10-Q 1 proterion_10q.txt FORM 10-Q 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: September 30, 2003 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: 0-14617 Proterion Corporation ------------------------------------------------------ (Exact name of registrant as specified in its charter) Delaware 61-0708419 ------------------------------- ------------------------------------ (State or other jurisdiction of (IRS Employer Identification Number) incorporation or organization) One Possumtown Road, Piscataway, NJ 08854-2103 ---------------------------------------- ---------- (Address of principal executive offices) (Zip Code) (732) 987-8200 ---------------------------------------------------- (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 the number of shares outstanding of each of the issuer's classes of Common Stock, as of the latest practicable date. Class Outstanding at November 10, 2003 -------------------------------------- -------------------------------- Common Stock, $.01 par value per share 26,032,835 Index to Form 10-Q Page No. -------- PART I - FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002 ............. 3 Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2003 and 2002 ........................................ 4 Condensed Consolidated Statement of Shareholders' Equity (Deficiency) for the nine months ended September 30, 2003 ................................... 5 Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and 2002 .... 6 Condensed Consolidated Statements of Comprehensive Income for the nine months ended September 30, 2003 and 2002 ............................................. 7 Notes to Condensed Consolidated Financial Statements ........................................... 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ........ 14 Item 3. Quantitative and Qualitative Disclosures About Market Risk ................................................. 21 Item 4. Controls and Procedures .............................. 21 PART II - OTHER INFORMATION Item 3. Defaults Upon Senior Securities ...................... 22 Item 6. Exhibits and Reports on Form 8-K ..................... 22 (a) Exhibits (b) Reports on Form 8-K Signatures .................................................... 23 2 PART I FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS

See Notes to Condensed Consolidated Financial Statements. 3

See Notes to Condensed Consolidated Financial Statements. 4

See Notes to Condensed Consolidated Financial Statements. 5

See Notes to Condensed Consolidated Financial Statements. 6 PROTERION CORPORATION (FORMERLY RHEOMETRIC SCIENTIFIC, INC.) AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In thousands) (Unaudited) Nine Months Ended September 30, -------------------- 2003 2002 -------- -------- Net Income/(loss) $ 4,420 ($ 3,131) Other comprehensive income/(loss) Foreign currency translation adjustments 93 278 -------- -------- Comprehensive income/(loss) $ 4,513 ($ 2,853) ======== ======== See Notes to Condensed Consolidated Financial Statements. 7 PROTERION CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. Accounting Policies The information included in the foregoing condensed consolidated financial statements is unaudited. In the opinion of management, all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods presented have been reflected herein. The results of operations for the interim periods are not necessarily indicative of the results for the entire year. This Quarterly Report on Form 10-Q should be read in conjunction with the latest Annual Report on Form 10-K for Proterion Corporation (hereinafter referred to as "Proterion" or the "Company"). Certain prior-period amounts have been reclassified to conform with the current-period presentation. 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 certain guarantees to be recorded at fair value and requires a guarantor to make significant new disclosures, even when the likelihood of making any payments under the guarantee is remote. Generally, FIN 45 applies to certain types of financial guarantees that contingently require the guarantor to make payments to the guaranteed party. The initial recognition and initial measurement provisions of FIN 45 are effective for financial statements for periods ending after December 15, 2002 and are applicable to all guarantees issued by a guarantor subject to FIN 45's scope, including guarantees issued prior to FIN 45. Management believes that the Company has no guarantees as defined by FIN 45. Accordingly, there was no material impact on the Company's financial statements attributable to FIN 45. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation--Transition and Disclosure" ("SFAS 148"). SFAS 148 amends SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123") to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The amendments to SFAS 123 regarding disclosure are effective for financial statements for fiscal years ending after December 15, 2002. The Company has adopted the disclosure provisions of SFAS 148 for its financial statements for the year ended December 31, 2002 and interim periods thereafter. The Company opted not to change to the fair value based method of accounting for stock-based compensation. At September 30, 2003, the Company had three stock-based employee compensation plans. The Company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations. The only stock-based employee compensation cost reflected in net income are options granted with an exercise price less than the market value of the underlying common stock on the date of the grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation. 8

