Gross to Net Sales Adjustments

Gross to net sales adjustments comprise the following:

		Quarter Ended June 30,
		2010				2009
Gross Sales		$	15,813,393			$	13,709,673
Trade rebates			(1,956,035	)			(1,604,132	)
Distributor fees			(339,280	)			(238,459	)
Sales incentives			(113,163	)			(130,875	)
Returns and allowances			(76,308	)			(80,549	)
Cash discounts			(98,501	)			(92,317	)
Total adjustments			(2,583,287	)			(2,146,332	)
Net sales		$	13,230,106			$	11,563,341

Trade rebates increased in 2010 versus 2009 due principally to higher Canadian sales subject to rebate, partially offset by the discontinuation of a significant U.S. private label customer rebate program effective November 1, 2009. The increase in distribution fee expense is commensurate with the increase in Canadian net sales upon which it is based. The decrease in sales incentive expense reflects a reduction in the number of the traditional wound care and first aid products sales incentive programs in 2010 versus 2009. The slight sales returns and allowances decrease is principally due to the non-recurrence of higher first aid products related returns in 2009, partially offset by higher Canadian returns. The increase in cash discounts reflects higher U.S. sales subject to cash discount.

 

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Rebate Reserve Roll Forward

A three month roll forward of the trade rebate accruals at June 30, 2010 and 2009 is outlined below:

		Quarter Ended June 30,
		2010				2009
Beginning balance – March 31		$	2,344,157			$	2,673,350
Rebates paid			(1,914,623	)			(1,968,178	)
Rebates accrued			1,956,035				1,604,132
Ending balance – June 30		$	2,385,569			$	2,309,304

Net Sales and Gross Margin

The following table highlights the June 30, 2010 versus 2009 product line net sales and gross profit:

		Quarter Ended June 30,								Variance
		2010				2009
Net Sales		$	13,230,106			$	11,563,341			$	1,666,765				14.4	%
Cost of sales			9,202,202				8,135,574				1,066,628				13.1	%
Gross Profit		$	4,027,904			$	3,427,767			$	600,137				17.5	%
Gross Profit %			30.4	%			29.6	%

Consolidated net sales increased $1,666,765, or 14.4% (11.4% adjusted for exchange), in 2010 versus 2009. Canadian net sales increased $814,867, or 29.7%, to $3,559,150 in 2010 from $2,744,282 in 2009. This increase was driven by favorable exchange of $352,827 associated with a 11.9% strengthening of the Canadian dollar, coupled with sales growth of $462,040. The sales growth reflects the impact of inventory rationalization on the part of our exclusive Canadian distributor of $603,605, partially offset by $141,565, or 3.8%, attributable to lower demand. U.S. net sales increased $555,673, or 6.3%, to $9,374,731 in 2010 from $8,819,058 in 2009. The increase was principally driven by higher advanced wound care sales of $471,506, or 27.1%, and first aid product sales of $260,112, or 8.4%. The balance of U.S. sales consisting of traditional wound care, private label, specialty fixation, burn care and skin care and bathing sales were down 4.4% quarter to quarter. The higher advanced wound care sales reflect continued growth of our new products in response to expanded sales and marketing efforts. The increase in first aid products sales reflects new business and improving demand. Sales of $296,225 associated with our recently initiated international growth strategy also contributed.

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Selling, General and Administrative Expenses

The following table highlights June 30, 2010 versus 2009 selling, general and administrative expenses by type:

		Quarter Ended June 30,								Variance
		2010				2009
Distribution		$	454,010			$	459,741			$	(5,731	)			(1.2	)%
Marketing			524,782				438,855				85,927				19.6	%
Sales			1,669,958				1,221,821				448,137				36.7	%
General and administrative			2,041,024				1,582,621				458,403				29.0	%
Total		$	4,689,774			$	3,703,038			$	986,736				26.6	%

Selling, general and administrative expenses increased $986,736, or 26.6% (24.6% adjusted for exchange), in 2010 versus 2009, including an increase of $72,282 in Canadian selling, general and administrative expenses attributable to exchange.

