10-Q 1 d885975-4.txt QUARTER ENDED: 12/31/2002 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------------- FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934. FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2002 Commission file number 1-10340 ALLOU HEALTHCARE, INC. (Exact Name of Registrant as Specified in Its Charter) Delaware 11-2953972 -------------------------------------------------------------------------------- (State or Other Jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 50 Emjay Boulevard, Brentwood, New York 11717 -------------------------------------------------------------------------------- (Address of Principal Executive Offices) (Zip Code) (Registrant's telephone number, including area code): (631) 273-4000 -------------- Indicate by a 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 as 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 ___ Below are indicated the number of shares outstanding of each of the issuer's classes of common stock:

================================================================================ TABLE OF CONTENTS Page ---- Cautionary Statement...........................................................1 PART I - Financial Information Item 1. Financial Statements..................................................2 Consolidated Balance Sheets..................................2 Consolidated Statements Of Income (nine-month period)........3 Consolidated Statements Of Income (three-month period).......4 Consolidated Statements Of Cash Flows........................5 Notes To Consolidated Financial Statements...................6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations...............13 Item 3. Quantitative and Qualitative Disclosures About Market Risk...........21 Item 4. Controls and Procedures..............................................21 PART II - Other Information Item 6. Exhibits and Reports on Form 8-K....................................22 Signature.....................................................................23 Certificates..................................................................24 Exhibits......................................................................26 UNLESS THE CONTEXT OTHERWISE REQUIRES, ALL REFERENCES TO "WE," "US," "OUR," "ALLOU" OR THE "COMPANY" INCLUDE ALLOU HEALTHCARE, INC. AND OUR SUBSIDIARIES. CAUTIONARY STATEMENT CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: Certain statements in this report, in particular "Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operation," are "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements, which may include words such as "expect," "believe", "anticipate," "estimate," "plan," "project," "strategy" and "intend," involve certain known and unknown risks, uncertainties and other factors that may cause the statements to be materially different from actual future results. These factors include, among others: the competitive environment in the consumer health and beauty aids products industries; the availability of financing to fund the anticipated growth of our business; changes in consumer preferences and demographics; and the integration of any acquired business and operations. -1- ITEM 1. FINANCIAL STATEMENTS ALLOU HEALTHCARE, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these consolidated financial statements. -2- ALLOU HEALTHCARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

The accompanying notes are an integral part of these consolidated financial statements. -3- ALLOU HEALTHCARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) For The Three Months Ended December 31, 2002 2001 ------------ ------------ Revenues $156,776,174 $163,306,563 Cost of Revenues 141,772,466 147,832,494 ------------ ------------ Gross Profit 15,003,708 15,474,069 ------------ ------------ Operating Expenses ------------------ Warehouse and Delivery 4,139,484 3,324,367 Selling, General and Administrative 6,675,027 5,137,853 ------------ ------------ Total Expenses 10,814,511 8,462,220 ------------ ------------ Income From Operations 4,189,197 7,011,849 ------------ ------------ Other Charges ------------- Interest Expense - Net 1,988,233 3,787,327 ------------ ------------ Income Before Income Taxes 2,200,964 3,224,522 Provision for Income Taxes 880,000 1,233,000 ------------ ------------ NET INCOME $ 1,320,964 $ 1,991,522 ============ ============ Earnings Per Common Share ------------------------- Basic $ .17 $ .29 ============ ============ Diluted $ .16 $ .28 ============ ============ Common Shares Used in Computing Per Share Amounts ------------------------------------------------- Basic 7,935,269 6,958,435 ============ ============ Diluted 8,080,393 7,228,959 ============ ============ The accompanying notes are an integral part of these consolidated financial statements. -4- ALLOU HEALTHCARE, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

The accompanying notes are an integral part of these consolidated financial statements. -5- Allou Healthcare, Inc. and subsidiaries notes to consolidated financial statements 1. The accompanying interim consolidated financial statements of Allou Healthcare, Inc. (the Company) have been prepared in conformity with accounting principles generally accepted in the United States of America consistent in all material respects with those applied in the Annual Report on Form 10-K for the year ended March 31, 2002. The interim financial information is unaudited, but reflects all normal adjustments which are, in the opinion of management, necessary to provide a fair presentation of results for the interim periods. The interim financial statements should be read in conjunction with the financial statements in the Company's Annual Report on Form 10-K for the year ended March 31, 2002. 2. On September 25-26, 2002, an extensive fire occurred at a public warehouse in Brooklyn, New York which is used by the Company and other tenants to store goods. The warehouse is operated by an entity unrelated to the Company. The operator leases the warehouse facility from an entity owned by relatives of certain officers of the Company. The Company recorded an insurance claim receivable of $86.6 million on its balance sheet representing the cost basis of the lost inventory, and has filed a claim with the insurance companies in the amount of $101 million, representing the selling price of the lost inventory. If the Company receives the entire amount of this $101 million insurance claim, the Company would recognize a gain of $14.4 million. In addition, the Company's policies provide for business interruption and extra expense insurance up to a maximum of $35 million. During December 2002, the Company received $1,700,279, representing the net proceeds of salvageable inventory, representing approximately $12,000,000 of inventory at the Company's cost. This has been reflected as a reduction of the inventory claim receivable. In October 2002, the Company received a "reservation of rights" letter from its primary insurance carrier claiming that the warehouse fire appeared to be incendiary in nature. The investigation by various parties as to the cause of the fire is ongoing. If payment by the insurance companies is delayed or if the amount of the payment is less than the sales price of the inventory, depending on the extent of the delay and the amount of the payment, there could be a material adverse effect on the Company's ability to finance its current operations at current levels. The Company has retained professionals to pursue insurance recovery. 3. The following table is a reconciliation of the weighted-average shares (denominator) used in the computation of basic and diluted EPS for the statement of income periods presented herein.

