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BUSINESS OVERVIEW

Forward Looking Statements

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by those sections. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to our management. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “goal,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “project,” “predict,” “potential” and similar expressions intended to identify forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance, time frames or achievements to be materially different from any future results, performance, time frames or achievements expressed or implied by the forward-looking statements. We discuss many of these risks, uncertainties and other factors in this Annual Report on Form 10-K in greater detail in Part I, Section 1A “Risk Factors.” Given these risks, uncertainties and other factors, you should not place undue reliance on these forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this filing. You should read this Annual Report on Form 10-K completely and with the understanding that our actual future results may be materially different from what we expect. We hereby qualify our forward-looking statements by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

Overview

Silicon Storage Technology, Inc. (SST, us or we) is a leading supplier of NOR flash memory semiconductor devices for the digital consumer, networking, wireless communications and Internet computing markets. We also produce and sell other semiconductor products including NAND flash controllers and NAND Controller-based modules; smart card integrated circuits, or ICs, and modules; flash microcontrollers; and radio frequency ICs and modules.

NOR flash memory is a form of nonvolatile memory that allows electronic systems to retain information when the system is turned off. NOR flash memory is used in hundreds of millions of consumer electronics and computing products annually.

We produce and sell many products based on our SuperFlash design and manufacturing process technology. Our products are incorporated into products sold by many well-known companies including Apple, Asustek, BenQ, Cisco, Dell, First International Computer, or FIC, Gigabyte, Haier, Huawei, Infineon, Intel, IBM, Inventec, Legend Lenovo, LG Electronics, Freescale Semiconductor, NEC, Nintendo, Panasonic, Philips, Quanta, Samsung, Sanyo, Seagate, Sony, Sony Ericsson, Toshiba, Texas Instruments, VTech and ZTE.

We license our SuperFlash technology for applications in semiconductor devices that integrate flash memory with other functions on a monolithic chip to leading semiconductor companies including X-Fab, Analog Devices, IBM, Freescale Semiconductor, Inc., National Semiconductor Corporation, NEC Corporation, Samsung Electronics Co. Ltd., Sanyo Electric Co., Ltd., or Sanyo, Seiko Epson Corporation, Shanghai Grace Semiconductor Manufacturing Corporation, or Grace, Shanghai Hua Hong NEC Electronics Co., Ltd., or HHNEC, Taiwan Semiconductor Manufacturing Co., Ltd., or TSMC, Toshiba Corporation, Vanguard International Semiconductor Corporation, Powerchip Semiconductor Corporation and Winbond Electronics Corporation.

We have installed our semiconductor manufacturing processes at several leading wafer foundries and semiconductor manufacturers including Advanced Wireless Semiconductor, Grace, Samsung Electronics Co., Ltd., Seiko Epson Corporation, HHNEC and TSMC. These companies produce semiconductor wafers for us that contain our intellectual property and technology. These wafers are electrically tested and then subdivided into many small rectangular chips, or die. We work with leading semiconductor assembly and test companies to finish our products by encapsulating them in a package and testing them. We are working with Grace, Powerchip Semiconductor Corporation and TSMC, among others, to develop new technology for manufacturing our products.

The semiconductor industry has historically been cyclical, characterized by periodic changes in business conditions caused by product supply and demand imbalance. When the industry experiences downturns, they often occur in connection with, or in anticipation of, maturing product cycles and declines in general economic conditions. These downturns are characterized by weak product demand, excessive inventory and accelerated decline of selling prices. The average selling price of our products remained relatively stable in 2006, 2007 and the first half of 2008. However, in the fourth quarter of 2008, in conjunction with the rapid slowdown in the global economy, we experienced a significant weakening in demand for our products. During this downturn, further deterioration of demand and decline in average selling prices is likely, and we cannot predict the extent or duration of the downturn. Our business could be further harmed by industry-wide prolonged downturns in the future.

The consumer electronics manufacturing industry is concentrated in Asia. We manufacture virtually all of our products in Asia and we sell most of our products in Asia. We derived 87.7%, 88.8% and 87.3% of our net product revenues during 2006, 2007 and 2008, respectively, from product shipments to Asia.

Flash Memory Industry Background

Semiconductor integrated circuits are critical components used in an increasingly wide variety of applications, such as computers and computer systems, communications equipment, consumer products and industrial automation and control systems. As integrated circuit performance has improved and physical size and costs have decreased, the use of semiconductors in many applications has grown significantly.

Historically, the demand for semiconductors has been driven by the personal computer, or PC market. In recent years, growth in demand for semiconductors relating to PCs has been outpaced by growth in demand for semiconductors that are used in digital electronic devices for communication and consumer applications. Communications applications include digital subscriber line modems, cable modems, networking equipment, wireless local area network, or WLAN, devices, cellular phones and Global Positioning Systems, or GPS. Consumer oriented digital electronic devices include digital cameras and camcorders, DVD and Blu-Ray players, MP3 players, personal media players, or PMPs, set-top boxes, digital TVs and video games.

Emphasizing the development of non-commodity memory products to enhance growth. We offer a selection of our products in wafer and die form. This allows our customers to develop multi-chip module products for extremely small form factor products such as Bluetooth modules for headset and GPS modules for cell phone applications. We also provide multi-chip module products that incorporate die from other semiconductor manufacturers. We intend to continue to develop new products and leverage our supply chain to take advantage of the significant growth opportunities in the wireless applications market with specific focus on cellular phone, GPS, WLAN and Bluetooth applications.

Continuing to expand our embedded flash licensing business . We believe that our proprietary SuperFlash technology is well-suited for both embedded memory applications and the licensing business model. Many electronic system manufacturers have incorporated our technology into the semiconductor devices that are at the heart of their products. To date, approximately thirteen billion devices incorporating SuperFlash technology have been shipped accumulatively by us or our licensees. We plan to expand our licensing of SuperFlash technology to additional and existing licensees at ever finer technology nodes for embedded flash applications to enhance the value of our technology to electronic system manufacturers. We also plan to add other product applications, thereby expanding our licensing business by first developing an application for our direct product sales model and then offering it to our licensees under our licensing model as we did with flash memory products for the smart card industry.

Leveraging our technology, sales channel and supply chain to become a premier provider of NAND Controller-based modules and radio frequency IC products. Many electronic products in the digital consumer, networking, wireless communications and Internet computing markets incorporate our flash memory products. We are expanding our product line beyond NOR flash to include additional devices that these manufacturers need for their products. We provide radio frequency power amplifier and front-end module products for wireless applications such as cellular phones, WLAN, WiMAX, and notebook and netbook PCs.

We are expanding our product offerings to include NAND Controllers and highly integrated NAND Controller-based modules that we believe give electronic systems manufacturers superior flexibility in the design and manufacture of their products. Many digital electronic devices currently being introduced, such as Smartphones, personal media players, and digital cameras and camcorders, require high-density NAND flash memory for storing music, pictures and other data that require large data storage capacities in addition to the NOR memory required to operate the system’s controller. We believe that the application market for high-density NAND flash memory is attractive based on its potential size and growth. Because of the inherent defects in NAND flash, the NAND Controller component plays a critical role in managing the NAND flash defects and ensuring product reliability and performance. We have more than 18 years of experience in NAND Controller design, which will enable us to create innovative NAND Controller-based modules that meet manufacturers’ demands for quality, reliability and performance. We believe demand for high-density code storage applications may be better addressed by an integrated system solution than by pure high-density NOR memory.

Operating Strategy

In 2004 we began a diversification strategy to invest in: the development of smaller and thinner package technology for portable applications, the development of smaller manufacturing geometries to reduce costs, the development of lower voltage technology for battery applications, the development of new fab relationships to provide additional capacity, and the development of non-memory products to expand our revenue base. As part of this strategy, we have incurred higher operating costs with the goal of increasing revenues and gross profit. During 2008, we began to re-evaluate our level of investment in these objectives and to focus our efforts toward making our diversification program more effective. To that end, and in response to the developing worldwide economic recession, we decided to restructure our operations in the fourth quarter of 2008, including a significant reduction in headcount and operating expenses as well as the realignment of our development priorities. This refined strategy continues the essential elements of diversification by focusing on a reduced number of projects in the areas of non-commodity NOR products, NAND Controllers and modules and radio frequency products which are synergistic with our memory markets. We believe this focus on a smaller set of projects, along with the reduction in operating expenses, will ultimately make our company more profitable and enhance shareholder value.

Most of our competitors are larger in size, and have greater financial resources available for development of fabrication and assembly facilities. While this model can allow quicker time-to-market and lower variable costs, it can reduce flexibility and ability to adapt to changes in market conditions. While our fabless model does not require us to assume debt, in order to remain competitive we have to continue to innovate. Our strategic investment program focuses on partners who are making large capital investments across a range of markets, in addition to the flash memory market. In this way we can effectively share costs with other investors in the strategic partner, often receiving exclusive use of their technology for the flash memory market. Although we cannot directly control our partners’ development processes and the allocation of their facilities’ capacity, we can adapt more easily to economic downturns in order to minimize adverse impact to our business. We have utilized this investment strategy in other areas such as software and systems development, logistic facilities, distributors and marketing representatives. We continually review both the strategic and financial returns on these investments and we may decide to sell any investment at any time. In addition, certain factors may require us to review the value of these investments and we may be required to record impairments to the carrying value of these investments.

Our Products

Currently, we offer low- to medium-density NOR flash devices (256 Kbit to 64 Mbit) and other products that target a broad range of existing and emerging applications in the digital consumer, networking, wireless communications and Internet computing markets. Our products are segmented largely based upon attributes such as density, voltage, access speed, package and target application. We divide our products into two reportable segments: Memory Products and Non-Memory Products.

Our Memory Product segment, which is comprised of NOR flash memory products, includes the Multi Purpose Flash, or MPF, family, the Multi Purpose Flash Plus, or MPF+ family, the Advanced Multi-Purpose Flash Plus, or Advanced MPF+ family, the Concurrent SuperFlash, or CSF family, the Firmware Hub, or FWH family, the SPI serial flash family, the Serial Quad Interface, or SQI, flash family, the ComboMemory family, the Many-Time Programmable, or MTP, family, and the Small Sector Flash, or SSF, family.

Our Non-Memory Product segment includes other semiconductor products including NAND Controllers and NAND Controller-based modules, flash microcontrollers, smart card ICs and modules, and radio frequency ICs and modules.

Technology Licensing

We license our SuperFlash technology to semiconductor manufacturers for use in embedded flash applications. We intend to increase our market share by entering into additional license agreements for our SuperFlash process and memory cell technology with leading wafer foundries and semiconductor manufacturers. We expect to continue to receive licensing fees and royalties from these agreements. We design our products using our patented memory cell technology and fabricate them using our patented process technology. As of December 31, 2008, we held 261 patents in the United States relating to certain aspects of our products and processes, with expiration dates ranging from 2010 to 2028 and have filed for several more. In addition, we hold several patents in Europe, Japan, Korea, Taiwan and China.

Customers

We provide high-performance flash memory solutions and other products to customers in four major markets: digital consumer, networking, wireless communications and Internet computing. Our customers benefit by obtaining products that we believe are highly reliable, technologically advanced and have attractive cost structures. As a result of these highly desirable benefits, we have developed relationships with many of the industry’s leading companies.

In digital consumer products, we provide products for consumer electronics companies including LG, Hon Hai, Micronas, Apple, Samsung, Lite-On, NEC, Funai, Sony, Orion, BenQ, Sigma Design, ALCO, Inventec, Pioneer, Nintendo, BBK, Toshiba, JVC, Mattel, Panasonic (Matsushita), Sanyo, Konka, Canon, Hisense, Creative, Daewoo, Thomson, Sharp, Reigncom, Olympus, TiVO, and Haier.

In networking, we provide products for Broadcom, Atheros, Conexant, Alpha Networks, Gemtek, Gongjin, Hon Hai, Edimax, Avocent, TP-Link, ZTE, Senao, Cameo Communications, Sagem Orga, Adtran, Askey, Intel, Asustek, Global Sun, Thomson, Huawei, TCL, Comtrend, Buffalo, Tecom, Mitsumi, Arris, Cybertan and Samsung.

In wireless communications, we provide products for companies including Syscom, Samsung, Crestfounder, USI, GN Netcom, Sagem Orga, Alps, Gemalto, ZTE, Hon Hai, Cambridge Silicon Radio, Watchdata System, Pansun Infotech, Haier, CCT, Wuhan Tienyu Information Industry, Magnificent Mile, Taiyo Yuden, Mitsumi, Ningbo Bird, Logitech, VTech,and Garmin.

In Internet computing, we provide a wide array of products for companies including Asustek, Seagate, Western Digital, TPV Technology, Hon Hai, Quanta, Intel, Giga-Byte, Quanta, ECS, Inventec, Titanic, Lenovo, Matsushita, Sharp, Fujitsu-Siemens, Wistron, Mitac, Microstar, Fujitsu, Epson, Buffalo, Samsung, Brother, USI, Canon, Lite-On, NEC, IBM and Toshiba.

Sales and Distribution

We sell a majority of our products to customers in Asia through our representatives and we distribute a majority of our products through our logistics center. We also sell and distribute our products in North America and Europe through manufacturers’ representatives and distributors. Our manufacturer representative and distributor relationships are generally cancelable, with reasonable notice, by either party.

Backlog

Our product sales are made primarily using short-term cancelable purchase orders. The quantities actually purchased by the customer, as well as shipment schedules, are frequently revised to reflect changes in the customer’s needs and in our supply of products. Accordingly, the dollar amount associated with our backlog of open purchase orders at any given time is not a meaningful indicator of future sales. Changes in the amount of our backlog do not necessarily reflect a corresponding change in the level of actual or potential sales.

Manufacturing

We purchase wafers and sorted die from semiconductor manufacturing foundries, have these products shipped directly to subcontractors for packaging, testing, and finishing, and then ship the final product to our customers. Virtually all of our subcontractors are located in Asia.

Wafer and Sorted Die. During 2008, our major wafer fabrication foundries were TSMC, Grace, HHNEC and Seiko-Epson. In 2008, wafer sort, which is the process of testing individual die on silicon wafer, was performed at King Yuan Electronics Company, Limited, or KYE, Lingsen, HHNEC, Sanyo, Seiko-Epson and TSMC. In order to obtain, on an ongoing basis, an adequate supply of wafers, we have considered and will continue to consider various possible options, including equity investments in foundries in exchange for secure production volumes, the formation of joint ventures to own and operate foundries and the licensing of our proprietary technology. We hold an equity investment in GSMC, a Cayman Islands company. Grace is GSMC’s wafer foundry subsidiary and is located in Shanghai, People’s Republic of China.

Packaging, Testing and Finishing. In the assembly process, the individual dies are separated and assembled into packages. Following assembly, the packaged devices require testing and finishing to segregate conforming from nonconforming devices and to identify devices by performance levels. Currently, all devices are tested and inspected pursuant to our quality assurance program at our international subcontracted test facilities before shipment to customers. Certain facilities currently perform consolidated assembly, packaging, test and finishing operations all at the same location. During 2008, most subcontracted facilities performing the substantial majority of our operations were in Taiwan. The subcontractors with the largest amount of our activity were KYE, Lingsen, and Powertech Technology, Incorporated, or PTI. We hold equity investments in three subcontractors: Apacer Technology, Inc., or Apacer, KYE and PTI.

Research and Development

We believe that our future success will depend in part on the development of next generation technologies with reduced feature size. During 2006, 2007 and 2008, we spent $52.0 million, $56.7 million and $59.0 million, respectively, on research and development. Our research efforts are focused on process development and product development. Our research strategy is to collaborate with our partners to advance our technologies. We work simultaneously with several partners on the development of multiple generations of technologies. In addition, we allocate our resources and personnel into category-specific teams to focus on new product development. From time to time we invest in, jointly develop with, and license or acquire technology from other companies in the course of developing products.

Competition

The semiconductor industry is intensely competitive and has been characterized by price erosion, rapid technological change and product obsolescence. We compete with major domestic and international semiconductor companies, many of whom have substantially greater financial, technical, marketing, distribution, manufacturing and other resources than us. Our low-density memory products, sales of which presently account for the majority of our product revenues, compete against products offered by Macronix, PMC, EON and Winbond. Our medium-density memory products compete with products offered by Spansion, Macronix, Winbond, Samsung and Numonyx. If we are successful in developing our high-density products, these products will compete principally with products offered by Spansion, Numonyx and Samsung, as well as any new companies who may enter the market. On March 1, 2009 Spansion filed for protection under Chapter 11 of the federal bankruptcy code. Spansion could operate under Chapter 11 protection for an extended period and could improve its competitive position while under such protection. In addition, competition may come from alternative technologies such as phase change memory technology.

The competition in the existing markets for some of our other product families, such as the FlashFlex microcontroller product family, is extremely intense. We compete principally with major companies such as Atmel, Microchip Technology, Freescale Semiconductor, Inc., Philips and Winbond in the microcontroller market. We may, in the future, also experience direct competition from our foundry partners. We have licensed to our foundry partners the rights to fabricate certain products based on our proprietary technology and circuit design, and to sell such products worldwide, subject to royalty payments back to us. Our smart card products compete with Masked ROM and flash or EEPROM offerings primarily from Infineon, Renesas, Samsung and STMicroelectronics. For radio frequency IC products, the competition in the existing markets is also extremely intense. Our radio frequency IC products compete primarily with Microsemi, RF Micro Devices, Richwave and ANADIGICS, especially in the WLAN markets. For our NAND Controller and NAND Controller-based module products, we compete primarily with Intel, Phison, Samsung, SanDisk, STEC and Toshiba.

We compete principally on price, reliability, functionality and the ability to offer timely delivery to customers. While we believe that our low-density memory products currently compete favorably on the basis of cost, reliability and functionality, it is important to note that some of our principal competitors have a significant advantage over us in terms of greater financial, technical and marketing resources. Our long-term ability to compete successfully in the evolving flash memory market will depend on factors both within and beyond our control, including access to advanced process technologies at competitive prices, successful and timely product development, wafer supply, product pricing, actions of our competitors and general economic conditions.

Employees

As of December 31, 2008, we employed 614 individuals on a full-time basis, 282 of whom reside in the United States. Of these 614 employees, 92 were employed in manufacturing support, 286 in engineering, 112 in sales and marketing and 124 in administration, finance and information technology. Our employees are not represented by a collective bargaining agreement, nor have we ever experienced any work stoppage related to strike activity. We believe that our relationship with our employees is good.


Bing Yeh , one of our co-founders, has served as our President and Chief Executive Officer and has been a member of our board of directors since our inception in 1989. Prior to that, Mr. Yeh served as a senior research and development manager of Xicor, Inc., a nonvolatile memory semiconductor company. From 1981 to 1984, Mr. Yeh held program manager and other positions at Honeywell Inc. From 1979 to 1981, Mr. Yeh was a senior development engineer of EEPROM technology of Intel Corporation. He was a Ph.D. candidate in Applied Physics and earned an Engineer Degree in Electrical Engineering at Stanford University. Mr. Yeh holds a M.S. and a B.S. in Physics from National Taiwan University.

Yaw Wen Hu, Ph.D., joined us in July 1993 as Vice President, Technology Development. In 1997, he was given the additional responsibility of wafer manufacturing and, in August 1999, he became Vice President, Operations and Process Development. In January 2000, he was promoted to Senior Vice President, Operations and Process Development. In April 2004, he was promoted to Executive Vice President and Chief Operating Officer. Dr. Hu has been a member of our board of directors since September 1995. From 1990 to 1993, Dr. Hu served as deputy general manager of technology development of Vitelic Taiwan Corporation. From 1988 to 1990, he served as FAB engineering manager of Integrated Device Technology, Inc. From 1985 to 1988, he was the director of technology development at Vitelic Corporation. From 1978 to 1985, he worked as a senior development engineer in Intel Corporation’s Technology Development Group. Dr. Hu holds a B.S. in Physics from National Taiwan University and a M.S. in Computer Engineering and a Ph.D. in Applied Physics from Stanford University.

Derek J. Best joined us in June 1997 as Vice President of Sales and Marketing. In June 2000 he was promoted to Senior Vice President, Sales & Marketing. Prior to joining SST he worked for Micromodule Systems, a manufacturer of high-density interconnect technology, as vice president marketing and sales world wide from 1992 to 1996. From 1987 to 1992 he was a co-founder and owner of Mosaic Semiconductor, a SRAM and module semiconductor company. Mr. Best holds an Electrical Engineering degree from Portsmouth University in England.

Chen Tsai joined us in August 1996 as Senior Manager, Yield Enhancement and became Director, Product and Test Engineering the same year. In 1999, he became Director of Worldwide Backend Operations and in 2000 he was promoted to Vice President of Worldwide Backend Operations. In October 2004, Mr. Tsai was appointed Senior Vice President of Worldwide Backend Operations. From 1992 to 1996, Mr. Tsai was Manager of Process Development at Atmel Corporation, a manufacturer of semiconductors, where he was also a staff engineer of E2PROM from 1989 to 1992. From 1988 to 1989, he was vice president of technology at Tristar Technology, Inc., a wireless systems company. From 1980 to 1988 he held various positions at Xicor, Inc. and Teledyne Semiconductor. Mr. Tsai holds a B.S. in Physics from Show Chu University and a M.S. in both Physics and Electrical Engineering from Florida Institute of Technology.

Paul S. Lui joined us as Vice President and General Manager of the Linvex Product Line in June 1999 and became Vice President, Special Product Group in June 2001. In May 2006, he was promoted to Senior Vice President, Standard and Special Product Group. From 1994 to 1999, he was the president and founder of Linvex Technology Corporation. From 1987 to 1994, he was the president and chief executive officer of Macronix, Inc. From 1981 to 1985, he served as group general manager at VLSI Technology, Inc. where he was responsible for transferring that company’s technology to Korea. In addition, Mr. Lui has held senior engineering positions at the Synertek Division of Honeywell and McDonnell Douglas. Mr. Lui holds an M.S.E.E. degree from University of California, Berkeley and a B.S. in Electrical Engineering and Mathematics from California Polytechnic State University, San Luis Obispo.

James B. Boyd joined us as Chief Financial Officer and Senior Vice President, Finance in June 2007. From 2000 to 2007, Mr. Boyd served as chief financial officer for ESS Technology, a manufacturer of DVD and image sensor chips, where he was responsible for all financial and legal functions. Prior to that, he was chief financial officer for Gatefield Corp., a manufacturer of nonvolatile reprogrammable FPGAs. Mr. Boyd has also held finance positions at companies ranging in size from Fortune 100 firms to start-ups. Mr. Boyd holds a B.S. and an M.B.A from the University of Wisconsin and a J.D. from Golden Gate University School of Law.

Available Information

We were incorporated in California in 1989. Additional information is available free of charge electronically through our Internet website, www.sst.com. This information includes our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and, if applicable, amendments to those reports filed or furnished pursuant to Section 13(a) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Additionally, these filings may be obtained by visiting the Public Reference Room of the SEC at 100 F Street, NE, Washington, DC 20549 or by calling the SEC at 1-800-SEC-0330, by sending an electronic message to the SEC at publicinfo@sec.gov or by sending a fax to the SEC at 1-202-777-1027. In addition, the SEC maintains a website (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically.

CEO BACKGROUND

Name Age

Position
Bing Yeh 58 Chairman, President and Chief Executive Officer
Yaw Wen Hu 59 Executive Vice President and Chief Operating Officer

Ronald Chwang 61 Director

Terry M. Nickerson 69 Director
Bryant R. Riley 42 Director

Edward Yao-Wu Yang 59 Director

MANAGEMENT DISCUSSION FROM LATEST 10K

Overview

We are a leading supplier of NOR flash memory semiconductor devices for the digital consumer, networking, wireless communications and Internet computing markets. NOR flash memory is a form of nonvolatile memory that allows electronic systems to retain information when the system is turned off. NOR flash memory is now used in hundreds of millions of consumer electronics and computing products annually.

We produce and sell many products based on our SuperFlash design and manufacturing process technology. Our products are incorporated into products sold by many well-known companies including Apple, Asustek, BenQ, Cisco, Dell, First International Computer, Gigabyte, Haier, Huawei, Infineon, Intel, IBM, Inventec, Legend, Lenovo, LG Electronics, Freescale Semiconductor, NEC, Nintendo, Panasonic, Philips, Quanta, Samsung, Sanyo, Seagate, Sony, Sony Ericsson, Toshiba, Texas Instruments, VTech and ZTE.

We also produce and sell other semiconductor products including flash microcontrollers, smart card ICs and modules, radio frequency ICs and modules, NAND Controllers and NAND Controller-based modules.

One of our goals is diversification through the active development of our non-memory business. Our objective is to transform SST from a pure play in flash memory to a multi-product line semiconductor company and a leading licensor of embedded flash technology. We continue to execute on our plan to derive a significant portion of our revenue from non-memory products, which includes flash microcontrollers, NAND Controller-based modules, smart card ICs and radio frequency ICs and modules. We believe non-memory products represent an area in which we have significant competitive advantages and also an area that, in the long run, can yield profitable revenue with higher and more stable gross margins than our memory products. We may also explore strategic alternatives such as acquisitions or investments in other businesses.

Our product strategy is two fold: to continue to develop and grow our core NOR flash memory and embedded flash technology licensing business, while diversifying our business by expanding into new markets and pursuing growth opportunities through the development of new NAND Controller-based module and radio frequency IC products. In the NOR flash market, our goals are to be the leading worldwide supplier of low-density NOR flash memory devices and to maintain our position as the world’s number one embedded flash licensor by growing both upfront fees and per unit royalties. In our new business markets, our objectives are to leverage our core competencies in NAND Controller design into systems solutions as adoption of solid state memory technology grows, and to leverage our radio frequency wireless technology and systems expertise as development continues on a multitude of electronic devices which are enabled for wireless communication.

The Board of Directors has appointed a Strategic Committee to review our investments and to investigate strategic alternatives, including acquisitions and divestitures. The Strategic Committee is working closely with management and an outside consultant to evaluate our operations and products, and identify potential new business opportunities. This evaluation involves all aspects of our business in order to drive value for our shareholders and position SST for future growth.

Market Conditions and Global Reorganization

The unprecedented sudden decrease in demand for semiconductor products during the fourth quarter of 2008, resulting from the deepening global financial crisis, has caused a significant decline in our revenues. This decline in demand is evident in our results, with revenue from nearly all application segments down significantly in the fourth quarter of 2008, as compared with the third quarter. The digital consumer segment saw especially sharp declines, with fourth quarter 2008 revenues decreasing more than 50% from the third quarter. This persistent difficult economic environment necessitated that we accelerate certain planned changes to our business and focus. We took important steps to reduce our inventory, streamline our organizational structure and reduce our expenses by focusing our efforts on our most strategic initiatives.

In December 2008, we announced the implementation of a global reorganization designed to reflect changes in anticipated demand for our products. This action was taken to reduce costs of operations, realign our development priorities, and to improve our focus on accelerating time-to-market of select new products. This refined strategy continues the essential elements of diversification by focusing on a reduced number of projects in the areas of non-commodity NOR products, NAND Controllers and modules and radio frequency products which are synergistic with our memory markets. We believe this focus on a smaller set of projects, along with the reduction in operating expenses, will ultimately make our company more profitable and enhance shareholder value. The reorganization included a reduction in overall headcount of approximately 120, or 17 percent of our global workforce, most of which was completed by the end of 2008. We incurred a restructuring charge of $2.5 million in the fourth quarter of 2008, all of which is related to severance costs associated with the workforce reduction, and we expect to incur an additional restructuring charge of approximately $0.4 million in the first quarter of 2009. The workforce reduction and other restructuring actions took place worldwide and in all functional areas of the company, and are expected to reduce payroll-related expenses by approximately $13 million in 2009.

2008 in Review

Over the past 19 years, we have established ourselves as an industry leader with our superior SuperFlash technology, deep customer relationships and a talented team of employees dedicated to a common goal of excellence. Several years ago, with the recognition that our core memory business will continue to experience average selling price pressure that would limit our revenue growth potential, we began a diversification plan of investing in products and technologies that are expected to yield average selling prices, or ASPs, that are higher than our current memory products. We believe that a strategy of diversification will allow for better growth opportunities and higher return for our shareholders. We have invested internally and externally on new technologies designed to enhance our competitive position, and have received strong initial market response to many of our initiatives. In the fourth quarter of 2008, our non-memory products contributed 19% of overall product revenue and 45% of product gross profit.