Distribution expense decreased $5,731, or 1.2% (2.8% adjusted for exchange), in 2010 versus 2009, including an increase of $7,329 due to exchange.  This decrease reflects lower labor requirements in the Houston distribution center and lower utilities due to a warmer average temperature in 2010, partially offset by higher inflation related compensation and benefit costs and higher U.S. lease costs.

Marketing expense increased $85,927, or 19.6% (18.6% adjusted for exchange), in 2010 versus 2009, including an increase of $4,377 due to exchange. The increase is attributable to higher U.S., Canada and international promotion/literature and show spending in support of our growth initiatives.

 

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Six Months Ended June 30, 2010 Compared to Six Months Ended June 30, 2009

Overview

The following table highlights the six months ended June 30, 2010 versus 2009 operating results:

 

		Six Months Ended June 30,								Variance
		2010				2009
Gross Sales		$	31,264,529			$	26,311,433			$	4,953,096				18.8	%
Sales adjustments			(5,190,042	)			(4,316,201	)			(873,841	)			20.2	%
Net sales			26,074,487				21,995,232				4,079,255				18.6	%
Cost of sales			18,021,184				15,213,830				2,807,354				18.5	%
Gross profit			8,053,303				6,781,402				1,271,901				18.8	%
Selling, general and administrative expense			8,913,019				7,567,164				1,345,855				17.8	%
Research and development expense			239,851				217,926				21,925				10.1	%
Interest expense			294,599				411,070				(116,471	)			(28.3	)%
Loss on debt extinguishment			114,072				-				114,072
Other income, net			(178,131	)			(43,789	)			(134,342	)			306.8	%
Total expenses			9,383,410				8,152,371				1,231,039				15.1	%
Loss before income taxes			(1,330,107	)			(1,370,969	)			40,862
Provision (benefit) for income taxes			137,652				(52,388	)			(190,040	)
Net loss		$	(1,467,759	)		$	(1,318,581	)		$	(149,178	)			11.3	%

 

Gross to Net Sales Adjustments

Gross to net sales adjustments comprise the following:

		Six Months Ended June 30,
		2010				2009
Gross Sales		$	31,264,529			$	26,311,433
Trade rebates			(3,903,902	)			(3,113,426	)
Distributor fees			(668,952	)			(445,197	)
Sales incentives			(236,973	)			(288,700	)
Returns and allowances			(173,462	)			(266,048	)
Cash discounts			(206,753	)			(202,830	)
Total adjustments			(5,190,042	)			(4,316,201	)
Net sales		$	26,074,487			$	21,995,232

Trade rebates increased in 2010 versus 2009 due principally to higher Canadian sales subject to rebate, partially offset by the discontinuation of a significant U.S. private label customer rebate program effective November 1, 2009. The increase in distribution fee expense is commensurate with the increase in Canadian net sales upon which it is based. The decrease in sales incentive expense reflects a reduction in the number of the traditional wound care and first aid products sales incentive programs in 2010 versus 2009. The sales returns and allowances decrease is principally due to the non-recurrence of higher first aid products related returns in 2009, partially offset by higher Canadian returns. The increase in cash discounts reflects higher U.S. sales subject to cash discount.

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Rebate Reserve Roll Forward

A six month roll forward of the trade rebate accruals at June 30, 2010 and 2009 is outlined below:

		Six Months Ended June 30,
		2010				2009
Beginning balance – January 1		$	2,493,232			$	2,660,086
Rebates paid			(4,011,565	)			(3,464,208	)
Rebates accrued			3,903,902				3,113,426
Ending balance – June 30		$	2,385,569			$	2,309,304

The $107,663 decrease in the trade rebate reserve balance for the six months ended June 30, 2010 reflects the decision of one significant U.S. private label customer to discontinue its rebate program effective November 1, 2009 and the subsequent payment of the outstanding balance due this customer in 2010, partially offset by an increase in the Canadian reserve due to higher sales. There has been no other discernable change in the nature of our business in 2010 as it relates to the accrual and subsequent payment of rebates.