Net income as presented in the unaudited consolidated statements of income is used as the numerator in the EPS calculation for both the basic and diluted computations. 4. During fiscal 2001, the Company issued to an institutional investor an aggregate of $15,000,000 of 12% -6- senior subordinated notes due July 2005 and seven year warrants to purchase an aggregate of 1,700,000 shares of the Company's Class A Common Stock at $4.50 per share. The exercise price of the warrants is subject to increase if the Company meets certain earnings and revenue targets. In the event that these warrants have not been converted to common stock, the investor may have the right, under certain circumstances, presently to be based on financial results for the year ending March 31, 2003, to put the warrants to the Company after five years at a price of $8 per warrant. These warrants were initially valued at $4,314,006 using the Black-Sholes Pricing Model. The initial value of the warrants was established as a discount to the subordinated debt, and this discount is being accreted over the life of the subordinated notes. Included in interest expense for the nine months ended December 31, 2002 and 2001 are $783,000 and $462,216 representing such accretion. Included in interest expense for the three months ended December 31, 2002 and 2001 are $261,000 and $154,072 representing such accretion. The value of these contingent put warrants has been reflected as a liability in the accompanying consolidated balance sheets. In accordance with Emerging Issues Task Force ("EITF") Issue No. 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock", the warrants are marked to market through earnings on a quarterly basis. The value of these warrants at December 31, 2002 is $3,505,000. Interest expense for the nine months ended December 31, 2002 was reduced by $1,034,000 representing the change in value of these warrants from April 1, 2002 through December 31, 2002. Interest expense for the three months ended December 31, 2002 was reduced by $1,415,220 representing the change in value of these warrants from September 1, 2002 through December 31, 2002. Interest expense for the nine months ended December 31, 2001 was reduced by $75,925 representing the change in the value of these warrants from April 1, 2001 through December 31, 2001. Included in interest expense for the three months ended December 31, 2001 is $166,845 representing the change in value of these warrants through December 31, 2001. 5. On July 12, 2002, certain officers of the Company exercised options to purchase 598,500 shares of Class A common stock pursuant to stock options previously granted to them. In connection with those exercises, these officers executed promissory notes totaling $2,641,742 due three years after the date of execution together with interest payable at 5% per annum. This amount is reflected as a reduction of stockholders' equity in the accompanying consolidated balance sheets. The accounting rules applicable to the present terms of these notes require the value of the issued stock to be marked to market each reporting period, while the notes are outstanding, which may add to earnings volatility. 6. In accordance with EITF Issue No. 00-10 "Accounting for Shipping and Handling Revenues and Costs", the Company's shipping and handling costs, billed to customers, are included in revenue. The purpose of this issue discussion was to clarify the classification of shipping and handling revenues and costs. The consensus reached was that all shipping and handling billed to customers should be recorded as revenue. Accordingly, the Company records its shipping and handling amounts within net sales and operating expenses. Shipping and handling billed to customers and included in revenues for the periods ended December 31, 2002 and 2001 was not material. Shipping and handling costs totaled approximately $3,306,048 and $2,512,012, for the nine months ended December 31, 2002 and 2001, respectively. Shipping and handling costs totaled approximately $1,184,865 and $1,399,712 for the three months ended December 31, 2002 and 2001, respectively. Effective April 2002, the Company adopted SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 141" and "SFAS No. 142", respectively). These statements established financial accounting and reporting standards for acquired goodwill and other intangible assets. Specifically, the standards address how acquired intangible assets should be accounted for both at the time of acquisition and after they have been recognized in the financial statements. The provisions of SFAS No. -7- 141 apply to all business combinations initiated after June 30, 2001. In accordance with SFAS No. 142, intangible assets, including purchased goodwill, must be evaluated for impairment. Those intangible assets that will continue to be classified as goodwill or as other intangibles with indefinite lives are no longer amortized. Effective April 1, 2002, the Company has adopted the provisions of SFAS 142, which reduced amortization charges by $291,000 for the nine months ended December 31, 2002. In accordance with SFAS No. 142, the Company completed its transitional impairment testing of intangible assets during the first quarter of fiscal 2003 and its final testing during the second quarter. That effort, and our assessments of our identifiable intangible assets, indicated that no adjustment was required upon adoption of this pronouncement. The Company has determined that as of December 31, 2002 these assets are not impaired. -8- The following table presents pro forma net earnings and earnings per share data restated to include the retroactive impact of the adoption of SFAS No. 142.