Through our recent focus on executing this diversification strategy, we have achieved important milestones on several new products and technologies, including:


•

NANDrive, a high-performance, small form-factor solid state drive. Our NANDrive products contain an integrated ATA Controller and NAND memory in a multichip package and are used as a basic building block for storage in a wide variety of applications. During 2008, we expanded our NANDrive family of products with the addition of 512 MByte, 1 GByte, 2 GByte and 4 GByte products, capable of operating at industrial temperature ranges, making them compelling storage options in harsh environments including medical equipment, factory automation and automotive electronics. Since introduction, our customer base for the NANDrive family has continued to grow, with early success coming from applications such as IP set top boxes, mobile Internet devices and industrial applications. In 2008, we saw the first meaningful revenue from our NANDrive devices, with total shipments in excess of 600,000 units, and we continue to work on many design-in opportunities. As we ramp up production at this early stage of product cycle, we expect to see significant fluctuations both in quarterly revenue and unit shipments.

•

Radio Frequency power amplifiers. Using advanced technologies, these devices feature a highly-efficient, low-power, small-footprint design that supports 802.11 wireless standard. We are beginning to see traction in the adoption of our radio frequency ICs and modules, targeted at a wide range of wireless and multimedia applications, including cell phones. We shipped nearly 40 million units in 2008 and expect continued growth in 2009.

Due to the complexity of these new product families, the design-in and qualification cycle is expected to be long, and we further expect our near term results to be significantly impacted by the challenging overall economic environment.

Despite the current economic and competitive challenges, we continued to develop our core flash memory business and we believe we are well positioned in our memory product business as well as our as well as our complementary technology licensing business. As an increasing number of electronic products have been designed around microprocessors and microcontrollers, virtually all of these products incorporate some low-density NOR flash memory for code storage. In many cases, the code size for each product is also increasing as consumers demand more features and functionality. Further, as the definition of low-density continues to expand into 16, 32 and 64 Mbit densities, we believe this creates an opportunity for us and gives strong evidence that our core business will benefit from market growth in the future. We address this market with feature-rich, cost-effective products which allow us to support a very broad range of applications. For applications requiring smaller memory, we offer embedded SuperFlash technology through licensing agreements.

Our investment in producing innovative solutions continues to build on the success of our memory business, and during 2008 we announced three developments in NOR flash memory products. First, we announced the 26 Series Serial Quad I/O (SQI) family of 4-bit multiplexed I/O serial interface flash memory devices. The 26 Series’ high data rate, combined with low pin count and enhanced serial interface architecture, provide an ideal code storage solution for applications such as ultra low-cost handsets, Bluetooth headsets, optical disk drives and GPS devices. The second was a new addition to our 1.8V SPI serial flash product family; a 4 Mbit, small form factor product which is ideal for battery-powered, space-constrained mobile applications. Third, we announced a collaboration with Freescale Semiconductor, in which our SPI serial flash devices enable Freescale’s latest products to deliver dramatically enhanced battery life. Also, in the area of memory technologies, we are continuing to reduce manufacturing costs through the transition to more advanced process technologies that generally carry a lower cost per die. During 2008 we successfully brought up our 120nm technology at both Grace and PowerChip; foundries which we expect to produce a majority of our products in 2009. Five products have been released to production from these lines and four more are under verification and qualification. These products include the 16, 32 and 64 Mbit parallel and serial family of products, which we believe will provide the proper cost structure to remain competitive in the broader commodity memory market.

Outlook

We have experienced a rapid deterioration in our booking activities since September 2008, as our customers delayed their purchase orders in response to the sudden slowdown in consumer demand. Booking activities remained weak through the fourth quarter of 2008 and early 2009. Our customers continue to report a lack of demand visibility and we believe there is still inventory in the sales channels that will need to be absorbed before bookings will accurately reflect demand. Our own inventory has declined significantly from the end of the third quarter of 2008, as we carefully monitor customer requirements and have adjusted wafer starts accordingly. We expect to reduce our inventory level further in the first quarter of 2009.

The global reorganization and reduction in workforce is being conducted in a manner that we believe will best enable us to support the current and future requirements of our customer base and invest appropriately in our technology roadmap in order to enhance both our shorter and longer term competitive position. Our objective is to continue to execute on our strategy of diversification and the advancement of our technology through

collaborated efforts with our strategic partners, while reducing operating expenses. Our fabless business model, in conjunction with our technology leadership, has been resilient during past business cycle downturns and we look forward to emerging stronger from this challenging environment.

The semiconductor industry has historically been cyclical, characterized by periodic changes in business conditions caused by product supply and demand imbalance. When the industry experiences downturns, they often occur in connection with, or in anticipation of, maturing product cycles and declines in general economic conditions. These downturns are characterized by weak product demand, excessive inventory and accelerated decline of selling prices. Our current operating environment represents such a downturn and we cannot predict the extent or duration of the downturn.

Concentrations

We derived 87.7%, 88.8% and 87.3% of our net product revenues during 2006, 2007 and 2008, respectively, from product shipments to Asia. In addition, substantially all of our wafer suppliers and packaging and testing subcontractors are located in Asia.

Shipments to our top ten end customers, which exclude transactions through stocking representatives and distributors, accounted for 20.1%, 17.8% and 21.4% of our net product revenues in 2006, 2007 and 2008, respectively.

No single end customer, which we define as original equipment manufacturers, or OEMs, original design manufacturers, or ODMs, contract electronic manufacturers, or CEMs, or end users, represented 10.0% or more of our net product revenues during 2006, 2007 and 2008.

We ship products to, and have accounts receivable from, OEMs, ODMs, CEMs, stocking representatives, distributors and our logistics center. Our stocking representatives, distributors and logistics center reship our products to our end customers, including OEMs, ODMs, CEMs and end users. Shipments, by us or our logistics center, to our top three stocking representatives for reshipment accounted for 48.5%, 60.0% and 54.6% of our product shipments in 2006, 2007 and 2008, respectively. In addition, the same three stocking representatives solicited sales, for which they received a commission, for 10.3%, 9.1% and 7.0% of our product shipments to end users in 2006, 2007 and 2008, respectively.

We out-source our end customer service logistics in Asia to Silicon Professional Technology Ltd., or SPT, which supports our customers in Taiwan, China and other Southeast Asia countries. SPT provides forecasting, planning, warehousing, delivery, billing, collection and other logistic functions for us in these regions. SPT is a wholly-owned subsidiary of one of our stocking representatives in Taiwan, Professional Computer Technology Limited, or PCT. Please see a description of our relationship with PCT under “Related Party Transactions.” Products shipped to SPT are accounted for as our inventory held at our logistics center, and revenue is recognized when the products have been delivered and are considered as sold to our end customers by SPT. For the years ended December 31, 2006, 2007 and 2008, SPT serviced end customer sales accounting for 59.1%, 60.1% and 56.2% of our net product revenues recognized. As of December 31, 2007 and 2008, SPT represented 65.3% and 50.9% of our net accounts receivable, respectively.

Our product sales are made primarily using short-term cancelable purchase orders. The quantities actually purchased by the customer, as well as shipment schedules, are frequently revised to reflect changes in the customer’s needs and in our supply of product. Accordingly, our backlog of open purchase orders at any given time is not a meaningful indicator of future sales. Changes in the amount of our backlog do not necessarily reflect a corresponding change in the level of actual or potential sales.

Results of Operations

On February 4, 2009 we announced our results for the quarter and year ended December 31, 2008. Since that time and prior to the filing of this Annual Report on Form 10K, we re-evaluated and increased our inventory write-down by $907,000 and re-assessed the valuation of our investment in GSMC, increasing our recorded impairment by $6.0 million. During the fourth quarter of 2008, we recorded a total impairment to our investment in GSMC of $11.6 million to adjust the carrying value to its estimated fair value of $11.5 million as of December 31, 2008. As a result, net loss for the fourth quarter of 2008 is $36.6 million, or $0.38 per share, based on 95.5 million shares outstanding and net loss for the year ended December 31, 2008 is $39.8 million, or $0.40 per share, based on 100.0 million diluted shares outstanding.

Memory Products

Memory product revenue decreased 31.6% in 2008 from 2007, primarily due to the overall reduction in demand for semiconductor products caused by the global economic downturn. In 2008, as compared with 2007, both unit shipments and average selling prices decreased across all memory product families, and were down 23.6% and 10.4%, respectively. Although unit shipments for serial flash products decreased 16.6% in 2008 from 2007, average selling prices remained relatively stable, down only 3.3%.

Memory revenue decreased in 2007 from 2006 primarily due to supply constraints due to wafer shortages from our foundry sources. These shortages led to orders that could not be fulfilled and forced us to be more selective in order acceptance. As a result, certain revenue opportunities were lost due to our inability to produce an adequate supply of products. While overall unit shipments increased 3.4% for 2007, average selling prices declined 8.8% due to continuing competitive pricing pressures in low-density markets.

We anticipate that memory product revenues will decline again in the first quarter of 2009, and may continue to fluctuate significantly in the future.

Non-Memory Products

Non-memory product revenue increased 0.4% in 2008 from 2007, with a decrease in unit shipments of 21.8%, led by smart card IC, offset by an increase in average selling prices of 32.5%, due to product mix. The decrease in unit shipments for smart card IC was due in part to our decision to focus on sales of higher margin products. The favorable mix primarily reflects the introduction of our NANDrive family of products.

Non-memory revenue decreased substantially in 2007 from 2006. Supply constraints, a 15.0% decrease in units shipped and a 27.8% decrease in average selling prices all led to the decline. The decline was led by NAND Controller shipments which declined 77.5% for 2007. Decreases of average selling prices in non-memory products in 2007 were mainly due to pricing pressures on smart card ICs.

We expect non-memory product revenue to fluctuate significantly throughout 2009 due to the current adverse economic conditions, as well as the start-up nature of our new product lines and diversification in our customer base.

Technology Licensing Revenue

Technology licensing revenue includes a combination of up-front fees and royalties. Technology licensing revenue increased 22.2% in 2008 from 2007, with the increase coming from royalties, primarily due to an ongoing trend toward flash technology within microcontroller markets.

Technology licensing revenue for 2007 increased 7.5% over 2006 primarily due to increased royalties from our licensees.

We anticipate revenues from technology licensing will remain relatively stable in 2009, but may fluctuate significantly in the future, depending on general economic conditions.

Memory products

Gross profit for memory products decreased 46.4% in 2008 from 2007, primarily due to the decrease in revenue resulting from the overall reduction in demand for semiconductor products. Average selling prices declined somewhat, as a result of the generally competitive industry environment. Gross profit for 2008 was also negatively impacted by inventory write-downs of $11.7 million, primarily on our serial flash and ComboMemory products, due to quantities in excess of forecasted demand and declining average selling prices. Comparatively, in 2007, high demand coupled with capacity constraints resulted in low inventory levels and favorable cost variances from the sale of products for which we had previously taken write-downs.

Gross profit for memory products in 2007 increased 13.5% from 2006. While supply constraints caused a loss of revenue, it also forced us to review existing business carefully and allowed us to pursue the most profitable opportunities. As a result, we concentrated on sales of higher margin products with just a 3.4% increase in units shipped over 2006. Overall memory gross margins were up 3.5% as a result of shipping more profitable products, despite an 8.8% decrease in average selling prices.

We expect memory product margins to fluctuate significantly in the future due to changes in sales volume, product mix, average selling prices and inventory write-downs.

Non-memory products

Gross profit for non-memory products increased 22.5% in 2008 from 2007, despite a reduction in overall unit shipments and the generally weak economic environment. The increase in gross profit was due to higher unit shipments and stable average selling prices for NANDrive and microcontroller products, which was partially offset by a decrease in unit shipments for other non-memory products and inventory write-downs of $1.5 million, primarily on smart card IC inventory.

Gross profit for non-memory products declined 55.9% in 2007 from 2006. NAND Controller shipments declined by 9.5 million units leading to the majority of the decline in gross profit. In addition, supply constraints led to an overall 15.0% decrease in unit shipments which, coupled with continuing pricing pressures on smart card, contributed to a 27.8% decrease in average selling prices as well as a 6.8% decrease in our overall non-memory gross margins.

We expect non-memory product margins to fluctuate significantly in the future due to changes in sales volume, product mix, average selling prices and inventory write-downs.

For other factors that could affect our gross profit, please also see Item 1A. “Risk Factors—We incurred significant inventory valuation and adverse purchase commitment adjustments in 2006, 2007 and 2008 and we may incur additional significant inventory valuation adjustments in the future.”

Research and development expenses include costs associated with the development of new products, enhancements to existing products, quality assurance activities and occupancy costs. These costs consist primarily of employee salaries, stock-based compensation and other benefit-related expenses, software and intellectual property licenses, the cost of materials such as wafers and masks and the cost of design and development tools.

Research and development expenses for 2008 increased by $2.2 million, or 4.0% from 2007, due primarily to increases of $2.2 million for product development related expenses including wafers, masks and evaluation parts and $2.3 million for software and intellectual property licenses. These increases were partially offset by decreases of $801,000 for salaries, bonuses and employee benefits, and $434,000 for stock-based compensation. Research and development expenses for 2008 included a $1.1 million charge to write off various intellectual property licenses, as we refined our focus toward our most strategic initiatives. Total expense related to compensation and benefits decreased in 2008, as compared to 2007, largely as a result of our emphasis on research and development activities in Asia. The decrease in expense for stock-based compensation is due primarily to the accelerated expense recognition in 2007 of options granted in prior years, coupled with a reduction in the number of options granted to research and development personnel in 2008.

For 2007 in comparison to 2006, research and development expenses increased due to higher depreciation expense of $626,000, increased salaries and wages of $1.3 million, additional software license fees of $617,000 and accruals for bonus programs of $999,000. Increased research and development expenses were generally due to the ramp up of next generation products.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

The following discussion may be understood more fully by reference to the consolidated financial statements, notes to the consolidated financial statements and management’s discussion and analysis of financial condition and results of operations contained in our Annual Report on Form 10-K for the year ended December 31, 2008, as filed with the Securities and Exchange Commission on March 20, 2009.

The following discussion contains forward-looking statements, which involve risk and uncertainties. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors which are difficult to forecast and can materially affect our quarterly or annual operating results. Fluctuations in revenues and operating results may cause volatility in our stock price. Please also see Item 1A. “Risk Factors.”

Business Overview

We are a leading supplier of NOR flash memory semiconductor devices for the digital consumer, networking, wireless communications and Internet computing markets. NOR flash memory is a form of nonvolatile memory that allows electronic systems to retain information when the system is turned off. NOR flash memory is now used in billions of consumer electronics and computing products annually.

We produce and sell many products based on our SuperFlash design and manufacturing process technology. Our products are incorporated into products sold by many well-known companies including Apple, Asustek, BenQ, Cisco, Dell, First International Computer, Gigabyte, Haier, Huawei, Infineon, Intel, IBM, Inventec, Legend, Lenovo, LG Electronics, Freescale Semiconductor, NEC, Nintendo, Panasonic, Philips, Quanta, Samsung, Sanyo, Seagate, Sony, Sony Ericsson, Toshiba, Texas Instruments, VTech and ZTE.

We also produce and sell other semiconductor products including flash microcontrollers, smart card ICs and modules, radio frequency ICs and modules, NAND Controllers and NAND Controller-based modules.

One of our goals is diversification through the active development of our non-memory business. Our objective is to transform SST from a pure play in flash memory to a multi-product line semiconductor company and a leading licensor of embedded flash technology. We continue to execute on our plan to derive a significant portion of our revenue from non-memory products, which includes flash microcontrollers, NAND Controller-based modules, smart card ICs and radio frequency ICs and modules. We believe non-memory products represent an area in which we have significant competitive advantages and also an area that, in the long run, can yield profitable revenue with higher and more stable gross margins than our memory products.

Our business strategy is two fold: to continue to develop and grow our core NOR flash memory and embedded flash technology licensing business, while diversifying our business by expanding into new markets and pursuing growth opportunities through the development of new NAND Controller-based module and radio frequency IC products. In the NOR flash market, our goals are to be the leading worldwide supplier of low-density NOR flash memory devices and to maintain our position as the world’s number one embedded flash licensor by growing both upfront fees and per unit royalties. In our non-memory business markets, our objectives are to leverage our core competencies in NAND Controller design into systems solutions as adoption of solid state memory technology grows, and to leverage our radio frequency wireless technology and systems expertise as development continues on a multitude of electronic devices which are enabled for wireless communication.

The Board of Directors has appointed a Strategic Committee to review our investments and to investigate strategic alternatives, including acquisitions and divestitures. The Strategic Committee is working closely with management and an outside consultant to evaluate our operations and products, and identify potential new business opportunities. This evaluation involves all aspects of our business in order to drive value for our shareholders and position SST for future growth.

Operations Overview

In response to the challenging market conditions of the past year, we began taking a fresh look at every aspect of our business; focusing our resources on areas that we believe will yield the most impact over time, while creating additional opportunities without incurring significant additional research and development expense in the near term. These efforts include a targeted approach to product development that emphasizes non-commodity applications through differentiated features, as well as new programs to enhance our licensing business. We have made good progress, and strong execution of these objectives, combined with an improved demand environment, resulted in solid financial performance for the third quarter of 2009, as well as yielding several key achievements in product development and technology licensing which we believe will help drive future growth.

After reaching a low point during the month of January, our product shipments rebounded in the first quarter of 2009. The end-market demand recovery that began in the second quarter continued through the third quarter, resulting in a greater than 30% sequential increase in unit shipments in the third quarter of 2009, as compared to the second quarter. Unit shipments to the digital consumer segment increased 47% sequentially, with digital camera, DVD and set-top-box applications showing especially strong growth. Unit shipments to the Internet computing segment increased 45% sequentially, with across-the-board increases, particularly in notebook and desktop PC, hard disk drive and PC monitor applications. Unit shipments to the networking segment increased 47% sequentially, driven primarily by shipment increases in DSL modem and wireless LAN applications. Unit shipments to the wireless communications segment were essentially flat, with the sequential growth in Bluetooth cordless phone and GPS applications offset by a steep decline in mobile phone shipments. Our licensing revenue increased significantly in the third quarter of 2009, reflecting the improvement in our licensees’ business in the second quarter.

We have begun to see stabilization in the pricing environment, as the rate of price decline for like products has slowed significantly from earlier in the year. Coupled with strong unit shipments, this stabilization contributed to a healthy growth in revenue across all application segments. Although our blended average selling price decreased approximately 7% in the third quarter of 2009, as compared to the second quarter, this decrease was primarily due to changes in our product mix, with strong revenue growth in serial flash and radio frequency power amplifier products, which have relatively lower average selling prices. Although seasonal trends in NOR flash, in combination with likely digestion of inventory in the cha]]>Fri, 15 Jan 2010 05:25:28 GMThttp://www.dailystocks.com/forum/showtopic.php?tid/3744/http://www.dailystocks.com/forum/showtopic.php?tid/3744/
BUSINESS OVERVIEW

Overview

CVS Caremark Corporation (“CVS Caremark”, the “Company”, “we” or “us”) is the largest provider of prescriptions and related health care services in the United States. We fill or manage more than one billion prescriptions annually. As a fully integrated pharmacy services company, we drive value for our customers by effectively managing pharmaceutical costs and improving health care outcomes through our approximately 6,900 CVS/pharmacy ® and Longs Drug ® retail stores; our pharmacy benefit management, mail order and specialty pharmacy division, Caremark Pharmacy Services ® ; our retail-based health clinic subsidiary, MinuteClinic ® ; and our online pharmacy, CVS.com ® . We currently operate two business segments: Pharmacy Services and Retail Pharmacy. Our business segments are operating units that offer different products and services and require distinct technology and marketing strategies.

The Caremark Merger

Effective March 22, 2007, we closed our merger with Caremark Rx. Inc. (the “Caremark Merger”). Following the Caremark Merger we changed our name to CVS Caremark Corporation and Caremark Rx, Inc. became a wholly-owned subsidiary, Caremark Rx, L.L.C. (“Caremark”). The Caremark Merger has positioned our Company to deliver significant benefits to (i) health plan sponsors through effective cost management solutions and innovative programs and (ii) consumers through expanded choice, improved access and more personalized services.

The Caremark Merger has enabled us to achieve significant synergies from purchasing scale and operating efficiencies. The purchasing synergies include additional purchase discounts (including rebates obtained from pharmaceutical manufacturers) and cost efficiencies obtained from our national network of retail pharmacies. Operating synergies include cost savings resulting from productivity increases and other efficiencies obtained by eliminating duplicate facilities and excess capacity and combining complementary operations.

The Caremark Merger has also created significant incremental revenue opportunities for our Company through a variety of new programs and plan designs that benefit from our client relationships, our integrated information systems and the ability of our more than 25,000 pharmacists, nurse practitioners and physician assistants to interact personally with the millions of consumers who shop our stores every day. In that regard, during 2008, we introduced Proactive Pharmacy Care™, an earlier, easier, more effective approach to engaging plan participants in behaviors that can help lower costs, improve health, and save lives. Examples of Proactive Pharmacy Care programs include: Maintenance Choice™ (a flexible fulfillment option that affords eligible plan participants the convenient choice of picking up their 90-day supply of maintenance medications at any CVS/pharmacy store or obtaining them through mail order in either case at the cost of mail for both the payer and the plan participant); Bridge Supply (which enables eligible plan participants to avoid gaps in care while waiting for their medications to arrive in the mail by obtaining a bridge supply of their prescriptions at any CVS/pharmacy store at no additional charge); and a new ExtraCare ® Health Card program (which offers discounts to eligible plan participants on certain Flexible Spending Account-eligible and over-the-counter health care products sold in any of our CVS/pharmacy stores). We are also creating new compliance and persistency programs designed to ensure that patients take their medications in the correct manner as well as enhanced disease management programs that are targeted at managing chronic disease states. In addition, we are working with our clients to (i) decrease unnecessary and expensive emergency room visits by encouraging plan participants to use our MinuteClinic locations for everyday common ailments and (ii) create pilot programs that offer convenient, unique services available at MinuteClinic such as injection training for specialty pharmacy patients.

While certain of these programs (like Maintenance Choice, Bridge Supply, and the ExtraCare Health Card program) have already been adopted by many CVS Caremark clients, others are still in the formative stage and require additional information system enhancements and/or changes in work processes. Accordingly, over the long-term, there can be no assurance as to the timing or amount of incremental revenues that can be achieved with these kinds of programs.

We believe the breadth of capabilities resulting from the Caremark Merger are resonating with our clients and contributed to our success at renewing existing clients and obtaining a significant number of new clients in the 2008 selling season.

The Longs Acquisition

Effective October 20, 2008, we acquired Longs Drug Stores Corporation, which includes 529 retail drug stores (the “Longs Drug Stores”) and RxAmerica LLC (“RxAmerica”), which provides pharmacy benefit management services, and certain other related assets (collectively the “Longs Acquisition”).

Pharmacy Services Segment

The Pharmacy Services business provides a full range of prescription benefit management (“PBM”) services including mail order pharmacy services, specialty pharmacy services, plan design and administration, formulary management and claims processing. Our customers are primarily employers, insurance companies, unions, government employee groups, managed care organizations and other sponsors of health benefit plans and individuals throughout the United States. In addition, through our SilverScript Insurance Company (“SilverScript”) and Accendo Insurance Company (“Accendo”) subsidiaries, we are a national provider of drug benefits to eligible beneficiaries under the Federal Government’s Medicare Part D program. Currently, the pharmacy services business operates under the Caremark Pharmacy Services ® , Caremark ® , CVS Caremark™, CarePlus CVS/pharmacy™, CarePlus™, RxAmerica ® , AccordantCare ® and TheraCom ® names. As of December 31, 2008, the Pharmacy Services segment operated 58 retail specialty pharmacy stores, 19 specialty mail order pharmacies and 7 mail service pharmacies located in 26 states, Puerto Rico and the District of Columbia.

Our Strategy ~ Our business strategy centers on providing innovative pharmaceutical solutions and quality customer service in order to enhance clinical outcomes for the participants in our customers’ health benefit plans while assisting our customers in better managing their overall health care costs. We believe the Caremark Merger has positioned our company to deliver significant benefits to health plan sponsors through effective cost-management solutions and innovative programs and to consumers through expanded choice, improved access and more personalized services.

Our Services ~ The PBM services we provide for our customers involve the design and administration of programs aimed at reducing the cost and improving the safety, effectiveness and convenience of prescription drug use. These services are described more fully below.

Plan Design and Administration ~ Our customers sponsor pharmacy benefit plans which facilitate the ability of eligible participants in these plans to receive medications prescribed by their physicians. We assist our customers in designing pharmacy benefit plans that minimize the costs to the customer while prioritizing the welfare and safety of the customers’ participants. We also administer these benefit plans for our customers and assist them in monitoring the effectiveness of these plans through frequent, informal communications as well as through a formal annual customer review.

We make recommendations to our customers encouraging them to design benefit plans promoting the use of the lowest cost, most clinically appropriate drug. We believe that we help our customers control costs by recommending plans that encourage the use of generic equivalents of brand name drugs when such equivalents are available. Our customers also have the option, through plan design, to further lower their pharmacy benefit plan costs by setting different participant payment levels for different products on our drug lists.

Formulary Management ~ We utilize an independent panel of doctors, pharmacists and other medical experts, referred to as our Pharmacy and Therapeutics Committee, to select drugs that meet the highest standards of safety and efficacy for inclusion on our drug lists. Our drug lists provide recommended products in numerous drug classes to ensure participant access to clinically appropriate alternatives under the customer’s pharmacy benefit plan. To improve clinical outcomes for participants and customers, we conduct ongoing, independent reviews of all drugs, including, but not limited to, those appearing on the drug list and generic equivalent products, as well as of our clinical programs.

Discounted Drug Purchase Arrangements ~ We negotiate with pharmaceutical manufacturers to obtain discounted acquisition costs for many of the products on our drug lists, and these negotiated discounts enable us to offer reduced costs to customers that choose to adopt our drug lists. The discounted drug purchase arrangements we negotiate typically provide for our receiving discounts from established list prices in one or a combination, of the forms. In that regard, these discounts generally take the form of a direct discount at the time of purchase, a discount for prompt payment of

invoices or, when products are indirectly purchased from a manufacturer (e.g., through a wholesaler or retail pharmacy/chain), a retroactive discount, or rebate. We also receive additional discounts under our wholesale contracts if we exceed contractually-defined annual purchase volumes. We record these discounts, regardless of their form, as a reduction of our cost of revenues.

Prescription Management Systems ~ We dispense prescription drugs both directly, through our own pharmacies, and indirectly, through a network of retail pharmacies. All prescriptions, whether they are filled through one of our mail service pharmacies or through a pharmacy in our retail network, are analyzed, processed and documented by our proprietary prescription management systems. These systems assist staff and network pharmacists in processing prescriptions by automating tests for various items, including, but not limited to, plan eligibility, early refills, duplicate dispensing, appropriateness of dosage, drug interactions or allergies, over-utilization and potential fraud.

Mail Pharmacy Program ~ We currently operate 7 large, automated mail service pharmacies in the continental United States, including one located in Largo, Florida, that we expect to consolidate during 2009. Our customers or their physicians submit prescriptions, primarily for maintenance medications, to these pharmacies via mail, telephone, fax or the Internet. We also operate a network of smaller mail service specialty pharmacies described below. Additionally, we operate a United States Food and Drug Administration (“FDA”) regulated repackaging facility in which we repackage certain drugs into the most common prescription amounts dispensed from our automated mail service pharmacies. Our staff pharmacists review mail service prescriptions and refill requests with the assistance of our prescription management systems. This review may involve communications with the prescribing physician and, with the physician’s approval, can result in generic substitution, therapeutic interchange or other actions to affect cost or to improve quality of treatment. In these cases, we inform participants about the changes made to their prescriptions.