In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities." This statement amends and clarifies the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. This statement is effective for contracts entered into or modified after June 30, 2003, except as for provisions that relate to SFAS No. 133 implementation issues that have been effective for fiscal quarters that began prior to June 15, 2003, which should continue to be applied in accordance with their respective dates. The Company does not expect the adoption of this pronouncement to have a material effect on the results of operations or financial position. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This statement requires that certain financial instruments that, under previous guidance, issuers could account for as equity, be classified as liabilities in statements of financial position. Most of the guidance in SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company has adopted this statement. 2. Earnings (Loss) Per Share The Company calculates net earnings/(loss) per share as required by SFAS No. 128, "Earnings Per Share" ("SFAS 128"). SFAS 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effect of stock options, warrants, and convertible securities. For the nine months ended September 30, 2003 the effect of stock options, warrants, and convertible securities were dilutive. For the nine months ended September 30, 2002, the effects of stock options, warrants, and convertible securities were anti-dilutive. On May 15, 2003, options to purchase 120,000 shares of Common Stock were granted to non-employee directors of the Company under the Company's 2003 Equity Incentive Plan and on June 27, 2003, options to purchase 643,000 shares of Common Stock were granted to employees as compensation under the Company's stock option plans. The dilutive Common Shares consist of stock options. 9 3. Sale of the Rheology Instruments and Services Business/Lease Termination On January 15, 2003, the Company completed the sale of its rheology instruments and services business to the TA Instruments Division of Waters Corporation for consideration of $17 million in cash and the assumption of $6 million of accounts payable, and accrued expenses, plus certain other specified obligations. Of such cash consideration, $15.3 million was paid to the Company at closing. The remainder was deposited in escrow to secure potential indemnification claims that could be brought by the purchaser, subject to the terms of the asset sale agreement. Under the terms of such escrow, $850,000 is to be released on each of July 22, 2003 (which date had been extended from July 15, 2003) and January 15, 2004, subject to the pendency of any such indemnification claims. The "Rheometric Scientific" and "Rheometrics" names were included in the sale. The Company used the proceeds received from this sale to retire all of its bank debt, which amounted to approximately $9,600,000, to discharge or reduce certain other obligations and to provide interim working capital. As part of this transaction, the Company changed its name to Proterion Corporation, which represents the Company's focus on its remaining life sciences business. During 2003 Waters Corporation made indemnification claims against the escrowed amounts that were subsequently resolved to the satisfaction of the Company. The Company collected receivables and received cash payments equal to $797,000 and receivables of $163,000, for a total amount remitted of $960,000. The Company has provided a $110,000 reserve against the receivables. Any amount received in excess of the net book value of the receivables will be recorded as a gain on the sale of the assets of the rheology instruments and services business. There are currently no claims against the escrow balance that is due in January 2004, but there can be no assurance that further claims will not arise. In connection with the sale, the Company entered into a lease termination agreement with the landlord of the facilities which house the Company's corporate headquarters and main manufacturing plant in Piscataway, New Jersey (the "Facility"). The lease termination agreement requires the Company to pay the landlord $3,000,000: (i) $2,250,000 of which the Company paid in January 2003; (ii) $500,000 of which was to be paid on July 22, 2003 (which date had been extended from July 15, 2003 to coincide with the scheduled release of the first escrow payment under the terms of the sale); and (iii) $250,000 of which is to be paid on January 15, 2004 (to coincide with the scheduled release of the second escrow payment under the terms of the sale). In addition, under the lease termination agreement the exercise price of the landlord's existing warrants for 464,160 shares of Common Stock was reduced from $.37 per share to $.01 per share and the Company issued 650,000 shares of Common Stock to the landlord. The Company has made payments of $290,000 against the balance that was to be paid on July 22, 2003 and is currently discussing plans to pay the remaining balance. The Company also signed a one-year agreement with the landlord to lease significantly less space in the same building that it occupied prior to the sale. This lease is classified as an operating lease. The Company recorded a net loss on the lease termination of $2,929,000, which is included in the gain from the sale of discontinued operations. As a result of the sale of the rheology instruments and services business, the Company recorded a gain before taxes, net of the loss on the lease termination, of $10,475,000. In addition, the results of operations for the rheology instruments and services business for the periods ended September 30, 2003 and 2002 are included in the accompanying Condensed Consolidated Statements of Operations as "discontinued operations." 10 4. Long-Term Debt and Short-Term Borrowings Long-term debt as of September 30, 2003 and December 31, 2002, respectively, consisted of the following:

(a) In connection with the sale of the Company's rheology instruments and services business on January 15, 2003, the Company terminated its existing lease. (See note 3 above.) (b) In connection with the sale of the rheology instruments and services business on January 15, 2003, this term loan was paid in full. (c) A settlement was entered into with the lessor to terminate this lease for office furniture and fixtures. (d) On September 25, 2003 the Company executed a note for $190,000 with an accredited private investor; such note secures the sale by the Company of certain New Jersey state net operating loss carryforwards (NOL's). The sale of the NOL's is governed by a program sponsored by the New Jersey Economic Development Authority. The note becomes due upon receipt of the proceeds received under the program, which is expected to be during December 2003. The Company pledged 1,500,000 treasury shares of common stock as additional collateral for the note. These shares are not considered to be outstanding. 11 Short-Term Borrowings On June 13, 2003, the Company entered into a factoring arrangement with KBK Financial, Inc. ("KBK") under which the Company could borrow up to $1,000,000 based on eligible accounts receivable. As of September 30, 2003, total outstanding fundings under this facility was $218,000. On January 15, 2003 and in connection with the sale of the rheology instruments and services business, the Company's entire working capital credit facility with PNC Bank, in the amount of approximately $8,700,000, was paid in full. 5. Affiliate Debt Affiliate debt consisted of the following: September 30, December 31, 2003 2002 ------------ ------------ Promissory note with interest at 6% $500,000 $750,000 Immediately prior to the sale of the Company's rheology instruments and services business, the Company owed Axess Corporation ("Axess") $787,000 (including accrued interest) under the terms of a promissory note (as amended and restated, the "Axess Note"). On January 15, 2003, at the closing of the sale, the Company and Axess amended the Axess Note with the Company agreeing to pay Axess: (i) $287,000 at the closing; (ii) $250,000 on July 15, 2003 (which date was extended to July 22, 2003, to coincide with the scheduled release of the first escrow payment - see note 3 above); (iii) $250,000 upon the scheduled release of the second escrow payment - see note 3 above; and (iv) interest on the outstanding principal amount on a monthly basis until maturity. Due to the indemnification claims of Waters Corporation referenced in note 3 above, the Company did not pay Axess the $250,000 due on July 22, 2003. As a result, Axess has declared all amounts under the Axess Note immediately due and payable. The escrow balance was subsequently paid; however, to date, the Company has not paid Axess, and is currently discussing plans to pay the amounts owed. 6. Operating Segments/Foreign Operations and Geographic Information Effective with the sale of the Company's rheology instruments and services business, the Company operates in one business segment: life sciences. 7. Redeemable Preferred Stock On August 8, 2002, the Company's Board of Directors approved our entering into a securities purchase agreement with Andlinger Capital XXVI LLC ("Andlinger Capital XXVI"), our controlling shareholder, under which Andlinger Capital XXVI purchased $1,500,000 of the Company's newly created Series B Preferred Stock, with the right, subject to future Board determination of the need for such capital, to invest up to an additional $500,000 on the same terms. The new Series B Preferred Stock does not carry a current dividend and is subject to redemption at the Company's option at any time or, at Andlinger Capital XXVI's option, upon a change in control of the Company or the occurrence of certain other major corporate events, including a sale of substantially all of the Company's assets. The redemption price is 101% of the original issuance amount plus an additional 1% for each calendar month completed following the date of original issuance. On October 30, 2002, the Company's Board of Directors approved our entry into an agreement with Andlinger Capital XXVI pursuant to which Andlinger Capital XXVI: (i) purchased an additional $500,000 of the Company's Series B Preferred Stock; 12 (ii) deferred its right to have all of the outstanding Series B Preferred Stock redeemed in full by the Company upon the closing of the sale of our rheology instruments and services business; and (iii) subordinated such deferred redemption payments to amounts payable by the Company to our landlord under the Facility lease and to Axess. In consideration therefor, the Company issued to Andlinger Capital XXVI a new warrant, with an expiration date of March 6, 2007, to purchase up to 1,000,000 shares of the Company's Common Stock at an exercise price equal to $1.00 per share (the average of the closing prices of the Company's Common Stock over the ten trading days immediately preceding October 30, 2002). At the closing of the sale of the Company's rheology instruments and services business, we paid Andlinger Capital XXVI $667,000 for the redemption of one-third of the shares of our Series B Preferred Stock then held by it. Pursuant to the Company's deferral agreement with Andlinger Capital XXVI referenced above, the Company had agreed to redeem the remaining shares of Series