**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

(Mark One)

 

| [ **X** ] | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE |
|-----------|---------------------------------------------------------|

SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended December 31, 2005

 

OR

 

| [ | ] | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE |
|---|---|----------------------------------------------------------|

SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from______to_______

 

**Commission file number 0-12992**

 

**SYNTHETECH, INC.**

(Exact name of registrant as specified in its charter)

 

| **OREGON**

(State or Other Jurisdiction

of Incorporation or Organization) | **84-0845771**

(I.R.S. Employer

Identification No.) |
|-----------------------------------------------------------------------------|-------------------------------------------------------|

 

**1290 Industrial Way**

**PO Box 646**

**Albany, Oregon  97321**

(Address of Principal Executive Offices)                          

 

**(541) 967-6575**

(Registrant's Telephone Number, Including Area Code)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. 

 

| **Yes** | **  X  ** | **No   ___** |
|---------|-------------------------------|-----------------------------|

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

| **Yes   ___** | **No** | **  X  **  |
|------------------------------|--------|-------------------------------------|

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

| **Yes   ___** | **No** | **  X  **  |
|------------------------------|--------|-------------------------------------|

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

 

| **Class: Common Stock, $0.001 par value** |
|-------------------------------------------|

**Shares outstanding as of February 13, 2006:  14,474,785**

 

 

 

 

 

 

 

**SYNTHETECH, INC**

 

**INDEX**

 

 

|  
**Page**

**Part I.**

**Financial Information**

 
 

Item 1.****

Condensed Financial Statements****

 

Balance Sheets

3

Statements of Operations

5

Statements of Cash Flows

6

Notes to Unaudited Condensed Financial Statements

7

 

Item 2.

Management’s Discussion and Analysis of Financial

 
 
Condition and Results of Operations

16

 

Item 3.

Quantitative and Qualitative Disclosure about Market

 
 
Risk

28

 

Item 4.

Controls and Procedures

28

 

**Part II.**

**Other Information**

 

Item 6.****

Exhibits****

29****

 

Signatures

30

 

 

 

 

 

 

 

 

 

 

 

2

**PART I.  FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements**

** **

** **

**SYNTHETECH, INC.******

**Condensed Balance Sheets******

(unaudited)

 

 

 

 

 

 

 

**December 31,******

** **

March 31,

 

**2005******

** **

2005 

 

 

 

 

Assets

 

 

Current Assets:

 

 

 

Cash and cash equivalents

**$******

**975,000******

 

$

1,828,000  

Marketable securities

** **

**800,000******

 

 

1,300,000

Accounts receivable, less allowance

** **

** **

 

 

 

for doubtful accounts of $15,000 for

** **

** **

 

 

 

both periods

** **

**931,000******

 

 

2,175,000 

Inventories

** **

**3,559,000******

 

 

3,354,000 

Prepaid expenses

** **

**472,000******

 

 

374,000 

 

** **

** **

 

 

 

Total Current Assets

** **

**6,737,000******

 

 

9,031,000 

 

** **

** **

 

 

 

Property, Plant and Equipment, net

** **

**4,162,000******

 

 

4,500,000 

 

** **

** **

 

 

 

Total Assets

**$******

**10,899,000******

 

$

13,531,000 

 

** **

 

 

 

 

 

 

 

 

*The accompanyingnotes are an integral part of these condensed financial statements.*

 

 

3

 

 

 

 

**SYNTHETECH, INC.**

**Condensed Balance Sheets******

(continued)

(unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**December 31,******

** **

March 31,

 

 

 

 

 

 

**2005******

** **

2005 

 

Liabilities and Shareholders’ Equity

 

 

Current Liabilities:

Current portion of long term debt

**$******

**28,000******

 

$

26,000 

Note payable

** **

**158,000******

 

 

- 

Accounts payable

** **

**528,000******

 

 

488,000 

Accrued compensation

** **

**177,000******

 

 

151,000 

Accrued termination benefits

** **

**212,000******

 

 

- 

Income taxes payable

** **

**-******

 

 

180,000    

Other accrued liabilities

** **

**7,000******

 

 

11,000 

 

** **

** **

 

 

 

Total Current Liabilities

** **

**1,110,000******

 

 

856,000 

 

** **

** **

 

 

 

Long term debt, net of current portion

** **

**5,000******

 

 

26,000 

Accrued termination benefits

** **

**-******

 

 

87,000

 

** **

** **

 

 

 

Total Liabilities

** **

**1,115,000******

 

 

969,000

 

** **

** **

 

 

 

Shareholders' Equity:

** **

** **

 

 

 

Common stock, $.001 par value; authorized 

** **

** **

 

 

 

100,000,000 shares; issued and outstanding,

** **

** **

 

 

 

14,475,000 and 14,470,000 shares

** **

**15,000******

 

 

14,000 

Paid-in capital

** **

**9,124,000******

 

 

9,100,000 

Retained earnings

** **

**645,000******

 

 

3,448,000 

 

** **

** **

 

 

 

Total Shareholders' Equity

** **

**9,784,000******

 

 

12,562,000 

 

** **

** **

 

 

 

Total Liabilities and Shareholders' Equity

**$******

**10,899,000******

 

$

13,531,000 

 

 

 

 

*The accompanying notes are an integral part of these condensed financial statements.***

 

 

4

 

 

**SYNTHETECH, INC.******

**Condensed Statements of Operations******

(unaudited)    

 

 

For the Three Months Ended

** **

For the Nine Months Ended

 

December 31,

** **

December 31,

 

**2005******

** **

2004

** **

**2005******

 

2004

 

Revenue

**$******

**1,736,000 ******

 

$

1,181,000 

 

**$******

**3,984,000 ******

 

$

6,453,000 

Cost of revenue

** **

**1,769,000 ******

 

 

1,675,000 

 

** **

**4,624,000 ******

 

 

6,102,000 

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Gross income (loss)

** **

**(33,000)******

 

 

(494,000)

 

** **

**(640,000)******

 

 

351,000 

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Research and development

** **

**263,000 ******

 

 

190,000 

 

** **

**652,000 ******

 

 

474,000 

Selling, general and administrative

** **

**541,000 ******

 

 

599,000 

 

** **

**1,782,000 ******

 

 

1,690,000 

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Total operating expenses

** **

**804,000 ******

 

 

789,000 

 

** **

**2,434,000 ******

 

 

2,164,000 

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Operating loss

** **

**(837,000)******

 

 

(1,283,000)

 

** **

**(3,074,000)******

 

 

(1,813,000) 

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Interest income

** **

**20,000 ******

 

 

17,000 

 

** **

**96,000 ******

 

 

36,000 

Interest expense

** **

**(3,000)******

 

 

(1,000)

 

** **

**(5,000)******

 

 

(5,000)

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Loss before income taxes

** **

**(820,000)******

 

 

(1,267,000)

 

** **

**(2,983,000)******

 

 

(1,782,000) 

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Income tax benefit

** **

**(180,000)******

 

 

-

 

** **

**(180,000)******

 

 

- 

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Net loss

**$******

**(640,000)******

 

$

(1,267,000)

 

**$******

**(2,803,000)******

 

$

(1,782,000)

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Net loss per common share:

** **

** **

 

 

 

 

** **

** **

 

 