Specialty Pharmacy ~ Our specialty pharmacies support individuals that require complex and expensive drug therapies. Our specialty pharmacies are comprised of 19 specialty mail order pharmacies located throughout the United States and are used for delivery of advanced medications to individuals with chronic or genetic diseases and disorders. One of our mail service specialty pharmacies, TheraCom ® , provides new product launch services for manufacturers of specialty drugs. Substantially all of these pharmacies have been accredited by the Joint Commission, which is an independent, not-for-profit organization which accredits and certifies more than 15,000 health care organizations and programs in the United States. The Company also operates a network of 58 retail specialty pharmacy stores (which operate under the Caremark, CarePlus™ or CVS/pharmacy name). These stores average 2,000 square feet in size and sell prescription drugs and a limited assortment of front store items such as alternative medications, homeopathic remedies and vitamins.

Onsite Pharmacies ~ We also operate a limited number of small pharmacies located at client sites under the CarePlus CVS/pharmacy, CVS/pharmacy or CarePlus™ name, which provide participants with a convenient alternative for filling their prescriptions.

Retail Pharmacy Network ~ We maintain a national network of approximately 60,000 retail pharmacies including CVS/pharmacy and Longs Drug stores. When a customer fills a prescription in a retail pharmacy, the pharmacy sends prescription data electronically to us from the point-of-sale. This data interfaces with our proprietary prescription management systems, which verify relevant customer data, including eligibility and participant information, and perform a drug utilization review to determine clinical appropriateness and safety in addition to confirming that the pharmacy will receive payment for the prescription.

Quality Assurance ~ We have adopted and implemented clinical quality assurance procedures as well as policies and procedures to help ensure regulatory compliance under our quality assurance programs. Each new mail service prescription undergoes a sequence of safety and accuracy checks and is reviewed and verified by a registered pharmacist before shipment. We also analyze drug-related outcomes to identify opportunities to improve the quality of care.

Disease Management Programs ~ Our clinical services utilize advanced protocols and offer customers convenience in working with health care providers and other third parties. Our AccordantCare health management programs include integrated disease management, which includes 27 diseases such as asthma, coronary artery disease, congestive heart failure, diabetes, hemophilia, rheumatoid arthritis and multiple sclerosis. The majority of these integrated programs are accredited by the National Committee for Quality Assurance (“NCQA”), a private, not-for-profit organization that evaluates, accredits and certifies a wide range of health care organizations.

Medicare Part D Services ~ We participate in the administration of the drug benefit added to the Medicare program through Part D of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (“MMA”) (the “Medicare Drug Benefit”) through the provision of PBM services to our health plan clients and other clients that have qualified as Medicare Part D prescription drug plans (“PDP”). We also participate (i) by offering Medicare Part D pharmacy benefits through our subsidiaries, SilverScript and Accendo, which have been approved by the Centers for Medicare and Medicaid Services (“CMS”), as PDPs, and (ii) by assisting employer, union and other health plan clients that qualify for the retiree drug subsidy available under Medicare Part D by collecting and submitting eligibility and/or drug cost data to CMS in order for them to obtain the subsidy. During 2008, our PharmaCare Management Services subsidiary, through a joint venture with Universal American Corp. (“UAC”), also participated in the offering of Medicare Part D pharmacy benefits by affiliated entities of UAC that qualified as PDPs. The Company and UAC dissolved this joint venture at the end of the 2008 plan year and have divided responsibility for providing Medicare Part D services to the affected UAC plan members beginning with the 2009 plan year.

Information Systems ~ We currently operate primary information systems platforms to support our PBM services, which are supplemented by additional information systems to support our pharmacy operations. These information systems incorporate integrated architecture that centralizes the data generated from filling mail service prescriptions, adjudicating retail pharmacy claims and fulfilling other customer service contracts.

Customers ~ Our customers are primarily sponsors of health benefit plans (employers, unions, government employee groups, insurance companies and managed care organizations) and individuals located throughout the United States. We provide pharmaceuticals to eligible participants in benefit plans maintained by our customers and utilize our information systems to perform safety checks, drug interaction screening and generic substitution. We generate substantially all of our Pharmacy Services Segment net revenue from dispensing prescription drugs to eligible participants in benefit plans maintained by our customers. During the year-ended December 31, 2008, we managed over 633 million prescriptions for individuals from over 3,300 organizations.

Competition ~ We believe the primary competitive factors in the industry include: (i) the ability to negotiate favorable discounts from drug manufacturers; (ii) the ability to negotiate favorable discounts from, and access to, retail pharmacy networks; (iii) responsiveness to customers’ needs; (iv) the ability to identify and apply effective cost management programs utilizing clinical strategies; (v) the ability to develop and utilize preferred drug lists; (vi) the ability to market PBM products and services; (vii) the commitment to provide flexible, clinically-oriented services to customers; and (viii) the quality, scope and costs of products and services offered to customers and their participants. The Pharmacy Services segment competes with a number of large, national PBM companies, including Medco Health Solutions, Inc. and Express Scripts, Inc., as well as many smaller local or regional PBMs. We also compete with several large health insurers/managed care plans (e.g. UnitedHealthcare, Wellpoint, Aetna, CIGNA) and retail pharmacies, which have their own PBM capabilities, as well as with several other national and regional companies which provide services similar to ours.

Retail Pharmacy Segment

As of December 31, 2008, the Retail Pharmacy Segment included 6,923 retail drugstores, of which 6,857 operated a pharmacy, our online retail website, CVS.com ® and our retail health care clinics. The retail drugstores are located in 41 states and the District of Columbia operating primarily under the CVS/pharmacy ® , or Longs Drug ® names. We currently operate in 89 of the top 100 U.S. drugstore markets and hold the number one or number two market share in 60 of these markets. Overall, we hold the number one or number two market share position in 67% of the markets in which our retail drugstores operate. CVS/pharmacy stores sell prescription drugs and a wide assortment of general merchandise, which we refer to as “front store” products. Existing stores range in size from approximately 8,000 to 25,000 square feet, although most new stores range in size from approximately 10,000 to 13,000 square feet and typically include a drive-thru pharmacy. During fiscal 2008, we filled approximately 559 million retail prescriptions, or approximately 17% of the U.S. retail pharmacy market.

As of December 31, 2008, we operated 560 retail health care clinics in 27 states under the MinuteClinic name, of which 534 were located within CVS/pharmacy stores. The clinics utilize nationally recognized medical protocols to diagnose and treat minor health conditions and are staffed by board-certified nurse practitioners and physician assistants.

Our Strategy ~ Our goal is to be the easiest pharmacy retailer for customers to use. We believe that ease of use means convenience for the time-starved customer. As such, our operating strategy is to provide a broad assortment of quality merchandise at competitive prices using a retail format that emphasizes service, innovation and convenience (easy-to-access, clean, well-lit and well stocked). One of the keys to our strategy is technology, which allows us to focus on constantly improving service and exploring ways to provide more personalized product offerings and services. We believe that continuing to be the first to market with new and unique products and services, using innovative marketing and adjusting our mix of merchandise to match our customers’ needs and preferences is very important to our ability to continue to improve customer satisfaction.

Our Products ~ A typical CVS/pharmacy store sells prescription drugs and a wide assortment of high-quality, nationally advertised brand name and private label merchandise. Front store categories include over-the-counter drugs, beauty products and cosmetics, film and photo finishing services, seasonal merchandise, greeting cards and convenience foods. We purchase our merchandise from numerous manufacturers and distributors. We believe that competitive sources are readily available for substantially all of the products we carry and the loss of any one supplier would not have a material effect on the business. Consolidated net revenues by major product group are as follows:


Pharmacy ~ Pharmacy revenues represented approximately 68% of Retail Pharmacy revenues in 2008, 2007 and 2006 respectively. We believe that our pharmacy operations will continue to represent a critical part of our business due to our ability to attract and retain managed care customers, favorable industry trends (e.g., an aging American population consuming a greater number of prescription drugs, pharmaceuticals being used more often as the first line of defense for managing illness) the proliferation of new pharmaceutical products, the federally funded prescription drug benefit promulgated in 2006 as part of the MMA and our on going program of purchasing customer lists from independent pharmacies. We believe our pharmacy business benefits from our investment in both people and technology. Given the nature of prescriptions, people want their prescriptions filled accurately and ready when promised, by professional pharmacists using the latest tools and technology. As such, our Pharmacy Service Initiative, which is designed to resolve potential problems at the point of drop-off that could delay a prescription being filled, has enabled us to improve our dispensing process resulting in improved customer service ratings. Further evidencing our belief in the importance of pharmacy service is our continuing investment in technology, such as our Drug Utilization Review system that checks for harmful interactions between prescription drugs, over-the-counter products, vitamins and herbal remedies; our Rx Connect system; our touch-tone telephone reorder system, Rapid Refill TM ; CVS/pharmacy Health Savings Pass; Proactive Pharmacy Care TM ; and our online business, CVS.com.

Front Store ~ Front store revenues benefited from our strategy to be the first to market with new and unique products and services, using innovative marketing and adjusting our mix of merchandise to match our customers’ needs and preferences. A key component of our front store strategy is our ExtraCare ® card program, which is helping us continue to build our loyal customer base. In addition, the ExtraCare program is one of the largest and most successful retail loyalty programs in the United States. The ExtraCare program allows us to balance our marketing efforts so we can reward our best customers by providing them automatic sale prices, customized coupons, ExtraBucks ® rewards and other benefits. Another component of our front store strategy is our unique product offerings, which include a full range of high-quality CVS brand products that are only available through CVS. We currently carry over 3,300 CVS brand and proprietary brand products, which accounted for approximately 15% of our front store revenues during 2008.

Store Development ~ The addition of new stores has played, and will continue to play, a major role in our continued growth and success. Our store development program focuses on three areas: entering new markets, adding stores within existing markets and relocating stores to more convenient, freestanding sites. During 2008, we opened 188 new retail pharmacy stores and 2 new specialty pharmacy stores, acquired 529 stores as part of the Longs Acquisition, relocated 129 retail pharmacy stores and 3 specialty pharmacy stores and closed 39 stores. During the last five years, we opened

more than 1,300 new and relocated stores, and acquired approximately 2,500 stores. More than two-thirds of our store base was opened or significantly remodeled within the last five years. During 2009, we expect to open between 250 and 300 new or relocated stores. We believe that continuing to grow our store base and locating stores in desirable geographic markets are essential components to compete effectively in the current managed care environment. As a result, we believe that our store development program is an integral part of our ability to maintain our leadership position in the retail drugstore industry.

Information Systems ~ We have continued to invest in information systems to enable us to deliver a high level of customer service while lowering costs and increasing operating efficiency. We were one of the first in the industry to introduce Drug Utilization Review technology that checks for harmful interactions between prescription drugs, over-the-counter products, vitamins and herbal remedies. We were also one of the first in the industry to install a chain wide automatic prescription refill system, CVS Rapid Refill TM , which enables customers to order prescription refills 24 hours a day using a touch-tone telephone. We continue to enhance our Visible Improvement in Profits, Execution and Results (“VIPER”) system, a transaction monitoring application designed to mitigate inventory losses attributable to process deficiencies or fraudulent behavior by providing visibility to transactions processed through our point-of-sale systems. In addition, we operate distribution centers with fully integrated technology solutions for storage, product retrieval and order picking. In addition, in 2009, we plan on implementing a new pharmacy fulfillment system Rx Connect, which will reengineer the way our pharmacists communicate and fill prescriptions. Further, we continue to enhance our Assisted Inventory Management system, which is designed to more effectively link our stores and distribution centers with suppliers to speed the delivery of merchandise to our stores in a manner that both increases in-stock positions in the stores and lowers our investment in inventory.

Customers ~ Managed care and other third party plans accounted for 96% of our 2008 pharmacy revenues. Since our revenues relate to numerous payors, including employers and managed care organizations, the loss of any one payor should not have a material effect on our business. No single customer accounts for 10% or more of our total revenues. We also fill prescriptions for many government funded programs, including State Medicaid plans and Medicare Part D drug plans.

Seasonality ~ The majority of our revenues, particularly pharmacy revenues, are generally not seasonal in nature. However, front store revenues tend to be higher during the December holiday season. For additional information, we refer you to the Note “Quarterly Financial Information” on page 64 in our Annual Report to Stockholders for the fiscal year ended December 31, 2008, which section is incorporated by reference herein.

Competition ~ The retail drugstore business is highly competitive. We believe that we compete principally on the basis of: (i) store location and convenience, (ii) customer service and satisfaction, (iii) product selection and variety and (iv) price. In each of the markets we serve, we compete with independent and other retail drugstore chains, supermarkets, convenience stores, pharmacy benefit managers and other mail order prescription providers, discount merchandisers, membership clubs, health clinics and Internet pharmacies.

Working Capital Practices

We fund the growth of our business through a combination of cash flow from operations, commercial paper and long-term borrowings. For additional information on our working capital practices, we refer you to the caption “Liquidity and Capital Resources” on page 29 in our Annual Report to Stockholders for the fiscal year ended December 31, 2008, which section is incorporated by reference herein. The majority of our non-pharmacy revenues are in cash, while managed care and other third party insurance programs, which typically settle in less than 30 days, represented approximately 98% of our consolidated pharmacy revenues in 2008. Our customer returns are not significant.

Associate Development

As of December 31, 2008, we employed approximately 215,000 associates, which included more than 25,000 pharmacists, nurse practitioners and physician assistants. In addition, approximately 90,000 associates were part-time employees who work less than 30 hours per week. To deliver the highest levels of service to our customers, we devote considerable time and attention to our people and service standards. We emphasize attracting and training, knowledgeable, friendly and helpful associates to work in our stores, clinics and throughout our organization.

CEO BACKGROUND

Nonqualified Deferred Compensation – Fiscal Year 2008



Name & 2008 Principal
Positions Type Executive
Contributions
in Last FY
($) (1) Registrant
Contributions
in Last FY
($) (2)

Aggregate
Earnings

in Last FY

($) (3)
Aggregate
Withdrawals/
Distributions
($) (4) Aggregate
Balance at
Last FYE
($) (5)

Thomas M. Ryan
Chairman of the Board, President and Chief Executive Officer
Cash 3,102,034 301,460 -744,140 — 11,788,815
Stock 7,466,716 — -11,513,107 15,143,903 31,045,163




David B. Rickard (6)
Executive Vice President, Chief Financial Officer and Chief Administrative Officer
Cash 1,032,521 119,750 -2,548,268 — 13,638,708
Stock 1,144,028 — -1,081,020 25,407 2,947,459






Chris W. Bodine
Special Advisor to the CEO
Cash 132,500 139,899 -327,104 118,119 5,171,990
Stock 1,144,028 — -2,847,060 66,795 7,677,953



Howard A. McLure
Executive Vice President and President - Caremark Pharmacy Services
Cash — — 21,433 63,878 4,365,399
Stock — — -254,654 6,102 682,835





Larry J. Merlo
Executive Vice President and President
- CVS/pharmacy - Retail
Cash 136,251 143,740 -136,273 — 3,933,512
Stock 1,144,028 — -4,267,289 100,076 11,482,136




Douglas A. Sgarro
Executive Vice President, Chief Legal Officer and President - CVS Realty Co.
Cash 287,500 108,751 -418,965 217,859 4,645,882
Stock 1,144,028 — -1,335,278 895,865 84,934

MANAGEMENT DISCUSSION FROM LATEST 10K

We refer you to the “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which includes our “Cautionary Statement Concerning Forward-Looking Statements” at the end of such section, on pages 35 through 36 of our Annual Report to Stockholders for the fiscal year ended December 31, 2008, which section is incorporated by reference herein.


CONF CALL

Nancy Christal
Thanks, Regina. Good morning, everyone and thanks for joining us today for our third quarter earnings call. I'm here with Tom Ryan, Chairman, President and CEO of CVS Caremark, who will provide a business update, and Dave Rickard, Executive Vice President and CFO, who will provide a financial review and guidance. During the Q&A that follows, we ask that you limit yourself to one to two questions, including follow-ups, so that we can get to as many analysts and investors as possible.
Please note that we expect to file our 10-Q by the end of day today and it will be available through our website at cvscaremark.com/investors.
This morning we'll discuss some non-GAAP financial measures in talking about our company's performance, namely free cash flow, EBITDA and adjusted EPS. In accordance with SEC regulations, you can find the definitions of the non-GAAP items I just mentioned as well as the reconciliations to comparable GAAP measures on the Investor Relations portion of our website at cvscaremark/investors.com.
As always, today's call is being simulcast on our IR website. It will also be archived there for a one-month period following the call to make it easy for all investors to access it.
Now before we continue, our attorneys have asked me to read the safe harbor statement --during this presentation, we'll make certain forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially. Accordingly, for these forward-looking statements we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. We strongly recommend that you become familiar with the specific risks and uncertainties that are described in the Risk Factors section of our most recently filed annual report on Form 10-K and that you review the section entitled Cautionary Statement Concerning forward-looking statements in our most recently filed quarterly report on Form 10-Q.
And now I will turn this over to our CEO, Tom Ryan.
Thomas M. Ryan
Thanks, Nancy, and good morning, everyone. We reported another excellent quarter this morning and I am certainly pleased with our results across the company, especially given the economic climate we are in.
Let me give a few highlights for the quarter -- total revenues increased 18%. Our PBM revenues increased 23% while retail revenues were up 18%. Retail comps up 5.7 and I should point out without any benefit from flu shots. Our adjusted EPS from continuing operations was $0.76. If you exclude the $0.11 tax benefit, adjusted EPS was $0.65, up more than 8%. And we maintained a healthy balance sheet and generated more than $490 million of free cash flow for the quarter, so a pretty good quarter all the way around.
On the retail side of our business, I am happy to report that we continue to outperform the industry. We are achieving healthy share gains in pharmacy. Our share in markets in which we operate grew over 100 basis points.
Total same-store sales increased 5.7% in the third quarter and when we came into this year, we told you we expected to see comps accelerate, pharmacy comps accelerate in the second half and we are seeing it -- pharmacy comps increased a solid 8%, better than the last quarter and in fact the highest level we have seen in two years and I guess almost close to twice the industry average. And that occurred even as our generic dispensing rate surpassed 70% on the retail side. Our pharmacy comps were negatively impacted by about 380 basis points due to recent generic introductions and further generic expansion.
As I said earlier, unlike some competitors, our pharmacy comps had little if any benefit from flu vaccines, vaccinations. That’s because we don’t count flu vaccinations administrated at minute clinic or outside flu clinics as a prescription. We saw approximately 250 basis point benefit in pharmacy comps from maintenance choice. That’s up 190 basis points in the second quarter and 120 from the first quarter.
Our integrated products continue to gain traction in the marketplace and they gained traction for two simple reasons -- they helped reduce -- help clients reduce pharmacy and overall healthcare costs and they help save patients time and money.
Comp scripts increased 4.9% in the third quarter. You should recall that our 90 day maintenance choice scripts filled at retail we count as one script rather than three -- in fact, if we counted maintenance choice as three scripts like some others, then our comp scripts would have been 8.1%.
Pharmacy growth was also helped by a double-digit increase in flu related prescriptions, which I expect will continue through the fourth quarter.
Front store comps increased just under 1%, with more customers seeking out promotional prices and private label products in the quarter. Consumers I think continue to be conservative with their spending and they opt for higher value, certainly and are looking for lower price points and as I said, more value. In fact, growth in private label sales during the quarter more than doubled the rate of other sales in the front store. Obviously this is good for us from a margin standpoint. [Moody Long’s] in the third quarter private label accounted for 17% of front store sale, up 120 basis points versus last year. We added about 250 new private label items and we expect to add over 900 for the full year.
We had pretty good growth across most of our categories and obviously as you would expect in light of the flu, we had especially strong growth in cough and cold. Conversely, back to school was relatively flat while photo and greeting cards were slightly down.
Like last quarter, our average front store transaction on a comp basis grew slightly in the third quarter. The better news is that this quarter we saw comp traffic up slightly. That’s a positive sign that the economy has started to improve. Having said that, we expect consumers to remain value conscious on a go-forward basis for a few quarters, at least.
Let me update you on the Long’s integration -- we completed the systems integration in May. We closed the headquarters in July and we completed all store remodels in October. We are right on track. We are introducing the stores to the marketplace with a multimedia advertising blitz as we speak.
Even before the promotions, however, the early results of store remodels have been very encouraging. The post remodel script performance has shown steady improvement while the post remodel front store sales have shown an immediate response since the resets. And as you all know, when you do remodels, you have a disruption of service so the disruption was lower and the comeback was certainly faster and better than we thought once the remodels are completed.
Since the acquisition, we have surveyed over 125,000 customers across the board. We track this data pre and post conversion. Our pharmacy service, neatness, and cleanliness metrics have improved dramatically and what is especially encouraging to me is that when you compare these service metrics with other acquisitions that we have done at the same point and time, we are virtually ahead on every dimension. We are already exceeding our profitability targets for Long’s, driven by strong margin performance as well as good expense management.
In the Long’s stores, many private label products were introduced in the spring with the initial update of Long’s merchandise assortment. The rest of the proprietary products we’ll introduce later. So right now we have private label is about 11% of front store sales. That’s obviously lower than our core business but up 700 basis points since the second quarter.
As a reminder, the Long’s acquisition was completed in October last year so the stores will be included in our comps for the first time in November. As we said before, we expect the initial impact of the comps to be slightly negative because of the remodels but we look forward to continuing to narrow the sales productivity and margin gaps between the former Long’s stores and core CVS stores.
As for new stores, on the real estate side we reached a milestone this quarter. Larry Murlow, our President of CVS Pharmacy, opened our 7,000th store in Little Canada, Minnesota -- who knew? In total, we opened up 87 new and relocated CVS pharmacy stores in the quarter and closed six others, resulting in 59 net new stores in the quarter.
Year-to-date, we opened or relocated 256 stores, so we are right on track to add about 3% retail square footage growth for ’09.
We also completed 37 file buys in the quarter and we expect to do about 250 for the year, which is up about 10% versus last year and it’s good to have this obviously because this is a great return for us and in fact many times the pharmacy staff and the owners actually come to work for us.
Let me touch on minute clinic, which has now surpassed 5 million patient visits since its inception. We opened up eight new clinics during the quarter and now we have 565 clinics across 25 states, about 100 of those operate seasonally. In the third quarter, we saw better than expected growth in the clinics, and this growth was really excluding the flu shot. So we had traffic up 77% in minute clinic and that’s not counting the flu shots. These are just people coming for acute sick visits. So it was really driven for three reasons -- one the severity of the flu like symptoms and people just coming in; second, we are benefiting from increased public awareness, which is one of our goals we had to get the consumer more aware of minute clinic and where we are and what we have to offer. And third, we increased third party coverage. As you know, third party coverage leads to higher utilization. We added another 4.5 million additional lives to the network in the third quarter so now 80%, slightly over 80% of the visits are third party paid.
We are focused on improving the returns at minute clinic. One step towards that goal is our recent decision to move the majority of minute clinic’s corporate functions from Minneapolis to Rhode Island. The move will facilitate sharing of infrastructure function and services and will improve speed to market for CVS Caremark’s chronic care and patient engagement and disease management initiatives. The cost of this move is approximately a penny a share, which will be primarily in 2010.
We remain very enthusiastic about the prospects for minute clinic. As you know, we are investing about $0.05 to $0.06 in minute clinic this year. We expect somewhat less next year, maybe $0.04 to $0.05 and we expect to break-even in 2011 on an all-in basis.
Now let me turn to the PBM business, which also had a very good quarter. Let me give you some highlights -- pharmacy network revenues were up 28%. Mail choice revenues were up 14.8, and recall that mail choice is our metric which includes mail order plus 90 day claims filled at retail via maintenance choice.
Our generic dispensing rate increased 320 basis points to a best-in-class 68.3 versus LY. Operating profit in the PBM was up 13% and EBITDA per adjusted claim increased 8% to 489 on an apples-to-apples basis. You have to adjust out the RX America which was not in last year’s results.
As I mentioned earlier, our new products are gaining traction. Today I am pleased to report that we now have 417 clients representing over 5 million lives who have adopted maintenance choice or will adopt it in the first quarter of ’10. That’s up from 270 clients in the second quarter and 200 at the beginning of the year, so clearly maintenance choice is gaining acceptance in the marketplace.
The 417 clients adopting maintenance choice represent only about 13% of our book, so there is clearly room to grow. Our early adopters of maintenance choice are telling us they are satisfied with the implementation process and that their members view the offering as a major enhancement to their benefit since now they have the convenient option of obtaining their prescriptions at any CVS retail store or mail order and they still get the benefit of mail order pricing.
Remember, this program is just an extension of our mail offering. It lowers cost for patients and payers. That is why it is being so well-received in the marketplace.
One of our next innovations we are working on is the consumer engagement engine. It is not a product like maintenance choice. It’s a data management system with a clinical rules engine which will combine and analyze data to provide us with a single view of every CVS Caremark patient. Of course the data analysis and other CEE initiatives are performed in compliance with applicable privacy laws. Whether a patient uses mail pharmacies, our minute clinics, our retail pharmacies, our specialty pharmacies, the CEE will further enhance the benefits of our integrated model by distilling data down to actionable messaging for our clients and our pharmacists. It may highlight opportunities for cost savings around formula recompliance or generic substitution. It may improve patient care through better compliance. Patients using our call centers, using our website, receiving outbound letters or interacting with pharmacists will all receive targeted messages to help them save money, save time, and stay healthy.
As an example, CVS pharmacists will be able to restart someone on therapy from a mail order prescription that they may have discontinued, or help a member at retail get started on mail order.
This will provide us with an unprecedented capability to engage patients and to eliminate gaps in care, improve adherence, and help drive cost savings. It will be rolled out to our core channels in mid 2010 and we will have evidence in the -- and drive it in the selling season for 2011.
Speaking of 2011, we announced on Monday that we renegotiated and extended our $4 billion contract to provide retail pharmacy benefit services and all clinical services for Blue Cross Blue Shield and known as the federal employee program, FEP. The three-year contract originally due to expire at the end of 10 has been extended through the end of 11. While it will cost us some margin dollars in 2010, I am certainly pleased with the extension.
So let me talk about the selling season -- we had some good wins. We had about 125 new clients. We had a retention rate of about 92%. Having said that, we had some big client losses and let me recap those for you so everybody is on the same page.
We had $1.4 billion in wins in 2010. Approximately $600 million of those gross wins came since the last quarterly call.
We had $4.5 billion in losses and approximately $2 billion plus of those came from the last call, since the last call, and those would be Horizon, I think you know about the State of New Jersey. This was a bid that the state wanted on a standalone basis so it was kind of a price and carve out issue. We lost the State of Ohio on the managed Medicare business. It was carved in, which was about $500 million plus. And then we had another $600 million miscellaneous. These were basically smaller clients around RX America or Pharmacare that just really wanted essentially smaller PBMs. So in total, that was about $2 billion plus since the last call.
And then lastly, we had $1.7 billion that we lost in Med D business. This was the 500,000 lives that we lost in the [duos], and once again this was since the last call. So net net, it’s about $4.8 billion in net loss for 2010 and approximately almost $3.7 billion since the last call.
If you look at the losses, total losses with Med D and the $4.5 billion contract losses, they really come from four contracts plus the Med D lives, the two really that I mentioned and then Chrysler and Coventry.
So what does this all mean for 2010? As you all know, on our last quarterly call, I said I would -- we were not in a position to provide 2010 guidance at that time, which we weren’t because we hadn’t done our budget. But I also said I would be disappointed if we didn’t have an EPS growth of at least 13% to 15% next year for the enterprise. To get to that 13% to 15% growth rate, I expected strong double-digit growth in our retail business, which I still do, and I expected low to mid single digit in our PBM business, which is not going to happen.
What has changed? Well, as I just said, we lost more PBM business than we expected since the call, $2 billion in contracts. We lost the Med D duos in 15 regions, which was $1.7 billion, which I just referred to. And we extended the $4 billion FAP contract through 2011 at the client’s request. This was an early renegotiation, not at our request but at the client’s request. So we are going to have obviously some margin implications in 2010.
Given all of that, it now looks like operating profit in the PBM will decline in 2010, perhaps as much as 10% to 12%. I want to point out that approximately 10 basis points of that -- 10 percentage basis points of that change is Med D alone. While our retail business is still expected to achieve strong double-digit operating profit growth in 2010, which will likely be -- the retail range will likely be in the 13% to 16% range.
With regards to the PBM, I want to announce the following changes in our organization. Howard McClure, President of Caremark, will be retiring effective November 27th. I will be the President of the PBM on an interim basis while we conduct a search and will keep you posted on the progress.
As you know, Howard was one of the chief architects of our integrated model. His experience has been invaluable to our company, yet after 30 plus years Howard felt it was right for him to retire and we wish him well in the next chapter of his life.
We also announced yesterday we hired a new senior VP of marketing for the PBM, Len Greer. Len’s knowledge of our industry and strong marketing skills make him qualified to deliver or help deliver our messages in the marketplace.
Now before turning it over to Dave, I am also pleased to announced that our board of directors approved a new share repurchase program for up to $2 billion of outstanding common stock. This reflects our confidence in the future growth of our business and our ongoing commitment to improve and increase shareholder value. We expect to repurchase the shares from time to time from now through 2011.
Now I will turn it over to Dave for his financial review and then I will be back with some additional remarks.
David B. Rickard
Thank you, Tom. Good morning, everyone. This morning I will walk you through our third quarter financial results. Then I will update full year 2009 guidance. But before I do that, let me highlight some key improvements that we have made to the way we report our segment financials, all of which I mentioned on last quarter’s call.
These changes reflect the way we look at the performance of our businesses, develop our strategies, and allocate resources. We hope they will make it easier for you to understand what is going on in our operating divisions.
The first change involves the reclassification of certain administrative expenses previously recorded within the PBM and retail segments to a new corporate segment. The corporate segment consists of certain costs which benefit both operating divisions equally. These are primarily associated with executive management, corporate relations, legal, compliance, human resources, corporate information technology, and finance.
Of course, this change had no impact on our consolidated results of operation but we now report on three operating segments -- pharmacy services, retail pharmacy, corporate. You will see that our historical segment disclosures have been revised to conform to the current presentation and we have made available on our website all the quarters going back to the first quarter of 2008. We believe that this change will give better visibility to the operating dynamics of both our retail and our PBM segments.
Secondly, we made a change to our PBM segment as it relates to our inter-segment activity, such as the maintenance choice program. This change impacts the gross profit and operating profit lines within the PBM segment. Under the maintenance choice program, a PBM client member can elect to pick up his maintenance prescriptions at one of our CVS pharmacy stores instead of receiving it through the mail. When this occurs, both the retail and the PBM segments now record the revenue, gross profit, and operating profit associated with this maintenance prescription on a standalone basis and corresponding inter-segment eliminations are created. Previously only the revenue was recorded by both segments.
We believe that this new method more clearly portrays the true performance of the individual operating segments, regardless of which segment creates the sale or dispenses the product or service. This change is reflected in our segment results for the third quarter and in the year-to-date results. The maintenance choice comparative amounts for 2008 were also revised, although the program was still in a pilot phase at that time and consequently the amounts were quite small.
Lastly, also beginning with the third quarter, we are now reporting mail choice volumes and related statistics as opposed to mail order volumes. Recall that mail choice is our metric that includes mail order claims plus 90 day claims filled at retail via maintenance choice. We believe that this provides a clearer picture of our business as it has become more channel agnostic in regard to 90 day claims. Those were previously overwhelmingly filled in mail order facilities.
Related to this, since maintenance choice is included in our mail choice metric, what we now refer to as pharmacy network is simply the PBM’s retail network less those maintenance choice scripts that moved to mail choice.
Now on to revenues -- Tom covered the highlights but let me add several details worth mentioning. The $24.6 billion in consolidated revenues is net of $2 billion of inter-segment eliminations. The inter-segment eliminations as a percent of PBM retail network revenues increased by approximately 400 basis points over the prior year period, from 18.1% to 22.2%. This is up sequentially from last quarter’s 330 basis point increase, further tangible evidence that there is an expanding base of our PBM customers choosing CVS as their retail pharmacy and an expanding number of PBM clients who choose to leverage the CVS retail service offerings, including maintenance choice.
In our PBM segment, third quarter net revenues of $13 billion increased 23.4%. RX America contributed approximately $1 billion of that growth during the quarter, while one extra day this year added approximately $136 million. So the underlying growth rate was 12.2%.
Drilling down a little deeper, the PBM pharmacy network revenues in the quarter rose 28.3% over 2008 levels to $8.8 billion. That was largely due to the change in revenue recognition method from net to gross for the RX America contracts that began in the second quarter. Pharmacy network claims grew 9%. This growth was driven by the addition of RX America, as well as the impact of net new business.
Total mail choice revenues grew by 14.8% to $4.2 billion. Our overall mail choice penetration rate of 23.8% was up approximately 50 basis points from the rate in the third quarter 2008 on a reported basis. However, RX America’s claims mix, which is heavily weighted toward retail network claims, diluted the mail choice penetration rate by 240 basis points. So adjusting for this factor, our underlying mail choice penetration rate grew from 23.3% to 26.2%, up 290 basis points.
Now what about the retail drug store side of our business? We saw revenues increase by 17.9% to $13.6 billion in the third quarter. Long’s contributed approximately $1.0 billion of that growth during the quarter, while one extra day this year added approximately $167 million. So the underlying growth rate was 7.5%.
As Tom mentioned, our third quarter comps increased 5.7%, with pharmacy comps up a very solid 8% and front-store comps up 0.8%.
Moving on to gross profit, the overall dollars improved by 14%, despite percentage margin dropping by 75 basis points. Within the PBM segment, the gross profit margin was down approximately 50 basis points. That was expected due to the change in the revenue recognition method for RX America, as well as the pricing decisions we made last year for a few key contracts.
The gross profit margin in the retail segment declined by approximately 100 basis points in the third quarter to 29.4%. That reflects pressure on third party reimbursement rates as well as a higher mix of promotional sales, which more than offset the positive impact of new generics.
And what about expenses? Overall operating expenses as a percentage of revenues improved by approximately 10 basis points. The PBM segment’s percentage stayed flat at 1.8%. That was despite the impact of the elimination of the universal American joint venture, the income from which was historically an offset to expenses.
We also saw some integration expenses for RX America flow through in the third quarter. So excellent expense control there.
In the retail segment, the improvement was approximately 20 basis points to 22.7%. We saw good spending discipline at the store level, as well as favorable timing of advertising spending in the quarter. Of course, partially offsetting that were the one-time expenses from the Long’s integration.
Within the corporate segment, we saw expenses rise by approximately 20%. The larger than normal increase was due primarily to the addition of Long’s and RX America corporate expenses, as well as some compensation and benefit costs.
So with the gross margin decline only partially offset by improvements in SG&A as a percentage of sales, operating margin declined as expected. It was down approximately 67 basis points to 6.4% of revenues.
Moving to the consolidated income statement, we saw net interest expense in the quarter increase to $123 million, largely reflecting the increased debt position due to Long’s. Our effective income tax rate was 29.1% in the third quarter. The large improvement was due to the recognition of approximately $155.7 million of previously unrecognized tax benefits relating to the expiration of various statutes of limitation and settlements with tax authorities. Excluding the impact of this reserve release, the effective income tax rate for the third quarter would have been approximately 39.8%.
Our weighted average diluted share count was 1.44 billion shares. Through the end of October, we have repurchased 57.7 million of our shares for $1.99 billion at an average share cost of $34.66, including commissions.
So we nearly completed our $2 billion share repurchase authorization and we expect to complete the remainder this month.
And then as Tom said, the board of directors just approved a new $2 billion share repurchase program and we expect to purchase shares from time to time between now and the end of 2011.
Adjusted EPS from continuing operations was $0.76; excluding the $0.11 tax benefit, it was $0.65, an increase of 8% over last year’s third quarter and just [above] guidance.
GAAP diluted EPS from continuing operations came in at $0.71 for the quarter, or $0.60 when adjusted for the tax benefit. That’s also approximately an 8% increase over last year.
Turning to the balance sheet and cash flows, we generated over $490 million in free cash flow in the third quarter. That compares to $386 million in the prior year’s third quarter, so we’ve made some nice progress there.
Net capital expenditures amounted to approximately $416 million in the third quarter. This was the result of offsetting the $661 million of gross capital expended with approximately $245 million worth of sale leaseback proceeds.
Barring any new and currently unforeseen financial market problems, we still expect that we will be able to complete the sale of the remaining $900 million or so in properties we had planned when the year began.
Lastly, in September, we issued $1.5 billion of 30-year unsecured senior notes that were well-received by the market. We used the proceeds primarily to repay a portion of our outstanding commercial paper borrowings, as well as a $650 million senior note that was due in September.
So we ended the quarter with total debt net of cash and cash equivalents of $10.8 billion. That’s up approximately $400 million from year-end and largely reflects normal swings in our working capital.
Now on to guidance for the year -- for the retail segment, we continue to expect revenue growth of between 12% and 14% for the year with total same-store sales in the range of 4% to 6%. For the PBM segment, revenues should be up between 16% and 18% for the year. For the total company, we expect revenue growth of around 12% to 14% for the full year after inter-company eliminations of over $7.5 billion.
Gross profit margins still are expected to be modestly below 2008 with retail flat and the PBM segment down. We expect total company operating expenses as a percent of revenues will be modestly up. That reflects the integration and one-time cost of Long’s, the increase in litigation reserves we saw in the first quarter, as well as the first year economics of a large amount of new PBM business. All of that will lead to operating profit margins for the total company which are moderately below the record levels of last year.
We expect EBITDA for adjusted claim to be down slightly on a reported basis but up mid-single-digits when normalized for RX America and the increase in litigation reserves.
We forecast net interest of about $530 million to $545 million. We expect our tax rate in the fourth quarter to approach 40%. Keep in mind that the full year rate will be impacted by the tax benefit we recognized in the third quarter.
And we are forecasting approximately 1.45 billion weighted average shares for the year.
We expect total consolidated amortization for 2009 to be a little shy of $450 million. Depreciation should be just under $1 billion.
Net capital expenditures are expected to be in the range of $1 billion to $1.2 billion for 2009. Free cash flow is expected to be in the neighborhood of $3.5 billion.
So given our continued strong performance year-to-date, we are narrowing our earnings guidance range for 2009. We expect to deliver adjusted earnings per share from continuing operations excluding the effect of the tax benefit of $2.61 to $2.64, up from our previous guidance of $2.59 to $2.64.
Now I will turn it back over to Tom for some closing remarks.
Thomas M. Ryan
Thanks, Dave. Before opening it up for questions, I want to update you all on the CFO search. Earlier this year, as you know, Dave Rickard announced his intention to retire and we launched an internal and external search for our new CF]]>Thu, 14 Jan 2010 07:06:25 GMThttp://www.dailystocks.com/forum/showtopic.php?tid/3739/http://www.dailystocks.com/forum/showtopic.php?tid/3739/
BUSINESS OVERVIEW