In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations" which addresses financial accounting and reporting for retirement obligations associated with the retirement of tangible long-lived assets and for the associated asset retirement costs. SFAS No. 143 requires a company to record the fair value of an asset retirement obligation in the period in which it is incurred. When the retirement obligation is initially recorded, the Company also records a corresponding increase to the carrying amount of the related tangible long-lived asset and depreciates that cost over the useful life of the tangible long-lived asset. The retirement obligation is increased at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the initial fair value measurement. Upon settlement of the retirement obligation, the Company either settles the retirement obligation for its recorded amount or incurs a gain or loss upon settlement. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002 with earlier application encouraged. We do not anticipate that the adoption of SFAS No. 143 in our fiscal year 2004 will have a material effect on our results of operations and financial condition. In August 2001, the Financial Accounting Standards Board issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". This statement addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 will be effective for financial statements of fiscal years beginning after December 15, 2001. The Company has adopted SFAS 144 as of April 1, 2002; adoption of SFAS 144 did not have a material impact on the Company's consolidated financial results. -9- In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." SFAS No. 145 rescinds the following pronouncements: SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt, "SFAS No. 44, "Accounting for Intangible Assets of Motor Carriers," and SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements". SFAS No. 145 amends SFAS No. 13, "Accounting for Leases," to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of SFAS No. 145 related to the rescission of Statement No. 4 shall be applied in fiscal years beginning after May 15, 2002, with early adoption encouraged. The provisions of SFAS No. 145 related to SFAS No. 13 shall be effective for transactions occurring after May 15, 2002, with early application encouraged. All other provisions of SFAS No. 145 shall be effective for financial statements issued on or after May 15, 2002, with early application encouraged. Adoption of this statement is not expected to have an effect on the Company's financial position and results of operations. In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities ("SFAS No. 146"). This statement requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. Adoption of SFAS No. 146 will not have a material impact on our results of operations and financial condition. In November 2002, the FASB issued FASB interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires that upon issuance of a guarantee, a guarantor must recognize a liability for the fair value of an obligation assumed under a guarantee. FIN 45 also requires additional disclosures by a guarantor in its interim and annual financial statements about the obligations associated with guarantees issued. The recognition provisions of Fin 45 will be effective for any guarantees that are issued or modified after December 31, 2002. Management does not expect the adoption of Fin 45 to have a material impact on the Company's financial position or results of operations. In December 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" ("SFAS 148"). SFAS 148 provides alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation as originally provided by SFAS No. 123 "Accounting for Stock-Based Compensation". Additionally, SFAS 148 amends the disclosure requirements of SFAS 123 to require prominent disclosure in both the annual and interim financial statements about the method of accounting for stock-based compensation and the effect of the method used on reported results. The transitional requirements of SFAS 148 will be effective for all financial statements for fiscal years ending after December 15, 2002. The disclosure requirements shall be effective for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002. The adoption of this is not expected to have a significant effect on the Company's financial position and results of operations. In November 2002, the Emerging Issues Task Force reached consensus on issue No. 02-16, "Accounting by a Reseller for Cash Consideration Received from a Vendor" ("EITF 02-16"). The consensus requires that certain cash consideration received by a customer from a vendor should be characterized as a reduction of cost of sales when recognized in the customer's income statement. However, that presumption is overcome if certain criteria -10- are met. If the presumption is overcome, the consideration would be presented as revenue if it represents a payment for goods or services provided by the reseller to the vendor, or as an offset to an expense if it represents a reimbursement of a cost incurred by the reseller. EITF 02-16 should be applied in annual and interim financial statements for fiscal periods beginning after December 15, 2002. The Company believes the impact of EITF will have no effect on its consolidated financial statements as the Company currently observes the provisions of this consensus. 7. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Company's chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company's chief operating decision maker is its Chief Executive Officer. The operating segments of the Company are managed separately because each segment represents a strategic business unit that offers different products or a different customer base. The Company evaluates the performance of its segments based on segment profit, which includes the overhead charges directly attributable to the segment and excludes certain expenses, which are managed outside the reportable segments. Corporate expenses such as income taxes are being allocated to the wholesale distribution segment only. -11- Segment data for the nine months ended December 31, 2002 and 2001 was as follows:

8. Subsequent Event - On January 31, 2003, the Company entered into an operating lease for a 125,000 square foot facility located in Simi Valley, CA. This location will be utilized by our manufacturing subsidiary, Stanford Personal Care Manufacturing. The rental agreement calls for monthly payments of approximately $70,000 and expires in five years. -12- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. RESULTS OF OPERATIONS We distribute consumer personal care products and prescription pharmaceuticals on a national basis. We also manufacture upscale hair and skin care products for sale under private labels. Our consumer personal care products distribution business includes prestige brand name designer fragrances, brand name health and beauty aids products and non-perishable packaged food items. Our prescription pharmaceuticals distribution business includes both brand name and generic pharmaceutical products. For the nine months ended December 31, 2002, our revenues have grown by approximately 11.5% through internal growth when compared to the same period in the prior year. Distribution of consumer personal care products accounted for approximately 67.0% of our revenues during the nine months ended December 31, 2002, and 60.5% of our revenues for the nine months ended December 31, 2001. Distribution of prescription pharmaceutical products accounted for approximately 31.0% of our revenues during the nine months ended December 31, 2002, and 38.0% of our revenues during the nine months ended December 31, 2001. Manufacture and distribution of hair and skin care products accounted for approximately 2.0% of our revenues during the nine months ended December 31, 2002 and 1.5% of our revenues for the nine months ended December 31, 2001. On September 25-26, 2002, an extensive fire occurred at Evergreen Warehouse Corp., a public warehouse, located at 40 Noll Street in Brooklyn, New York. The warehouse, which is used by us and other tenants to store goods, is operated by an entity unrelated to us. The operator of the warehouse leases the warehouse facility from an entity owned by relatives of certain of our officers. Our cost basis of inventory that had been stored in this warehouse was $86.6 million. We were able to salvage and sell a portion of this inventory for net proceeds of $1.7 million; the remaining $84.9 million of this inventory was destroyed and is recorded on our balance sheet as an insurance claim receivable. The timing and amount of any payment we receive as a result of our insurance claims with respect to this inventory will have a material effect on our ability to finance our operations at current levels. Because the warehouse fire reduced the amount of inventory we had available for sale to customers, our level of operations was reduced in the third quarter ended December 31, 2002. The resulting reduced cash flow limited the amount of product purchases we could make, and thereby limited the sales by those segments from the levels that might otherwise have been achieved. In addition, pending the outcome of our insurance claim receivable, we modified our business practices in both the consumer products and pharmaceuticals segments to place greater emphasis on products with shorter time periods between purchase and sale, and by pricing these products to ensure timely sale. We took these steps in order to reduce the possibility for volatility in our sales levels and to maintain our customer relationships. Because products with shorter time periods between purchase and sale generally have lower profit margins, and because we aggressively priced many of these products, our gross profit as a percentage of sales declined during the third quarter ended December 31, 2002. This revised procurement and marketing policy had a greater impact on our pharmaceuticals segment compared with our consumer personal products segment. -13- Our operating results for the nine and three months ended December 31, 2002 and 2001 expressed as a percentage of sales were as follows: Statements of Income Items As a Percentage of Net Sales FOR THE NINE MONTHS ENDED DECEMBER 31 2002 2001 ---- ---- Net sales 100.0% 100.0% Costs of goods sold 89.1% 89.1% ------------------- Gross profit 10.9% 10.9% Warehouse & delivery expenses 2.5% 2.2% Selling, general and administrative expenses 4.1% 3.9% ------------------- Operating income 4.3% 4.8% Net interest expense 2.0% 3.0% ------------------- Income before income tax 2.3% 1.8% Income tax provision 0.9% 0.7% ------------------- Net income 1.4% 1.1% =================== FOR THE THREE MONTHS ENDED DECEMBER 31 2002 2001 ---- ---- Net sales 100.0% 100.0% Costs of goods sold 90.4% 90.5% ------------------- Gross profit 9.6% 9.5% Warehouse & delivery expenses 2.6% 2.0% Selling, general and administrative expenses 4.3% 3.2% ------------------- Operating income 2.7% 4.3% Net interest expense 1.3% 2.3% ------------------- Income before income tax 1.4% 2.0% Income tax provision 0.6% 0.8% ------------------- Net income 0.8% 1.2% =================== THE NINE MONTHS ENDED DECEMBER 31, 2002 COMPARED TO THE NINE MONTHS ENDED DECEMBER 31, 2001 Revenues. Revenues for the nine months ended December 31, 2002 increased $48.5 million to $471.0 million, representing an 11.5% gain as compared to revenues of $422.5 million for the nine months ended -14- December 31, 2001. The increased demand for our products resulted from an expanded customer base and increases in same store sales. The increase in revenues for the nine months ended December 31, 2002 resulted from increased revenues from certain segments of our business as follows. Sales of brand name health and beauty aids, prestige designer fragrances and non-perishable food products, increased 23% for the nine months ended December 31, 2002 compared to the same period in fiscal 2001, due to increases in same store sales and an expanded customer base. Sales of prescription pharmaceuticals decreased 7.7% in the comparable period. This decrease in revenues was due to our revised product purchasing and marketing policies which we were required to implement in response to the circumstances resulting from the warehouse fire of September 25-26, 2002 and the reduced level of cash available to us for product purchases during the three months ended December 31, 2002. Reduced cash availability for product purchases in turn was due primarily to the reduction in sales resulting from the warehouse fire of September 25-26, 2002 and the insurance companies' failure to date to make any payment in respect of our insurance claim. Our manufacturing subsidiary had a 42% increase in revenues for the nine months ended December 31, 2002 as compared to the comparable period in the prior year. This increase was due in part to the