B Preferred Stock in two equal installments on July 15, 2003 (which date was extended to July 22, 2003 to coincide with the scheduled release of the first escrow payment - see note 3 above) and January 15, 2004 (to conicide with the scheduled release of the second escrow payment - see note 3 above). The Company, however, was unable to make the scheduled July 22, 2003 redemption. In connection therewith, Andlinger Capital XXVI has agreed to further defer this redemption until July 15, 2004. As a result of this additional deferment, the Company is obligated to issue to Andlinger Capital XXVI a new warrant to purchase up to 333,333 shares of our Common Stock at an exercise price equal to $.64 per share. In addition, the expiration date of this warrant will be March 6, 2007 and the other terms and conditions of this warrant will be similar to those contained in the existing warrants to purchase shares of our Common Stock held by Andlinger Capital XXVI. 13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties that are referred to or described in more detail below under the caption "Forward Looking Statements." The Company's actual results could differ materially from those anticipated in these forward-looking statements. This Quarterly Report on Form 10-Q should be read in conjunction with the latest Annual Report on Form 10-K filed by the Company. The terms "Proterion," the "Company," "our," "we" and "us," as used in this Management's Discussion and Analysis of Financial Condition and Results of Operations refer to Proterion Corporation and its wholly owned subsidiaries, except where it is clear that the term refers only to the parent company. Comparison of nine months and three months ended September 30, 2003 and 2002 Please note that except where specifically noted, the comparative discussion below does not include the operations of our rheology instruments and services business which we sold to the TA Instruments Division of Waters Corporation on January 15, 2003. This sold business is referred to as "discontinued operations" in the accompanying financial statements. Continuing Operations Revenues In the nine months ended September 30, 2003, we achieved revenues of $4,133,000 from continuing operations, compared to revenues of $4,215,000 in the corresponding period in 2002; a decrease of $82,000, or 2%. This decrease in revenue was primarily the result of a decreased rate of orders placed for the Company's Circular Dichroism product line, which was partially offset by an increase in orders placed for the Company's DynaPro product line. For the three months ended September 30, 2003, we achieved revenues of $1,368,000 from continuing operations compared to revenues of $1,312,000 in the corresponding period in 2002; an increase of $56,000, or 4%. The revenue increase from DynaPro shipments was partially offset by decreased revenue in the Company's Circular Dichroism product line. Both product lines experienced a slowdown in orders during the three month period ended September 30, 2003. We believe this slowdown was caused by the reorganization of our new sales and marketing group, overall reductions in capital spending caused by global economic and political uncertainties, and government-sponsored funding delays to major research organizations, primarily in North America. Order rates in both our Circular Dichroism and DynaPro product lines have historically been characterized by a high level of variability. Revenue did not fall as much as orders as the Company worked its way through a backlog of orders. Gross Profit Gross profit from continuing operations for the three month period ended September 30, 2003 totaled $536,000, or 39% of revenues, compared to $413,000, or 31% of revenues, in the corresponding period in 2002, an increase of $123,000. The gross profit for the nine month period ended September 30, 2003 totaled $1,508,000, or 36% of revenues, compared to $1,234,000, or 29% of revenues, in the corresponding period in 2002, an increase of $274,000. The increases were achieved primarily as the result of changes made to our Circular Dichroism product line manufacturing strategy. Outsourcing most major mechanical operations reduced overhead and the overall manufacturing cost of each instrument. We expect these benefits to continue. Gross margins on our DynaPro product line improved as a result of higher margins achieved on a recently introduced high-throughput "Plate-Reader" version of the DynaPro. We expect 14 higher margins in the future on our DynaPro product line, as the product mix continues to shift in favor of this higher-margin product. Product mix changes in favor of the higher-margin DynaPro product line are also contributing to improved margins. Operating Expenses Operating expenses for the three months ended September 30, 2003 were $944,000 compared to $1,193,000 in the corresponding period last year, a decrease of $249,000. The operating expenses for our life sciences business for the nine month period ended September 30, 2003 were $2,418,000, compared to $3,617,000 for the same period in the prior year, a decrease of $1,199,000. The decrease is primarily the result of corporate expenses that were eliminated with the sale of the rheology instruments and services business. General and Administrative. General and administrative expenses for the three and nine month periods ended September 30, were $724,000, and $1,794,000, respectively, a decrease of $282,000 and $1,333,000, respectively, over the corresponding periods in the prior year. This decrease is primarily the result of corporate expenses that were eliminated with the sale of the rheology instruments and services