General

Saul Centers, Inc. (“Saul Centers”) was incorporated under the Maryland General Corporation Law on June 10, 1993. Saul Centers operates as a real estate investment trust (a “REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). The Company is required to annually distribute at least 90% of its REIT taxable income (excluding net capital gains) to its stockholders and meet certain organizational and other requirements. Saul Centers has made and intends to continue to make regular quarterly distributions to its stockholders. Saul Centers, together with its wholly owned subsidiaries and the limited partnerships of which Saul Centers or one of its subsidiaries is the sole general partner, are referred to collectively as the “Company”. B. Francis Saul II serves as Chairman of the Board of Directors and Chief Executive Officer of Saul Centers.

The Company’s principal business activity is the ownership, management and development of income-producing properties. The Company’s long-term objectives are to increase cash flow from operations and to maximize capital appreciation of its real estate.

Saul Centers was formed to continue and expand the shopping center business previously owned and conducted by the B.F. Saul Real Estate Investment Trust, the B.F. Saul Company and certain other affiliated entities, each of which is controlled by B. Francis Saul II and his family members (collectively, “The Saul Organization”). On August 26, 1993, members of The Saul Organization transferred to Saul Holdings Limited Partnership, a newly formed Maryland limited partnership (the “Operating Partnership”), and two newly formed subsidiary limited partnerships (the “Subsidiary Partnerships”, and collectively with the Operating Partnership, the “Partnerships”), shopping center and office properties, and the management functions related to the transferred properties. Since its formation, the Company has developed and purchased additional properties.

As of December 31, 2008, the Company’s properties (the “Current Portfolio Properties”) consisted of 45 operating shopping center properties (the “Shopping Centers”), five predominantly office operating properties (the “Office Properties”) and six (non-operating) development properties. Shopping Centers and Office Properties represent reportable business segments for financial reporting purposes. Revenue, net income, total assets and other financial information of each reportable segment are described in Note 16 to the Consolidated Financial Statements contained in Item 8 of this Form 10-K.

The Company established Saul QRS, Inc., a wholly owned subsidiary of Saul Centers, to facilitate the placement of collateralized mortgage debt. Saul QRS, Inc. was created to succeed to the interest of Saul Centers as the sole general partner of Saul Subsidiary I Limited Partnership. The remaining limited partnership interests in Saul Subsidiary I Limited Partnership and Saul Subsidiary II Limited Partnership are held by the Operating Partnership as the sole limited partner. Through this structure, the Company owns 100% of the Current Portfolio Properties.

Management of the Current Portfolio Properties

The Operating Partnership manages the Current Portfolio Properties and will manage any subsequently acquired properties. The management of the properties includes performing property management, leasing, design, renovation, development and accounting duties for each property. The Operating Partnership provides each property with a fully integrated property management capability, with approximately 60 employees and with an extensive and mature network of relationships with tenants and potential tenants as well as with members of the brokerage and property owners’ communities. The Company currently does not, and does not intend to, retain third party managers or provide management services to third parties.

The Company augments its property management capabilities by sharing with The Saul Organization certain ancillary functions, at cost, such as computer and payroll services, benefits administration and in-house legal services. The Company also shares insurance administration expenses on a pro rata basis with The Saul Organization. Management believes that these arrangements result in lower costs than could be obtained by

contracting with third parties. These arrangements permit the Company to capture greater economies of scale in purchasing from third party vendors than would otherwise be available to the Company alone and to capture internal economies of scale by avoiding payments representing profits with respect to functions provided internally. The terms of all sharing arrangements with The Saul Organization, including payments related thereto, are specified in a written agreement and are reviewed annually by the Audit Committee of the Company’s Board of Directors.

The Company’s corporate headquarters lease commenced in March 2002 and is a sublease of office space from The Saul Organization at the Company’s share of the cost. A discussion of the lease terms are provided in Note 7, Long Term Lease Obligations, of the Notes to Consolidated Financial Statements.

Principal Offices

The principal offices of the Company are located at 7501 Wisconsin Avenue, Suite 1500, Bethesda, Maryland 20814-6522, and the Company’s telephone number is (301) 986-6200. The Company’s internet web address is www.saulcenters.com . Information contained on the Company’s internet website is not part of this report. The Company makes available free of charge on its internet website its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after the reports are electronically filed with, or furnished to, the Commission. Alternatively, you may access these reports at the Commission’s internet website: www.sec.gov.

Policies with Respect to Certain Activities

The following is a discussion of the Company’s operating strategy and certain of its investment, financing and other policies. These strategies and policies have been determined by the Board of Directors and, in general, may be amended or revised from time to time by the Board of Directors without a vote of the Company’s stockholders.

Operating Strategies

The Company’s primary operating strategy is to focus on its community and neighborhood shopping center business and to operate its properties to achieve both cash flow growth and capital appreciation. Community and neighborhood shopping centers typically provide reliable cash flow and steady long-term growth potential. Management actively manages its property portfolio by engaging in strategic leasing activities, tenant selection, lease negotiation and shopping center expansion and reconfiguration. The Company seeks to optimize tenant mix by selecting tenants for its shopping centers that provide a broad spectrum of goods and services, consistent with the role of community and neighborhood shopping centers as the source for day-to-day necessities. Management believes that such a synergistic tenanting approach results in increased cash flow from existing tenants by providing the Shopping Centers with consistent traffic and a desirable mix of shoppers, resulting in increased sales and, therefore, increased cash flows.

Management believes there is potential for long term growth in cash flow as existing leases for space in the Shopping Centers expire and are renewed, or newly available or vacant space is leased. The Company intends to renegotiate leases where possible and seek new tenants for available space in order to maximize this potential for increased cash flow. As leases expire, management expects to revise rental rates, lease terms and conditions, relocate existing tenants, reconfigure tenant spaces and introduce new tenants with the goal of increasing cash flow. In those circumstances in which leases are not otherwise expiring, management selectively attempts to increase cash flow through a variety of means, or in connection with renovations or relocations, recapturing leases with below market rents and re-leasing at market rates, as well as replacing financially troubled tenants. When possible, management also will seek to include scheduled increases in base rent, as well as percentage rental provisions, in its leases.

Certain Shopping Centers contain undeveloped parcels within the centers which are suitable for development as free-standing retail facilities, such as restaurants, banks or auto centers. Management will continue to seek desirable tenants for facilities to be developed on these sites and to develop and lease these sites in a manner that complements the Shopping Centers in which they are located.

The Company will also seek growth opportunities in its Washington, DC metropolitan area office portfolio, primarily through development and redevelopment. Management also intends to negotiate lease renewals or to re-lease available space in the Office Properties, while considering the strategic balance of optimizing short-term cash flow and long-term asset value.

It is management’s intention to hold properties for long-term investment and to place strong emphasis on regular maintenance, periodic renovation and capital improvement. Management believes that characteristics as cleanliness, lighting and security are particularly important in community and neighborhood shopping centers, which are frequently visited by shoppers during hours outside of the normal work-day. Management believes that the Shopping Centers and Office Properties generally are attractive and well maintained. The Shopping Centers and Office Properties will undergo expansion, renovation, reconfiguration and modernization from time to time when management believes that such action is warranted by opportunities or changes in the competitive environment of a property. Several of the Shopping Centers have been renovated recently. During 2008 and 2007, the Company was involved in redevelopment or expansions of five of its operating properties and developing three new shopping centers, Ashland Square Phase I, Westview Village and Northrock. Additionally the Company is constructing Clarendon Center, a mixed-use development containing ground floor retail, office and apartments. The Company will continue its practice of expanding existing properties by undertaking new construction on outparcels suitable for development as free standing retail or office facilities.

Investment in Real Estate or Interests in Real Estate

The Company’s redevelopment and renovation objective is to selectively and opportunistically redevelop and renovate its properties, by replacing leases with below market rents with strong, traffic-generating anchor stores such as supermarkets and drug stores, as well as other desirable local, regional and national tenants. The Company’s strategy remains focused on continuing the operating performance and internal growth of its existing Shopping Centers, while enhancing this growth with selective retail redevelopments and renovations.

In light of the current capital constrained market, management believes acquisition and development opportunities for investment in existing and new shopping center and office properties are limited. However, management believes that the Company is positioned to take advantage of these opportunities when market conditions change because of its conservative capital structure. (See “Capital Policies” following) It is management’s view that several of the sub-markets in which the Company operates have very attractive supply/demand characteristics. The Company will continue to evaluate acquisition, development and redevelopment as an integral part of its overall business plan.

In evaluating a particular redevelopment, renovation, acquisition, or development, management will consider a variety of factors, including (i) the location and accessibility of the property; (ii) the geographic area (with an emphasis on the Washington, DC/Baltimore metropolitan area and the southeastern region of the United States) and demographic characteristics of the community, as well as the local real estate market, including potential for growth and potential regulatory impediments to development; (iii) the size of the property; (iv) the purchase price; (v) the non-financial terms of the proposed acquisition; (vi) the availability of funds or other consideration for the proposed acquisition and the cost thereof; (vii) the “fit” of the property with the Company’s existing portfolio; (viii) the potential for, and current extent of, any environmental problems; (ix) the current and historical occupancy rates of the property or any comparable or competing properties in the same market; (x) the quality of construction and design and the current physical condition of the property; (xi) the financial and other characteristics of existing tenants and the terms of existing leases; and (xii) the potential for capital appreciation.

Although it is management’s present intention to concentrate future acquisition and development activities on community and neighborhood shopping centers and office properties in the Washington, DC/Baltimore metropolitan area and the southeastern region of the United States, the Company may, in the future, also acquire other types of real estate in other areas of the country as opportunities present themselves. While the Company may diversify in terms of property locations, size and market, the Company does not set any limit on the amount or percentage of Company assets that may be invested in any one property or any one geographic area.

The Company intends to engage in such future investment or development activities in a manner that is consistent with the maintenance of its status as a REIT for federal income tax purposes and that will not make the Company become regulated as an investment company under the Investment Company Act of 1940, as amended. Equity investments in acquired properties may be subject to existing mortgage financings and other indebtedness or to new indebtedness which may be incurred in connection with acquiring or refinancing these investments.

Investments in Real Estate Mortgages

While the Company’s current portfolio of, and its business objectives emphasize, equity investments in commercial and neighborhood shopping centers and office properties, the Company may, at the discretion of the Board of Directors, invest in mortgages, participating or convertible mortgages, deeds of trust and other types of real estate interests consistent with its qualification as a REIT. However, the Company does not presently have nor intend to invest in real estate mortgages.

Investments in Securities of or Interests in Persons Engaged in Real Estate Activities and Other Issues

Subject to the tests necessary for REIT qualification, the Company may invest in securities of other REITs, other entities engaged in real estate activities or securities of other issuers, including for the purpose of exercising control over such entities. However, the Company does not presently have any investment in securities of other REITs.

Dispositions

The Company does not currently intend to dispose of any of its properties, although the Company reserves the right to do so if, based upon management’s periodic review of the Company’s portfolio, the Board of Directors determines that such action would be in the best interest of the Company’s stockholders.

Capital Policies

The Company has established a debt capitalization policy relative to asset value, which is computed by reference to the aggregate annualized cash flow from the properties in the Company’s portfolio rather than relative to book value. The Company has used a measure tied to cash flow because it believes that the book value of its portfolio properties, which is the depreciated historical cost of the properties, does not accurately reflect the Company’s ability to incur indebtedness. Asset value, however, is somewhat more variable than book value, and may not at all times reflect the fair market value of the underlying properties. As a general policy, the Company intends to maintain a ratio of its total debt to total asset value of 50% or less and to actively manage the Company’s leverage and debt expense on an ongoing basis in order to maintain prudent coverage of fixed charges. Given the Company’s current debt level, it is management’s belief that the ratio of the Company’s debt to total asset value is below 50% as of December 31, 2008.

The organizational documents of the Company do not limit the absolute amount or percentage of indebtedness that it may incur. The Board of Directors may, from time to time, reevaluate the Company’s debt capitalization policy in light of current economic conditions, relative costs of capital, market values of the Company property portfolio, opportunities for acquisition, development or expansion, and such other factors as the Board of Directors then deems relevant. The Board of Directors may modify the Company’s debt capitalization policy based on such a reevaluation without shareholder approval and consequently, may increase or decrease the Company’s debt to total asset ratio above or below 50% or may waive the policy for certain periods of time, subject to maintaining compliance with financial covenants within existing debt agreements. The Company selectively continues to refinance or renegotiate the terms of its outstanding debt in order to achieve longer maturities, and obtain generally more favorable loan terms, whenever management determines the financing environment is favorable.

The Company intends to finance future acquisitions and developments and to make debt repayments by utilizing the sources of capital then deemed to be most advantageous. Such sources may include undistributed operating cash flow, secured or unsecured bank and institutional borrowings, proceeds from the Company’s Dividend Reinvestment and Stock Purchase Plan, proceeds from the sale of properties and private and public offerings of debt or equity securities. Borrowings may be at the Operating Partnership or Subsidiary Partnerships’ level and securities offerings may include (subject to certain limitations) the issuance of Operating Partnership interests convertible into common stock or other equity securities.

Other Policies

The Company has authority to offer equity or debt securities in exchange for property and to repurchase or otherwise acquire its common stock or other securities in the open market or otherwise, and may engage in such activities in the future. The Company expects, but is not obligated, to issue common stock to holders of units of the Operating Partnership upon exercise of their redemption rights. The Company has not engaged in trading, underwriting or agency distribution or sale of securities of other issues other than the Operating Partnership and does not intend to do so. The Company has not made any loans to third parties, although the Company may in the future make loans to third parties. In addition, the Company has policies relating to related party transactions discussed in “Item 1A. Risk Factors.”

Competition

As an owner of, or investor in, community and neighborhood shopping centers and office properties, the Company is subject to competition from an indeterminate number of companies in connection with the acquisition, development, ownership and leasing of similar properties. These investors include investors with access to significant capital, such as domestic and foreign corporations and financial institutions, publicly traded and privately held REITs, private institutional investment funds, investment banking firms, life insurance companies and pension funds.

With respect to acquisitions and developments, this competition may reduce properties available for acquisition or development or increase prices for raw land or developed properties of the type in which the Company invests. The Company faces competition in providing leases to prospective tenants and in re-letting space to current tenants upon expiration of their respective leases. If the Company’s tenants decide not to renew or extend their leases upon expiration, the Company may not be able to re-let the space. Even if the tenants do renew or the Company can re-let the space, the terms of renewal or re-letting, including the cost of required renovations, may be less favorable than current lease terms or than expectations for the space. This risk may be magnified if the properties owned by our competitors have lower occupancy rates than the Company’s properties. As a result, these competitors may be willing to make space available at lower prices than the space in the Current Portfolio Properties.

Management believes that success in the competition for ownership and leasing property is dependent in part upon the geographic location of the property, the tenant mix, the performance of property managers, the amount of new construction in the area and the maintenance and appearance of the property. Additional competitive factors impacting the Company’s properties include the ease of access to the properties, the adequacy of related facilities such as parking, and the demographic characteristics in the markets in which the properties compete. Overall economic circumstances and trends and new properties in the vicinity of each of the Current Portfolio Properties are also competitive factors.

Finally, retailers at our Shopping Centers face increasing competition from outlet stores, discount shopping clubs and other forms of marketing goods, such as direct mail, internet marketing and telemarketing. This competition may reduce percentage rents payable to us and may contribute to lease defaults or insolvency of tenants.

Environmental Matters

The Current Portfolio Properties are subject to various laws and regulations relating to environmental and pollution controls. The impact upon the Company from the application of such laws and regulations either prospectively or retrospectively is not expected to have a materially adverse effect on the Company’s property operations. As a matter of policy, the Company requires an environmental study be performed with respect to a property that may be subject to possible environmental hazards prior to its acquisition to ascertain that there are no material environmental hazards associated with such property.

Employees

As of March 12, 2009, the Company employed approximately 60 persons, including six leasing officers. None of the Company’s employees are covered by collective bargaining agreements. Management believes that its relationship with employees is good.

Recent Developments

The current economic slowdown, lack of credit availability, rising unemployment and deterioration of the housing market have had an effect on the Company’s results of operations during 2008. Increased vacancies and credit loss reserves, particularly independent small shop retailers and restaurants at the Company’s Loudoun County, Northern Virginia and Florida shopping centers, have negatively impacted current year earnings. The Company has also experienced an increase in credit loss reserves as small shop tenants have slowed their rent payments as a result of declining year over year sales. Management believes that our portfolio, both its geographic locations and tenant mix, is well positioned for this economic downturn, but believes operating results will continue to be negatively affected. In addition, at December 31, 2008 approximately 97% of the Company’s debt consisted of fixed rate, amortizing non-recourse mortgage loans, none of which mature until December 2011. The Company believes it has adequate capital capacity, consisting of construction loans and borrowing availability on its revolving credit facility to continue its current development projects.

Acquisition and Development Activity

A significant contributor to the Company’s recent growth in its shopping center portfolio has been its land acquisitions and subsequent development, redevelopment of existing centers and operating property acquisition activities. Redevelopment activities reposition the Company’s centers to be competitive in the current retailing environment. These redevelopments typically include an update of the facade, site improvements and reconfiguring tenant spaces to accommodate tenant size requirements and merchandising evolution. During the period January 1, 2006 though February 2009, the Company acquired three land parcels located in the Washington, DC metropolitan area, is developing neighborhood shopping centers on two of the parcels and acquired six operating neighborhood shopping center properties. In summary, since year end 2005, the Company’s leasable area has grown by approximately 11% (0.8 million square feet), from 7.4 million square feet to approximately 8.2 million square feet.