partial fulfillment of manufacturing contracts awarded to the company amounting to approximately $10.0 million in revenues from a major consumer manufacturing company. Gross Profit. Gross profit for the nine months ended December 31, 2002 was $51.5 million, representing an 11.9% increase over gross profit of $46.0 million for the same period in the prior year. Gross profit as a percentage of sales remained at 10.9% for the nine months ended December 31, 2002, which was the same level for the nine months ended December 31, 2001. Warehouse, Delivery, Selling, General and Administrative Expenses. Warehouse, delivery, selling, general and administrative expenses for the nine months ended December 31, 2002 increased $5.5 million, or 21.6% to $31.1 million from $25.6 million in the prior year. Warehouse, delivery, selling, general and administrative expenses increased as a percentage of revenues to 6.6% for the nine months ended December 31, 2002 from 6.1% when compared to the same period in the prior year. This increase as a percentage of revenues is due to increases in insurance costs, new hires and professional expenses incurred due to the warehouse fire of September 25-26, 2002. Interest Expense. Interest expense as a percentage of revenues for the nine months ended December 31, 2002 decreased to 1.9% from 3.1% for the same period in the prior year. This decrease was due to a decrease in interest rates offset by the accretion of discounts associated with the original value of the warrants associated with the subordinated debt and by the change in the fair market value of the warrants based on the Black-Scholes calculation method which for the nine months ended December 31, 2002 was approximately $1.0 million. This adjustment for the change of approximately $1.0 million was primarily due to the market price of our Common Stock at December 31, 2002, which was $2.67. As of December 31, 2002, the fair market value for our warrants was approximately $3.5 million. Income Tax Expense. We recorded an income tax expense of $4.3 million for the nine months ended December 31, 2002 compared to $2.8 million for the nine months ended December 31, 2002. The increase of $1.6 million, or 59.0%, is attributable to higher earnings during the current period compared to the prior period in addition to a higher effective income tax rate of 39.9% for the nine months ended December 31, 2002 compared to 37.9% for the nine months ended December 31, 2001. -15- Net Income. Our net income for the nine months ended December 31, 2002 increased $2,059,921 or 45.7%, to $6,561,619 as compared to $4,501,698 for the same period in the prior year. This increase in net income is primarily due to the reasons described above. THE THREE MONTHS ENDED DECEMBER 31, 2002 COMPARED TO THE THREE MONTHS ENDED DECEMBER 31, 2001 Revenues. Revenues for the three months ended December 31, 2002 decreased $6.5 million to $156.8 million, representing a 4.0% reduction as compared to revenues of $163.3 million for the three months ended December 31, 2001. This decrease in revenues for the three months ended December 31, 2002 resulted from decreased revenues from certain segments of our business as follows. Sales of brand name health and beauty aids, prestige designer fragrances and non-perishable food products, increased 8.1% for the three months ended December 31, 2002 compared to the same period in fiscal 2001. Because of the financial constraints resulting from the September 25-26, 2002 warehouse fire and the product purchasing and pricing policies we were required to implement in response to the circumstances we faced as a result of that fire, the level of growth in this segment was lower than it otherwise might have been. Sales of prescription pharmaceuticals decreased 33% for the three months ended December 31, 2002 compared to the same period in fiscal 2001, again due to the same financial constraints and product purchasing and pricing policy changes as a result of the warehouse fire. Our manufacturing subsidiary had a 77% increase in revenues for the three months ended December 31, 2002 as compared to the comparable period in the prior year. This increase was due to in part to an agreement with a major consumer manufacturing company to produce under private label approximately $10.0 million in hair care products which has been partially shipped during this period with the balance to be shipped over the next six months. Gross Profit. Gross profit for the three months ended December 31, 2002 was $15.0 million, representing a 3.0% decrease from gross profit of $15.5 million for the same period in the prior year. This decrease in gross profit resulted from the financial constraints and product purchasing and pricing policy changes as a result of the warehouse fire discussed above. Gross profit as a percentage of sales for the period remained relatively stable at 9.6% for the three months ended December 31, 2002 compared with 9.5% for the same period in the prior year Warehouse, Delivery, Selling, General and Administrative Expenses. Warehouse, delivery, selling, general and administrative expenses for the three months ended December 31, 2002 increased $2.3 million, or 27.8%, to $10.8 million from $8.5 million in the prior year. Warehouse, delivery, selling, general and administrative expenses increased as a percentage of revenues to 6.9% for the three months ended December 31, 2002 from 5.2% when compared to the same period in the prior year. This increase as a percentage of revenues was due in part to increased costs associated with our manufacturing subsidiary including R&D expenses associated with manufacturing contracts, additional employment costs and increased rent and insurance expenses. Interest Expense. Interest expense as a percentage of revenues for the three months ended December 31, 2002 decreased to 1.3% from 2.3% for the same period in the prior year. This decrease was due to a decrease in interest rates offset by the accretion of discounts associated with the original value of the warrants associated with the subordinated debt and, to a larger extent, by the change in the fair market value of the warrants based on the Black-Scholes calculation method which for the three months ended December 31, 2002 was approximately $1.4 -16- million. This adjustment for the change of approximately $1.4 million was primarily due to the market price of our Common Stock at December 31, 2002, which was $2.67. As of December 31, 2002, the fair market