business. Marketing and Selling. Marketing and selling expenses for the three and nine month periods ended September 30, 2003 were $160,000 and $483,000, respectively, an increase of $51,000 and $172,000, respectively, over the corresponding periods in the prior year. This increase primarily reflects additional sales and marketing personnel, and expenses associated with hiring three new sales professionals during the three month period ended September 30, 2003. Engineering. Engineering expenses for the three and nine month periods ended September 30, 2003 were $60,000 and $141,000, respectively, a decrease of $18,000 and $38,000, respectively, compared to the corresponding periods in the prior year. The decrease is caused largely by a reduction in headcount in the engineering department. Interest Expense Net interest expense for the three and nine month periods ended September 30, 2003 was $56,000 and $73,000, respectively, a decrease of $24,000 and $142,000, respectively, compared to the corresponding periods in 2002. An increase in interest due to the initiation of the financing arrangement with KBK Financial, Inc, was less than the reduction in interest from the payoff of the Company's line of credit with PNC Bank that accompanied the sale of our rheology instruments and services business in January 2003. Foreign Currency The foreign currency transactions for the three and nine months ended September 30, 2003 resulted in a gain of $42,000 and $6,000, respectively, compared to losses of $13,000 and $46,000, respectively, compared to the corresponding periods in 2002. The gains over the corresponding prior periods are due to currency fluctuations, primarily the weakening of the US dollar versus the British Pound. Income Tax Benefit During the three month period ended September 30, 2003 the New Jersey Department of Taxation accepted the Company's application to sell its New Jersey net operating loss carryforwards (NOL's). As a result, the Company has recognized a deferred tax benefit of $510,000. Continuing operations accounted for $200,000 of the NOL's, and $310,000 of the NOL's related to discontinued operations. 15 Loss from continuing operations after taxes The three and nine month periods ended September 30, 2003 resulted in a net loss from continuing operations of $222,000 and $777,000, respectively, compared to losses of $848,000 and $2,563,000, respectively, for the corresponding periods in 2002. Discontinued Operations Income/Loss from discontinued operations For the three and nine month periods ended September 30, 2003, the rheology instruments and services business achieved income of $227,000 and $5,197,000, respectively. The income of $5,197,000 is comprised of a $1,378,000 loss from discontinued operations and a $6,575,000 gain on the sale of discontinued operations. Income from discontinued operations for the three month period ended September 30, 2002 is primarily due to the recognition of a deferred tax benefit related to the Company's sale of its New Jersey NOL's. Expenses for the nine month period ended September, 2003 include 15 days of expenses for the operation of discontinued operations with no associated revenue to offset the expenses. Gain from the sale of the rheology instruments and services business As a result of the sale of the rheology instruments and services business and consummation of the lease termination, in the first quarter of 2003 the Company recorded a net gain on the transaction of $6,575,000, after income tax expense of $3,900,000. Liquidity and Capital Resources The Company received $15,300,000 from Waters Corporation as consideration for the sale of the rheology instruments and services business on January 15, 2003. In addition, during the three month period ended September 30, 2003, the Company received from Waters Corporation, in satisfaction for the $850,000 escrow payment due the Company, $290,000 in cash and $670,000 in receivables of which $507,000 has been collected. The Company has provided a $110,000 receivable reserve against the remaining outstanding receivables. At the time of the sale of the rheology instruments and services businesses the Company used the cash proceeds to pay off our senior credit facility with PNC Bank and satisfy certain vendor obligations which were not assumed by the purchaser. In addition, we were required to make substantial payments at the closing of this transaction: (i) to the landlord of our Piscataway, New Jersey facility in connection with a lease termination agreement; (ii) to repay, in part, certain obligations to Axess Corporation ("Axess"), our former controlling stockholder; (iii) to redeem a portion of the shares of Series B Preferred Stock issued to Andlinger Capital XXVI LLC ("Andlinger Capital XXVI") with respect to amounts provided as interim financing by Andlinger Capital XXVI; (iv) to pay certain other obligations to Andlinger Capital XXVI; and (v) to pay legal, accounting and other expenses incurred relative to the sale transaction. We made payments totaling $14,400,000 to satisfy these obligations. Following the sale of our rheology instruments and services business, and the payment in full of all outstanding indebtedness thereunder, we terminated our senior credit facility with PNC Bank. Until the successful commercialization of our Plasmon Waveguide Resonance ("PWR") product line we anticipate that with our current cost structure, cash flow from operations will be insufficient to optimally fund the development of our PWR technology, or to retire all our obligations as they come due. Our near-term and medium-term liquidity is contingent on sales as well as on securing additional financing, and our long-term liquidity is dependent on the success of our PWR technology. 