CEO BACKGROUND

Name
Age

Principal Occupation and Current Directorships
Class One Directors–Term Ends at 2012 Annual Meeting (if elected)

Philip D. Caraci 70 Vice Chairman since March 2003, Director since June 1993. President from 1993 to March 2003. Senior Vice President and Secretary of the B. F. Saul Real Estate Investment Trust from 1987 to 2003. Executive Vice President of the B. F. Saul Company from 1987 to 2003, with which he had been associated since 1972. President of B. F. Saul Property Company from 1986 to 2003. Trustee of the B. F. Saul Real Estate Investment Trust.

Gilbert M. Grosvenor 77 Director since June 1993. President (1980 through 1996) and Chairman of the Board of Trustees since 1987 of the National Geographic Society, with which he has been associated since 1954. Trustee of the B. F. Saul Real Estate Investment Trust.

Philip C. Jackson, Jr. 80 Director since June 1993 . Adjunct Professor Emeritus at Birmingham-Southern College from 1989 to 1999. Member of the Thrift Depositors’ Protection Oversight Board from 1990 until 1993. Vice Chairman and a Director of Central Bancshares of the South (Compass Bancshares, Inc.) from 1980 to 1989. Member of the Board of Governors of the Federal Reserve System from 1975 to 1978.

David B. Kay 52 Director since October 2002 . Chief Financial Officer for Municipal Mortgage & Equity, LLC, (MMA) a publicly traded real estate investment company specializing in arranging debt and equity financing for real estate and clean energy projects. Managing Director of Navigant Consulting, Inc. from September 2005 to November 2007. Chief Financial Officer of J.E. Robert Companies from 2002 to 2005. Partner with Arthur Andersen LLP from 1990 to 2002. Director of Union Street Acquisition Corporation.*

Mark Sullivan III 67 Director since April 2008, previously served as Director from 1997 through 2002. U.S. Executive Director of the European Bank for Reconstruction and Development from 2002 to April 2008. Attorney representing financial service providers from 2000 to 2002. President of the Small Business Funding Corporation, a company providing a secondary market facility for the purchase and securitization of small business loans from 1996 to 1999. Practiced law in Washington, DC, advising senior management of financial institutions on legal and policy matters from 1989 to 1996.
Class Two Directors–Term Ends at 2010 Annual Meeting

General Paul X. Kelley 80 Director since June 1993 . Partner, J. F. Lehman & Company since 1998. Chairman of American Battle Monuments Commission from 2001 to 2005. Commandant of the Marine Corps and member of the Joint Chiefs of Staff from 1983 to 1987. Director of OAO Technology Solutions, Inc. and London Life Reinsurance Company.

Charles R. Longsworth 79 Director since June 1993 . Chairman Emeritus of Colonial Williamsburg Foundation. President and Trustee of Colonial Williamsburg Foundation from 1977 through 1994. President Emeritus, Hampshire College. Chairman Emeritus, Trustees of Amherst College.

Patrick F. Noonan 66 Director since June 1993 . Chairman Emeritus of The Conservation Fund. Chairman of The Conservation Fund from 1985 through 2003. Trustee of the National Geographic Society and Vice-Chairman of the National Geographic Education Foundation. Member of the Board of Advisors of Duke University School of the Environment.


MANAGEMENT DISCUSSION FROM LATEST 10K

Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) begins with the Company’s primary business strategy to give the reader an overview of the goals of the Company’s business. This is followed by a discussion of the critical accounting policies that the Company believes are important to understanding the assumptions and judgments incorporated in the Company’s reported financial results. The next section, beginning on page 41, discusses the Company’s results of operations for the past two years. Beginning on page 46, the Company provides an analysis of its liquidity and capital resources, including discussions of its cash flows, debt arrangements, sources of capital and financial commitments. Finally, on page 55, the Company discusses funds from operations, or FFO, which is a relative non-GAAP financial measure of performance of an equity REIT used by the REIT industry.

The MD&A should be read in conjunction with the other sections of this Annual Report on Form 10-K, including the consolidated financial statements and notes thereto appearing in Item 8 of this report. Historical results set forth in Selected Financial Information, the Consolidated Financial Statements and Supplemental Data included in Item 6 and Item 8 and this section should not be taken as indicative of the Company’s future operations.

Overview

The Company’s principal business activity is the ownership, management and development of income-producing properties. The Company’s long-term objectives are to increase cash flow from operations and to maximize capital appreciation of its real estate investments.

The Company’s primary operating strategy is to focus on its community and neighborhood shopping center business and to operate its properties to achieve both cash flow growth and capital appreciation. Management believes there is potential for growth in cash flow as existing leases for space in the Shopping Centers expire and are renewed, or newly available or vacant space is leased. The Company intends to renegotiate leases where possible and seek new tenants for available space in order to maximize this potential for increased cash flow. As leases expire, management expects to revise rental rates, lease terms and conditions, relocate existing tenants, reconfigure tenant spaces and introduce new tenants with the goal of increasing cash flow. In those circumstances in which leases are not otherwise expiring, management selectively attempts to increase cash flow through a variety of means, or in connection with renovations or relocations, recapturing leases with below market rents and re-leasing at market rates, as well as replacing financially troubled tenants. When possible, management also will seek to include scheduled increases in base rent, as well as percentage rental provisions, in its leases.

The Company’s redevelopment and renovation objective is to selectively and opportunistically redevelop and renovate its properties, by replacing leases with below market rents with strong, traffic-generating anchor stores such as supermarkets and drug stores, as well as other desirable local, regional and national tenants. The Company’s strategy remains focused on continuing the operating performance and internal growth of its existing Shopping Centers, while enhancing this growth with selective retail redevelopments and renovations.

In light of the current capital constrained market, management believes acquisition and development opportunities for investment in existing and new shopping center and office properties are limited. However, management believes that the Company is positioned to take advantage of these opportunities when market conditions change because of its conservative capital structure. It is management’s view that several of the sub-markets in which the Company operates have very attractive supply/demand characteristics. The Company will continue to evaluate acquisition, development and redevelopment as an integral part of its overall business plan.

Although there has been a downturn in the national real estate market, to date, the effects on the office and retail markets in the metropolitan Washington, D.C. area, where the majority of the Company’s properties are located, have been less severe. However, continued deterioration in the local economies where the Company’s properties are located may lead to increased tenant bankruptcies, increased vacancies and decreased rental rates.

With a severe decline in overall consumer spending, retailers continue to struggle with declining sales and limited access to capital. Store closings are on the increase and retailers expanding their store count have disappeared. Vacancies have increased from a year ago. Our overall portfolio leasing percentage ended the year at 94.2%, a decrease from 95.3% at year end 2007. Weakness was largely centered in small shop closures in both our Loudoun County, Virginia and Florida shopping centers. Small in-line restaurants were particularly hard hit, although consumer’s spending at grocery stores increased by 2% in 2008 at our 28 grocery stores which reported sales.

In addition, because of the Company’s conservative capital structure, the Company has not been significantly affected by the recent turmoil in the credit markets. First, the Company maintains a ratio of total debt to total assets of under 50%, which allows the Company to obtain additional secured borrowings if necessary. Second, as of December 31, 2008, fixed rate debt represented approximately 97% of the Company’s notes payable, thus minimizing the effect of increased interest rates on the Company’s financial condition. Third, the Company’s earliest significant fixed rate debt maturity is not until 2011. Finally, as of December 31, 2008, the Company has loan availability of more than $149,000,000 on its $150,000,000 unsecured revolving line of credit.

Although it is management’s present intention to concentrate future acquisition and development activities on community and neighborhood shopping centers and office properties in the Washington, DC/Baltimore metropolitan area and the southeastern region of the United States, the Company may, in the future, also acquire other types of real estate in other areas of the country as opportunities present themselves. While the Company may diversify in terms of property locations, size and market, the Company does not set any limit on the amount or percentage of Company assets that may be invested in any one property or any one geographic area. In addition to investing in properties in the Washington, DC/Baltimore metropolitan area, from 2006 through 2008, the Company also acquired a grocery-anchored neighborhood shopping center in Florida, totaling 102,000 square feet and a grocery-anchored neighborhood shopping center in Georgia totaling 88,000 square feet.

Critical Accounting Policies

The Company’s accounting policies are in conformity with U.S. generally accepted accounting principles (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to use judgment in the application of accounting policies, including making estimates and assumptions. These judgments affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the Company’s financial statements and the reported amounts of revenue and expenses during the reporting periods. If judgment or interpretation of the facts and circumstances relating to various transactions had been different, it is possible that different accounting policies would have been applied resulting in a different presentation of the financial statements. Below is a discussion of accounting policies which the Company considers critical in that they may require judgment in their application or require estimates about matters which are inherently uncertain. Additional discussion of accounting policies which the Company considers significant, including further discussion of the critical accounting policies described below, can be found in the notes to the Consolidated Financial Statements.

Real Estate Investments

Real estate investment properties are stated at historic cost basis less depreciation. The Company intends to own its real estate investment properties over a long-term. No real estate investment properties have been sold since the Company’s formation in 1993. Management believes that these assets have generally appreciated in value since their acquisition and, accordingly, the aggregate current value exceeds their aggregate net book value and also exceeds the value of the Company’s liabilities as reported in these financial statements. Because these financial statements are prepared in conformity with U.S. GAAP, they do not report the current value of the Company’s real estate investment properties. The Company purchases real estate investment properties from time to time and allocates the purchase price to various components, such as land, buildings, and intangibles related to in-place leases and customer relationships in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) 141, “Business Combinations.” The purchase price is allocated based on the relative fair value of each component. The fair value of buildings is determined as if the buildings were vacant upon acquisition and subsequently leased at market rental rates. As such, the determination of fair value considers the present value of all cash flows expected to be generated from the property including an initial lease up period. The Company determines the fair value of above and below market intangibles associated with in-place leases by assessing the net effective rent and remaining term of the lease relative to market terms for similar leases at acquisition. In the case of above and below market leases, the Company considers the remaining contractual lease period and renewal periods, taking into consideration the likelihood of the tenant exercising its renewal options. The fair value of a below market lease component is recorded as deferred income and amortized as additional lease revenue over the remaining contractual lease period and any renewal option periods included in the valuation analysis. The fair value of above market lease intangibles is recorded as a deferred asset and is amortized as a reduction of lease revenue over the remaining contractual lease term. The Company determines the fair value of at-market in-place leases considering the cost of acquiring similar leases, the foregone rents associated with the lease-up period and carrying costs associated with the lease-up period. Intangible assets associated with at-market in-place leases are amortized as additional expense over the remaining contractual lease term. To the extent customer relationship intangibles are present in an acquisition, the fair value of the intangibles are amortized over the life of the customer relationship.

If there is an event or change in circumstance that indicates an impairment in the value of a real estate investment property, the Company prepares an impairment analysis to assess that the carrying value of the real estate investment property does not exceed its estimated fair value. The Company considers both quantitative and qualitative factors including recurring operating losses, significant decreases in occupancy, and significant adverse changes in legal factors and business climate. If impairment indicators are present the Company performs a comparison of the projected cash flows of the property over its remaining useful life, on an undiscounted basis, to the carrying value of that property. The Company assesses its undiscounted projected cash flows based upon estimated capitalization rates, historic operating results and market conditions that may affect the property. If such carrying value is greater than the undiscounted projected cash flows, the Company would recognize an impairment loss equivalent to an amount required to adjust the carrying amount to its then estimated fair market value. The value of any property is sensitive to the actual results of any of the aforementioned estimated factors, either individually or taken as a whole. Should the actual results differ from management’s projections, the valuation could be negatively or positively affected.

When incurred, the Company capitalizes the cost of improvements that extend the useful life of property and equipment. All repair and maintenance expenditures are expensed when incurred. In addition, we capitalize leasehold improvements when certain criteria are met, including when we supervise construction and will own the improvement. Tenant improvements we own are depreciated over the life of the respective lease or the estimated useful life of the improvements, whichever is shorter.

Interest, real estate taxes, development related salary costs and other carrying costs are capitalized on projects under construction. Once construction is substantially complete and the assets are placed in service, rental income, direct operating expenses, and depreciation associated with such properties are included in current operations.

In the initial rental operations of development projects, a project is considered substantially complete and available for occupancy upon completion of tenant improvements, but no later than one year from the cessation of major construction activity. Substantially completed portions of a project are accounted for as separate projects. Depreciation is calculated using the straight-line method and estimated useful lives of 35 to 50 years for base buildings and up to 20 years for certain other improvements.

Deferred Leasing Costs

Certain initial direct costs incurred by the Company in negotiating and consummating successful leases are capitalized and amortized over the initial base term of the leases. Deferred leasing costs consist of commissions paid to third party leasing agents as well as internal direct costs such as employee compensation and payroll related fringe benefits directly related to time spent performing successful leasing related activities. Such activities include evaluating prospective tenants’ financial condition, evaluating and recording guarantees, collateral and other security arrangements, negotiating lease terms, preparing lease documents and closing transactions. In addition, deferred leasing costs include amounts attributed to in-place leases associated with acquisition properties as determined pursuant to the application of SFAS No.141.

Revenue Recognition

Rental and interest income is accrued as earned except when doubt exists as to collectibility, in which case the accrual is discontinued. Recognition of rental income commences when control of the space has been given to the tenant. When rental payments due under leases vary from a straight-line basis because of free rent periods or scheduled rent increases, income is recognized on a straight-line basis throughout the initial term of the lease. Expense recoveries represent a portion of property operating expenses billed to tenants, including common area maintenance, real estate taxes and other recoverable costs. Expense recoveries are recognized in the period when the expenses are incurred. Rental income based on a tenant’s revenue, known as percentage rent, is accrued when a tenant reports sales that exceed a specified breakpoint specified in the lease agreement.

Allowance for Doubtful Accounts—Current and Deferred Receivables

Accounts receivable primarily represent amounts accrued and unpaid from tenants in accordance with the terms of the respective leases, subject to the Company’s revenue recognition policy. Receivables are reviewed monthly and reserves are established with a charge to current period operations when, in the opinion of management, collection of the receivable is doubtful. In addition to rents due currently, accounts receivable include amounts representing minimum rental income accrued on a straight-line basis to be paid by tenants over the remaining term of their respective leases. Reserves are established with a charge to income for tenants whose rent payment history or financial condition casts doubt upon the tenant’s ability to perform under its lease obligations.

Legal Contingencies

The Company is subject to various legal proceedings and claims that arise in the ordinary course of business. These matters are generally covered by insurance. While the resolution of these matters cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse effect on its financial position or the results of operations. Once it has been determined that a loss is probable to occur, the estimated amount of the loss is recorded in the financial statements. Both the amount of the loss and the point at which its occurrence is considered probable can be difficult to determine.

Total revenue increased 6.5% for the 2008 year compared to 2007 primarily due to (1) the contribution of operating revenue from three operating properties acquired during 2008 (Great Falls Center, BJ’s Wholesale Club and Marketplace at Sea Colony), an operating property acquired July 2007 (Orchard Park) and a development property (Ashland Square) placed in service during the fourth quarter of 2007 together defined as the “2008/2007 Development and Acquisition Properties” whose operating results are included in 2008’s operating income but not fully in the previous year’s results. The 2008/2007 Development and Acquisition Properties contributed $4,943,000 or 50.6% of the increase in revenue. Also contributing to the 2008 revenue increase was a revenue increase of $1,575,000 or 16.1% from the stabilization of Lansdowne Town Center. The balance of 2008’s revenue growth resulted from rental rate growth, increased parking revenue and increased lease termination fees in the remainder of the Company’s Current Portfolio Properties (the “Core Properties”).

Total revenue increased 9.1% for the 2007 year compared to 2006 primarily due to (1) the contribution of operating revenue from three development properties (Lansdowne Town Center, Broadlands Village III and Ashland Square Phase I) and an acquisition property (Orchard Park) placed in service during 2007 and two operating properties acquired during 2006, (Hunt Club Corners and Smallwood Village Center) together defined as the “2007/2006 Development and Acquisition Properties” whose operating results are included in 2007’s operating income but not fully in the previous year’s results. The 2007/2006 Development and Acquisition Properties contributed $7,013,000 or 55.6% of the increase in revenue. Also contributing to the 2007 revenue increase was rental rate growth in the remainder of the Company’s Core Properties and increased lease termination fees. A discussion of the components of revenue follows.

Base rent

The $6,193,000 increase in base rent for 2008 versus 2007 was primarily attributable (68.8% or approximately $4,258,000) to leases in effect at the 2008/2007 Development and Acquisition Properties and the stabilization of Lansdowne Town Center (18.1% or approximately $1,123,000). The balance of the increase was provided by rental rate growth in the Core Properties, particularly Southdale, Seven Corners and Leesburg Pike shopping centers, offset in part by base rent decreases at Broadlands Village, South Dekalb Plaza and Ashburn Village resulting from tenant vacancies.

The $8,685,000 increase in base rent for 2007 versus 2006 was primarily attributable (68.5% or approximately $5,950,000) to leases in effect at the 2007/2006 Development and Acquisition Properties. New leases at higher base rental rates than the predecessor leases at certain other properties accounted for the balance of the increase.

Expense recoveries

Expense recoveries represent a portion of property operating expenses billable to tenants, including common area maintenance, real estate taxes and other recoverable costs. The largest single contributor to the $2,976,000 increase in expense recovery income in 2008 compared to 2007, resulted from billings to tenants for their share of increased real estate tax expense in the Core Properties (58.0% or approximately $1,727,000). The operation of the 2008/2007 Development and Acquisition Properties (21.5% or approximately $639,000) and property operating expenses (20.5% or approximately $610,000) throughout the Core Properties accounted the balance of the increase.

The largest portion of the $3,454,000 increase in expense recovery income from 2006 to 2007 resulted from recovery of increased real estate tax resulting from higher assessed valuations in the Core Properties, and to a lesser extent the payment of taxes at 2007/2006 Development and Acquisition Properties (40.6% or approximately $1,402,000). Increased property operating expenses, particularly snow removal costs, at the Core Properties (39.4% or approximately $1,360,000) and 2007/2006 Development and Acquisition Properties (20.0% or approximately $692,000) contributed the balance of the increase.

Percentage rent

Percentage rent is rental revenue calculated on the portion of a tenant’s sales revenue that exceeds a specified breakpoint. Percentage rent increased slightly for 2008 compared to 2007.

Percentage rent decreased $270,000 in 2007 versus 2006 primarily as a result of timing differences in the submission of sales reports used to calculate percentage rent by two retail tenants (50.7% or approximately $137,000, each).

Other revenue

Other revenue consists primarily of parking revenue at three of the Office Properties, temporary lease rental income, payments associated with early termination of leases and interest income from the investment of cash balances. The increase in other revenue for 2008 compared to 2007 resulted primarily from increased parking revenue primarily at 601 Pennsylvania Avenue (38.2% or approximately $221,000), increased lease termination fees (29.7% or approximately $172,000), and interest income resulting from the investment of increased cash balances (23.7% or approximately $137,000).

Other revenue increased $738,000 during 2007 versus 2006 as a result of increased lease termination fees (62.3% or approximately $460,000), increased interest income from short-term investments (16.3% or approximately $120,000), and increased parking revenue in the office portfolio (11.7% or approximately $86,000).



Property operating expenses

Property operating expenses consist primarily of repairs and maintenance, utilities, payroll, insurance and other property related expenses. The largest single item contributing to the $1,119,000 increase in 2008 property operating expenses compared to the 2007 year was utility expense in the Core Properties (41.4% or approximately $463,000), a 10.8% increase over the prior year’s amount. The operation of the 2008/2007 Development and Acquisition Properties contributed 32.3% or approximately $361,000. The balance of the 2008 increase represents a 2.0% increase in repairs and maintenance, payroll, insurance and other property related expenses for the Core Properties.

The $2,480,000 increase in 2007 versus 2006 property operating expenses was caused primarily by the operation of the 2007/2006 Development and Acquisition Properties (47.9% or approximately $1,188,000) and increased snow removal costs due to winter storms experienced during the 2007 year (22.1% or approximately $549,000). The balance of the increase represents a 4.9% increase in property operating expenses for the Core Properties.

Provision for credit losses

The provision for credit losses represents the Company’s estimation that amounts previously included in income and owed by tenants may not be collectible. The largest contributor to the $737,000 credit loss increase in 2008 versus 2007 was a provision established for a rent dispute with a major tenant (55.5% or approximately $409,000). The Company established credit loss reserves for tenant rents receivable the majority of which were independent, small shop retailers, primarily at the Company’s Loudoun County, Northern Virginia shopping centers. The provision for credit losses of approximately seven tenths of one percent (0.7%) and three tenths of one percent (0.3%), of total revenue for 2008 and 2007, respectively, reflects the deteriorating impact of the declining housing conditions and frozen credit market.

The provision for credit losses was virtually unchanged from the prior year, a decrease of $24,000 for 2007 versus 2006. The provision for credit losses is less than three tenths of one percent (0.3%) of total revenue for each year, a reflection of the relative credit quality of the Company’s tenants.

Real estate taxes

The $2,524,000 increase in real estate taxes for 2008 versus 2007 was primarily due to a same property shopping center increase of $1,619,000 (64.1% of total real estate tax increase), a 16.5% increase over 2007’s amount, impacted largely by increased expense at several of the Company’s Northern Virginia shopping centers.

The Office Properties, particularly Van Ness Square and 601 Pennsylvania Avenue, contributed toward the increase (22.3% or approximately $564,000), a 13.6% increase over 2007’s amount, as well as the 2008/2007 Development and Acquisition Properties (13.6% or approximately $341,000).

The $1,581,000 increase in real estate taxes for 2007 versus 2006 was largely impacted by an increased value assessment at 601 Pennsylvania Avenue (35.8% or approximately $566,000). The 2007/2006 Development and Acquisition Properties also contributed to the increase (24.0% or approximately $380,000). In addition, several of the Company’s properties (Ashburn Village, Beacon Center, Countryside, The Glen and White Oak) received increases in assessed values during 2007 resulting in increased tax expense (together 28.3% or approximately $447,000).

Interest and amortization of deferred debt

Interest expense increased $423,000 in 2008 versus 2007 due to increased borrowing for the 2008/2007 Development and Acquisition Properties offset in part by increased capitalized interest on development projects. Average outstanding borrowing increased approximately $35,785,000 (average fixed rate borrowings increased approximately $38,678,000 while average variable rate borrowings (revolving credit line and construction loans) decreased approximately $2,893,000). The new borrowing reduced the average interest rate by approximately 0.13%. The combined impact of the new borrowings, at a lower average rate, resulted in an approximately $1,700,000 increase in interest expense. Interest capitalized as a cost of construction and development projects increased during 2008 compared to 2007 which resulted in a decrease of interest expense by approximately $1,270,000 ($4,159,000 versus $2,889,000) resulting primarily from construction activity at Clarendon Center, Northrock and Westview Village. Increased deferred debt cost amortization increased interest expense by approximately $13,000 ($1,162,000 versus $1,149,000).

Interest expense increased $1,261,000 and Deferred debt cost amortization increased $60,000 in 2007 versus 2006. Interest expense increased primarily due to the placement of a new permanent 15-year fixed rate mortgage on Lansdowne Town Center. During 2006, interest on Lansdowne’s construction borrowings were capitalized while those dollars were largely expensed in 2007 as the property became fully operational. On a portfolio wide basis, the average outstanding borrowings from 2006 to 2007 increased approximately $13,000,000 (approximately $871,000 increase in interest expense). Additionally, interest capitalized as a cost of construction and development projects decreased during 2007 compared to 2006 ($784,000 increase in interest expense). The change in capitalized interest is the equivalent of approximately $11,500,000 in construction borrowings converted to operating property debt. Offsetting these increases in interest expense was an approximately 8 basis point decrease in the average interest rate for the loan portfolio resulting from Lansdowne’s permanent mortgage rate being lower than the variable rate borrowings the permanent loan replaced ($394,000 decrease in interest expense). Deferred debt cost amortization expense was $1,149,000 and $1,089,000, for the 2007 and 2006 periods, respectively, ($60,000 increase in interest expense).

Depreciation and amortization

The $3,319,000 increase in depreciation and amortization of deferred leasing costs resulted primarily from asset retirements in conjunction with the redevelopment of Smallwood Village Center and Clarendon Center development (42.4% or approximately $1,406,000) and the commencement of depreciation on the 2008/2007 Development and Acquisition Properties placed in service during the preceding twelve months (22.0% or approximately $729,000). The write-off of deferred leasing costs and undepreciated leasehold improvements from tenants terminating their leases prior to their contractual lease expiration dates contributed to the remaining increase in depreciation and amortization of deferred leasing costs.

The $816,000 increase in depreciation and amortization expense resulted primarily from the 2007/2006 Development and Acquisition Properties placed in service during 2007 and 2006, and reflects the Company’s reduced level of acquisition activity compared to the 2004 and 2005 years.

General and administrative

General and administrative expenses consists of payroll, administrative and other overhead expenses. The $655,000 increase in general and administrative expenses for 2008 compared to 2007 resulted from increased staff expenses (88.9% or approximately $582,000) and real estate tax on land held for investment (31.0% or approximately $203,000), offset in part by reduced professional fees.

The $1,524,000 increase in general and administrative expenses for 2007 versus 2006 was largely attributable to increased payroll and employee benefit expenses for staff over 2006 levels and to the addition of several new administrative staff members (49.1% or approximately $748,000), the write-off of costs related to an abandoned acquisition of a land parcel (31.8% or approximately $484,000) and an increase in non-cash expense related to the issue of options to the Company’s directors and officers (19.4% or approximately $296,000).

Gain on property dispositions

In 2008, the Company recognized a gain of approximately $1,096,000, arising from insurance proceeds related to minor fire damage sustained at two shopping centers. The insurance proceeds are expected to fund substantially all of the restoration. The gain recognized was measured as the difference between insurance proceeds and the depreciated carrying value of the assets replaced. Additionally, the Company recognized a gain on property dispositions of approximately $205,000 representing proceeds from an insurance settlement for HVAC units vandalized at the Company’s West Park shopping center in Oklahoma City, Oklahoma.

The Company recognized a gain on the disposition of real estate of $139,000 in 2007. The 2007 gain represents additional condemnation proceeds recognized from the State of Maryland’s condemnation and taking of a small strip of unimproved land for a road widening project at White Oak shopping center. Original proceeds from the condemnation were received in 2004. There were no property dispositions in 2006.

Impact of Inflation

Inflation has remained relatively low during 2008 and 2007, with the exception of energy costs which fluctuated widely during 2008. Rising energy prices caused increases in utility expense, primarily gas and electric costs. The impact of rising operating expenses on the operating performance of the Company’s portfolio however, has been mitigated by terms of substantially all of the Company’s leases which contain provisions designed to increase revenues to offset the adverse impact of inflation on the Company’s results of operations. These provisions include upward periodic adjustments in base rent due from tenants, usually based on a stipulated increase and to a lesser extent on a factor of the change in the consumer price index, commonly referred to as the CPI.

In addition, substantially all of the Company’s properties are leased to tenants under long-term leases, which provide for reimbursement of operating expenses by tenants. These leases tend to reduce the Company’s exposure to rising property expenses due to inflation. Inflation and increased costs may have an adverse impact on the Company’s tenants if increases in their operating expenses exceed increases in their revenue.

Operating Activities

Cash provided by operating activities increased $1,904,000 to $73,101,000 for the year ended December 31, 2008 compared to $71,197,000 for the year ended December 31, 2007 primarily reflecting increased operating income of the 2008/2007 Development and Acquisition Properties as well as positive contributions from the core portfolio. Cash provided by operating activities represents, in each year, cash received primarily from rental income, plus other income, less property operating expenses, normal recurring general and administrative expenses and interest payments on debt outstanding.

