering a total of 158,333 shares of common stock, which provides for a one-time automatic grant of options to purchase 8,333 shares of common stock and annual grants thereafter of options to purchase 3,333 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. This plan has expired. On June 25, 2003 the Board of Directors adopted the 2003 Non-Employee Directors Stock Option Plan (the "2003 Plan") of Human Pheromone Sciences, Inc. A maximum of 300,000 shares of commons stock may be issued on exercise of the Options granted pursuant to the 2003 Plan. The 2003 Plan will expire on June 24, 2010. This plan replaces the Directors' Plan which expired June 13, 2003. The 2003 Plan provides for annual grants of options to purchase 20,000 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 the grant. A summary of the stock option activity under the Director's Plans is as follows (in thousands except per share data): WEIGHTED AVERAGE EXERCISE SHARES PRICE ------ ----- Outstanding, January 1, 2004 155 $3.23 Granted 60 $0.60 Canceled or Expired (15) $5.40 ------ Outstanding, December 31, 2004 200 $2.28 Granted 60 $0.40 Canceled or Expired (10) $6.60 ------ Outstanding, December 31, 2005 250 $1.66 ====== At December 31, 2005, a total of 120,000 shares of the Company's common stock were reserved for future grants under the Directors' Plan, and options to purchase 210,000 shares were exercisable, at a weighted average exercise price of $1.90. 26 Human Pheromone Sciences, Inc. Notes to Financial Statements December 31, 2005 6. SHAREHOLDERS' EQUITY (continued) The following table summarizes information about stock options outstanding at December 31, 2005 (in thousands except per share data) under both of the Company's plans
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------------------------------------- ---------------------------- WEIGHTED AT A AVERAGE WEIGHTED WEIGHTED RANGE OF NUMBER REMAINING AVERAGE NUMBER AVERAGE EXERCISE OUTSTANDING CONTRACTUAL EXERCISE EXERCISABLE EXERCISE PRICES AT 12/31/05 LIFE (YEARS) PRICE AT 12/31/05 PRICE OF ------ ----------- ------------ ----- ----------- -------- $ 0.09 to $ 1.00 200 5.8 $ 0.37 160 $ 0.36 $ 1.01 to $ 2.00 208 2.5 $ 1.07 208 $ 1.07 $ 2.01 to $ 5.00 10 2.5 $ 2.02 10 $ 2.02 $ 5.01 to $23.64 20 0.9 $ 14.49 20 $ 14.49 ----- ----- ------- ----- ------- $ 0.09 to $23.64 438 3.6 $ 1.39 398 $ 1.49 ===== =====
The weighted average fair value of options granted during 2005 and 2004 was $0.40 and $0.60, respectively. The Company applies APB 25 and related Interpretations in accounting for its employee stock options. Had compensation expense been determined based upon the fair value of the awards at the grant date and consistent with the method under SFAS No. 123, the Company's net income (loss) per share would have been increased as shown by the proforma amount indicated in the following table (in thousands): Years ended December 31, ------------------------ 2005 2004 ------- ------- Net income (loss): As reported $ (934) $ (542) Deduct total stock based employee compensation expense determined under fair value method for all awards, net of tax (22) (34) ------- ------- Pro forma $ (956) $ (576) ======= ======= Basic and diluted loss per share: As reported $ (0.22) $ (0.13) Pro forma $ (0.22) $ (0.14) For purposes of computing the pro forma disclosures required by SFAS No. 123, the fair value of each option granted to employees and directors is estimated using the Black-Scholes option-pricing model with the following weighted-average assumptions for the years ended December 31, 2005 and 2004;
2005 Option Grants 2004 Option Grants ------------------ ------------------ Weighted Average Interest Rates 4.0% 3.3% Dividend Yield 0% 0% Volatility factor of the Company's common stock 149% 177% Weighted average expected life beyond each respective vesting period 5 years 5 years
27 Human Pheromone Sciences, Inc. Notes to Financial Statements December 31, 2005 6. SHAREHOLDERS' EQUITY (continued) The weighted-average fair value of options granted during the years ended December 31, 2005 and 2004 for which the exercise price was equal to the market price on the grant date was $0.40 and $0.60, respectively, and the weighted-average exercise price was $0.40 and $0.60, respectively. No stock options were granted during the years ended December 31, 2005 and 2004 for which the exercise price was greater than or less than the market price on the grant date. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which do not have 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. 7. INCOME TAXES There was no provision for income taxes for the year ended December 31, 2005 or 2004 as the Company incurred net operating losses for which no benefit was recognized, or utilized tax loss carryforwards. A reconciliation of the effective tax and the statutory U.S. federal income tax is as follows: Years ended December 31, ------------------------ 2005 2004 ---- ---- Federal tax (tax benefit) at the federal statutory rate $ (318) $ (184) Other differences 95 (74) Permanent differences 1 2 Increase (decrease) in valuation allowance 222 256 ------ ------ Income tax benefits $ -- $ -- ====== ====== At December 31, 2005, the Company had federal net operating loss carryforwards of approximately $19,175,000. The Company also had federal and state research and development tax carryforwards of approximately $222,000. The net operating loss and credit carryforwards will expire between 2006 and 2021. The utilization of certain of the loss carryforwards is limited under Section 382 of the Internal Revenue Code. Temporary differences that give rise to a significant portion of the deferred tax asset are as follows (in thousands): December 31, -------------------- 2005 2004 ------ ------ Deferred tax asset: Net operating loss carryforward $ 6,813 $ 6,526 Research credit carryforward 222 214 Reserves and accruals 62 61 Other, net (112) (39) Valuation allowance for deferred tax assets (6,985) (6,762) ------ ------ Net deferred tax assets $ -- $ -- ====== ====== 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 by $223,000 in 2005 and increased by $256,000 in 2004. The valuation allowance was established because the Company was not able to determine that it is more likely than not that the deferred tax asset will be realized. 28