 

Basic and diluted loss per share

**$******

**(0.04)******

 

$

(0.09) 

 

**$******

**(0.19)******

 

$

(0.12) 

Weighted average shares outstanding: 

** **

** **

 

 

 

 

 

 

 

 

 

Basic and diluted 

** **

**14,474,785 ******

 

 

14,463,093  

 

** **

**14,472,160 ******

 

 

14,457,663  

 

 

 

 

 

 

 

 

* *

* *

*The accompanying notes are an integral part of these condensed financial statements.***

 

 

5

 

**SYNTHETECH, INC.**

**Condensed Statements of Cash Flows******

(unaudited)

 

 

 

 

 

 

For The Nine Months Ended December 31,

**2005******

 

2004

 

** **

 

 

CASH FLOWS FROM OPERATING ACTIVITIES:

** **

 

 

Net loss

**$******

**(2,803,000)******

 

$

(1,782,000)

Adjustments to reconcile net loss to

** **

** **

 

 

 

net cash used in operating activities:

** **

** **

 

 

 

Depreciation expense

** **

**408,000 ******

 

 

806,000 

Restricted stock awarded to employees

** **

**22,000 ******

 

 

- 

Amortization of deferred compensation

** **

**- ******

 

 

12,000 

 

 

 

** **

** **

 

 

 

(Increase) decrease in assets:

** **

** **

 

 

 

Accounts receivable, net

** **

**1,244,000 ******

 

 

470,000 

Inventories

** **

**(205,000)******

 

 

(51,000)

Prepaid expenses

** **

**104,000 ******

 

 

(93,000)

 

 

 

** **

** **

 

 

 

Increase (decrease) in liabilities:

** **

** **

 

 

 

Accounts payable

** **

**40,000 ******

 

 

(83,000)

Accrued compensation

** **

**26,000 ******

 

 

(28,000)

Accrued termination benefits

** **

**125,000 ******

 

 

26,000 

Income taxes payable

** **

**(180,000)******

 

 

- 

Other accrued liabilities

** **

**(4,000)******

 

 

(13,000)

Cash Used In Operating Activities

** **

**(1,223,000)******

 

 

(736,000)

 

 

 

** **

** **

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

** **

** **

 

 

 

Property, plant and equipment purchases

** **

**(70,000)******

 

 

(65,000)

Cash Used In Investing Activities

** **

**(70,000)******

 

 

(65,000)

 

 

 

** **

** **

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

** **

** **

 

 

 

Purchase of marketable securities, available for sale

** **

**(1,300,000)******

 

 

**- **

Sale of marketable securities, available for sale

** **

**1,800,000 ******

 

 

**- **

Principal payments under long-term debt obligations

** **

**(19,000)******

 

 

(18,000)

Repayment of note payable

** **

**(44,000)******

 

 

- 

Repurchase of common stock

** **

**-******

 

 

(2,000)

Proceeds from stock purchase plan 

** **

**3,000 ******

 

 

10,000 

Cash Provided By (Used In) Financing Activities

** **

**440,000 ******

 

 

(10,000)

 

 

 

** **

** **

 

 

 

Decrease in Cash and Cash Equivalents

** **

**(853,000)******

 

 

(811,000)

 

 

 

** **

** **

 

 

 

Cash and Cash Equivalents at Beginning of Period

** **

**1,828,000 ******

 

 

3,018,000 

 

 

 

** **

** **

 

 

 

Cash and Cash Equivalents at End of Period

**$******

**975,000 ******

 

$

2,207,000 

 

 

 

** **

** **

 

 

 

Non-Cash Financing Activities:

** **

** **

 

 

 

Insurance premiums financed with note payable

**$******

**202,000 ******

 

 

- 

Forfeiture of stock options issued below fair value

** **

**- ******

 

$

1,000 

 

** **

** **

 

 

 

*The accompanying notes are an integral part of these condensed financial statements.***

6

 

 

**SYNTHETECH, INC.**

**NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS**

(Information as of December 31, 2005 and for the three- and nine-month

periods ended December 31, 2005 is unaudited)

 

 

**NOTE A.**

**GENERAL AND BUSINESS**

 

Synthetech, Inc., an Oregon corporation, is a fine chemicals company specializing in organic synthesis, biocatalysis and chiral technologies.  Synthetech develops and manufactures amino acid derivatives, specialty amino acids, peptide fragments, proprietary custom chiral intermediates and specialty resins primarily for the pharmaceutical and cosmeceutical industries.  Synthetech’s products support the development and manufacture of therapeutic peptides and peptidomimetic small molecule drugs at every stage of a customer’s clinical development pipeline, and are used as ingredients in drugs for the treatment of AIDS, cancer, cardiovascular and other diseases, and in cosmeceuticals.  A cosmeceutical is a product that makes no therapeutic claims, but is intended for topical use by humans.

 

The summary financial statements included herein have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations, although Synthetech management believes that the disclosures are adequate to make the information presented not misleading.  Synthetech’s management suggests that these summary financial statements be read in conjunction with the financial statements and the notes thereto included in Synthetech’s Annual Report on Form 10-K for the year ended March 31, 2005.

 

The interim period information included in this Quarterly Report on Form 10-Q reflects all adjustments, consisting of normal recurring adjustments, that are, in the opinion of Synthetech’s management, necessary for a fair statement of the results of the respective interim periods.  Results of operations for interim periods are not necessarily indicative of results to be expected for an entire year.

 

 

**NOTE B.**

**LIQUIDITY**

 

The revenue Synthetech may generate in upcoming periods is uncertain.  Without a stable source of adequate revenue or new debt or equity financing, Synthetech may be unable to continue operations.  The accompanying financial statements do not include any adjustments that might result should Synthetech be unable to continue operations.  As of December 31, 2005, Synthetech was in compliance with its debt agreements.  Synthetech has employment agreements in place with certain employees, which require severance payments to the employee if certain conditions surrounding termination are met.

 

Synthetech has reported significant operating losses during each of its last three fiscal years and the nine-month period ended December 31, 2005.  During that nine-month period, Synthetech's working capital decreased $2.5 million, to $5.6 million as of December 31, 2005, compared to $8.2 million as of March 31, 2005.  As of December 31, 2005, quick assets (*i.e.* cash and cash equivalents, marketable securities and accounts receivable) less current liabilities totaled $1.6 million.  With this level of net quick assets, Synthetech would be unable to absorb operating losses at the level that occurred during the first nine months of fiscal 2006.  Synthetech believes that the amount it could realize upon disposition of its inventory outside the normal course of its operations would be significantly below the carrying value of its inventory as reflected in ourfinancial statements.  

 

 

7

 

 

 

As reported in Synthetech’s Annual Report on Form 10-K for the year ended March 31, 2005, Synthetech reduced the carrying value of its property, plant and equipment by $6.3 million to an estimated fair value of $4.5 million.  The March 31, 2005 valuation of Synthetech’s property, plant and equipment was performed in accordance with Statement of Financial Accounting Standards *(SFAS)* No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets,” and was derived from an appraisal based on orderly liquidation value.

 

Synthetech is pursuing various strategies to stabilize and expand its revenues.  The following items are further discussed in the Overview section of Management's Discussion and Analysis in Part I, Item 2 of this Quarterly Report on Form 10-Q:  

 

**•**

Effective October 1, 2005, Synthetech engaged a contract research and manufacturing company located in India to serve as a satellite Research and Development team.  