Investing Activities

Cash used in investing activities increased $63,034,000 to $115,070,000 for the year ended December 31, 2008 compared to $52,036,000 for the year ended December 31, 2007. Investing activities for 2008 primarily reflects the acquisition of properties (Great Falls Center, BJ’s Wholesale and Marketplace at Sea Colony ), the construction of new and renovated shopping center properties (Clarendon Center, Northrock and Westview Village developments and the Smallwood Village Center and Boulevard renovations), tenant improvements and property capital expenditures throughout the portfolio. Investing activities for 2007 primarily reflects the development and construction of new properties (Lansdowne Town Center, Ashburn Village V, Ashland Square and Clarendon ]]>Wed, 13 Jan 2010 05:14:46 GMThttp://www.dailystocks.com/forum/showtopic.php?tid/3737/http://www.dailystocks.com/forum/showtopic.php?tid/3737/
BUSINESS OVERVIEW

With respect to this discussion, the terms “we,” “us,” “our,” “New Motion”, and the “Company” refer to New Motion, Inc., a Delaware corporation and its wholly-owned subsidiaries, including New Motion Mobile, Inc. and Traffix, Inc. (“Traffix”), also Delaware corporations.

A Note Concerning Presentation

This Annual Report on Form 10-K contains information concerning New Motion, Inc. as it pertains to the period covered by this report – for the two years ended December 31, 2008 and 2007. As a result of the acquisitions of Traffix, Inc., a Delaware corporation (“Traffix”), and Ringtone.com LLC (“Ringtone”), a Minnesota limited liability company, by New Motion, Inc. on February 4, 2008 and June 30, 2008 respectively, (explained herein), this Annual Report on Form 10-K also contains information concerning the combination of New Motion, Traffix and Ringtone, as of the date of this Annual Report.

Background and History of New Motion

New Motion, formerly known as MPLC, Inc., and prior to MPLC, Inc. as The Millbrook Press, Inc. was incorporated under the laws of the State of Delaware in 1994. Until 2004, the Company was a publisher of children’s nonfiction books for the school and library market and the consumer market under various imprints. As a result of market factors, and after an unsuccessful attempt to restructure its obligations out of court, on February 6, 2004, the Company filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code with the United States Bankruptcy Court for the District of Connecticut (the “Bankruptcy Court”). After filing for bankruptcy, the Company sold its imprints and remaining inventory and by July 31, 2004, had paid all secured creditors 100% of amounts owed. At that point in time, the Company was a “shell” company with nominal assets and no material operations. Beginning in January 2005, after the Bankruptcy Court’s approval, all pre-petition unsecured creditors had been paid 100% of the amounts owed (or agreed) and all post petition administrative claims submitted had been paid. In December 2005, $0.464 per eligible share was available for distribution and was distributed to stockholders of record as of October 31, 2005. The bankruptcy proceedings were concluded in January 2006 and no additional claims were permitted to be filed after that date.

New Motion Mobile, Inc. (our wholly-owned subsidiary) was formed in March 2005 and subsequently acquired the business of Ringtone Channel, an Australian aggregator of ringtones in June 2005. Ringtone Channel was originally incorporated on February 23, 2004. In 2004, Ringtone Channel began to sell ringtones internationally and then launched its first ringtone subscription service in the U.S. in February 2005. In August 2005, New Motion Mobile launched its first successful text message campaign incorporating music trivia. As of December 31, 2007, the Company’s Australian entity was dissolved.

On October 24, 2006, the Company and certain stockholders entered into a Common Stock Purchase Agreement with Trinad Capital Master Fund, Ltd. (“Trinad”), pursuant to which we agreed to redeem 23,448,870 shares of our common stock from existing stockholders and sell an aggregate of 69,750,000 shares of our common stock, representing 93% of our issued and outstanding shares of common stock, to Trinad in a private placement transaction for aggregate gross proceeds of $750,000.

In February 2007, we completed an exchange transaction (the “Exchange”) pursuant to which New Motion Mobile became our wholly-owned subsidiary. In connection with the Exchange, we raised gross proceeds of approximately $20 million in equity financing through the sale of our Series A Preferred Stock, Series B Preferred Stock and Series D Preferred Stock.

After receiving the requisite approval of our stockholders, on May 2, 2007, we filed a certificate of amendment to our restated certificate of incorporation with the Delaware Secretary of State to, among other things, change our corporate name to New Motion, Inc. from MPLC, Inc., and effect a 1-for-300 reverse split. In connection with these corporate actions, we also changed our ticker symbol to “NWMO.”

On February 4, 2008, we completed a merger with Traffix, Inc., a Delaware corporation. Pursuant to the merger, Traffix became our wholly owned subsidiary. Traffix is a leading interactive media and marketing company that provides complete end-to-end marketing solutions for its clients who seek to increase sales and customer contact deploying the numerous facets of online marketing Traffix offers. Following the consummation of our merger with Traffix, Traffix stockholders owned approximately 45% of our capital stock, on a fully-diluted basis. Also upon the closing of our transaction with Traffix, we commenced trading on The NASDAQ Global Market under the symbol “NWMO.”

On June 30 2008, New Motion entered into an Asset Purchase Agreement (“APA”) with Ringtone.com, LLC (“Ringtone”) and W3i Holdings LLC (“W3i”) pursuant to which the Company acquired certain assets from Ringtone.com, including but not limited to short codes, subscriber database, covenant not to compete , working capital, and certain domain names. In consideration for the assets and certain liabilities assumed, the Company at the closing paid to Ringtone.com approximately $7 million in cash. In addition, the Company delivered to Ringtone.com a convertible promissory note (the “Note”) in the aggregate principal amount of $1.75 million, which accrues interest at a rate of 10% per annum. As the effective conversion price was significantly greater than the fair value of the Company's stock at the commitment date, no value was assigned to the conversion feature upon issuance. The Note is payable on the earlier to occur of either (i) July 1, 2009, or (ii) 5 days after the Company gives written notice to Ringtone.com of its intent to prepay the Note (the “Maturity Date”). The Note is optionally convertible by Ringtone.com on the Maturity Date into the Company’s common stock at a conversion price of $5.42 per share. This payment of principal and interest on the Note is subject to certain recoupment provisions contained in the Note and APA.

On July 30, 2008, we entered into a Joint Venture Agreement to launch online and mobile marketing services and offer our mobile products in the Indian market. Under the agreement, we own 19% of the Joint Venture and are required to pay up to $325,000 in return for Compulsory Convertible Debentures which can be converted to common stock at any time, at our sole discretion. Amounts paid under the agreement as of December 31, 2008 were $125,000.

On October 30, 2008, we acquired a 36% minority interest in The Billing Resource, LLC (“TBR”). TBR provides alternative billing services to us and unrelated third parties. We contributed $2.2 million to TBR upon its formation and are committed to provide an additional $1.0 million of working capital to TBR to support its near-term growth.

On December 2, 2008, we entered into a Marketing Services and Content Agreement with Central Internet Corporation which operates the website www.shopit.com (Hereinafter referred to as “Shopit”). Under the agreement, we are required to perform certain marketing and administrative services for Shopit and distribute proprietary and third party advertisements through Shopit.com and its social media advertising network. The agreement provides Shopit with a revenue share of all leads monetized by the Company. As part of the agreement, we are required to make periodic advance payments totaling $1.025 million through March 2009. The advances, which are secured under separate agreement, are recoverable on a dollar for dollar basis against future revenues. As of December 31, 2008, we had advanced $425,000 to Shopit pursuant to the terms of the agreement.

The Business of New Motion

New Motion, Inc., doing business as Atrinsic, is one of the leading digital advertising and marketing services company in the United States. Atrinsic is organized as a single segment with two principal offerings: (1) Transactional services - offering full service online marketing and distribution services which are targeted and measurable online campaigns and programs for marketing partners, corporate advertisers, or their agencies, generating qualified customer leads, online responses and activities, or increased brand recognition, and (2) Subscription services - offering our portfolio of proprietary subscription based content applications direct to consumers distributed on a mobile internet or PC internet billed in three ways: to a mobile phone number, landline phone number , or, a credit card.

Atrinsic brings together the power of the Internet, the latest in mobile technology, and traditional marketing/advertising methodologies, creating a fully integrated multi platform vehicle for the advanced generation of qualified leads monetized by the sale and distribution of subscription content, brand-based distribution and pay-for-performance advertising. Atrinsic’s service’s content is organized into four strategic content groups - digital music, casual games, interactive contests, and communities/lifestyles. The Atrinsic brands include GatorArcade, a premium online and mobile gaming site, Ringtone.com, a mobile music download service, and iMatchUp, one of the first integrated web-mobile dating services. Feature-rich Transactional advertising services include a mobile ad network, extensive search capabilities, email marketing, one of the largest and growing publisher networks, and proprietary subscription content. Services are provided on a variety of pricing models including cost per action, fixed fee, or commission based arrangements.

Transactional Service - Full Service Online Marketing and Lead Generation

Our online marketing and distribution assets provide customers with a full range of marketing alternatives, which includes our wholly owned content network, affiliate marketing services, search engine marketing and optimization and list management – for both email and mobile mediums.

Proprietary Content Network : We own and operate a variety of Internet websites featuring specialized content across four principal content categories: interactive contests; casual games; communities and lifestyles; and digital music. Traffic is directed to these proprietary websites through advertisements on third-party Internet media (e.g., search engines, email and banner advertisements) and through cross-marketing within Atrinsic’s own network. Visitors to a content network website are ultimately directed to the valuable and unique content which they are registering for, but during this registration process, users are given the opportunity to sign-up or submit their contact information, for other offers and for various products and services.

Each of the content sites is designed for a specific consumer interest category that we match with client advertising/promotions that are expected to appeal to such interest category. The advertisements are served across all of the network using internally developed technology that serves ads to websites using an algorithm that takes into account a number of factors, including information supplied by the visitor upon registration, and by taking into account the price paid to Atrinsic by the client for the advertisement (the higher the price the earlier the offer or advertisement is displayed to the user).

Affiliate Marketing : Our affiliate marketing service comprises an online marketplace of more than 5,600 independent publishers who distribute internal and third party offers. The affiliate marketing group manages the online marketing mix for clients on a pay for performance basis via display advertisements and lead generation across a diverse set of industry verticals. This online marketplace allows publishers and advertisers to incorporate numerous unique and exclusive deals and customized promotions. We also provide affiliate partners with detailed tracking capabilities and significant multi-level customer support services.

Search Engine Marketing : We offer search engine marketing services, as well as search engine optimization, giving clients access to organic search engine results, which is one of the most popular mediums on which to advertise websites. We develop and manage search engine marketing campaigns for our third party advertising clients, as well as for our own proprietary websites, promotions and offers. Using proprietary technology, we build, manage and analyze the effectiveness of hundreds of thousands of pay per click keywords in real time across each of the major search engines, like Google, Yahoo and MSN. We also perform search engine optimization services, for which advertising clients are billed a monthly retainer fee.

List Management (Email and Mobile): Our list management services include targeted access to both email addresses and mobile phone numbers. Through online registrations, we capture email and cell phone addresses on free and paid for websites, which allows us to aggregate a large amount of email and mobile data. In addition to utilizing these lists for internal direct to consumer offers, we serve clients through our list management business. We rent and manage our proprietary, profiled databases. Programs can be implemented either through our numerous web properties, through email marketing, or to mobile phones. We, as a result of our regular operations, are constantly adding to our databases of unique mobile phone records and online registrations and cell phone submissions, in the process creating a substantial set of email and mobile lists that can be marketed to clients or utilized for internal marketing programs.

New Motion Subscription Based Services - Direct to Consumer Product

We have a diverse portfolio of products and sites promoted as “direct to consumer” and centered around four key areas: interactive contests; casual games; communities and lifestyles; and digital music. We are focused on selectively increasing our services portfolio with high-quality, innovative applications. This growing portfolio of mobile subscription and Internet media services is based primarily on internally generated content, augmented by licensed identifiable content, such as games, ringtones, wallpapers and images from third parties to whom we pay a licensing fee, generally on a per-download basis. The monthly end user subscription fees for our wireless subscription products and services generally range from $3.99 to $9.99.

Communities and Lifestyles Whether it is cooking, dating, or astrology, we build the spaces where relationships happen. Our communities are themed social networking destinations, designed to connect people to other people with similar interests. This category has users who self-select themselves in, so targeting is easy and advertiser return on investment is high.

Digital Music Everybody’s favorite tune has a home in Atrinsic’s digital music sector. One of the first formats to make the transition from web to phone, we started early on to gather one of the biggest music libraries in the digital space. All music is fully licensed and legal for download. Across this category, our products offer a selection of more than 35 genres and more than 30,000 songs. For our private label customers, our music library is customizable.

Casual Games Our casual gaming portfolio is expansive and growing, capturing most every demographic and interest area, and offering multiple marketing solutions. In addition to brand-building opportunities, our casual gaming destinations can deliver traffic to third-party sites through our search, data, email and publisher network. We also provide the option of flexible configurations and alternative packaging of the casual game portfolio in myriad combinations to suit the needs of publisher partners, to target niche markets, and, of course, to serve our own gaming audience.

Interactive Contests Our interactive contest and sweepstakes sites encourage an engaged, repeat audience ideal for both advertising programs and lead generation. As a result of the feature-rich relationship with participants, advertisers have many ways to reach out and touch subscribers and users, including through product placement through prize system and proprietary stores. The sites feature sweepstakes, games, loyalty programs, discount online stores, and extras like downloadable ringtones and wallpapers.

Our direct to consumer business, regardless of the product or service sold, is primarily a subscription based business. We frequently monitor a range of key metrics that have a direct impact on our ability to retain existing subscribers and our efficiency in acquiring new subscribers. Management regularly monitors the Long Term Value (“LTV”) of those subscribers taking into consideration cost per acquisition, churn rate of existing subscribers, churn rate of recurring subscribers, average revenue per user, billability of new subscribers, billability of existing subscribers and refund rates among others. Our ability to receive information on a daily, weekly, and monthly basis in order to calculate our operational metrics is critical to successfully running our business.

The Mobile Content Market

The wireless market has emerged as a result of the rapid growth and significant technological advancement in the wireless communications industry. Wireless carriers are delivering new handsets to new and existing subscribers which have the capability to download rich media content. Due to the increase in advanced mobile phones with the capabilities to handle rich media downloads, the potential market for mobile services will increase significantly in the coming years.

We believe that the growth in the wireless market has been positively influenced by a number of key factors and trends that we expect to continue in the near future, including:

• Growth in Wireless Subscribers. In 2005, the number of global wireless subscribers surpassed two billion and subscriber growth is expected to continue as wireless communications increase in emerging markets, including China and India. According to ITFacts Mobile Usage, which information is available publicly, the number of global wireless subscribers will grow from approximately 2 billion in 2005 to 2.3 billion in 2009. The North American wireless subscriber base currently exceeds 219 million. New handset delivery and adoption is expected to continue to accelerate in the U.S. market as current and new subscribers embrace newer mobile technology and media.

• Deployment of Advanced Wireless Networks. Wireless carriers are deploying high-speed, next-generation digital networks to enhance wireless voice and data transmission. These advanced networks have enabled the provisioning and billing of data applications and have increased the ability of wireless subscribers to quickly download large amounts of data, including games, music and video.

• Availability of Mobile Phones with Multimedia Capabilities. Annual mobile phone sales are expected to grow from 520 million units in 2003 to over one billion units in 2009, according to publicly available research conducted by Gartner Inc. In recent years, the mobile phone has evolved from a voice-only device to a personal data and voice communications device that enables access to wireless content and data services. Mobile phone manufacturers are competing for consumers by designing next-generation mobile phones with enhanced features including built-in digital cameras, color screens, music and data connectivity. Manufacturers are also embedding application environments such as BREW, Java, Symbian, iPhone and Android into mobile phones to enable multimedia applications, including gaming. We believe the availability of these next-generation mobile phones is driving demand for wireless subscription applications taking advantage of these advanced multimedia capabilities. According to data released by NPD Group, 23% of all mobile phones sold in the United States in the 4 th quarter of 2008, were Smartphones compared to 12% in the fourth quarter of 2007.

Off Portal Direct to Consumer Market Dynamics. Prior to November 2004, all U.S. carriers maintained a “walled garden” approach that prevented any direct to consumer off portal sites from succeeding, while in Europe and Asia, a large percentage of mobile subscription revenue came from off deck direct to consumer portals. Witnessing the huge success of direct to consumer portals in those geographies, specific U.S. carriers opened the walled garden in late 2004 and early 2005. By allowing premium SMS billing to direct-to-consumer off portal sites, the carriers opened up a potential multi-billion dollar industry opportunity.

• Demand for Wireless Entertainment. Wireless carriers and other off-deck content providers are increasingly launching and promoting wireless subscription applications to differentiate their services and increase average revenue per user. The delivery of games, ringtones, images and other subscription content to subscribers enables wireless carriers to leverage both the increasing installed base of next-generation mobile phones and their investment in high-bandwidth wireless networks. Consumers are downloading and paying for wireless subscription content offered by the carriers and off-deck providers. According to eMarketer, the mobile content market is expected to grow from $1.5 billion in revenue in 2007 to $37.5 billion by 2010, representing a compound annual growth rate of 62%.

• Growth in Our Core Market – North America. According to IDC, the wireless messaging market is forecast to grow from 54.6 billion messages in 2004 to 387.9 billion messages exchanged in 2009, and Juniper Research expects the North American user base to increase steadily with a compounded growth rate of around 28%, which is roughly twice that of Europe. Even though Asia and Europe are expected to remain the largest market for mobile entertainment, the North American market will represent the highest growth potential. According to Juniper Research, North America will represent a total of 12% of the mobile subscription industry in 2006 and growing to 19% in 2009.

Mobile Subscription and Internet Media Competitive Landscape

The development, distribution and sale of wireless subscription applications is a highly competitive business. In this market, we compete primarily on the basis of marketing acquisition costs, brand strength, and carrier and distribution breadth. We are also subject to intense competition in the online advertising and Internet media market. Within these markets, we compete on the basis of employing traditional direct marketing disciplines, such as continuously analyzing marketing results and measuring advertising cost effectiveness, and applying it to the online marketing world.

The wireless subscription and online marketing markets are highly competitive and characterized by frequent product introductions, evolving platforms and new technologies. As demand for these services continues to increase, we expect new competitors to enter the market and existing competitors to allocate more resources to develop and market to customers. As a result, we expect competition to intensify.

The current and potential competition in the markets in which we operate includes major media companies, traditional publishing companies, wireless carriers, wireless software providers, Internet affiliate and network companies. Larger, more established companies are increasingly focused on developing and distributing products and services that directly compete with us.

Currently some of our competitors in the mobile subscription market are Buongiorno, Playphone, Dada Mobile, Acotel, Glu Mobile, Cellfish (Lagadere), Jamster (Fox), Hands on Mobile and Thumbplay.

In the online advertising and network market, competitors include Azoogle, Value Click, Miva, Kowabunga! (Think Partnership), Right Media, Aptimus, iCrossing, 360i, Omnicom, iProspect, Publicis(Formerly Digitas), and, Blue Lithium. We believe that our extensive experience in Internet marketing, our existing subscriber base and our range of products and services enable us to compete effectively against all current and potential new entrants.

Distribution Channels

We currently distribute the majority of our subscription products and services directly to consumers, or “offdeck,” which is independent of the carriers, primarily through the Internet. We bill and collect revenues for our products and services through third-party aggregators who are connected to the majority of U.S. wireless carriers and their customers. We have agreements through multiple aggregators who have direct access to U.S. carriers for billing. Our customers download products or subscribe to services on their mobile phones and are billed monthly through their wireless carrier. Both the carriers and the aggregators retain fees for their services before amounts are remitted to us. Our aggregator agreements are not exclusive and generally have a limited term of one or two years, with evergreen or automatic renewal provisions upon expiration of the initial term. The agreements generally do not obligate the carriers or aggregators to market or distribute any of our products and services. In addition, any party can terminate these agreements early and, in some instances, without cause.

We have agreements to distribute our subscription products in North America through a number of aggregators who have access to the majority of U.S. and Canadian based wireless carriers, whose networks serve approximately 215 million subscribers. These wireless carriers include Cingular / AT&T Wireless, Nextel, Sprint PCS, T-Mobile, Verizon Wireless and Alltel. In addition to agreements with aggregators, we also have an agreement in place with AT&T Wireless to distribute and bill for our products directly to subscribers on their network.

For the year ended December 31, 2008, we billed approximately 13% of our revenue through aggregation services provided by one Aggregator with no more than 8% billed through a second Aggregator. For the year ended December 31, 2007, we billed approximately 87 % of our revenue through aggregation services provided by one Aggregator with no more than 1% of our revenue billed through a second Aggregator.

Technology Platform

Our web properties utilize proprietary technologies to generate real-time response-based marketing results for our advertising clients. Our proprietary technology continually analyzes marketing results to gauge whether campaigns are generating adequate results for the client, whether the media is being utilized cost-efficiently, and to determine whether new and different copy is yielding better overall results. We also employ other proprietary tools which allow us to monitor and analyze, in real time, our marketing and media costs associated with various campaigns. The technology measures, in real time, effective buys on a per campaign basis which allows us to adjust marketing efforts immediately towards the most effective campaigns and mediums. These tools allow us to be more efficient and effective in our media buys. We believe we have a low cost per acquisition rate, due in large part due to these technologies.

Employees

As of December 31, 2008, New Motion has 206 employees and full-time consultants in the United States and Canada. We have never had a work stoppage and none of our employees are represented by a labor organization or under any collective bargaining arrangements. We consider our employee relations to be good.

Government Regulation

As a direct-to-consumer marketing company we are subject to a variety of Federal, State and Local laws and regulations designed to protect consumers that govern certain of our marketing practices. Also, since our products and services are accessible on mobile phones and the Internet, we are exposed to legal and regulatory developments affecting the Internet and telecommunications services in general.

There is substantial uncertainty as to the applicability to the Internet of existing laws governing issues such as property ownership, copyrights and other intellectual property issues, taxation, defamation, obscenity and privacy. The vast majority of these laws were adopted prior to the advent of the Internet and, as a result, did not contemplate the unique issues of the Internet. In addition, there have been various regulations and court cases relating to companies’ online business activities, including in the areas of data protection, trademark, copyright, fraud, indecency, obscenity and defamation. Future developments in the law might decrease the growth of the Internet, impose taxes or other costly technical requirements, create uncertainty in the market or in some other manner have an adverse effect on the Internet. These developments could, in turn, have a material adverse effect on our business, prospects, financial condition and results of operations.

Due to the increasing popularity and use of the Internet, a number of laws and regulations have been adopted at the international, federal, state and local levels with respect to the Internet. Many of these laws cover issues such as privacy, freedom of expression, pricing, online products and services, taxation, advertising, intellectual property, information security and the convergence of traditional telecommunications services with Internet communications. Moreover, a number of laws and regulations have been proposed and are currently being considered by Federal, State, Local and foreign legislatures with respect to these issues. The nature of any new laws and regulations and the manner in which existing and new laws and regulations may be interpreted and enforced cannot be fully determined.


We provide many of our services through carriers’ networks. These networks are subject to regulation by the U.S. Federal Communications Commission (“FCC”), state public utility commissions and foreign governmental authorities. However, in the Company’s capacity of providing services via the Internet, it is generally not subject to direct regulation by the FCC.

Federal legislation was signed into law, effective January 1, 2004, substantially pre-empting existing and pending state email marketing legislation. The CAN-SPAM Act of 2003 (“CAN-SPAM”) requires that certain “opt-out” procedures, including, but not limited to, a functioning return e-mail address, be included in commercial e-mail marketing. CAN-SPAM prohibits the sending of e-mail containing false, deceptive or misleading subject lines, routing information, headers and/or return address information; however, CAN-SPAM does not permit consumers to file suit against e-mail marketers for violations of CAN-SPAM. We believe that this may benefit us, as individuals will be more limited in their ability to file frivolous suits against us. If any subsequent federal regulations are enacted, including, but not limited to, those implementing regulations promulgated by the FCC that limit our ability to market our products and services, such regulations could potentially have a material adverse impact in our future fiscal period net revenue growth, and, therefore, our profitability and cash flows could be adversely affected.

In contrast to CAN-SPAM, most state deceptive marketing statutes contain private rights of action. Such private right of action lawsuits may have an adverse impact in future fiscal period net revenue growth, as individuals may be more inclined to file frivolous state deceptive marketing suits against us.

In August 2004, under its rule-making authority, the FCC adopted rules prohibiting sending of unsolicited commercial e-mails to wireless phones and pagers. To assist in compliance with the rules, the FCC published on February 7, 2005 a list of mail domain names associated with wireless devices. Senders were given thirty (30) days to come into compliance. Thereafter, it became illegal to send unsolicited commercial e-mail to a domain address on the list unless the subscriber gave prior express authorization. The effect of these rules is to create a ‘double opt-in’ requirement for each sender of mail (advertiser and publisher). The practical consequence of these requirements on senders of commercial e-mail is that conducting compliant campaigns will necessitate the suppression of the domains listed in the FCC's list of wireless domains. Additionally, since domain suppression is now required as a practical matter by law, any campaigns that have domain suppression lists will have those lists included with the regular e-mail suppression lists. Our publishers will be required to suppress the domain lists associated with each campaign in the same manner that they already suppress the e-mail address lists. Although these regulations do not have a material adverse impact on our current operations, there can be no assurance that they will not have a material adverse impact on our future operations.

Under its rule-making authority, in May 2005, the Department of Justice adopted rules that amend the record keeping and inspection requirements for producers of sexually explicit performances. Codified in 18 U.S.C. 2257 of the federal criminal code, Section 2257, as amended, went into effect on June 23, 2005 and requires a class referred to as “secondary producers” to comply with the record keeping and inspection requirements that apply to primary producers. On June 16, 2005, The Free Speech Coalition, Inc. brought an action challenging, among other things, the extent to which webmasters and/or web sites fall under the definition of secondary producers under the new Section 2257 regulations. In a ruling issued December 28, 2005, the U.S. District Court rejected the establishment of a class of secondary producers that would have to comply with the recordkeeping and inspection requirements of Section 2257 and reaffirmed the decision in Sundance Associates v. Reno, which held that primary producers would be limited to those persons involved in the “hiring, contracting for, managing, or otherwise arranging for the participating of the depicted performer.” Secondary producers will likely still have to comply with the labeling requirements of Section 2257, which require that secondary producers obtain from the primary producer a letter or other correspondence indicating who the custodian of records is, where such records are kept and the date of production of the material. The ruling in this proceeding is limited to current or future members of The Free Speech Coalition, Inc. There is the risk that the definition of secondary producers may be reinstated and/or more broadly interpreted in the future. At this juncture, Section 2257 has had no material effect on our net revenue growth, profitability and cash flows.

The states of Michigan and Utah have passed Child Protection Registry laws that bar the transmission of commercial e-mail to registered state residents under the age of eighteen (collectively, the “Statutes”). The Statutes contain provisions for fines and jail time for violators, and create a private right of action for aggrieved parties. Under the Statutes, state residents may register any e-mail address, fax number, wireless contact information or instant message identifier assigned to the account of a minor or one to which a minor has access. Unlike other e-mail marketing statutes, there are no opt-in or pre-existing business relationship exceptions. The Statutes provide that once an address of a state resident is on the registry for thirty (30) days, commercial emailers are prohibited from sending to that address anything containing an advertisement, or even a link to an advertisement, for a product or service that a minor is legally prohibited from accessing. Such products and/or services include, but are not limited to, alcohol, tobacco, gambling, firearms, automotive, financial, prescription drug and adult material. This prohibition remains in force even if the e-mail or other communication is otherwise solicited. The Free Speech Coalition, Inc. has brought an action that challenges certain aspects of the Utah Child Protection Registry law; no decision on this proceeding has yet been rendered. We await the results of this action. To the extent we market these types of products and/or services; we have blocked sending such e-mail to Michigan and Utah residents. State action was initiated in 2005 and early 2006 in the respective legislative bodies in the states of Illinois, Connecticut, Georgia, Hawaii, Iowa and Wisconsin in order to pursue the enactment of legislation similar to the Statutes that will create state-level e-mail registries for minors. None of the proposed legislation has been enacted as of yet. We await the results of the respective legislative processes associated with these proposed child email registry laws. Depending on the outcome, and to the extent we market these types of products and/or services, we may have to block sending such e-mail to Illinois, Connecticut, Georgia, Hawaii and/or Iowa.