value for our warrants was approximately $3.5 million. Income Tax Expense. We recorded an income tax expense of $880 thousand for the three months ended December 31, 2002 compared to $1.2 million for the three months ended December 31, 2002. The decrease of $353 thousand, or 28.6%, is attributable to lower earnings during the current quarter compared to the prior period. Net Income. Our net income for the three months ended December 31, 2002 decreased $670,538, or 33.7%, to $1,320,964 as compared to $1,991,522 for the same period in the prior year. This decrease in net income is due primarily to decreased revenue levels, decreased profit margins and increases in warehouse, delivery, selling, general and administrative expenses, all as described above. LIQUIDITY AND CAPITAL RESOURCES Cash decreased approximately $667 thousand to $578 thousand at December 31, 2002 from $1.2 million at the beginning of the fiscal year. We maintain a minimum cash balance sufficient to meet our daily operational needs. All excess cash is used to reduce debt thereby lowering interest expense. At December 31, 2002, we had $189.0 million in borrowings and approximately $11.0 million of unused credit under our $200 million credit facility. Availability under this credit facility is based on a formula applied to eligible accounts receivable, eligible inventory and our insurance claim receivable. Our credit facility is secured by a security interest in certain of our assets and properties, including the capital stock of certain of our subsidiaries. Our working capital increased approximately $6.1 million to approximately $96.1 million at December 31, 2002 from approximately $90.0 million at March 31, 2002, primarily due to an increase in accounts receivable and reduced borrowings. We meet our working capital requirements from internally generated funds and from a financing agreement entered into on September 4, 2001 with a consortium of banks led by Congress Financial Corporation and Citibank, N.A. for financing our accounts receivable and inventory. As of December 31, 2002, we had $189.0 million outstanding under our $200 million bank line of credit. The credit facility is secured by a security interest in most of our assets. Interest on the loan balance is payable at .25% per annum above the prime rate or 2.75% per annum above the Eurodollar rate at our option. The effective rate of interest charged to us at December 31, 2002 was 4.83%. We utilize cash generated from operations to reduce short-term borrowings which in turn acts to increase loan availability consistent with our financing agreement. During the quarter ended September 30 of fiscal year 2001, we issued to RFE Investment Partners, an institutional investor, $15,000,000 principal amount 12% Senior Subordinated notes due 2005 and seven year warrants exercisable to purchase 1,700,000 shares of our Class A common stock at $4.50 per share. Under certain circumstances the investor has the right to require us to repurchase the warrants after five years at a price of $8.00 per warrant. The change in the fair market value of these warrants resulted in a non-cash interest -17- reduction of approximately $1.4 million, which was primarily due to the market price of our Common Stock at December 31, 2002. Our accounts receivable increased to $123,990,597 as of December 31, 2002 from $109,655,884 as of March 31, 2002, representing an increase of 13.1%. This increase is due to an increase in sales. Inventories decreased by approximately $108.9 million, or 58.7%, for the three months ended December 31, 2002 when compared to the fiscal year ended March 31, 2002. This decrease in inventory was primarily due to the inventory loss resulting from the warehouse fire of September 25-26, 2002, to our revised product purchasing and marketing policies which we were required to implement in response to the circumstances resulting from that fire and to the reduced level of cash available to us for product purchases during the three months ended December 31, 2002. Reduced cash availability for product purchases in turn was due primarily to the reduction in sales resulting from the warehouse fire and the insurance companies' failure to date to make any payment in respect of our insurance claim. In order for us to stabilize our level of sales and to achieve growth, it will be necessary for us to obtain additional financing. We have had discussions with certain financial institutions concerning additional financing arrangements, and anticipated that such arrangements would be in place during the quarter ending September 30, 2002, or shortly thereafter. However, due to the September 25-26, 2002 warehouse fire, these discussions with certain financial institutions have been suspended pending resolution of the insurance claims. The Company carried insurance with several insurance companies covering the merchandise lost in the fire. The Company has recorded an insurance claim receivable of $84.9 million on its balance sheet representing the cost basis of the lost inventory. In addition, the Company has filed a claim with the insurance companies in the amount of $101 million representing the selling price of the lost inventory. The Company's policies provide for business interruption and extra expense insurance up to a maximum of $35 million resulting from this incident. In October 2002, the Company received a reservation of rights letter from its primary insurance carrier claiming that the warehouse fire appeared to be incendiary in nature. The investigation by various parties as to the cause of the fire is ongoing. If payment by the insurance companies is delayed or if the amount of the payment is less than the sales price of the inventory, depending on the extent of the delay and the amount of the payment, there could be a material adverse effect on the Company's ability to finance its current operations at current levels. The Company has retained professionals to pursue insurance recovery. Based upon current levels of operations we expect that sufficient cash flow will be generated from operations so that we will be able to meet all of our debt service, capital expenditure and working capital requirements for the next twelve months. Operations for the nine months ended December 31, 2002, excluding non-cash charges for depreciation and amortization, the change in the fair market value of the warrants, and deferred income taxes, provided cash of $7.7 million. This amount was offset by