 

**•**

In December 2005, Synthetech acquired the technology assets of Colorado Biotechnology Associates, Incorporated for a range of cross-linked and functionalized polymeric resins used widely in Solid Phase Peptide Synthesis.  This purchase represents Synthetech’s entry into the specialty resin market as a domestic supplier.  

 

**•**

During the quarter ended December 31, 2005, Synthetech installed equipment to support low temperature chemical processing.  Synthetech believes that the addition of low temperature processing capabilities will allow Synthetech to attract a broader range of customer projects.  

 

In addition to the above, in February 2006, Synthetech expanded its sales agent representation in Western Europe.  

 

Synthetech anticipates that it will require additional capital, which may be substantial, to implement certain elements of its growth strategy, although Synthetech has not yet determined the amount or timing of such additional funding.  Synthetech may not be able to obtain required financing to implement its growth strategy.

 

 

**NOTE C.**

**SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

**Use of Estimates:**The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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.  Significant items subject to such estimates and assumptions include the valuation of inventory, accounts receivable, deferred tax assets and the carrying amount of property, plant and equipment. 

 

 

 

 

 

 

8

 

 

 

**Cash and Cash Equivalents:**  Cash and cash equivalents include demand cash and highly liquid debt instruments with maturities of three months or less when purchased.

 

Cash and cash equivalents consist of the following:

 

 

**December 31,******

 

March 31,

 

 

**2005******

 

2005

 

 

 

** **

 

 

 

Cash

 

$

**195,000******

 

$

551,000 

Cash equivalents

 

 

**780,000******

 

 

1,277,000      

 

 

$

**975,000******

 

$

1,828,000 

 

**Marketable Securities, Available-for-Sale:**In accordance with Statement of Financial Accounting Standards (*SFAS*) No. 115, “Accounting for Certain Debt and Equity Securities,” marketable securities are classified as available-for-sale.  Available-for-sale securities are carried at fair value, with the unrealized gains and losses reported in comprehensive income.  The amortized cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity.  Such amortization is included in interest income.  Realized gains and losses and declines in value judged to be other than temporary, if any, on available-for-sale securities would be included in other income or expense.  The cost of securities sold is based on the specific identification method.  Interest and dividends onsecurities classified as available-for-sale are included in interest income.

 

At March 31, 2005, our investment in marketable securities, available-for-sale, included $1.3 million of auction rate municipal bonds.  Our investments in these securities were recorded at cost, which approximated fair market value due to their variable interest rates, which typically reset every 7 to 35 days.  We sold our auction rate municipal bonds at par in August 2005 and reinvested in the cumulative preferred shares described below.  We had no realized gains or losses from the sale of these securities.  

 

At December 31, 2005, our investment in marketable securities, available-for-sale, included $800,000 of auction rate preferred shares.  Our investments in these securities are recorded at cost, which approximates fair market value due to their variable interest rates, which typically reset every seven to 28 days based upon the results of an auction.  As a result of the periodic adjustment in rates, we had no cumulative gross unrealized holding gains or losses or gross realized gains or losses from these securities.  

 

All income from our available-for-sale securities is recorded in interest income.  Marketable securities are held with a major financial institution in Synthetech’s name.

 

**Accounts Receivable:** Accounts receivable are recorded at the invoiced amount and do not bear interest.  Synthetech does not finance its trade receivables by factoring the balances to a third party.   The allowance for doubtful accounts is established by a review of aged accounts receivables and a review of collectibility of specific accounts.  The allowance for doubtful accounts as of December 31, 2005 and March 31, 2005 was $15,000.  For the nine months ended December 31, 2005 and 2004, Synthetech’s provision for credit losses was insignificant.  

 

**Concentrations of Credit Risk:**  Financial instruments that potentially subject Synthetech to significant concentrations of credit risk consist principally of cash equivalents, marketable securities and trade accounts receivable. Cash equivalents primarily consist of money market accounts with 

 

9

 

 

maturities at purchase of less than three months.  Marketable securities are discussed above.  Synthetech’s customers consist primarily of major pharmaceutical, emerging biopharmaceutical, contract drug synthesis and cosmeceutical companies.  Synthetech’s customers are primarily located in the United States and Western Europe.  Synthetech’s reliance on major customers and the absence of long term contracts could adversely affect operating results if a major customer were lost or failed to pay Synthetech. 

 

**Inventories:**  Inventories are stated at the lower of cost or market, determined on the first-in, first-out basis.  Costs include direct material, direct labor, applicable manufacturing overhead, and other direct costs.  

 

Management evaluates Synthetech’s inventory for impairment whenever it becomes aware that indicators of impairment exist.  It is Synthetech’s policy to write-down inventories to reflect an estimate for impairment in an amount equal to the excess, if any, of the cost of inventory compared to the estimated market value based upon assumptions about future demand and market conditions.  Write-downs of inventory are reported as a component of cost of revenue in the relevant period.

 

**Property, Plant and Equipment:**  Property, plant and equipment are recorded at cost.  Expenditures for maintenance and repairs are expensed as incurred.  Expenditures that materially increase values, change capacities or extend useful lives are capitalized.  When assets are retired, sold or otherwise disposed of, the applicable costs and accumulated depreciation are removed from the accounts and the resulting gain or loss is recognized.  Depreciation and amortization are calculated on a straight-line basis over the estimated useful lives of the individual assets which range from three to 40 years.

 

In accordance with SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets”, Synthetech, assesses the impairment of property, plant and equipment whenever events or changes in circumstances indicate that their carrying value may not be recoverable.  If Synthetech determines that the carrying value of property, plant and equipment may not be recoverable, we compare the carrying values of our property, plant and equipment to the undiscounted cash flows expected to be generated by the asset group.  If the carrying value exceeds the undiscounted cash flows, Synthetech may record an impairment charge.  Synthetech recognizes an impairment charge to the extent that the carrying amount of property, plant and equipment is in excess of its determined fair value.  

 

**Income Taxes:**Synthetech accounts for income taxes in accordance with SFAS No. 109 “Accounting for Income Taxes.”  In accordance with SFAS No. 109, deferred tax assets arise from the tax benefit of amounts expensed for financial reporting purposes but not yet deducted for tax purposes and from unutilized tax credits and net operating loss carryforwards.  We evaluate our deferred tax assets on a regular basis to determine if a valuation allowance is required.  To the extent it is determined the recoverability of the deferred tax assets is unlikely, we record a valuation allowance against deferred tax assets.

 

**Revenue Recognition:**  Synthetech recognizes revenue, including shipping and handling charges billed to customers, upon shipment of product when title and risk of loss pass to customers.  Shipping and handling costs are classified as part of cost of revenue.

 

**Research and Development Costs:**  Research and development costs are expensed as incurred.

 

 

10

 

 

 

**Comprehensive Income or Loss:**Synthetech has no material components of comprehensive loss other than net loss.  Accordingly, comprehensive income/loss was equal to net loss for all periods presented.