16 To better conserve cash and manage our liquidity, in 2002 we implemented an expense reduction program. For example, we reduced our employee headcount from 50 at June 30, 2002 (excluding discontinued operations) to 31 at September 30, 2003. We will continue to assess our cost structure as it relates to our revenues and cash position in 2003, and we may make further reductions if such actions are deemed appropriate. In addition, on June 13, 2003 we entered into a factoring agreement with KBK Financial, Inc. ("KBK") to provide up to $1,000,000 of financing based on eligible accounts receivable. As of September 30, 2003, total outstanding fundings under this facility was $218,000. In November 2003, we replaced that facility with a new facility provided by Entrepreneur Growth Capital LLC of up to $700,000 based on eligible receivables and inventory (as defined) and $120,000 secured by a deposit of that amount made by Andlinger Capital XXVI. In addition, in October 2003, Andlinger Capital XXVI loaned $120,000 to the Company on a short-term basis. Waters Corporation's claim against the escrowed funds prevented us from making full payments due on July 22, 2003 to Axess, Andlinger Capital XXVI and the landlord for our Facility. Consequently, we are currently in discussion with our landlord concerning how to remedy our failure to make the remaining $210,000 payment on July 22, 2003. Axess has declared all amounts due under the Axess Note immediately due and payable, of which principal and interest currently totals $539,000. We are currently seeking additional debt and equity financing on acceptable terms in order to obtain the liquidity necessary to fund our operations, fund development of PWR, and meet our other obligations, but there can be no assurance that we will be able to obtain such additional financing or that it will be available on terms acceptable to us. If we do not increase our sales or are not successful in our expense reduction efforts and do not obtain such additional financing, we are unlikely to have an adequate level of cash and other financial resources to fund our operations, meet our other obligations, or fund continued development of PWR. In light of this uncertainty, we approached Andlinger Capital XXVI and requested a further delay of the July 22, 2003 Series B Preferred Stock redemption. Andlinger Capital XXVI has agreed to defer this redemption until July 15, 2004 when the final redemption of the Series B Preferred Stock is scheduled, provided that the Company must make this redemption earlier if it obtains sufficient financing or has adequate working capital to do so. We are also pursuing other alternatives for alleviating our liquidity requirements, but despite our direct and indirect fundings from and agreements with Andlinger Capital XXVI and our continuing efforts to seek alternative sources of liquidity, there can be no assurance that: (a) we will have sufficient financial resources to meet all of our cash flow needs and obligations; or (b) any alternatives sought by the Company will be successful and/or result in positive cash flow for the Company. If the Company does not obtain sufficient additional financing, it raises substantial doubt about the Company's ability to continue as a going concern. Cash Flows Through the nine month period ended September 30, 2003, the net change in cash was a decrease of $664,000 compared to a $14,000 increase over the corresponding period last year. Effects of exchange rate changes on cash were minimal. Cash Flows from Operations In the nine months ended September 30, 2003, excluding the gain on the sale of the Company's rheology instruments and services businesses, the Company incurred a loss of $2,155,000, of which $777,000 was related to continuing operations, 17 and $1,378,000 was related to discontinued operations. Aside from the net loss, of which cash used in operating activities amounted to $1,774,000, the primary use of cash was a reduction in accounts payable of $925,000, a reduction of accrued liabilities of $387,000, and an increase in accounts receivable of $180,000. Cash was provided by a reduction in inventory of $272,000, a reduction in prepaid expenses and other current assets of $487,000, and a reduction of other assets of $414,000. Management anticipates that until the PWR is commercialized, net cash flows from operations will continue to be negative. Cash Flows from Investing The proceeds from the sale of our rheology instruments and services business provided net cash of $13,758,000. The Company generated $87,000 on the sale of property and equipment. In the nine months ended September 30, 2003, we made a capital expenditure of $25,000 for the acquisition of patents. In the nine months ended September 30, 2002, the Company purchased $118,000 of property and equipment. Cash Flows from Financing Net cash used by financing activities for the nine months ended September 30, 2003 was $12,712,000 compared to net cash provided of $1,199,000 in the same period in 2002. The cash generated from the sale of the rheology instruments and services business was used to repay borrowings under our now terminated line of credit and term debt with PNC Bank of $9,598,000, a payment under our lease termination agreement of $2,544,000, a redemption payment on our Series B Preferred Stock to Andlinger Capital XXVI of $667,000, and repayment of affiliate debt of $250,000. Proceeds from borrowings under our factoring agreement with KBK in the nine months ended September 30, 2003 was $218,000. In addition, the Company received proceeds from executing a short-term note