Federal legislation was signed into law, effective December 1, 2006, that makes changes to the Federal Rules of Civil Procedure (“Rules”) affecting the storing, retention and production of electronically stored information (“ESI”) in connection with discovery pursuant to litigation. As a result of the changes to the Rules, attorneys will be required to advise their adversaries, during litigation, of the details of their clients’ ESI retention and management systems and, in many instances, produce ESI including, but not limited to, e-mails. As a result of these changes to the Rules, companies should: (i) identify the various forms of ESI generated in the course of business, and where such ESI is stored; (ii) implement systems and technology capable of storing and retrieving such ESI, as necessary; and (iii) adopt a clear ESI document retention program and adhere to same at all times. The requirements imposed by the changes to the Rules as detailed above could require us to change our ESI-related programs at some additional cost. In addition, any subsequent litigation could result in substantially higher costs as a result of the need to produce greater quantities of ESI, which could have a material adverse impact on profitability and cash flows.

Legislation has been passed in a number of states that are intended to regulate “spyware” and, to a limited extent, the use of “cookies.” Of particular significance is the Revised Utah Spyware Control Act (the “Utah Act”) that bars a person or company from using a context-based trigger mechanism to display an advertisement that partially or wholly covers paid advertising or other content on a website in a way that interferes with the user's ability to view the website. The Utah Act also requires purveyors of pop-up advertising to ask whether a user is a resident of the state of Utah before downloading spyware software onto the user's computer and further allows a trademark owner to sue any person or company who displays a pop-up advertisement in violation of a specific trademark protection which is set forth in the Utah Act. The State of Alaska has enacted similar legislation that bars the same means of delivering advertisements as the Utah Act, and requires similar verification of residency prior to downloading spyware or “adware” software onto the user's computer. In practice, we do not provide or use spyware in our marketing, but if more restrictive legislation is adopted, we may be required to develop new technology and/or methods to provide our services or discontinue services in some jurisdictions altogether. Additionally, there is a risk that state courts will broadly interpret the term spyware to include legitimate ad-serving software and/or cookie technology that we currently provide or use.

At the federal level, competing bills are pending which are also intended to regulate spyware and, to a limited extent, the use of cookies. Spyware has not been precisely defined in existing and pending legislation, but is generally considered to include software which is installed on consumers’ computers and designed to track consumers’ activities and collect and possibly disseminate information, including personally identifiable information, about those consumers without their knowledge and consent. As stated above, Atrinsic does not provide or use spyware in its marketing practices, but there is the risk that the definition of spyware may be broadly interpreted to include legitimate ad-serving software and/or cookie technology that is currently provided or used by us. Anti-spyware legislation has (1) generally included a limited exemption for the use of cookies; and (2) focused on providing consumers with notification and the option to accept or decline the installation of spyware software. However, there can be no assurance that future legislation will not incorporate more burdensome standards by which the use of cookies will not be exempted and software downloading onto consumers’ computers will not be more strictly enforced. If more restrictive legislation is adopted, we may be required to develop new technology and/or methods to provide our services or discontinue services in some jurisdictions altogether.

CEO BACKGROUND

CURRENT DIRECTORS/DIRECTOR NOMINEES

The following table sets forth the name, age and position of each of our current directors, as well as the director nominees for election to our Board of Directors as of April 15, 2009.

Name



Age



Position
Burton Katz (1)

37

Chief Executive Officer and Director
Raymond Musci

49

Executive Vice President, Corporate Development and Director
Robert Ellin

42

Director
Lawrence Burstein

66

Director
Jerome Chazen

82

Chairman of the Board
Mark Dyne

47

Director
Jeffrey Schwartz (2)

43

Director

MANAGEMENT DISCUSSION FROM LATEST 10K

Cautionary Statement

The following discussion and analysis should be read together with the Consolidated Financial Statements of New Motion, Inc. and the “Notes to Consolidated Financial Statements” included elsewhere in this report. This discussion summarizes the significant factors affecting the consolidated operating results, financial condition and liquidity and cash flows of New Motion, Inc. for the fiscal years ended December 31, 2008 and 2007. Except for historical information, the matters discussed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations are forward-looking statements that involve risks and uncertainties and are based upon judgments concerning various factors that are beyond our control.

Executive Overview

New Motion, Inc., doing business as Atrinsic, is one of the leading digital advertising and marketing services company in the United States. Atrinsic is organized as a single segment with two principal offerings: (1) Transactional services - offering full service online marketing and distribution services which are targeted and measurable online campaigns and programs for marketing partners, corporate advertisers, or their agencies, generating qualified customer leads, online responses and activities, or increased brand recognition, and (2) Subscription services - offering our portfolio of subscription based content applications direct to users working with wireless carriers and other distributors.

Atrinsic brings together the power of the Internet, the latest in mobile technology, and traditional marketing/advertising methodologies, creating a fully integrated multi platform vehicle for the advanced generation of qualified leads monetized by the sale and distribution of subscription content, brand-based distribution and pay-for-performance advertising. Atrinsic’s service’s content is organized into four strategic content groups - digital music, casual games, interactive contests, and communities/lifestyles. The Atrinsic brands include GatorArcade, a premium online and mobile gaming site, Ringtone.com, a mobile music download service, and iMatchUp, one of the first integrated web-mobile dating services. Feature-rich Transactional advertising services include a mobile ad network, extensive search capabilities, email marketing, one of the largest and growing publisher networks, and proprietary subscription content. Services are provided on a variety of pricing models including cost per action, fixed fee, or commission based arrangements.

New Motion, Inc. is operating under the trade name of Atrinsic and is in the process of formally changing its name. Our goal is to optimize revenues from each of our qualified leads, regardless of the nature of the services we provide to such parties. Over an extended period of time our ability to generate incremental revenues relies on our ability to increase the size and scope of our media, our ability to target campaigns, and our ability to convert qualified leads into appropriate revenue generating opportunities.

In managing our business, we internally develop programming or partner with online content providers to match users with our service offerings, and those of our advertising clients. Our continued success and prospects for growth are dependent on our ability to acquire content in a cost effective manner. Our results may also be impacted by overall economic conditions, trends in the online marketing and telecommunications industry, competition, and risks inherent in our customer database, including customer attrition.

There are a variety of factors that influence our revenues on a periodic basis including but not limited to: (1) economic conditions and the relative strengths and weakness of the U.S. economy; (2) client spending patterns and their overall demand for our service offerings; (3) increases or decreases in our portfolio of service offerings; and (4) competitive and alternative programs and advertising mediums.

Similar to other media based companies, our ability to specifically isolate the relative historical aggregate impact of price and volume regarding our revenue is not practical as the majority of our services are sold and managed on an order by order basis and our revenues are greatly impacted by our decisions regarding qualified lead monetization. Factors impacting the pricing of our services include, but are not limited to: (1) the dollar value, length and breadth of the order; (2) the quality of the desired action; (3) the quantity of actions or services requested by our clients; and (4) the level of customization required by our clients.

The principal components of operating expenses are labor, media and media related expenses (including affiliate compensation, content development and licensing fees), marketing and promotional expenses (including sales commissions and customer acquisition and retention expenses) and corporate general and administrative expenses. We consider our operating cost structure to be predominantly variable in nature over a short time horizon, and as a result, we are immediately able to make modifications to our cost structure to what we believe to be increases or decreases in revenue and market trends. This factor is important in monitoring our performance in periods when revenues are increasing or decreasing. In periods where revenues are increasing as a result of improved market conditions, we will make every effort to best utilize existing resources, but there can be no guarantee that we will be able to increase revenues without incurring additional marketing or operating costs and expenses. Conversely, in a period of declining market conditions we are immediately able to reduce certain operating expenses and preserve operating income. Furthermore, if we perceive a decline in market conditions to be temporary, we may choose to maintain or increase operating expenses for the future maximization of operating results.

STRATEGIC INITIATIVES

Our business strategy involves increasing our overall scale and profitability by offering a large number of diversified products through a unique distribution network in the most cost effective manner possible. To achieve this goal, we are pursuing the following objectives.

Achieve Cross Media Benefits . One of our strategic objectives is to leverage the cross media benefit derived primarily from the combination of New Motion and Traffix which was consummated on February 4, 2008. Our premium-billed subscriptions allow us to integrate and to leverage online and mobile distribution channels to deliver compelling media and entertainment. The advantage of the fixed Internet is that from a marketing expense standpoint, the cost of customer acquisitions is generally determinable. In addition, the Internet is full of free content that is advertisement supported. The Internet also allows for the delivery of rich media over broadband. The advantage of mobile media is that it already has a well established customer activation and customer retention capability and is accessible and portable for those using it to access content. Our cross media strategy seamlessly enables our subscriber to realize true convergence. Atrinsic enables subscribers to interact with our content at work, at home or on a remote basis.

Vertically Integrate and Expand Distribution Channels . We own a large library of wholly owned content, proprietary premium billed services, and our own media and distribution. By allocating a large proportion of the qualified leads acquired by our subscription properties to our owned marketing and distribution networks, we expect to generate cost savings through the elimination of third-party margins. These cost savings are expected to result in lower customer acquisition costs throughout our business. We also expect to continue to enhance our distribution channels by expanding existing channels to market and sell our products and services online and explore alternative marketing mediums. We also expect, with limited modification, to market and sell our existing online-only content directly to wireless customers. Finally, we expect to continue to drive a portion of our consumer traffic directly to our proprietary products and services without the use of third-party media outlets and media publishers.

Multiple Revenue Streams and Advertiser Network. Our merger with Traffix has allowed for a reduction in customer concentration and more diversification of the combined company’s revenue streams. We will continue to generate recurring revenue streams from a subscription -based model, which is targeted at end user mobile subscribers. We will also have the traditional revenue streams inherent in our online performance-based model, which is targeted to publishers and advertisers. Further revenue diversification is expected to result from our larger distribution reach, and our ability to generate ad revenue across the combined company’s portfolio of web properties.

Publish High-Quality, Branded Subscription Content . We believe that publishing a diversified portfolio of the highest quality, most innovative applications is critical to our business. We intend to continue to develop innovative and sought-after content and intend to continue to devote significant resources to the development of high-quality, innovative products, services and Internet storefronts. The U.S. consumer’s propensity to use the fixed Internet to acquire, redeem and use mobile subscription products is unique. In this regard, we aim to provide complementary services between these two high-growth media channels. We also expect to continue to create Atrinsic-branded applications, products and services, which typically generate higher margins. In order to enhance the Atrinsic brand, and our product brands, we plan to continue building brands through product and service quality, subscriber, customer and carrier support, advertising campaigns, public relations and other marketing efforts.

Revenues increased approximately by $76.9 million, or 208%, to $113.9 million for the year ended December 31, 2008, compared to $37.0 million for the year ended December 31, 2007. Subscription based revenue increased by approximately $7.2 million, or 20%, to $44.2 million for the year ended December 31, 2008, compared to $37.0 million for the year ended December 31, 2007. The increase in subscription service revenue was principally attributable to an increase in the average number of billable subscribers added during the period and our purchase of Ringtone.com, coupled with our efforts to improve subscriber retention. Although we ended 2008 with approximately 501,000 subscribers as compared to approximately 840,000 subscribers at the end of 2007, during 2008 the average number of monthly billable subscribers was higher than in 2007 and the number of subscribers increased disproportionally at the end of 2007. The number of subscribers is largely, but not precisely, correlated to the periodic reported revenues as a result of inter-period volatility and the circumstance that subscribers are billed on a monthly basis.

Cost of Media increased by $45.5 million to $74.5 million in 2008 from $29 million in 2007. For 2008, Cost of Media – 3 rd party includes media purchased for monetization of both transactional and subscription revenues. The increase was principally attributed to the media necessary to source the revenue acquired with the acquisition of Traffix, Inc. which took place February 4, 2008.

Product and Distribution

Product and distribution increased by $6.6 million to $9.7 million for the year ended December 31, 2008 compared to $3.1 million for the year ended December 31, 2007. The increase was principally attributed to the acquisition of Traffix, Inc. which took place February 4, 2008. Product and distribution expenses are costs necessary to develop and maintain proprietary content, support and maintain our websites and user data, technology platforms which drives both transactional and subscription based revenue. Included in product and distribution cost is stock compensation expense of $6,593 and $288,443 for 2008 and 2007 respectively.

Selling and marketing

Selling and marketing expense increased by $8.4 million to $9.9 million in 2008 as compared to $1.5 million for the year ended December 31, 2007. The increase is primarily due to an increase in fixed and variable labor, principally attributed to the acquisition of Traffix, Inc. which took place February 4, 2008. In addition, the company incurred approximately $2.2 million of bad debt expense in 2008 and none in 2007.

General, Administrative and Other Operating

General and administrative expenses increased by approximately $8.7 million to $16.1 million for the year ended December 31, 2008 compared to $7.4 million for the year ended December, 31, 2007. The increase is primarily due to an increase in labor and related costs necessary to support core operations, professional and consulting fees, facilities and related costs principally attributable to the growth the company experienced as of result of the acquisition of Traffix, Inc. Management has taken action to achieve approximately $4.0 million of efficiencies resulting from the acquisition of Traffix, however the Company continues to make appropriate and modest investments in labor, facilities, technology infrastructure, and utilization of third party professional service providers to support its continued growth, business development and corporate governance initiatives. Included in general and administrative expense is stock compensation expense of $1.3 million and $828,045 for 2008 and 2007 respectively.

Depreciation and amortization

Depreciation and amortization expense increased $4.5 million to $5.9 million for the year ended December 31, 2008 compared to $1.3 million for the year ended December 31, 2007 principally as the result of the amortization of intangible assets and depreciation of fixed assets acquired in connection with the acquisition of the Traffix, Inc. and Ringtone.com.

Impairment of Goodwill

In connection with its annual goodwill impairment testing for the year ended December 31, 2008, the Company determined there was impairment and recorded a non-cash charge of $114.8 million. The goodwill impairment, the majority of which is not deductible for income tax purposes, is primarily due to our declining market price and reduced valuation multiples. Such negative factors are reflected in our stock price and market capitalization.

Income (Loss) from Operations

Operating loss increased to approximately $117.0 million for the year ended December 31, 2008, compared to an operating loss of $5.5 million for the year ended December 31, 2007. This increase was principally attributable to the $114.8 million charge for the impairment of goodwill taken during the fourth quarter of 2008. Excluding the charge for impairment, the operating loss for the year ended December 31, 2008 decreased $3.2 million to ($2.3) million compared to an operating loss of ($5.5) million for the year ended December 31, 2007. Management has taken action to gain approximately $4.0 million of efficiencies resulting from the acquisition of Traffix, however the Company continues to make appropriate and modest investments in labor, facilities, technology infrastructure, and utilization of 3 rd party professional service providers to support its continued growth, business development and corporate governance initiatives.

Interest income and dividends

Interest and dividend income increased $284,000 to $748,000 for the year ended December 31, 2008, compared to $464,000 for the year ended December 31, 2007. The increase is primarily due to interest income earned on higher cash balances maintained throughout 2008, offset by lower rates, and interest and dividends earned on marketable securities.

Interest expense

Interest expense increased $125,000 to $147,000 for the year ended December 31, 2008, compared to $22,000 for the year ended December 31, 2007. The increase is primarily attributable to interest expense of $90,000 on the note payable associated with the purchase of the assets of Ringtone .com.

Other Income (Expense)

Other expense increased $141,000 to $153,000 for the year ended December 31, 2008, compared to $12,000 for the year ended December 31, 2007. The increase is primarily attributable to loss on the sale of marketable securities of $174,000.

Income Taxes

Income tax benefit for the year ended December 31, 2008 was $852,000 and reflects an effective tax rate of 0.73%, which was computed taking into consideration the non-deductible impairment charge noted above, the effects of the merger with Traffix, Inc. which occurred on February 4, 2008, and includes the result of changes in the weighted average statutory rate attributable to the addition of certain local jurisdictions resulting from the merger, and certain adjustments realized in connection with the finalization of tax returns.

Minority interest

Minority interest represents the income allocable to the non-controlling interests and net income attributable to the shareholders of the Company for its interest in MECC. Minority interest for the year ended December 31, 2008 was $24,000 compared to ($283,000) for the year ended December 31, 2007.

Net Loss

Net loss increased by $111.6 million to $115.8 million for the year ended December 31, 2008 as compared to a net loss of $4.1 million for the year ended December 31, 2007. The increase is as described above.

Liquidity and Capital Resources

The Company continually projects anticipated cash requirements, which may include share repurchases, business combinations, capital expenditures, principal and interest payments on its outstanding and future indebtedness, and working capital requirements. Funding requirements have been financed through business combinations, cash flow from operations, issuance of preferred stock, option exercises and issuance of long-term debt. As of December 31, 2008, the Company had cash and cash equivalents of approximately $20.4 million, marketable securities of approximately $4.2 million (including Auction Rated Securities of $4.0 million that was redeemed and converted to cash at par plus interest in January 2009) and a working capital balance of approximately $23.7 million. The Company generated approximately $4.4 million from operations for the year ended December 31, 2008 and expects to generate cash flows from operating activities prospectively, which, contingent on prospective operating performance, may require reductions in discretionary variable costs and other realignments to permanently reduce fixed operating costs.

In conjunction with the Company’s objective of enhancing shareholder value, the Company’s Board of Directors authorized a share repurchase program. Under this share repurchase program, the Company purchased 1,908,926 shares of the Company’s common stock for an aggregate price of approximately $4.05 million during the Fiscal 2008.

The Company believes that its existing cash and cash equivalents and anticipated cash flows from our operating activities will be sufficient to fund minimum working capital and capital expenditure needs for at least the next twelve months. The extent of the Company’s future capital requirements will depend on many factors, including its results of operations. If the Company’s cash flows from operations is less than anticipated or its working capital requirements or capital expenditures are greater than expectations, or if the Company expands its business by acquiring or investing in additional products or technologies, it may need to secure additional debt or equity financing. The Company is continually evaluating various financing strategies to be used to expand its business and fund future growth. There can be no assurance that additional debt or equity financing will be available on acceptable terms, it at all. The potential inability to obtain additional debt or equity financing, if required, could have a material adverse effect on the Company’s operations.

In connection with its investments as further described in footnote 14, the Company is obligated to fund investments totaling approximately $1.6 million in 2009. Furthermore, management anticipates the risk adjusted return is sufficiently in excess of the contributed capital obligations, as of this date. There is however, no guarantee of the anticipated returns. In addition, management has taken considerable actions to secure its interest in achieving such a return.

Significant Estimates and Accounting Policies

Principles of Consolidation

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BUSINESS OVERVIEW

Webster Financial Corporation (“Webster” or the “Company”), a bank holding company and financial holding company under the Bank Holding Company Act of 1956, as amended, was incorporated under the laws of Delaware in 1986. Webster, on a consolidated basis, at December 31, 2008 had assets of $17.6 billion and shareholders’ equity of $1.9 billion. Webster’s principal assets at December 31, 2008 were all of the outstanding capital stock of Webster Bank, National Association (“Webster Bank”).

Webster, through Webster Bank and various non-banking financial services subsidiaries, delivers financial services to individuals, families and businesses throughout southern New England and into eastern New York State. Webster also offers equipment financing, commercial real estate lending, asset-based lending, health savings accounts and insurance premium financing on a regional or national basis. Webster provides business and consumer banking, mortgage lending, financial planning, trust and investment services through 181 banking offices, 489 ATMs, telephone banking and its Internet website ( www.websteronline.com ). Through its HSA Bank division ( www.hsabank.com ), Webster Bank offers health savings accounts on a nationwide basis. Webster’s common stock is traded on the New York Stock Exchange under the symbol “WBS”.

Webster’s mission statement, the foundation of its operating principles, is stated simply as “We Find A Way” , to help individuals, families and businesses achieve their financial goals. The Company operates with a local market orientation and with a vision to be New England’s bank. Operating objectives include acquiring and developing customer relationships through marketing, on boarding and cross-sale efforts to fuel internal growth and expanding geographically in contiguous markets through a build and buy strategy. Webster also pursues acquisitions of like-minded partners who share Webster’s vision to be New England’s bank.

Commercial Banking

Webster’s Commercial Banking group takes a direct relationship approach to providing lending, deposit and cash management services to middle-market companies in its four-state franchise territory and commercial real estate loans principally in New England and the mid-Atlantic region. Additionally, it serves as a primary referral source to wealth management and retail operations. Asset-based lending is located in New York with a national presence. All credit underwriting, contract preparation and closings, as well as servicing (including collections) are centrally performed by the applicable group. At December 31, 2008 the loan portfolio of the Commercial Banking group grew 5.1% to $3.6 billion from $3.5 billion at December 31, 2007.

Middle-Market Banking

The Middle-Market group delivers Webster’s broad range of financial services to a diversified group of companies with revenues greater than $10 million, primarily privately held companies located within southern New England. Typical loan facilities include lines of credit for working capital, term loans to finance purchases of equipment and commercial real estate loans for owner-occupied buildings. Unit and relationship managers within the Middle-Market group average over 20 years of experience in their markets. The Middle-Market loan portfolio was $819.1 million at December 31, 2008, a decrease of 5.4%, compared to $865.7 million at December 31, 2007, primarily due to prepayment volume. Total Middle-Market loan originations were $106.2 million in 2008 compared to $126.7 million in 2007.

Webster Business Credit Corporation

Webster Business Credit Corporation (“WBCC”) is Webster Bank’s asset-based lending subsidiary with headquarters in New York, New York and eight regional offices. Asset-based loans are generally secured by accounts receivable and inventories of the borrower and, in some cases, also include additional collateral such as property and equipment. The asset-based lending segment of the commercial portfolio was $753.4 million at December 31, 2008, a decrease of 5.3%, compared to $795.3 million at December 31, 2007. Loan originations for the asset-based lending portfolio were $83.5 million in 2008 compared to $285.3 million in 2007.

Deposit and Cash Management Services

Webster offers a wide range of deposit and cash management services for clients ranging from sole proprietors to large corporations. For depository needs, Webster offers products ranging from core checking and money market accounts, to treasury sweep options including repurchase agreements and Euro dollar deposits. For clients with more sophisticated cash management needs, available services include ACH origination and payment services such as lockbox for receipts posting, positive pay for fraud control and controlled disbursement for cash forecasting. All of these services are available through Webster’s online banking system Webster Web-Link (tm) which uses image technology to provide online information to customers.

Retail Banking

Retail Banking is dedicated to serving the needs of over 412,000 consumer households and approximately 60,000 small business customers in southern New England and eastern New York State. Webster’s Retail Banking segment is focused on growing its customer base through the acquisition of new customer relationships and the retention and expansion of existing customer relationships.

Distribution Network

Retail Banking’s distribution network provides convenience and easy access to Webster’s full range of products and services. This multi-channel network is comprised of 181 banking offices and 489 ATMs in Connecticut, Massachusetts, Rhode Island and New York. In the fourth quarter of 2007, Webster announced an ATM branding agreement for Webster branded ATMs in select Walgreens locations. As of December 31, 2008, 147 ATMs were actively operating in select Walgreens across eastern Massachusetts (115), Rhode Island (23) and Connecticut (9). This branding agreement complements Webster’s branch expansion program and establishes another distribution platform for future growth in Rhode Island and Massachusetts. The distribution network also includes a telephone banking center and a full-range of internet banking services. In addition to transaction and servicing convenience, Retail Banking’s distribution network delivers a full range of deposit, lending and investment products and services to both consumer and small business customers within Webster’s regional footprint.

Deposit Activities

Retail Banking’s primary focus is on core deposit growth, which provides a low-cost funding source for the Bank in addition to an increasing stream of fee revenues. As of December 31, 2008, consumer retail deposits within the branch footprint totaled $8.4 billion. Webster’s successful execution of its strategy is evidenced by its #2 ranking in deposit market share in the state of Connecticut. Core deposit growth is driven by a growing base of checking relationships, strong customer retention and successful cross-sell efforts including increasing debit card and on-line banking usage. Revenue growth is achieved by offering a range of deposit products that pay competitive interest rates to meet customer savings and liquidity management needs and deepen customer relationships.

Business & Professional Banking

Retail Banking includes the Business & Professional Banking division (“B&P”). B&P is focused on the development and delivery of a full array of credit and deposit-related products to small businesses and professional services firms with annual revenue up to $10 million. B&P markets and sells to these customers through a combination of direct sales (‘Business Bankers’) and branch-delivered efforts. B&P is a significant generator of deposits to Webster and the B&P lending effort is focused on those customers with borrowing needs from $10,000 to $2 million. Deposits from B&P customers totaled $1.2 billion as of December 31, 2008. Webster was recognized in 2008, for the sixth consecutive year, by the Connecticut district of the Small Business Administration (“SBA”) as the state’s leading bank SBA 504 lender, as well as recognized as the leading Connecticut bank lender based on number of loans, dollars of loans approved, and loans to veterans. The B&P loan portfolio was $927.0 million in 2008 compared to $909.9 million in 2007. Total loan originations for B&P were $238.0 million in 2008 compared to $198.0 million in 2007.

Investment Services

Webster offers the investment and securities-related services, including brokerage and investment advice that it had previously offered through its subsidiary Webster Investment Services, Inc. (“WIS”), through a strategic partnership with UVEST Financial Services Group, Inc. UVEST, a provider of investment and insurance programs in financial institutions’ branches, is a broker dealer registered with the Securities and Exchange Commission, a registered investment advisor under federal and applicable state laws, a member of the Financial Industry Regulatory Authority (“FINRA”), and a member of the Securities Investor Protection Corporation (“SIPC”). Webster, through its relationship with UVEST, has over 100 dual employees who are registered representatives located throughout its branch network offering customers an array of insurance and investment products including stocks and bonds, mutual funds, annuities and managed accounts. Brokerage and online investing services are available for customers. At December 31, 2008, Webster had $1.6 billion of assets under administration in its strategic partnership with UVEST, compared with $1.9 billion of assets under administration at December 31, 2007. These assets are not included in the Consolidated Financial Statements.

Expansion and Acquisition

An important element of Webster’s growth strategy is its build and buy strategy for franchise expansion. The Company opened one de novo location, in the third quarter of 2008, in North Kingstown, Rhode Island. In 2009, Webster intends to open three new locations in Rhode Island and Massachusetts and to relocate its downtown Providence office. Webster intends to offset expenses associated with expansion into new locations with consolidation within its existing network.

Consumer Finance

Webster’s Consumer Finance division provides a convenient and competitive selection of residential first mortgages, home equity loans and lines and direct installment lending programs through Webster Bank. Webster Bank’s loan distribution channels consist of the branch network, loan officers and the contact center. Webster’s Consumer Finance segment offers a broad range of products to meet the needs of its customers in and around its retail branch footprint.

Consumer loan products are underwritten in accordance with accepted industry guidelines including, but not limited to, the evaluation of the credit worthiness of the borrower(s) and collateral. Independent credit reporting agencies, Fair Isaac scoring model (FICO) and the analysis of personal financial information are utilized to determine the credit worthiness of potential borrowers. Also, the Consumer Finance division obtains and evaluates an independent appraisal of collateral value to determine the adequacy of the collateral. Updated FICO scores and collateral values are obtained on at least a quarterly basis.

In late 2007, Webster discontinued its indirect residential construction lending and its indirect home equity lending outside of its primary New England market area referred to as National Wholesale Lending. Webster placed these two portfolios into a liquidating portfolio and disclosed this as a separate category from its continuing portfolio. The liquidating portfolio is managed by a designated credit team. At December 31, 2008 and 2007, these two indirect out-of-footprint loan portfolios totaled $302.4 million and $423.9 million, respectively, and were comprised of $283.7 million and $340.6 million, respectively, of indirect home equity loans and $18.7 million and $83.3 million, respectively, of residential construction loans.