 

**Loss Per Share:**  Basic loss per share is computed by dividing net loss by the weighted average number of shares of common stock outstanding during the period.  Diluted loss per share is computed by dividing net loss by the weighted average number of shares of common stock and common stock equivalents outstanding during the period, calculated using the treasury stock method as defined in SFAS No. 128.  For the three months and nine months ended December 31, 2005 and 2004, the weighted average number of shares used to compute diluted loss per share did not differ from the weighted average number of shares used to compute basic loss per share.

 

The following common stock equivalents were excluded from the earnings per share computation because their effect would have been anti-dilutive:

 

 

For the Three Months

 

For the Nine Months

 

Ended December 31,

 

Ended December 31,

 

**2005******

 

2004

 

**2005******

 

2004

 

 

 
Common stock options outstanding

**1,287,850******

 

1,245,000

 

**1,287,850******

 

1,245,000

Award of restricted stock - unvested

**43,000******

 

-

 

**43,000******

 

-

 

**1,330,850******

 

1,245,000

 

**1,330,850******

 

1,245,000

 

 

**Stock-Based Compensation:**In accordance with SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure – an Amendment of Financial Accounting Standards Board (*FASB*) Statement No. 123” and SFAS No. 123, “Accounting for Stock-Based Compensation”, Synthetech’s pro forma option expense is computed using the fair value method.

 

As permitted by SFAS No. 123, as amended by SFAS No. 148, Synthetech has elected to continue to apply the provisions of Accounting Principles Board (or *APB*) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its Equity Incentive Plan (the *Plan*) and Employee Stock Purchase Plan (*ESPP)*.  Synthetech is generally not required under APB Opinion No. 25 and related interpretations to recognize compensation expense in connection with its stock-based employee compensation plans.  Synthetech is required by SFAS No. 123 to present, in the notes to its financial statements, the pro forma effects on reported net income and earnings per share as if compensation expense had been recognized based on the fair value methodof accounting prescribed by SFAS No. 123.  Resulting compensation expense is recognized in the notes over the vesting period. 

 

 

 

 

 

 

 

11

 

The following table illustrates the effect on the net loss and net loss per share if Synthetech had applied the fair value recognition provisions of SFAS No. 123, as amended, to options granted under the stock-based employee compensation plans.  For purposes of this pro forma disclosure, the estimated value of the options is recognized over the options’ vesting periods.

 

 

Three Months Ended December 31,

 

Nine Months Ended December 31,

 

**2005******

** **

2004

** **

**2005******

** **

2004

 

** **

** **

** **

** **

** **

 

 

 

Net loss, as reported

 

**$******

**(640,000)******

 

$

(1,267,000)

 

**$******

**(2,803,000)******

 

$

(1,782,000)

Add: Stock-based employee compensation expense included in reported net loss 

 

 

 

** **

 

 

**- ******

 

 

 

 

 

 

4,000 

 

 

 

** **

 

 

**22,000 ******

 

 

 

 

 

 

12,000 

 

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards

 

 

 

 

** **

 

 

 

**(44,000)******

 

 

 

 

 

 

 

 

(50,000)

 

 

 

 

** **

 

 

 

**(134,000)******

 

 

 

 

 

 

 

 

(146,000)

 

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Pro forma net loss

 

**$******

**(684,000)******

 

$

(1,313,000)

 

**$******

**(2,915,000)******

 

$

(1,916,000)

 

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Net loss per share:

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Basic and Diluted – as reported

 

**$******

**(0.04)******

 

$

(0.09)

 

**$******

**(0.19)******

 

$

( 0.12)

Basic and Diluted – pro forma   

 

**$******

**(0.05)******

 

$

(0.09)

 

**$******

**(0.20)******

 

$

(0.13)

 

In calculating pro forma compensation, the fair value of each stock option grant and stock purchase right is estimated on the date of grant using the Black-Scholes option pricing model and the following weighted average assumptions.  No stock options were granted during the three months ended December 31, 2005.  No ESPP shares were issued during the three months ended December 31, 2004 and 2005.

 

 

Three Months Ended December 31,

** **

Nine Months Ended December 31,

 

**2005******

** **

2004

** **

**2005******

** **

2004

 

** **

** **

** **

** **

** **

 

 

 

**Stock Options:******

 

** **

** **

 

 

 

 

 

 

 

 

 

Dividend yield

 

 

**-**

 

 

**-**

 

 

**-**

 

 

**-**

Expected volatility

 

 

**-**

 

 

61%

 

** **

**62%******

 

 

58%

Risk-free interest rate

 

 

**-**

 

 

3.91%

 

** **

**4.23%******

 

 

3.91%

Expected life (in years)

 

 

**-**

 

 

7.00

 

** **

**7.00******

 

 

7.00

Weighted-average fair value of stock options granted:

 

** **

** **

 

** **

** **

 

** **

** **

 

 

 

At market value

 

 

**-**

 

$

0.53

 

**$**

**0.32**

 

$

1.06

All options granted  

 

 

**-**

 

$

0.53

 

**$**

**0.32**

 

$

1.06

 

 

** **

** **

 

 

 

 

** **

** **

 

 

 

**ESPP:******

 

** **

** **

 

 

 

 

** **

** **

 

 

 

Dividend yield

** **

 

**-**

 

 

**-**

 

 

**-**

 

 

**-**

Expected volatility

** **

 

**-**

 

 

**-**

 

** **

**76%******

 

 

68%

Risk-free interest rate

** **

 

**-**

 

 

**-**

 

** **

**3.06%******

 

 

0.67%

Expected life (in years)

** **

 

**-**

 

 

**-**

 

** **

**0.50******

 

 

0.50

Weighted-average fair value of                              purchase rights granted

** **

** **

**-******

 

** **

**-******

 

**$******

**0.35******

 

$

0.69

 

12

The Plan authorizes the granting of restricted stock, which is held by Synthetech until the terms and conditions of the specific award are satisfied.  Except for the right of disposal, holders of restricted stock have full shareholders’ rights during the period of restriction, including voting rights.  There were 43,000 shares of restricted stock awarded to employees during the three months ended September 30, 2005, with a fair market value of $0.50 per share.  The vesting period for these shares begins on April 1, 2005, the shares are 50% vested on April 1, 2006 and 100% vested on April 1, 2007.  

 

 

**NOTE D.**

**INVENTORIES**

 

The major components of inventories, net of reserves, are as follows:

 

 

 

**December 31,******

 

March 31,

 

 

**2005******

 

2005

 

 

** **

 

 

Finished products

 

**$******

**1,907,000******

 

$

1,870,000 

Work in process

 

** **

**688,000******

 

 

581,000 

Raw materials

 

** **

**964,000******

 

 

903,000 

 

 

**$******

**3,559,000******

 

$

3,354,000 

 

 

**NOTE E.**

**PROPERTY, PLANT AND EQUIPMENT**

 

Property, plant and equipment and depreciable lives are summarized as follows:

** **

Depreciable Life

** **

 

**December 31,******

** **

 

March 31,

** **

In Years

** **

**2005******

** **

2005

Land

 

** **

**$******

**241,000 ******

** **

$

241,000 

Buildings

15 - 40

** **

** **

**1,611,000 ******

** **

 

1,609,000 

Machinery and equipment

5 - 17

** **

** **

**2,262,000 ******

** **

 

2,199,000 

Laboratory equipment

5 - 17

** **

** **

**1,012,000 ******

** **

 