changes in assets and liabilities resulting from operating activities for the nine months ended December 31, 2002, which used cash of $5.6 million, resulting in net cash provided by operating activities of $2.1 million. Investing activities, which principally consisted of acquisitions of property, plant and equipment, resulted in a use of cash of $3.2 million for the nine months ended December 31, 2002. For the nine months ended December 31, 2002, financing activities provided cash of $0.4 million, principally consisting of the issuance of common stock from the exercise of options. -18- Subsequent Event. On January 31, 2003, the Company entered into an operating lease for a 125,000 square foot facility located in Simi Valley, CA. This location will be utilized by our manufacturing subsidiary, Stanford Personal Care Manufacturing. The rental agreement calls for monthly payments of approximately $70,000 and expires in five years. CRITICAL ACCOUNTING POLICIES This management discussion and analysis is based on our consolidated financial statements which are prepared using certain critical accounting policies that require management to make judgments and estimates that are subject to varying degrees of uncertainty. While we believe that these accounting policies, and management's judgments and estimates, are reasonable, actual future events can and often do result in outcomes that can be materially different from management's current judgments and estimates. We believe that the accounting policies and related matters described in the paragraphs below are those that depend most heavily on management's judgments and estimates. Reserves for Uncollectible Accounts. At December 31, 2002, our accounts receivable balance was $123.9 million. Our accounting policy is to reserve for the accounts receivable of specific customers based on our assessment of certain customers' financial condition. We make these assessments using our knowledge of the industry and our past experiences. During the nine months ended December 31, 2002, we increased our reserve for uncollectible accounts by approximately $220 thousand, bringing the total of that reserve to approximately $2.5 million at December 31, 2002. We did not write off any receivables during the nine months ended December 31, 2002. Inventory Obsolescence Estimates. We take physical inventories in each of our significant warehouse locations at or near the end of each fiscal year. Inventories at the balance sheet dates are valued using the lower of average cost or market reduced by estimated inventory obsolescence reserves. These estimates are based on an inventory analysis of the movement and expiration dates of specific inventory items. In addition, we may return health and beauty aids and prescription pharmaceutical products to our suppliers for full credit if the products are damaged, their shelf life has expired, or they are otherwise not saleable. Inventories. Inventories are principally purchased rather than manufactured. They are stated at the lower of cost or market value. Cost is principally determined by the first-in, first-out method. We record adjustments to the value of inventory based upon forecasted sales projections, and the physical condition (e.g., age and quality) of the inventories. These adjustments are estimates, which could vary significantly, either favorably or unfavorably, from actual requirements if future economic conditions, customer inventory levels or competitive conditions differ from our expectations. Property, Plant and Equipment. Property, plant and equipment is recorded at cost and is depreciated on straight-line and accelerated methods over the estimated useful lives of such assets. Changes in circumstances such as technological advances or changes in our capital strategy can result in the actual useful lives differing from our estimates. In those cases where we determine that the useful life of property, plant and equipment should be shortened, we would depreciate the net book value in excess of the salvage value over its revised remaining useful life thereby increasing depreciation expense. Factors such as changes in the planned use of fixtures or software or closing of facilities could result in shortened useful lives. -19- Long Lived Assets. Statement of Financial Accounting Standards ("SFAS") No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," requires management judgments regarding the future operating and disposition plans for marginally performing assets, and estimates of expected realizable values for assets to be sold. Goodwill. Goodwill is calculated as the excess of the cost of purchased businesses over the value of their underlying net assets. Goodwill and other intangible assets that have an indefinite life are not amortized. On an annual basis, we will test goodwill and other intangible assets for impairment. To determine the fair value of these intangible assets, there are many assumptions and estimates used that directly impact the results of the testing. We have the ability to influence the outcome and ultimate results based on the assumptions and estimates we choose. To mitigate undue influence, we will use industry accepted valuation models and set criteria that are reviewed and approved by various levels of management. Income Taxes. Our effective tax rate and the tax bases of our assets and liabilities reflect our best estimate of the ultimate outcome of tax audits. Valuation allowances are established where expected future taxable income does not support the realization of the deferred tax assets. Considerable management judgment is also necessary in estimating future taxable income. Assumptions used in these estimates are consistent with internal forecasts. Valuation of Contingent Put Warrants. The contingent put warrants associated with the subordinated debt are being valued on a quarterly basis using the Black-Scholes Pricing Model. This model is subject to change in our stock price, as well as the potential that the warrants will become exercisable due to market conditions, and the change in risk free interest rates. FACTORS THAT COULD IMPACT OUR FINANCIAL CONDITION The timing and amount of any payment in respect of our insurance claim will have a significant effect on our ability to finance our operations. We carry an insurance claim receivable of $84.9 million on our balance sheet, which amount represents the cost basis of inventory destroyed by the September 25-26, 2002 warehouse fire. If