payable, in the amount of $190,000. The note is secured by the pending proceeds from the sale of the net operating loss carryforwards under a program sponsored by the New Jersey Economic Development Authority. During the nine months ended September 30, 2003, restricted cash increased by $61,000. For the nine months ended September 30, 2003 the net change in cash was a decrease of $664,000, compared to an increase of $14,000 for the corresponding period last year. Critical Accounting Policies and Estimates The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis management evaluates its estimates, including those related to inventory reserves and the allowance for doubtful accounts. Management bases its estimates on historical experience and on various other assumptions that management believes to be reasonable under the circumstances, the results of which form a basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, however, management believes that its estimates, including those for the above described items, are reasonable and that the actual results will not vary significantly from the estimated amounts. The following critical accounting policies relate to the more significant judgments and estimates used in the preparation of the consolidated financial statements: 18 Inventory Reserves The Company continuously monitors its exposure relating to excess and obsolete inventory and has established reserves for any exposure that may be required. Factors considered in evaluating the reserves include product changes, usage, technology changes, shifts in sales patterns and quantities on hand. An estimate is made of the market value, less costs to dispose, of products whose value is determined to be impaired. If these products are ultimately sold at less than estimated amounts, additional reserves may be required. Allowance for Doubtful Accounts The Company maintains an allowance for doubtful accounts for estimated losses resulting from customers or other parties failure to make payments on a trade receivable due to the Company. The estimates for the allowance and discounts are based on a number of factors, including: (1) historical experience; (2) aging of the trade accounts receivable; (3) specific information obtained by the Company on the financial condition and current credit worthiness of customers or other parties; and (4) specific agreements or negotiated amounts with customers. If the financial condition on the Company's customers were to deteriorate and reduce the ability of the Company's customers to make payments on their accounts, the Company may be required to increase its allowances by recording additional bad debt expense. Likewise, should the financial condition of the Company's customers or other parties improve and result in payments or settlements of previously reserved amounts, the Company may be required to record a reduction in bad debt expense to reverse recorded allowances. Impairment of Long-lived Assets The Company reviews long-lived assets and intangible assets with a definite life for impairment whenever events or changes in circumstances indicate the carrying value of such assets may not be recoverable. Revenue Recognition Product sales are recorded upon shipment, provided that the price is fixed, title has been transferred, collection of the resulting receivable is reasonably assured, and there are no significant obligations. Maintenance agreement revenue is recorded on a straight-line basis over the terms of the respective agreements. Other service revenue is recorded as services are performed. We accrue for expected warranty cost on product sales. Contractual Obligations The Company is a party to a lease relating to office facilities. The commitment under this lease is $36,000 for the remainder of 2003. Forward-Looking Statements This Quarterly Report on Form 10-Q (this "10-Q") includes forward-looking statements, particularly in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" section. In some cases, you can identify forward-looking statements by terms such as "may," "will," "should," "could," "would," "expects," "plans," "anticipates," "believes," "estimates," "projects," "predicts," "potential" and similar expressions intended to identify forward-looking statements. Additional written or oral forward-looking statements may be made by or on behalf of the Company from time to time, in 19 filings with the Securities and Exchange Commission, in press releases and other public announcements, or otherwise. All such forward-looking statements are within the meaning of that term in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements may include, but not be limited to: o projections of revenue, income, losses and cash flows; o plans for future capital and other expenditures; o plans for future operations; o financing needs or plans; o plans relating to products or services; o estimates concerning the effects of litigation or other disputes; as well as o expectations and assumptions relating to any or all of the foregoing relating to the Company, its subsidiaries and/or divisions. Although the Company believes that its forward-looking statements are based on expectations and assumptions that are reasonable, forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted. Accordingly, no assurance can be given that such expectations or assumptions will prove to have been correct, and future events and actual results could differ materially from those described in or underlying the forward-looking statements. Among the factors that could cause future events and actual results to differ materially are: o the demand for the Company's products and services and other