Net Sales and Gross Margin

The following table highlights the June 30, 2010 versus 2009 product line net sales and gross profit:

		Six Months Ended June 30,								Variance
		2010				2009
Net Sales		$	26,074,487			$	21,995,232			$	4,079,255				18.6	%
Cost of sales			18,021,184				15,213,830				2,807,354				18.5	%
Gross Profit		$	8,053,303			$	6,781,402			$	1,271,901				18.8	%
Gross Profit %			30.9	%			30.8	%

Consolidated net sales increased $4,079,255, or 18.6% (15.0% adjusted for exchange), in 2010 versus 2009. Canadian net sales increased $2,160,238, or 43.6%, to $7,109,925 in 2010 from $4,949,687 in 2009. This increase was driven by favorable exchange of $783,369 associated with a 14.2% strengthening of the Canadian dollar, coupled with sales growth of $1,376,869. The sales growth reflects the impact of inventory rationalization on the part of our exclusive Canadian distributor of $1,406,566, partially offset by $29,697 attributable to lower demand. U.S. net sales increased $1,502,070, or 8.8%, to $18,547,615 in 2010 from $17,045,545 in 2009. The increase was principally driven by higher advanced wound care sales of $1,198,603, or 39.1%, and first aid product sales of $479,196, or 7.9%. The balance of U.S. sales consisting of traditional wound care, private label, specialty fixation, burn care and skin care and bathing sales were down 2.2% period to period. The higher advanced wound care sales reflect continued growth of our new products in response to expanded sales and marketing efforts. The increase in first aid products sales reflects new business and improving demand. Sales of $416,947 associated with our recently initiated international growth strategy also contributed.

Consolidated gross profit increased $1,271,901, or 18.8%, in 2010 versus 2009. The consolidated gross profit margin percentage increased slightly to 30.9% in 2010 from 30.8% in 2009. The change in gross profit dollars reflects the higher sales. While comparable period to period, the slight improvement in gross profit percentage reflects a favorable sales mix towards higher margined products, offset by increasing products costs and higher obsolescence and transportation expense.

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Selling, General and Administrative Expenses

The following table highlights June 30, 2010 versus 2009 selling, general and administrative expenses by type:

		Six Months Ended June 30,								Variance
		2010				2009
Distribution		$	905,437			$	887,474			$	17,963				2.0	%
Marketing			852,864				829,787				23,077				2.8	%
Sales			3,128,385				2,436,862				691,523				28.4	%
General and administrative			4,026,333				3,413,041				613,292				18.0	%
Total		$	8,913,019			$	7,567,164			$	1,345,855				17.8	%

Selling, general and administrative expenses increased $1,345,855, or 17.8% (15.2% adjusted for exchange), in 2010 versus 2009, including an increase of $197,455 in Canadian selling, general and administrative expenses attributable to exchange.

Distribution expense increased $17,963, or 2.0%, in 2010 versus 2009 due to exchange. Excluding exchange, distribution expenses decreased $408. This slight decrease reflects lower labor requirements in the Houston distribution center and lower utilities due to a warmer average temperature in 2010, partially offset by higher inflation related compensation and benefit, lease and operating expenses.

Marketing expense increased $23,077, or 2.8% (1.5% adjusted for exchange), in 2010 versus 2009, including an increase of $10,693 due to exchange. The increase is attributable to higher U.S., Canada and international promotion/literature and show spending in support of our growth initiatives, partially offset by lower sampling expense in Canada and product development related consulting expense in the U.S..

Sales expense increased $691,523, or 28.4% (26.3% adjusted for exchange), in 2010 versus 2009. Expenses in Canada increased $93,348 (including a $50,442 increase related to exchange) due to higher compensation and benefit costs, advanced wound care related consulting expenses, sales volume related group purchasing organization and travel expenses.  Expenses in the U. S. increased $396,378. This increase is attributable to incremental costs of approximately $342,000 consisting of compensation and benefits, travel and recruiting expenses associated with the expansion of the advanced wound care sales force from ten to twenty representatives that was completed in June 2010 and approximately $124,000 of first aid products severance expense associated with the termination of an executive in the first quarter 2010, partially offset by lower administrative related operating expenses. Also contributing were incremental international expenses of $201,797 consisting of compensation and benefits, travel, recruiting and sample expenses associated with the start up of our international growth initiative.