payment by the insurance companies is delayed or if the amount of the payment is less than the sales price of the lost inventory, depending on the extent of the delay and the amount of the payment, there could be a material adverse effect on the Company's ability to finance its current operations at current levels. The Company has retained professionals to pursue insurance recovery. If our banks reduce our borrowing limits due to the loss of inventory from the warehouse fire, we would not be able to continue operations at current levels. The credit available to us under our bank facility is based on the amount of our inventory and accounts receivable. Since the warehouse fire of September 25-26, 2002 destroyed $86.6 million of inventory, our banks have continued to extend credit to us based on a borrowing base that included the $86.6 million we recorded as an insurance claim receivable. As requested by the banks, we intend to use the amount received from the insurance claim to pay down the outstanding balance under the bank facility. The banks initially stated that they would continue to lend against a borrowing base that included the insurance claim only until December 31, 2002, but have extended that date to January 31, 2003 and again to February 28, 2003. We have worked with the banks and their attorneys to keep them apprised of the status of our insurance claim. There can be no assurance that the banks will extend their current practice of lending -20- against the insurance claim beyond February 28, 2003. If we do not receive payment of the insurance claim before February 28, 2003 or the banks do not extend their current practice of lending against the insurance claim beyond such date, we would not be able to continue operations at current levels. Substantial defaults in payment or a material reduction in purchases of our products by large customers could have a significant negative impact on our financial condition and results of operations and liquidity. In recent years, a significant portion of our revenue growth has been with a limited number of large customers. Any defaults in payment or a material reduction in purchases from us by these large customers could have a significant negative impact on our financial condition, results of operations and liquidity. Our business could be hindered if we are unable to complete and integrate acquisitions successfully. An element of our strategy is to identify, pursue and consummate acquisitions that either expand or complement our business. Integration of acquisitions involves a number of risks, including the diversion of management's attention to the assimilation of the operations of businesses we have acquired; difficulties in the integration of operations and systems and the realization of potential operating synergies; the assimilation and retention of the personnel of the acquired companies; challenges in retaining the customers of the combined businesses; and potential adverse effects on operating results. If we are unable to successfully complete and integrate strategic acquisitions in a timely manner, our business and our growth strategies could be negatively affected. We will require additional financing to complete acquisitions. If we are not able to secure additional financing on terms we consider acceptable to us, we will not be able to execute on our business and growth strategies. In addition, if we experience rapid growth, we may require additional funds to expand our operations or enlarge our organization through acquisitions of complementary businesses. INFLATION AND SEASONALITY Inflation has not had any significant adverse effects on our business and we do not believe it will have any significant effect on our future business. Our fragrance business is seasonal, with greater sales during the Christmas season than in other seasons. Our other product lines are not seasonal. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. We are exposed to market risk related to the variable interest rate on our line of credit. Interest on the loan balance is payable at .25% per annum above the prime rate or, at our option, 2.75% per annum above the Eurodollar rate. We do not practice derivative trading in the form of interest rate swaps. Currently, our international operations are not material and, therefore, the risk related to foreign currency exchange rates is not material. ITEM 4. CONTROLS AND PROCEDURES. (a) Evaluation of Disclosure Controls and Procedures. Within the 90-day period prior to the filing date of this report, the Company carried out an evaluation, under the supervision and with the participation of management of the Company, including the Company's Chief Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on the -21- Company's evaluation, the Company's Chief Executive Officer and Principal Financial Officer concluded that the Company's disclosure controls and procedures were effective. (b) Changes in Internal Controls. Since the date of the evaluation described above, there have not been any significant changes in the Company's internal accounting controls or in other factors that could significantly affect those controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits The following Exhibits are filed as a part of this report: 99.01 Chief Executive Officer Certification................................26 99.02 Chief Financial Officer Certification................................27 (b) Reports on Form 8-K During the quarter for which this report is filed we did not file any reports on Form 8-K. -22- SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: February 13, 2003 ALLOU HEALTHCARE, INC. By: /s/ David Shamilzadeh ----------------------------------------- Name: David Shamilzadeh Title: President, Principal Financial Officer and Principal Accounting Officer -23- CERTIFICATE I, Herman Jacobs, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Allou Healthcare, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: February 13, 2003 /s/ Herman Jacobs -------------------------------- Herman Jacobs Chief Executive Officer (Principal Executive Officer) -24- CERTIFICATE I, David Shamilzadeh, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Allou Healthcare, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: February 13, 2003 /s/ David Shamilzadeh --------------------------------- Name: David Shamilzadeh President, Principal Financial Officer and Principal Accounting Officer -25-

ALLOU HEALTH & BEAUTY CARE INC 10-Q