1,011,000 

Furniture and fixtures

3 - 5

** **

** **

**49,000 ******

** **

 

45,000 

 

 

** **

** **

**5,175,000 ******

** **

 

5,105,000 

 

 

** **

** **

** **

** **

 

 

Less:

 

** **

** **

** **

** **

 

 

Accumulated depreciation

 

** **

** **

**(1,013,000)******

** **

 

(605,000)

** **

** **

** **

** **

** **

** **

 

 

** **

** **

** **

**$******

**4,162,000 ******

** **

$

4,500,000 

 

 

 

 

 

13

 

 

 

**NOTE F.**

**LINE OF CREDIT**

 

Synthetech’s bank line of credit provides for borrowings of up to $1 million or the maximum available under the borrowing base calculation, or financial covenants, whichever is less.  As of December 31, 2005, the financial covenants contained in the credit agreement would limit the amount of borrowings under the agreement to approximately $250,000.  Interest is payable at the prime rate with an annual facility fee of $5,000.  The agreement is collateralized by cash and cash equivalents, marketable securities, accounts receivable, inventory and equipment.  The agreement requires Synthetech to maintain various financial and other covenants.  On January 6, 2006, the agreement was amended to adjust the maturity date to March 31, 2006.  As of December 31, 2005, Synthetech had no borrowings outstanding under the credit agreement.  On June 27, 2005, Synthetech entered into a loan modification agreement whichrequires Synthetech to maintain a quick ratio of 2 to 1 and a tangible net worth of $9 million, increased by 50% of net income and other additions to shareholders’ equity.  Synthetech was in compliance with these covenants as of December 31, 2005.  If the lender determines that a material adverse change has occurred in Synthetech’s business, operations or financial condition, this would constitute an event of default under the credit agreement.  

 

 

**NOTE G.**

**NOTE PAYABLE**

 

In November 2005, Synthetech entered into a commercial premium finance agreement, financing annual premiums for certain of its insurance policies.  The amount financed was $202,000.  Payments consist of nine monthly installments of $23,000, including interest at 6.84%.  The final payment is due August 2006.  The amount outstanding under this finance agreement as of December 31, 2005 was $158,000.  

 

 

**NOTE H.**

**ACCRUED TERMINATION BENEFITS**

 

In accordance with an employment agreement between Synthetech and Synthetech’s President and Chief Executive Officer, upon termination of employment, the former executive is to receive one year of base salary and healthcare benefits, to be paid in twelve monthly installments.  An estimate of the amount to be paid under this agreement, $212,000, is reported as a current liability on Synthetech’s December 31, 2005 balance sheet.

 

**NOTE I.**

**SYNTHETECH COMMON STOCK DELISTED BY NASDAQ**

On October 13, 2005, Synthetech’s common stock was delisted from the Nasdaq SmallCap Market due to noncompliance with Nasdaq’s minimum bid price requirement.  Synthetech’s common stock is currently traded on the Pink Sheets under the symbol NZYM.PK.

 

 

 

 

 

14

 

 

 

**NOTE J.**

**STATEMENTS OF CASH FLOWS**

 

Supplemental cash flow disclosures: 

 

Cash Paid

 

Three Months Ended December 31,

 

Nine Months Ended December 31,

 

 

**2005******

 

2004

 

**2005******

 

2004

 

 

 

 

 

 

 

Interest

 

**$******

**3,000******

 

$

1,000

 

**$******

**5,000******

 

$

5,000

 

 

**NOTE K.**

**RELATED PARTY TRANSACTIONS**

 

Synthetech has engaged Paul Ahrens, a Director, to assist with Synthetech’s new product development efforts, and, until May 31, 2005, had engaged David Clarke, a former Director, to assist with Synthetech’s marketing and strategic development efforts.  Aggregate fees incurred by Synthetech under these arrangements during the quarter ended December 31, 2005 and the first nine months of fiscal 2006 were $15,000 and $88,000, respectively. 

 

 

 

 

 

 

 

 

 

15

 

 

 

**Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations**

 

The following discussion of the results of Synthetech’s operations and financial condition should be read in conjunction with the accompanying condensed financial statements and the notes thereto included within this report.

 

**FORWARD LOOKING STATEMENTS**

 

*This Quarterly Report on Form 10-Q containsforward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  All statements, otherthan statements of historical fact, including statements regarding industry prospects and future results of operations orfinancial position, made in this Quarterly Report are forward looking. Words such as “anticipates,”“believes,” “expects,” “future” and “intends” and similar expressions mayidentify forward-looking statements. In particular, forward-looking statements in this report include statementsregarding:  our future performance and operating results, including revenue for the second half and fourth quarter of fiscal 2006,cash flow from operations for fiscal 2006 and our ability to continue as a going concern and to absorb operating losses;expected revenue from and shipping dates for customerorders; implementation of our growth strategy, including the contributions of chemists in India we recently engaged, production of specialty resins as a result of our acquisition of CBA, expansion of our processing capabilities and our ability to finance our growth strategy; the conditions of the fine chemicals industry; obtaining regulatory approval for new drugs and other matters relating to drug development progress, including filings and filing dates related to the approval process; financing our current and future capital expenditures and the amount of such expenditures; the effect any change in foreign currency exchange rates would have on our operating results; whether our cash and cash equivalents, marketable securities, borrowing capacity and internally generated funds will be adequate to operate our business; our ability to liquidate our market rate securities; and our inability to recognize deferred tax assets. Forward-looking statements reflect management’s currentexpectations, plans or projections and are inherently uncertain.  Actual results could differ materially from management's**expectations, plans or projections.  Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. The risks and uncertainties that may cause actual results to vary materially from any forward-looking statements include, but are not limited to, the following: the uncertainty regarding our ability to continue our operations; our delisting from the Nasdaq SmallCap Market,  the uncertain market for our products; potential loss of a significant customer; customer concentration; potential termination or suspension by customers of significant projects; our limited experience in entering new markets and market segments; potential period-to-period revenue or expense fluctuations; our limited financial and other resources; higher than expected cash use,or inability to borrow funds under our line of credit or to raise other debt or equity capital required to continue operations or to implement our growth strategy; production factors; industry cost factors; competition; government regulation; labor disputes; technological change; and international business risks.  Investors are urged  to read our filings with the Securities and Exchange Commission, including our Annual Report on Form 10-K for the fiscal year ended March 31, 2005, for a further description of risks and uncertainties related to forward-looking statements made by us as well as to other aspects of our business. Synthetech does not intend to release any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events*

 

**OVERVIEW**

 

Synthetech is a fine chemicals company specializing in organic synthesis, biocatalysis and chiral technologies.  Synthetech develops and manufactures amino acid derivatives, specialty amino acids, peptide fragments, proprietary custom chiral intermediates and specialty resins primarily for the pharmaceutical and cosmeceutical industries.  Synthetech’s products support the development and manufacture of therapeutic peptides and peptidomimetic small molecule drugs at every stage of a 

 

16

 

 

customer’s clinical development pipeline.  Synthetech’s domestic and international customer base includes major pharmaceutical and emerging biopharmaceutical companies, as well as contract drug synthesis firms.  Synthetech also supplies catalog quantities of specialty amino acids to research institutions, universities and drug discovery firms.  Our integrated “grams to tons” production capabilities allow us to be involved with our customers from the early phases of pharmaceutical discovery and clinical development through approval, market launch and commercialization.