General and administrative expense increased $613,292, or 18.0% (14.5% adjusted for exchange), in 2010 versus 2009. Expenses in Canada increased $172,388 (including a $117,950 increase related to exchange). Net of exchange, expenses were up $54,438 driven principally by compensation and benefits associated with inflationary increases and one new position, coupled with higher travel and information technology expenses. Expenses in the U.S. increased $347,671. This increase reflects incremental amortization expense of $148,587 associated with the Worldwide Medihoney License Agreement signed in February 2010, higher planned investor relations expenses of $104,258 designed to increase investor awareness and improve our stock’s trading volume, bad debt expense of $67,354, together with slightly higher overall operating expenses.  Incremental international expenses of $93,233 consisting principally of transition related management, legal and travel expenses associated with the start up of our international growth initiative also contributed.

Research and Development Expense

Research and development expense increased $21,925 to $239,851 in 2010 from $217,926 in 2009. The increase principally reflects higher data management expense that started in the second half of 2009, less lower patent related legal expenses.

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Interest Expense

Interest expense decreased $116,471 to $294,599 in 2010 from $411,070 in 2009. The decrease is principally attributable to lower term and promissory note interest associated with the payoff of these loans in February 2010, lower loan related fees and lower deferred financing expense due to the write-off of a portion of the outstanding deferred financing balance in connection with the payoff of the term loan. These decreases were partially offset by higher line of credit interest principally attributable to higher interest rates.

Loss on Extinguishment of Debt

In connection with the payoff of our term loan in February 2010, we took a charge of $114,072 representing that portion of the unamortized deferred financing costs relating to the term loan.

Other Income

Other income increased $134,342 to $178,131 in 2010 from $43,789 in 2009. The main drivers for the net period to period increase was an exchange gain of $199,450 (2010 income of $162,910 versus a 2009 loss of $36,540), partially offset by the non-recurrence of approximately $60,000 of gains on miscellaneous asset sales principally associated with the closure of the first aid product manufacturing operation.

Income Taxes

We recorded a $137,652 foreign income tax provision for 2010 consisting of a $176,644 current foreign tax provision and a $38,992 deferred foreign tax benefit based on our Canadian subsidiary’s operating results. No tax benefit was recorded for our U.S. operations in 2010 or 2009 due to uncertainty surrounding our ability to use available net operating loss carry forwards and net deferred tax assets.  In 2009, we recorded a $52,388 foreign income tax benefit consisting of a $29,684 current tax benefit and a $22,704 deferred foreign tax benefit based on our Canadian subsidiary’s operating results.

Due to uncertainties surrounding our ability to use our U.S. net operating loss carry forwards and net deferred tax assets, a full valuation allowance for the U.S. net deferred tax assets has been provided.

Net Loss

We generated a net loss of $1,467,759, or $0.24 per share (basic and diluted), in 2010 compared to a net loss of $1,318,581, or $0.26 per share (basic and diluted), in 2009.

Liquidity and Capital Resources

Cash Flow and Working Capital

              At June 30, 2010 and December 31, 2009, we had cash and cash equivalents of $385,424 and $243,524, respectively. The $141,900 increase in cash reflects net cash provided by financing activities of $4,282,586, partially offset by cash used in investing activities of $2,389,236 and operating activities of $1,750,140, together with cash used as a result of exchange rate changes of $1,310.

Net cash used in operating activities of $1,750,140 stems from $642,460 cash provided from operations (net loss plus non-cash items), together with $2,392,600 cash used from the net change in operating assets and liabilities. The increase in cash provided from operations reflects the non-cash items, partially offset by the operating loss. Higher receivables and inventory, offset by accounts payable and accrued liabilities, were the main drivers behind the net cash used in connection with the change in operating assets and liabilities. The increase in receivables reflects a higher level of sales in June, addition of receivables related to the international business and the final payoff of rebates owed in connection with the discontinuation of a significant rebate program. The increase in inventory reflects a build up to support new products, addition of the international business and to improve customer service levels in certain segments of our business. The increase in accounts payable reflects an increase in payables related to inventory purchases, addition of the international business and higher overall spending levels. The increase in accrued expenses and other current liabilities principally reflects higher Canadian rebates due to higher sales, accrued foreign taxes payable and the recording of a severance accrual.