market acceptance risks; o the presence in the Company's markets of competitors with greater financial resources and the impact of competitive products and services and pricing; o the ability of the Company to develop new technologies that may be more accurate, reliable, user-friendly or cost-effective than those currently utilized in the Company's products; o the ability of the Company to procure the requisite intellectual property rights to any such new technologies developed by others, and to incorporate such technologies into new products; o the loss of any significant customers or group of customers; o further reductions in outside fundings or capital budgets for our customers (such as universities) for whom purchases of the Company's products represent substantial capital outlays; o general economic and market conditions; and o the Company's ability to meet its current financial obligations and to obtain new financing necessary to meet its working capital needs. More detail regarding these and other important factors that could cause actual results to differ materially from such expectations, assumptions and forward-looking statements ("Cautionary Statements") may be disclosed in this 10-Q, other Securities and Exchange Commission filings and other public announcements of the Company. All subsequent written and oral forward-looking statements attributable to the Company, its subsidiaries or divisions or persons acting on their behalf are expressly qualified in their entirety by the Cautionary Statements. The Company assumes no obligation to update its forward-looking statements or advise of changes in the expectations, assumptions and factors on which they are based. 20 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is the potential loss arising from adverse changes in market rates and prices, such as foreign currency exchange and interest rates. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. The Company is exposed to market risk related to changes in foreign exchange and interest rates. ITEM 4. CONTROLS AND PROCEDURES We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Securities Exchange Act of 1934 reports is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission (the "SEC"), and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, as ours are designed to do, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. As of September 30, 2003, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in enabling us to record, process, summarize and report information required to be included in our periodic SEC filings within the required time period. There have been no changes in our internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 21 PART II OTHER INFORMATION ITEM 3. DEFAULTS UPON SENIOR SECURITIES In connection with the sale of the Company's rheology instruments and services business in January 2003, the Company entered into a lease termination agreement with the landlord of the facilities which house the Company's corporate headquarters and main manufacturing plant in Piscataway, New Jersey (the "Facility"). The lease termination agreement requires the Company to pay the landlord $3,000,000: (i) $2,250,000 of which the Company paid in January 2003; (ii) $500,000 of which was to be paid on July 15, 2003 (which date was extended to July 22, 2003 to coincide with the scheduled release of the first escrow payment under the terms of the sale); and (iii) $250,000 of which is to be paid on January 15, 2004 (to coincide with the scheduled release of the second escrow payment under the terms of the sale). The Company, however, was unable to pay the landlord $210,000 of the $500,000 due on July 22, 2003 and the parties are currently discussing how to address the non-payment. Immediately prior to the sale of the Company's rheology instruments and services business, the Company owed Axess Corporation ("Axess") $787,000 (including accrued interest) under the terms of a promissory note (as amended and restated, the "Axess Note"). On January 15, 2003, at the closing of the sale, the Company and Axess amended the Axess Note with the Company agreeing to pay Axess: (i) $287,000 at the closing; (ii) $250,000 on July 15, 2003 (which date was extended to July 22, 2003, to coincide with the scheduled release of the first escrow payment); (iii) $250,000 upon the scheduled release of the second escrow payment; and (iv) interest on the outstanding principal amount on a monthly basis until maturity. Due to the indemnification claims of Waters Corporation, the Company did not pay Axess the $250,000 due on July 22, 2003. As a result, Axess has declared all amounts under the Axess Note immediately due and payable. The escrow balance was subsequently paid; however, to date, the Company has not paid Axess, and is currently discussing plans to pay the amounts owed. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits. 31.1* Certification of Robert M. Castello Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2* Certification of Stephen M. Obeda Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1* Certification of Robert M. Castello pursuant to Item 601(b)(32) of Regulation S-K, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2* Certification of Stephen M. Obeda pursuant to Item 601(b)(32) of Regulation S-K, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Filed herewith (b) Reports on Form 8-K. None. 22 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PROTERION CORPORATION (Registrant) November 14, 2003 By /s/ STEPHEN M. OBEDA -------------------------------------- Stephen M. Obeda, Vice President, Finance, Chief Financial Officer and Authorized Officer 23

PROTERION CORP 10-Q