 

*Synthetech's Ability to Continue as a Going Concern*

 

The revenue Synthetech may generate in upcoming periodsis uncertain.  Without a stable source of adequate revenue or new debt or equity financing, Synthetech may be unable to continue operations.Synthetech has reported significant operating losses during each of our last three fiscal years and thenine-month period ended December 31, 2005. During that nine-month period, our working capital decreased $2.5 million, to $5.6 millionas of December 31, 2005, compared to $8.2 million as of March 31, 2005. As of December 31, 2005, quick assets (i.e. cash and cashequivalents, marketable securities and accounts receivable) less current liabilities totaled $1.6 million. With this level of netquick assets, Synthetech would be unable to absorb operating losses at the level that occurred during the first nine months of fiscal2006. We believe that the amount we could realize upon disposition of our inventory outside the normal course of our operations wouldbe significantly below the carrying value of our inventory as reflected in our financial statements.  

 

*Business Conditions*

 

Revenue in the third quarter and first nine months of fiscal 2006 was $1.7 million and $4.0 million, respectively, which was below the level of revenue required for Synthetech to operate profitably.  Our industry remains generally affected by a low rate of new drug approvals, ongoing customer insourcing and available capacity, although there continues to be signs of improvement.  During periods where manufacturing capacity is generally available, Synthetech is at a competitive disadvantage compared to contract drug synthesis companies that can support further downstream production in accordance with the FDA’s current Good Manufacturing Practices (cGMP).

 

During the first nine months of fiscal 2006, our manufacturing activities and related financial performance were adversely affected by low utilization of our large reactors due to the lack of significant large-scale customer projects.  Although Synthetech is involved in many active customer projects, large-scale customer projects represent our main source of revenue.  We are unable to determine with reasonable certainty our revenues relating to large-scale projects beyond our current order base, in part due to unpredictable drug approval processes and the short-term supply chain planning by several of our customers.  

 

Synthetech’s order backlog has approximatelytripled at December 31, 2005, compared to the order backlog of $799,000 at March 31, 2005.  We expect that a majority of thesecustomer orders will ship during the fiscal fourth quarter ending March 31, 2006.  

 

We are encountering competition, primarily for more basic products, from developing countries such as India and China that have substantially lower cost structures, primarily because salaries and other costs are a fraction of what they are in industrialized countries.  This trend has resulted in pricing 

 

17

 

 

pressures in the United States and is affecting our ability to maintain historical margins on some of our products and to retain and attract business. 

 

GROWTH STRATEGY

 

*Recent Activity*

 

*Specialty Resins.*In December 2005, Synthetech acquired the technology assets and customer lists of Colorado Biotechnology Associates, Incorporated (CBA) for a range of cross-linked and functionalized polymeric resins used widely in Solid Phase Peptide Synthesis.  This purchase represents Synthetech’s entry into the specialty resin market as a domestic supplier and is consistent with Synthetech’s strategy of leveraging its core expertise to expand into related markets.  Under the arrangement, Dr. Rodger Raubach, CBA’s founder and principal owner, will transfer proprietary resin know-how to Synthetech, and will serve as a consultant for scale-up, technical support, customer qualification and business development for a period of three years.  Synthetech plans to produce and have available for distribution resin batches during the first quarter offiscal 2007.   

 

*Expanded Research and Development.*The market in our sector of the early-stage drug development cycle is active and opportunities have stretched the capacity of our Research and Development (R&D) Department.  Effective October 1, 2005, Synthetech engaged a contract research and manufacturing company located in India to supply laboratory space and a team of seven experienced chemists.  The seven chemists in India supplement the ten chemists who currently are active in Synthetech’s domestic R&D Department.  The additional R&D resources in India enable Synthetech to participate in a larger number of customer projects.

 

*Expanded Processing Capabilities.*During the quarter ended December 31, 2005, Synthetech installed equipment to support low temperature chemical processing.  Temperatures as low as -80°C (-112°F) can now be routinely achieved in equipment sizes of up to 2,000 gallons.  Synthetech believes that the addition of low temperature processing capabilities will allow Synthetech to attract a broader range of customer projects as low temperature processing is required to produce many pharmaceutical projects. 

 

*Growth platforms*

 

Synthetech's primary business objective is to create and build upon a more stable base of revenue by implementing the following strategies: 

 

**•**

*Continue With Core Focus*.  Synthetech is a leader in the development of amino acid derivatives, specialty amino acids, peptide fragments and proprietary custom chiral intermediates for the pharmaceutical industry.  Synthetech intends to continue to focus on these core markets and to support and build upon the projects in its drug development pipeline.

 

**•**

*Leverage Core Expertise to Expand into More Complicated and Value-added Projects*.  With over 20 years' of experience, Synthetech has developed extensive experience and process technology in its core areas of expertise.  In recent years, Synthetech has leveraged this expertise to enter "downstream" pharmaceutical intermediates that involve more complicated products and generally offer higher margins, and Synthetech intends to expand its involvement with these value-added projects.  Synthetech's expansion into more sophisticated projects is also in response to the increasing competition for more basic product offerings from developing countries.

 

 

18

 

 

 

 

**•**

*Cost-effectively Expand Research and Development Capabilities*.  The new product development sector of the pharmaceutical industry remains active, and Synthetech is participating in a variety of early-stage projects, which traditionally have been the source for its future large-scale projects.  As mentioned above, we recently have supplemented our domestic R&D capabilities by engaging R&D resources in India, where cost structures are substantially lower than in the United States.  We believe this strategy will (a) enable us to continue to participate actively in early-stage projects, (b) increase the potential business within our core area of expertise, and (c) free up existing Synthetech chemists to pursue more sophisticated and value-added projects.  

 

**•**

*Stabilize Revenue Base Through Pharmaceutical and Limited Non-pharmaceutical Manufacturing Opportunities*.  To help stabilize our revenue base, Synthetech is exploring custom synthesis opportunities that are both within and outside of the pharmaceutical industry.  We believe that our existing manufacturing capabilities combined with our location on the West Coast of the United States provides a potential platform from which to develop a limited base of custom synthesis revenue that will not be subject to the same level of volatility we currently experience in the pharmaceutical marketplace.  Currently we are not producing significant quantities of products for market sectors outside of the pharmaceutical industry.   

**•**

*Develop Proprietary Products Based on our Core Competencies.*  Synthetech’s primary business model has been to manufacture products on behalf and to the specifications of our pharmaceutical customer base.  In order to gain an increased level of control over our sources of revenue, we are exploring opportunities to develop proprietary products for potential emerging markets related to our existing expertise.    

 

We anticipate that we will require additional capital, which may be substantial, to implement certain elements of our growth strategy, although we have not yet determined the amount or timing of such additional funding.  We may not be able to obtain required financing to implement our growth strategy.

 

 

 

 

 

 

 

 

 

 

 

 

 

19

 

 

 

**RESULTS OF OPERATIONS**

 

The following table sets forth, for the periods indicated, the percentage of revenues represented by each item included in our Statements of Operations.