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Net cash used in investing activities of $2,389,236 reflects $2,250,000 cash used to purchase the worldwide Medihoney license rights and capital expenditures of $139,236.

Net cash used in financing activities of $4,282,586 reflects net proceeds of $4,491,279 from the sale of stock in connection with a secondary public offering completed in February and the exercise of stock options, removal of the restriction on the use of $2,032,164 in cash and $1,801,170 from an increase in the amount drawn against our line of credit. Offsetting these increases were $4,042,027 in debt payments consisting of regularly scheduled debt repayments, together with the full payment of the balances of our term loan and our promissory note.

Working capital increased $2,473,301 at June 30, 2010 to $9,264,882 from $6,791,581 at December 31, 2009. This increase principally reflects the cash infusion associated with the equity raise completed in February, a portion of the proceeds of which were used to pay off short term debt of $1,700,000, and the net balance of $461,619 that was used for general working capital purposes. Working capital of this magnitude is considered sufficient to support ongoing operations.

Based on current forecasts, there are no Medihoney sales related milestone payments anticipated in the next twelve months.

Financing Arrangements

With cash on hand of $385,424, together with available cash under our line of credit of $2,125,247, we had $2,510,671 of available liquidity at June 30, 2009, versus $2,342,579 at December 31, 2009.

On February 22, 2010, we raised $4,478,801 (net of commission and other offering expenses) from the sale in a secondary public offering of shares of our common stock. These proceeds, together with $2,032,818 of previously restricted cash, were used to acquire the worldwide Medihoney licensing rights for $2,250,000, pay off the outstanding U.S. term loan of $3,300,000 and pay off our $500,000 promissory note due April 14, 2010, leaving $461,619 of the net proceeds available for general working capital purposes. Payment of the foregoing indebtedness has had a positive impact on cash flow by eliminating associated debt service.

On March 26, 2010, our U.S. lender modified the terms of our five year revolving credit and security agreement to take into account the payment of the term loan.  The existing financial covenants were replaced with twelve month rolling fixed charge coverage and total debt coverage covenants. The lender also reduced the minimum 3 month LIBOR rate from 3.00% to 1.50% and authorized the payment of our $500,000 unsecured promissory note, which was paid on March 31, 2010. In addition, the minimum excess availability reserve was reduced from $1,500,000 to $1,000,000, thereby increasing our borrowing availability by $500,000 upon satisfactory completion of the lenders’ latest field exam in May 2010.

Prospective Assessment

Our strategic objective is to in-license, develop and launch novel higher margined advanced wound care products while utilizing our core business (to the extent possible) to fund this objective. In addition, we will continue to evaluate external opportunities to leverage our core capabilities for growth. To the extent we determine that we cannot finance our growth initiatives internally, we will evaluate the feasibility of doing so via the sale of equity.

The launch of a number of new products in recent years bodes well for the future growth of our higher-margined advanced wound care products both domestically and abroad. We continue to work on our pipeline and have identified several product line extensions for existing products and new products that are capable of contributing to future sales growth. We believe that the first aid products line continues to represent a solid growth opportunity. Sales for the balance of our product lines are expected to remain relatively stable.

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Our strategy for growth is:

 

1.

Assuming the existing resources in place are generating the expected return, we will continue to expand our investment in sales and marketing resources in support of our advanced wound care products in the U.S. Starting with ten sales representatives at the beginning of the year, we presently have twenty direct sales representatives in place.

2.

The first aid products business represents a growth opportunity. In addition to its core business opportunities, the first aid products business will serve as a platform for introducing our existing advanced and traditional wound care products to new customers and markets, especially the retail market. We continue to work on completion of a cost effective supply chain for first aid products. The supply chain is expected to be fully operational within the next six months, at which time we expect to be able to improve liquidity by reducing the level of inventory required to support the business.

3.

In February 2010, we licensed the worldwide rights to Medihoney. This will serve as the catalyst for the expansion of our international business. Plans are in place to establish a direct presence in Europe immediately and, ultimately, in other areas of the world employing a direct presence or distributor model as the basis for conducting business, as circumstances dictate.

 

4.

We made a significant investment in DSC 127 beginning in December 2007. While the launch of DSC 127 is several years away, we believe the market potential for this product is considerable. The product began Phase II trials in early 2008 to achieve proof of principle in a human model. The projected cost to complete the Phase II trial is approximately $1,750,000, including $1,292,735 incurred through June 2010. We plan to continue with this investment and anticipate spending approximately $457,265 to complete the Phase II trial.  We expect to announce top-line efficiency data by the end of the year and complete the study in the first quarter of 2011.

 

The results of the Phase II trial will determine the efficacy and safety of the product and further refine its market potential. The cost of the Phase III trial and bringing the product to market are expected to be significant. Should we decide to proceed with the DSC 127 development plan after completion of Phase II, we plan to fund the additional development costs via a joint venture, out of available cash flow or the sale of equity. Alternatively, we may determine to sublicense or sell the rights to the compound.

With the planned improvement in operations and expected working capital requirements, together with the available cash on hand and available borrowing capacity as of June 30, 2010, we anticipate having sufficient liquidity in place to meet our operating needs and debt covenants for the foreseeable future.

Our common stock is traded on the NASDAQ Capital Market under the symbol “DSCI.” We have paid no cash dividends in respect of our common stock and do not intend to pay cash dividends in the near future.

Additional Financial Information

Forward Looking Statements

Statements that are not historical facts, including statements about our confidence, strategies, expectations about new or existing products, technologies, opportunities, market demand or acceptance of new or existing products are forward-looking statements that involve risks and uncertainties.  These uncertainties include, but are not limited to, product demand and market acceptance risk, impact of competitive products and prices, product development, commercialization or technological delays or difficulties, and trade, legal, social, financial and economic risks.

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Critical Accounting Policies

Estimates and assumptions are required in the determination of sales deductions for trade rebates, sales incentives, discounts and allowances. Significant estimates and assumptions are also required in determining the appropriateness of amortization periods for identifiable intangible assets, the potential impairment of goodwill and the valuation of inventory. Some of these judgments can be subjective and complex and, consequently, actual results may differ from these estimates. For any individual estimate or assumption made by us, there may also be other reasonable estimates or assumptions. We believe, however, that given current facts and circumstances, it is unlikely that applying any such other reasonable judgment would cause a material adverse effect on the consolidated results of operations, financial position or cash flows for the periods presented. Our most critical accounting policies are described below.

Revenue Recognition and Adjustments to Revenue

We sell our products through our own direct sales force and through independent distributors and manufacturers’ representatives. The primary end users of our products are nursing homes, hospitals, clinics and home healthcare agencies. We recognize revenue from the sale of our products when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed and determinable, and collectability is reasonably assured, which is generally at the time of shipment or receipt by our customers, depending on the terms of the related sales or distribution agreement. When we recognize revenue from the sale of our products, we simultaneously adjust revenue for estimated trade rebates and distribution fees (in Canada), and estimates of returns and allowances, cash discounts and other sales incentives.

A trade rebate represents the difference between the invoice price to the wholesaler/distributor and the end user’s contract price. These rebates are estimated monthly based on historical experience, distributor rebate submission trends, estimated distributor inventory levels, and existing contract sales terms with our distributors and end users. We have a contract with our exclusive Canadian distributor and we pay a fixed fee based on sales subject to the fee (as defined) for distribution services in Canada. Because the services performed by the distributor cannot be separated from the purchase of our products by the distributor, we treat this distribution fee as a reduction of revenue. The distribution fee is accrued monthly based on net sales to the distributor multiplied by the ratio of recent historical distributor fee expense to net sales. The percentage of distributor fee expense to net sales is re-evaluated quarterly for reasonableness.

Sales incentives represent credits granted to specific customers based on attainment of pre-determined sales objectives. Sales incentives are accrued monthly in accordance with the terms of the underlying sales incentive agreement and actual customer sales. Sales incentive agreements are generally for a period of one year.