 

**Percentage of Revenue******

 

 

 

For the Three Months Ended

 

For the Nine Months Ended

 

 

December 31,

 

December 31,

 

 

**2005******

 

2004

 

**2005******

 

2004

 

 

** **

 

 

 

** **

 

 

Revenue

 

**100.0%******

 

100.0%

 

**100.0%******

 

100.0%

Cost of revenue

 

**(101.9)******

 

141.8

 

**116.1******

 

94.6

 

 

** **

 

 

 

** **

 

 

Gross income (loss)

 

**(1.9)******

 

(41.8)

 

**(16.1)******

 

5.4

 

 

** **

 

 

 

** **

 

 

Research and development

 

**15.1******

 

16.1

 

**16.4******

 

7.3

Selling, general and administrative

 

**31.2******

 

50.7

 

**44.7******

 

26.2

 

 

** **

 

 

 

** **

 

 

Total operating expenses

 

**46.3******

 

66.8

 

**61.1******

 

33.5

 

 

** **

 

 

 

** **

 

 

Operating loss

 

**(48.2)******

 

(108.6)

 

**(77.2)******

 

(28.1)

 

 

** **

 

 

 

** **

 

 

Interest income

 

**1.1******

 

1.4

 

**2.4******

 

0.6

Interest expense

 

**(0.2)******

 

(0.1)

 

**(0.1)******

 

(0.1)

 

 

** **

 

 

 

** **

 

 

Loss before income taxes

 

**(47.3)******

 

(107.3)

 

**(74.9)******

 

(27.6)

 

 

** **

 

 

 

** **

 

 

Benefit for income taxes

 

**(10.4)******

 

-

 

**(4.5)******

 

-

 

 

** **

 

 

 

** **

 

 

Net loss

 

**(36.9)%******

 

(107.3)%

 

**(70.4)%******

 

(27.6)%

 

 

**Revenue**

 

Revenue of $1.7 million in the third quarter of fiscal 2006 increased by $555,000, or 47%, from revenue of $1.2 million in the third quarter of fiscal 2005.  Revenue for the first nine months of fiscal 2006 was $4.0 million, a decrease of $2.5 million, or 38%, compared to revenue of $6.5 million in the first nine months of fiscal 2005.  

 

Because large-scale customer projects represent our primary source of revenue, the size and timing of shipments related to these projects can cause significant fluctuations in quarter to quarter revenue.  Revenue from large-scale customer projects was $100,000 and $349,000 during the third quarter and first nine months of fiscal 2006, respectively, compared to $563,000 and $3.7 million in the third quarter and first nine months of fiscal 2005, respectively.  

 

Large-scale project revenue during the first nine months of fiscal 2005 included revenue from five customer projects.  Due to conditions such as customer inventory levels, expected market demand, the development status of individual customer projects, or other matters, Synthetech’s fiscal 2005 portfolio of large-scale projects has not contributed significantly to revenue during fiscal 2006.  Additionally, during the first nine months of fiscal 2006, none of Synthetech’s small-scale projects have developed into new large-scale projects.      

 

 

20

 

 

 

The third quarter and first nine-months of fiscal 2006 have benefited from an increase in revenue from a variety of small-scale projects.  Average quarterly revenue from small-scale projects was approximately $1.2 million, $940,000 and $830,000 for the first nine months of fiscal 2006, fiscal 2005 and fiscal 2004, respectively.  The market environment for smaller customer projects is very active.  While generally individually smaller in dollar value, these projects support a wide variety of programs for our major pharmaceutical, emerging biopharmaceutical and contract drug synthesis customers.  Synthetech’s large-scale projects typically originate from the company’s portfolio of successful small-scale early stage drug development projects.  

 

International sales, mainly to Europe, were $534,000 and $1.7 million in the third quarter and first nine months of fiscal 2006, respectively, compared to $520,000 and $1.3 million in the third quarter and first nine months of fiscal 2005, respectively.  International sales, like all of our revenues, are subject to significant quarterly fluctuations.  

 

To the extent successful customer projects develop into larger volumes, either during late stage clinical trials, pre-launch or as a marketed product, our per unit pricing may decline.  There is a risk that the impact on future sales and profitability from declines in pricing may not be offset by an increase in volume. 

 

The level of Synthetech’s business from period to period is largely unpredictable. Although revenue associated with marketed products is more likely to provide a longer term, on-going revenue stream than revenue associated with drugs at the clinical or discovery stages, continuation of customer demand for our products from customers with marketed products remains subject to various market conditions, including potential use of alternative manufacturing methods, continued market demand for drugs or cosmeceuticals that we support, and competition from other suppliers.  Accordingly, while significant orders related to marketed products provide increased and more predictable revenue, we expect revenue related to marketed products and other projects to continue to fluctuate significantly from period to period.

 

**Gross income (loss)**

 

Gross loss for the third quarter of fiscal 2006 decreased $461,000 to $33,000, or 2% of revenue, compared to a gross loss of $494,000, or 42% of revenue, for the third quarter of fiscal 2005.  Compared to the third quarter of fiscal 2005, gross loss for the third quarter of fiscal 2006 improved primarily as a result of a $555,000, or 47%, increase in sales between the periods, and a decrease in manufacturing costs and charges for impaired inventory which are discussed below.  

 

Gross income (loss) for the first nine months of fiscal 2006 decreased $991,000 to a gross loss of $640,000, or 16% of revenue, compared to gross income of $351,000, or 5% of revenue, in the first nine months of fiscal 2005.  Compared to the first nine months of fiscal 2005, the first nine months of fiscal 2006 incurred a gross loss primarily as a result of a $2.5 million, or 38%, decrease in sales between the periods, which was partially offset by a decrease in manufacturing costs which is discussed below.   

 

Manufacturing department costs incurred during the third quarter and first nine months of fiscal 2006 were down $362,000 and $1.3 million, respectively, compared to the comparable periods of fiscal 2005.  The decreases in manufacturing costs for the third quarter and first nine months of fiscal 2006 include decreases in depreciation expense of $125,000 and $368,000, respectively.  The decreases in fiscal 2006 depreciation expense resulted from the impairment charge and related reduction in basis of Synthetech’s property, plant and equipment that was recorded in the fourth quarter of fiscal 2005.  The decrease in manufacturing department costs for the first nine months of fiscal 2006 also includes a property tax refund in the amount of $201,000 received during the second quarter of fiscal 2006.  Variable operating costs such as labor, maintenance, supplies and utility expenses were also downsignificantly between the periods as a result of lower production levels.

 

 

21

 

 

 

The gross loss for the third quarter and first nine months of fiscal 2006 reflect charges for impaired inventory of $293,000 and $856,000, respectively.  Gross loss for the third quarter and first nine months of fiscal 2005 reflect charges for impaired inventory of $393,000 and $790,000, respectively.  Synthetech routinely develops manufacturing processes to produce new products or to refine procedures for existing products.  It is not unusual for manufacturing costs associated with new processes or certain existing processes to exceed the selling price for batches of product, which results in an inventory write-off.  It remains difficult to rework certain materials on a cost effective basis.  Synthetech will also write-off inventory that is specific to a customer project which has been discontinued.

 

Cost of revenue includes raw materials, direct labor, manufacturing overhead, other direct costs, and adjustments to inventory.