We provide our customers certain limited return rights and we have a formal returned goods policy that guides the disposition of returns with our customers. We accrue for sales returns and allowances and cash discounts monthly based on current sales and historical activity. We do not offer our customers price protection rights or concessions. Returns have historically represented less than 1% of gross sales.

We continually monitor the factors that influence rebates and fees, returns and allowances, and other discounts and sales incentives and make adjustments as necessary.

Goodwill

At June 30, 2010, we had $7,119,726 of goodwill consisting of $4,679,684 relating to the First Aid Products acquisition in November 2007 and $2,440,042 relating to the Western Medical acquisition in April 2006. We assess the impairment of goodwill annually in the fourth quarter or whenever events or changes in circumstances indicate that the carrying value of goodwill may not be recoverable. The assessment is performed using the two-step process required by FASB accounting guidance relating to goodwill. The first step is a review for potential impairment, while the second step measures the amount of the impairment, if any. The first step of the goodwill impairment test compares the fair value of a reporting unit with its carrying amount, including goodwill. For 2009 and 2008, the first step of our goodwill impairment test reflected a fair value in excess of the carrying value of our reporting units. Accordingly, we did not perform the second step of this test during these periods.

The cash generating unit level or reporting unit at which we test goodwill for impairment is the operating segment level as that term is used in FASB accounting guidance relating to segment reporting. We have three operating segments: wound care, wound closure – specialty securement devices and skin care. Products are allocated to each segment based on the nature and intended use of the product. All of our goodwill has been allocated to the wound care segment as the business acquisitions which gave rise to the goodwill were wound care businesses.

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For 2009 and 2008 and consistent with prior periods, we estimated the fair value of our wound care segment using the “income approach” where we use a discounted cash flow model (“DCF”) in preparing our goodwill impairment assessment.  This approach calculates fair value by estimating the after-tax cash flows attributable to a reporting unit and then discounting these after-tax cash flows to a present value using a risk-adjusted discount rate.  We selected this method as being the most meaningful in preparing our goodwill assessments because we believe the income approach most appropriately measures our income producing assets.

Significant estimates used in the fair value calculation include: (i) estimates of future revenue and expense growth, (ii) future estimated effective tax rates, (iii) future estimated capital expenditures, (iv) future required investments in working capital, (v) average cost of capital, and (vi) the terminal value of the reporting unit.

The amount and timing of future cash flows within our DCF analysis is based on our five year forecast.   Beyond our five year forecast we assumed a terminal value to calculate the value of cash flows beyond the last projected period in our DCF analysis.  Annual revenue growth rates in our DCF model reflect expected growth in our advanced wound care products as well as growth in the products which we gained access to when we acquired First Aid Products in November of 2007 as we introduce these products across our existing customer base.  The weighted average cost of capital used to discount cash flows for the annual 2009 goodwill impairment test was estimated to be 17%.

Over time, our wound care segment has become an increasingly significant portion of our overall business. For the year ended December 31, 2009, our wound care segment accounted for approximately 95% of our consolidated revenue. Given the significance of this segment to our overall results, we also look to our publicly traded market value, which we may adjust in consideration of an appropriate control premium, as an indicator of the fair value of our wound care segment and the reasonableness of our DCF model.

There have been no substantial changes to the methodology employed, significant assumptions or calculations applied in the first step of the goodwill impairment test over the past several years.

Inventory

We write down the value of inventory by the estimate of the difference between the cost of the inventory and its net realizable value.  The estimate takes into account projected sales of the inventory on hand and the age of the inventory in stock.  If actual future demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required.  The provision for the write-down of inventory is recorded in cost of sales.

Stock-Based Compensation

We record compensation expense associated with stock options and other equity-based compensation based on their fair value at the grant date and recognized over the requisite service periods.  We estimate the fair value of stock options as of the date of grant using the Black-Scholes for service and performance based awards or binomial/lattice pricing model for market based awards and restricted stock based on the quoted market price.  Significant judgment and the use of estimates to value the equity-based compensation, particularly surrounding Black-Scholes or binomial/lattice pricing model assumptions such as stock price volatility and expected option lives, as well as expected option forfeiture rates, are made by the Company.

 

 

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