 

**Operating Expenses**

 

***R&D Expense.***  Research and development (R&D) expense in the third quarter of fiscal 2006 increased $73,000 to $263,000, or 15% of revenue, compared to $190,000, or 16% of revenue, in the third quarter of fiscal 2005.  The increase in R&D expense between the two quarters includes increased costs of $79,000 in fees for contract research. Beginning October 2005, Synthetech engaged a contract research and manufacturing company located in India to supply laboratory space and a team of seven experienced chemists.  Additionally, the increase in contract research fees includes $15,000 in fees paid to Paul Ahrens, a Synthetech Director, for contract research services.      

 

R&D expense in the first nine months of fiscal 2006 increased $178,000 to $652,000, or 16% of revenue, compared to $474,000, or 7% of revenue, in the first nine months of fiscal 2005.  The increase in R&D expense between these two periods includes increased costs of $115,000 in fees for contract research as described in the preceding paragraph; an increase in compensation costs of $21,000, principally arising from an increase in the number of graduate students working in R&D; and an increase of $26,000 arising from a change in the amount of R&D department costs allocated to R&D expense versus to inventory for the manufacture of small-scale products. 

 

Synthetech’s R&D department primarily develops processes to manufacture and optimize the production of our products and their related scale-up to manufacturing quantities.  Additionally, the R&D department will manufacture small-scale products for sale.  The cost of producing these small-scale products is captured in inventory and not reflected in R&D expense.  The amount of R&D department costs charged to the manufacture of small scale products can cause fluctuations between reporting periods in the amount of reported R&D expense.  R&D department costs charged to inventory in the first nine months of fiscal 2006 and 2005 were $76,000 and $102,000, respectively.

 

***SG&A Expense.***  Selling, general and administrative (SG&A) expense in the third quarter of fiscal 2006 decreased $58,000 to $541,000, or 31% of revenue, compared to $599,000, or 51% of revenue, in the third quarter of fiscal 2005.  The decrease in SG&A expense between the two quarters includes a decrease in marketing and travel expenses of $45,000; and a decrease in consulting services of $42,000.  The decrease in cost between the two quarterly periods was partially offset by an increase in legal fees of $26,000    

 

SG&A expense in the first nine months of fiscal 2006 increased $92,000 to $1.8 million, or 45% of revenue, compared to $1.7 million, or 26% of revenue, in the first nine months of fiscal 2005.  The increase in SG&A expense between these two periods includes an increase in compensation costs of $100,000 related to an executive compensation agreement; and an increase in charges for legal and accounting services of $49,000.  The increases in costs between the two nine month periods were partially offset by a decrease in marketing and travel expense of $38,000; a decrease in contract labor 

 

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of $21,000 and a decrease in depreciation expense of $19,000.  The decrease in fiscal 2006 depreciation expense resulted from the impairment charge and related reduction in basis of Synthetech’s property, plant and equipment that was recorded in the fourth quarter of fiscal 2005.       

 

SG&A expense consists of compensation and related fringe benefits for sales and administrative employees, cost of professional services, marketing costs, costs associated with being a public company and costs related to administrative facilities and information services.

 

**Interest Income**

 

Interest income in the third quarter and first nine months of fiscal 2006 was $20,000 and $96,000, respectively, compared to $17,000 and $36,000, respectively, in the same periods in fiscal 2005.  Interest income arising from a partial refund of prior years property taxes added $31,000 to interest income during the second quarter and first nine months of fiscal 2006.  Other than the interest income related to this tax refund, Synthetech’s interest income is primarily derived from earnings on our cash equivalents and marketable securities, which earnings are affected by the amount of cash equivalents and the interest rates in effect during the periods.  The average rate of interest earned on Synthetech’s cash equivalents during the first nine months of fiscal 2006 was 2.8%, compared to 1.2% during the first nine months of fiscal 2005.  

 

**Income Taxes**

 

During the third quarter of fiscal 2006, Synthetech determined that the amount it was carrying in income tax payable was no longer necessary.  Accordingly, Synthetech reported $180,000 as an income tax benefit in the third quarter of fiscal 2006.  

 

Based on Synthetech’s recent history of losses, our near-term outlook and management’s evaluation of available tax planning strategies, we have concluded that it is more likely than not that Synthetech will be unable to recognize its net deferred tax assets as an income tax benefit, continuing for an uncertain period of time.

 

**Net Loss**

 

Net loss in the third quarter of fiscal 2006 was $640,000, or 37% of revenue, compared to a net loss of $1.3 million, or 107% of revenue, in the third quarter of fiscal 2005.  Net loss for the first nine months of fiscal 2006 was $2.8 million, or 70% of revenue, compared to a net loss of $1.8 million, or 28% of revenue, in the first nine months of fiscal 2005.  

 

**CRITICAL ACCOUNTING POLICIES AND ESTIMATES**

 

The discussion and analysis of Synthetech’s financial condition and results of operations are based upon its financial statements, which have been prepared in conformity with generally accepted accounting principles in the United States. The preparation of these financial statements requires Synthetech to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities.  On an on-going basis, Synthetech evaluates its estimates, including those related to deferred tax asset realization, inventory realization, allowance for doubtful accounts and long-lived asset impairments.  Synthetech bases its estimates on historical experience and on various other assumptions. Actual results may differ from these estimates under different assumptions or conditions.  Synthetech believes the following are among thecritical accounting policies and the related judgments and estimates that affect the preparation of its financial statements.  Please see Note C to the Financial Statements.

 

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**Allowance for Doubtful Accounts**

 

We analyze a customer’s creditworthiness by reviewing the customer’s payment history and financial stability.  We establish the allowance for doubtful accounts by reviewing aged accounts receivables and the collectibility of specific accounts.  The allowance for doubtful accounts as of December 31, 2005 and March 31, 2005 was $15,000.  For the nine months ended December 31, 2005 and 2004, Synthetech’s provision for credit losses was insignificant.  If circumstances related to a specific customer change, Synthetech’s estimate of the recoverability of receivables could materially change.    

 

**Inventories** 

 

Inventories are valued at the lower of cost or market, determined on the first-in first-out (FIFO) basis.  Costs include direct material, direct labor, applicable manufacturing overhead, and other direct costs.  

 

Management evaluates Synthetech’s inventory for impairment whenever it becomes aware that indicators of impairment exist.  Factors contributing to inventory impairment include, but are not limited to: decreases in selling price; changes in customer specifications; project terminations or holds; variations in material produced by Synthetech from customer specifications; and production costs materially in excess of current market price.  It is our policy to write-down inventories to reflect an estimate for impairment in an amount equal to the excess, if any, of the cost of inventory compared to the estimated market value based upon assumptions about future demand and market conditions.  If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required in the future.  Write-downs of inventory are reported as a component of cost of revenuein the relevant period.  

 

**Long-Lived Asset Impairment**

 

In accordance with the provisions of SFAS No. 144, Synthetech assesses the impairment of long-lived assets such as property, plant and equipment whenever events or changes in circumstances indicate that their carrying value may not be recoverable.  Factors that could trigger an impairment review include, among others:

 
  **•**  asignificant change in the extent or manner in which a long-lived asset is being used;   **•**  asignificant change in the business climate that could affect the value of a long-livedasset; and   **•**  asignificant decrease in the market value of assets. |
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