Residential Mortgages and Mortgage Banking

Consumer Finance is dedicated to providing a full complement of residential mortgage loan products that are available to meet the financial needs of Webster’s customers. Webster offers customers products including conventional conforming and jumbo fixed rate loans, conforming and jumbo adjustable rate loans, Federal Housing Authority (“FHA”), Veterans Administration (“VA”) and state agency mortgage loans through the Connecticut Housing Finance Authority (“CHFA”). Various programs are offered to support the Community Reinvestment Act goals at the state level. Types of properties consist of one-to-four family residences, owner and non-owner occupied, second homes, construction, permanent and improved single family building lots. Webster both retains and sells servicing on originated loans. The determination to sell or retain servicing is dependent on several factors including borrower relationships with Webster.

Total residential mortgage originations for the group were $600 million in 2008 compared to $3.2 billion in 2007. Originations in 2007 included mortgages originated from the discontinued National Wholesale Lending channel. Webster discontinued all national wholesale mortgage banking activities in the fourth quarter of 2007 and, as a result, closed its wholesale lending offices in Seattle, Washington; Phoenix, Arizona; Cheshire, Connecticut; and Chicago, Illinois. In 2007, Webster recorded severance and other costs, primarily for lease terminations and outplacement of $3.5 million (pre-tax) related to the discontinuance of national wholesale mortgage banking activities. Webster’s remaining mortgage and consumer lending operations in Cheshire, Connecticut focus solely on direct to consumer retail originations.

Consumer Loans

Webster Bank concentrates on offering a range of products including home equity loans and lines of credit, as well as second mortgages. Although there are no credit card loans in the consumer loan portfolio as of December 31, 2008, Webster offers its customers credit card programs issued by a third party provider. The consumer continuing loan portfolio remained relatively flat year over year with a total continuing portfolio balance of $3.0 billion at December 31, 2008 compared to $2.9 billion at December 31, 2007. The liquidating consumer loan portfolio was $283.7 million and $340.6 million at December 31, 2008 and 2007, respectively. Total consumer loan originations were $0.9 billion in 2008 compared to $1.2 billion in 2007.

Investment Planning

Webster Financial Advisors (“WFA”) targets high net worth clients, not-for-profit organizations and business clients with investment management, trust, credit and deposit products and financial planning services. WFA takes a comprehensive view when dealing with clients in order to fully serve their short and long-term financial objectives. Proprietary and non-proprietary investment products are offered through WFA and the J. Bush & Co. division. WFA provides several different levels of financial planning expertise including specialized services through another wholly-owned subsidiary, Fleming, Perry & Cox. At December 31, 2008 there were approximately $1.7 billion of client assets under management and administration, a decrease of 26.1% when compared to December 31, 2007, of which $1.1 billion were under management and administration. The decline in assets under management and administration is directly related to the decline in the market value of these assets. These assets are not included in the Consolidated Financial Statements.


Insurance Premium Financing

Budget Installment Corp. (“BIC”), an insurance premium financing subsidiary headquartered in Garden City, New York, provides insurance premium financing products covering commercial property and casualty policies. Its dedicated staff of insurance premium financing professionals works directly with local, regional and national insurance agents and brokers to market BIC’s financing products to customers nationwide. BIC’s portfolio was $86.1 million at December 31, 2008, a increase of 2.0%, compared to $84.4 million at December 31, 2007. Originations totaled $187.0 million in 2008 compared to $204.8 million in 2007.

Risk Management Functions

Webster’s risk management framework has been designed to identify, monitor, report and manage risk issues throughout the Company. The Audit and Risk Committees of the Board of Directors, comprised solely of independent directors, oversee all Webster’s risk-related matters. Webster’s Enterprise Risk Management Committee, which reports directly to the Risk Committee, is chaired by Webster’s Chief Risk Officer and is comprised of Webster’s Executive Management Committee and Senior Risk Officers. Webster’s Senior Risk Officers oversee matters related to market, credit and operational risk and report directly to the Chief Risk Officer. Webster’s Corporate Treasurer, Chief Credit Risk Officer and Chief Compliance and Operating Risk Officer are Webster’s Senior Risk Officers and are responsible for overseeing matters related to the Company’s risk environment.

Market Risk

Market risk refers to the risk of loss arising from adverse changes in interest rates, foreign currency exchange rates, commodity prices and other relevant market rates and prices, such as equity prices. The risk of loss can be assessed from the perspective of adverse changes in fair values, cash flows and future earnings. Due to the nature of its operations, Webster is primarily exposed to interest rate risk and, to a lesser extent, liquidity risk. Accordingly, Webster’s interest rate sensitivity and liquidity are monitored on an ongoing basis by its Asset and Liability Committee (“ALCO”), whose primary goal is to manage interest rate risk to maximize net income and net economic value over time in changing interest rate environments subject to Board of Director approved risk limits. ALCO is chaired by Webster’s Treasurer who, as a Senior Risk Officer, regularly reports ALCO findings to the Enterprise Risk Management Committee and the Risk Committee of the Board of Directors.

Credit Risk

Webster Bank manages and controls risk in its loan and investment portfolios through adherence to consistent standards. Written credit policies establish underwriting standards, place limits on exposure and set other limits or standards as deemed necessary and prudent. Exceptions to the underwriting policies arise periodically, and to ensure proper identification and disclosure, additional approval requirements and a tracking requirement for all qualified exceptions have been established. In addition, regular reports are made by the Chief Credit Risk Officer to the Enterprise Risk Management Committee and the Risk Committee of the Board of Directors regarding the credit quality of the loan and investment portfolios.


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Credit Risk Management, which is under the supervision of the Chief Credit Risk Officer, is independent of the loan production and Treasury areas, oversees the approval process, ensures adherence to credit policies and monitors efforts to reduce classified and nonperforming assets.


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The Loan Review Department, which is independent of the loan production areas and loan approval, performs ongoing independent reviews of the risk management process, the adequacy of loan documentation and the assigned loan risk ratings. The results of its reviews are reported directly to the Risk Committee of the Board of Directors.

Operational Risk

Operational Risk is the risk of loss resulting from inadequate or failed internal processes, people or systems or from external events. The definition includes the risk of loss from failure to comply with laws, ethical

standards and contractual obligations. Webster’s Chief Compliance and Operating Risk Officer oversees the management and effectiveness of Webster’s compliance and operational risk management framework which includes the Compliance Program, the Bank Secrecy Act Program, the CRA and Fair Lending Programs, the Privacy Program, the Information Security Program, the Identity Theft Prevention Program, the Bank Security Program and the Enterprise Risk Management Program. The Chief Compliance and Operating Risk Officer is responsible for reporting on the adequacy of all operating risk management components and programs to the Enterprise Risk Management Committee and the Risk Committee of the Board of Directors and/or other committees of the Board as provided for under relevant charters.

Compliance Risk Management which is under the supervision of the Chief Compliance and Operating Risk Officer, is independent of the operational lines of business and manages and controls compliance risks at the corporate level. Webster’s Compliance Program defines the infrastructure to support this oversight with defined roles and responsibilities, compliance risk assessments, policies and procedures, training and communication, testing and monitoring, issue management and supervision, evaluation and reporting mechanisms.



The Information and Corporate Security department is responsible for the effective management of the Information Security Program which is designed to protect against loss or unauthorized access to Webster’s information assets and the Bank Security Program which is designed to ensure physical security of Webster’s employees, customers and physical assets. In addition, the Privacy Program and Identity Theft Prevention Program are managed in the Information and Corporate Security Department of the Operational Risk Management division.

The Bank Secrecy Act (BSA) Department, Financial Intelligence Unit and Fraud Mitigation and Recovery Department work together to ensure that BSA Program elements and internal and external fraud prevention and investigation processes are coordinated to mitigate losses and achieve regulatory reporting objectives.

The Community Reinvestment Act and Fair Lending Department is responsible for ensuring the respective programs, regulatory requirements and performance objectives are monitored for ongoing effectiveness.

Enterprise Risk Management, which is under the supervision of the Chief Compliance and Operating Risk Officer, is responsible for evaluating, aggregating and reporting on all enterprise risks to the Enterprise Risk Management Committee and the Risk Committee of the Board of Directors.

Internal Audit provides an independent assessment of the quality of internal controls for all major business units and operations throughout Webster. Results of Internal Audit reviews are reported to management and the Audit Committee. Corrective measures are monitored to ensure risk issues are mitigated or resolved. Internal Audit reports directly to the Audit Committee.

The OneWebster Initiative

The OneWebster initiative, which began in January 2008, is an ongoing, company-wide review of business practices designed to enhance the customer experience and improve the Company’s overall operating efficiency. As a result of this initiative, Webster expects to increase pre-tax earnings by an annual rate of $50 million by the middle of 2010 through actions that will save approximately $40 million in costs and achieve an additional $10 million in incremental revenue growth on an annual run-rate basis compared with 2007. Webster plans to achieve the $40 million in cost savings by streamlining processes by instituting other efficiency initiatives. About 240 positions were eliminated, with more than half to be achieved through attrition and elimination of open positions. Webster incurred severance and other related charges of approximately $13.1 million in connection with the implementation of over 1,100 OneWebster ideas generated by employees during 2008. The remaining OneWebster charges are expected to be recorded in the first two quarters of 2009.

MANAGEMENT DISCUSSION FROM LATEST 10K

The following discussion should be read in conjunction with the Consolidated Financial Statements of Webster Financial Corporation and the Notes thereto included elsewhere in this report (collectively, the “Financial Statements”).

Critical Accounting Policies and Estimates

Critical accounting estimates are necessary in the application of certain accounting policies and procedures, and are particularly susceptible to significant change. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. Management believes that the most critical accounting policies, which involve the most complex or subjective decisions or assessments, are as follows:

Allowance for Credit Losses

Arriving at an appropriate level of allowance for credit losses involves a high degree of judgment. The allowance for credit losses, which comprises the allowance for loan losses and the reserve for unfunded credit commitments, provides for probable losses based upon evaluations of known and inherent risks in the loan portfolio and in unfunded credit commitments. To assess the adequacy of the allowance, management considers historical information as well as the prevailing business environment, as it is affected by changing economic conditions and various external factors, which may impact the portfolio in ways currently unforeseen. The allowance is increased by provisions for credit losses and by recoveries of loans previously charged-off, and reduced by loans charged-off. For a full discussion of the methodology of assessing the adequacy of the allowance for credit losses, see the “Asset Quality” section elsewhere within Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Valuation of Investment Securities

Management evaluates securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. The consideration of the above factors are subjective and involve estimates and assumptions about matters that are inherently uncertain. Should actual factors and conditions differ materially from those used by management, the actual realization of gains or losses on investment securities could differ materially from the amounts recorded in the financial statements.

Valuation of Goodwill/Other Intangible Assets

Webster, in part, has increased its market share through acquisitions accounted for under the purchase method, which requires that assets acquired and liabilities assumed be recorded at their fair values estimated by means of internal or other valuation techniques. These valuation estimates affect the measurement of goodwill and other intangible assets recorded in the acquisition. Goodwill is subject to ongoing periodic impairment tests and is evaluated using various fair value techniques including multiples of revenue, discounted cash flows, price/equity and price/earnings ratios.

Income Taxes

Certain aspects of income tax accounting require significant management judgment, including determining the expected realization of deferred tax assets and evaluating uncertain tax positions. Such judgments are subjective and involve estimates and assumptions about matters that are inherently uncertain. Should actual factors and conditions differ materially from those used by management, the actual realization of the net deferred tax assets could differ materially from the amounts recorded in the financial statements.

Deferred tax assets generally represent items that can be used as a tax deduction or credit in future income tax returns, for which a financial statement tax benefit has already been recognized. The realization of the net deferred tax asset generally depends upon future levels of taxable income and the existence of prior years’ taxable income to which “carry back” refund claims could be made. Valuation allowances are established against those deferred tax assets determined not likely to be realized.

Deferred tax liabilities generally represent items that will require a future tax payment, for which tax expense has been recognized in the Company’s financial statements and a payment has been deferred, or a deduction taken on the Company’s tax return but not yet recognized as an expense in the financial statements. Deferred tax liabilities are also recognized for certain “non-cash” items such as certain acquired intangible assets subject to amortization which results in future financial statement expenses that are not deductible for tax purposes.

For more information about income taxes, see Note 9 of Notes to Consolidated Financial Statements included elsewhere within this report.

Pension and Other Postretirement Benefits

The determination of the obligation and expense for pension and other postretirement benefits is dependent upon certain assumptions used in calculating such amounts. Key assumptions used in the actuarial valuations include the discount rate, expected long-term rate of return on plan assets and rates of increase in compensation and health care costs. Actual results could differ from the assumptions and market driven rates may fluctuate. Significant differences in actual experience or significant changes in the assumptions may materially affect the future pension and other postretirement obligations and expense. See Note 20 of Notes to Consolidated Financial Statements for further information.

Results of Operations

Summary

Webster’s net loss for the year ended December 31, 2008 was $321.8 million or $6.42 per diluted common share, compared to net income of $96.8 million or $1.76 per diluted common share for the year ended December 31, 2007. Loss from continuing operations was $318.8 million or $6.36 per diluted common share for the year ended December 31, 2008, compared to income from continuing operations of $110.7 million or $2.01 per diluted common share in 2007, a decrease of 388.0%.

The year over year decrease in results from continuing operations for 2008 as compared to 2007 is primarily attributable to the increase in the loss on write-down of investments to fair value of $215.7 million, the $198.4 million impairment of goodwill, a $118.6 million increase in the provision for credit losses and a $10.0 million increase in net losses on sales of investment securities offset by a $113.9 million reduction in the income tax expense. Excluding the net impact of these items, pre-tax income from continuing operations would have been $158.0 million and pre-tax income from continuing operations per common share would have been $3.04.

The year over year decrease in results from continuing operations for 2007 as compared to 2006 include an increase in provision for credit losses of $56.8 million, severance and other charges of $15.6 million, a net charge of $6.8 million related to the redemption of debt and a $3.6 million loss on the write-down of investments to fair value. Excluding the net impact of these items, pre-tax income from continuing operations would have been $158.9 million and pre-tax income from continuing operations per common share would have been $2.89.

Net interest income of $505.8 million for the year ended December 31, 2008 decreased 0.47% when compared to 2007 due to a decrease in the net interest margin of 12 basis points when compared to the prior year. The decline year over year was primarily due to reductions in the Federal Reserve rates as well as an increase in non-performing assets and lower yields on assets tied to prime and LIBOR. Average interest bearing liabilities increased $0.5 billion, or 3.23%, with increases in average borrowings of $0.9 billion partially offset by decreases in average deposits of $0.4 billion. Average earning assets increased $0.5 billion, or 3.23% when compared to 2007, which includes the December 2008 receipt and subsequent investment of $400 million pursuant to the Capital Purchase Program under TARP.

Non-interest income of $(28.1) million decreased by $230.4 million, or 113.9%, in 2008 compared to 2007. The decrease in non-interest income was primarily due to the $215.7 million increase in loss on write-down of investments to fair value, the $10.0 million increase in net losses on sales of investment securities and the $8.1 million decrease in income from mortgage banking activities due to the decision to exit the National Wholesale origination channel, partially offset by a $5.5 million increase in deposit service fees. The decrease in non-interest income was also impacted by a $2.8 million decline in loan fees and income from wealth and investment services in 2008 when compared to the results for 2007.

Non-interest expenses of $676.0 million increased $192.1 million, or 39.7%, in 2008 compared to 2007. The decrease is primarily due to the $198.4 million goodwill impairment charge, partially offset by $4.9 million lower compensation expense.

Net Interest Income

The following table describes the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have impacted interest income and interest expense during the periods indicated. Information is provided in each category with respect to changes attributable to changes in volume (changes in volume multiplied by prior rate), changes attributable to changes in rates (changes in rates multiplied by prior volume) and the total net change. The change attributable to the combined impact of volume and rate has been allocated proportionately to the change due to volume and the change due to rate. The table below is based upon reported net interest income.

Net interest income, the difference between interest earned on interest-earning assets and interest expense incurred on deposits and borrowings, totaled $505.8 million for the year ended December 31, 2008, compared to $508.2 million for the year ended December 31, 2007, a decrease of $2.4 million. Average interest-earning assets grew by 3.23% to $15.8 billion at December 31, 2008 from $15.3 billion at December 31, 2007 while average interest-bearing liabilities also grew 3.23% to $15.3 billion at December 31, 2008 from $14.8 billion at December 31, 2007. Despite the offsetting growth in interest-earning assets to interest-bearing liabilities, the net interest margin declined by 12 basis points to 3.28% for the year ended December 31, 2008 from 3.40% for the year ended December 31, 2007. The yield on interest-earning assets declined by 102 basis points for the year ended December 31, 2008 while the cost of interest-bearing liabilities declined 91 basis points for the year ended December 31, 2008.

The decline in yields in certain asset classes within the loan portfolio reflects the effects that the 400 basis point reductions made by the Federal Reserve during 2008 have had on the floating rate home equity lines, commercial real estate (“CRE”) and commercial and industrial (“C&I”) interest bearing assets. At December 31, 2008 approximately 70.0% of Webster’s CRE portfolio and 64.4% of its C&I portfolio are floating rate assets, while 97.4% of the equipment finance portfolio is fixed rate. The decline in yields is also impacted by the increase in non-accruing loans. Webster’s total non-performing assets increased to $263.2 million at December 31, 2008 in comparison with $121.1 million at December 31, 2007, with C&I, residential development, 1-4 family residential and residential construction representing $100.0 million of the $142.1 million increase. The majority of the increase is a result of residential development loans along with 1-4 family residential and construction loans that reflect the continuing challenge of the residential housing market as well as the deterioration of economic conditions of the market in general.

Since net interest income is affected by changes in interest rates, by loan and deposit pricing strategies, competitive conditions, the volume and mix of interest-earning assets and interest-bearing liabilities as well as the level of non-performing assets, Webster manages the risk of changes in interest rates on its net interest income through an Asset/Liability Management Committee and through related interest rate risk monitoring and management policies. See “Asset/Liability Management and Market Risk” for further discussion of Webster’s interest rate risk position.

Interest Income

Interest income decreased $126.3 million, or 12.7%, to $869.3 million for the year ended December 31, 2008 as compared to 2007. The decrease in the average yield of 102 basis points was partially offset by an increase in average interest earning assets of $492.4 million. The average loan portfolio, excluding loans held for sale,


increased by $310.0 million for the year ended December 31, 2008, or 2.5%, compared to 2007. Average investment securities increased by $552.6 million for the year ended December 31, 2008, or 22.4%, compared to 2007. In addition, higher yielding commercial and consumer loans partially replaced reductions in residential loans.

The 102 basis point decrease in the average yield earned on interest-earning assets for the year ended December 31, 2008 to 5.58% compared to 6.60% for 2007 is a direct result of actions taken by the federal government to reduce the fed fund rates by 400 basis points during the year ended December 31, 2008. The loan portfolio yield decreased 116 basis points to 5.60% for the year ended December 31, 2008 and comprised 80.6% of average interest-earning assets at December 31, 2008 compared to the loan portfolio yield of 6.76% and 81.2% of average interest-earning assets for the year ended December 31, 2007. Additionally, the yield on investment securities was 5.51%, a 28 basis point decrease over 2007.

Interest Expense

Interest expense for the year ended December 31, 2008 decreased $123.9 million, or 25.4%, compared to 2007. The decrease was primarily due to competitive deposit pricing, a decline in average deposits of $445.8 million for the year ended December 31, 2008 and the 400 basis points in rate reductions made by the Federal Reserve, offset by a $925.5 million increase in average total borrowings when compared to 2007.

The cost of interest-bearing liabilities was 2.37% for the year ended December 31, 2008, a decrease of 91 basis points compared to 3.28% for 2007. Deposit costs for the year ended December 31, 2008 decreased to 2.08% from 2.90% in 2007, a decrease of 82 basis points. Total borrowing costs for the year ended December 31, 2008 decreased 189 basis points to 3.45% from 5.34% for 2007.

Provision for Credit Losses

The provision for credit losses was $186.3 million for the year ended December 31, 2008, an increase of $118.5 million compared to $67.8 million for the year ended December 31, 2007. The increase in the provision is primarily due to increased charge-offs and increased reserve coverage levels given the increase in nonperforming loans as well as the general deteriorating economic conditions affecting all of the Company’s loan portfolios. For the year ended December 31, 2008, total net charge-offs were $138.1 million compared to $25.2 million in 2007. See Tables 18 through 24 for information on the allowance for credit losses, net charge-offs and nonperforming assets.

Management performs a quarterly review of the loan portfolio and unfunded commitments to determine the adequacy of the allowance for credit losses. Several factors influence the amount of the provision, primarily loan growth and portfolio mix, performance, net charge-offs and the general economic environment. At December 31, 2008, the allowance for credit losses totaled $245.8 million or 2.02% of total loans compared to $197.6 million or 1.58% at December 31, 2007. See the “Allowance for Credit Losses Methodology” section later in Management’s Discussion and Analysis for further details.

Non-interest revenue which represents the recurring component of non-interest income decreased of $6.3 million, or 3.1%, when compared to 2007. The decrease from the prior year is primarily attributable to the $8.1 million decrease in mortgage banking activities directly related to the closure of National Wholesale mortgage lending, a $1.8 million and $1.0 million decrease in loan related fees and wealth and investment services, respectively, offset by an increase in deposit service fees of $5.5 million. See below for further discussion of various components of non-interest income.

Deposit Service Fees. Deposit service fees increased $5.5 million, or 4.8%, for the year ended December 31, 2008 as compared to 2007. The increase was primarily due to the implementation of a new tiered consumer fee structure during 2008, increased ATM surcharges and increased debit card usage.

Loan Related Fees. Loan related fees decreased by $1.8 million, or 5.7%, for the year ended December 31, 2008 as compared to 2007. The decrease was primarily due to a decrease in loan servicing fee income which is the direct result of fewer loans originated for sale.

Wealth and Investment Services. Wealth and investment service fees decreased $1.0 million or 3.5% for the year ended December 31, 2008 as compared to 2007. The decrease is due to a decline in the value of assets under management due to adverse market conditions resulting in a reduction in management fees earned.

Total non-interest expense for the year ended December 31, 2008 was $676.0 million, an increase of a $192.1 million or 39.7% compared to 2007. The increase in non-interest expense for the year ended December 31, 2008 is primarily a result of a $198.4 million impairment charge for the goodwill related to commercial banking, consumer finance and other lending business segments, partially offset by the one time expense of $8.9 million premium for the redemption of Webster Capital Trust I and II in 2007. In addition, the amortization of intangible assets decreased by $4.4 million primarily due to core deposit intangibles from several past acquisitions becoming fully amortized during the year. Further changes in various components of non-interest expense are discussed below.

Compensation and Benefits. Total compensation and benefits decreased by $4.9 million for the year ended December 31, 2008 or 2.0% compared to 2007. The decrease in compensation and benefits is related to workforce reductions from the OneWebster initiative, reduced incentive compensation as well as a decline in benefit expenses.

Occupancy. Total occupancy expense increased by $3.7 million or 7.4% for the year ended December 31, 2008 compared to 2007. The increase in occupancy is primarily expenses related to the de novo branch expansion program, higher rent expense and increased utilities. The Company intends to offset future de novo expansion expenses with consolidation within its existing branch network.

Furniture and Equipment. Total furniture and equipment expense increased by $1.4 million or 2.3% for the year ended December 31, 2008 compared to 2007. The increase is primarily due to higher depreciation on data processing equipment, increases in equipment maintenance contracts and service contract costs.

Foreclosed and Repossessed Property Expenses. Total foreclosed and repossessed property expenses increased $6.9 million or 344.9% for the year ended December 31, 2008 compared to 2007. The increase is directly related to the $22.5 million increase in foreclosed and repossessed property, reflective of higher levels of delinquency and non-performing assets in 2008.

FDIC Deposit Insurance Assessment. Total FDIC deposit insurance assessment increased by $3.2 million or 209.1% due to the expiration of Webster’s remaining credit that had previously been offset premium assessments. Assessments for 2009 are expected to remain at these levels or greater depending on FDIC actions.

Severance and other costs. Charges totaling $16.2 million were recorded in 2008. Included in this charge was $13.1 million of severance and other OneWebster implementation costs. Additional severance of approximately $1.0 million was recorded for early retirement and other executive changes. A charge of $1.8 million was recognized to reduce the carrying value of a building and office complex currently being marketed for sale to market value and classified as assets held for disposition in accordance with generally accepted accounting principles. See the following table for a breakout of the costs.

Discontinued Operations

The results of operations of Webster Insurance and Webster Risk Services are reported as discontinued operations. Loss from discontinued operations, net of tax, totaled $3.1 million for the year ended December 31, 2008 compared to the loss from discontinued operations of $13.9 million for 2007 and income from continuing operations of $0.1 million for 2006. The sales of Webster Insurance and Webster Risk Services were completed on February 1, 2008 and April 22, 2008, respectively. See Note 2 of Notes to Consolidated Financial Statements contained elsewhere within this report for additional information.

Income Taxes

During 2008 Webster recognized an income tax benefit of $65.8 million applicable to its loss from continuing operations. As a result of the pre-tax loss and tax benefit, Webster’s 2008 effective tax rate and other comparative measures are not meaningful for these purposes. In 2007, Webster recognized tax expense of $48.1 million applicable to continuing operations and its effective tax rate was 30.3%.

Webster’s 2008 tax benefit was impacted by certain components of its loss that resulted in no tax benefit which otherwise would have increased the benefit by over $80 million. Those loss items resulting in no tax benefit pertained to substantially all of the $198 million goodwill impairment (tax benefit of nearly $69 million otherwise) and certain securities losses treated as capital and limited for U.S. tax-deductibility purposes (tax benefit of more than $11 million otherwise).

The other significant item, when comparing 2008 to 2007, relates to a higher level of tax-exempt interest income in 2008 that resulted in an increased tax benefit of more than $2.7 million when compared to 2007.

For more information on income taxes, including Webster’s deferred tax assets and valuation allowance, see Note 9 of Notes to Consolidated Financial Statements included elsewhere within this report.

Comparison of 2007 and 2006 Years

Webster’s net income was $96.8 million or $1.76 per diluted share in 2007, compared to $133.8 million or $2.47 per diluted share in 2006, a decrease of 27.7%. Income from continuing operations was $110.7 million or $2.01 per diluted share in 2007, compared to $133.7 million or $2.47 per diluted share in 2006, a decrease of 17.2%.

During the fourth quarter of 2007, management determined that the sale of its insurance agency business (Webster Insurance) would be structured such that the consideration would comprise an upfront payment and additional potential consideration over a multi-year earn-out period. Given this structure, Webster accordingly wrote down the carrying value of its investment and as of year end 2007 reported Webster Insurance separately from its continuing operations. The results of Webster Insurance (and the loss on write-down of the assets held for disposition to fair value) are shown as discontinued operations, net of tax in the Consolidated Statements of Income. Webster has reported the assets and liabilities of Webster Insurance as assets and liabilities held for disposition at December 31, 2007.

Results from continuing operations include an increase in provisions for credit losses of $56.8 million, severance and other charges of $15.6 million, a net charge of $6.8 million related to the redemption of debt and a $3.6 million loss on the write-down of direct investments to fair value. The net impact of these items was $82.8 million ($53.8 million after tax or $0.98 per diluted share). Results from continuing operations in 2006 include charges of $57.0 million ($37.0 million after tax or $0.69 per diluted share) related to the balance sheet repositioning actions taken in 2006.

The net interest margin for 2007 increased by 24 basis points when compared to the prior year. This was primarily due to increases in higher yielding commercial and consumer loans and a decrease in average outstanding securities and borrowings partially offset by an increase in the cost of deposits. Average interest bearing liabilities decreased $1.2 billion, or 7.3%, with decreases in borrowings of $1.5 billion partially offset by increases in average deposits of $0.4 billion. Average earning assets decreased $1.1 billion, or 6.6%, ($409.9 million in loans and $704.8 million in securities) when compared to 2006 as a result of the balance sheet restructuring actions.

Non-interest income of $202.3 million increased by $70.7 million, or 53.7%, in 2007 compared to 2006. The increase in non-interest income was primarily due to the $48.9 million and $2.3 million in losses recognized to write-down and subsequently sell, respectively, the available for sale mortgage-backed securities portfolio in 2006, the $5.7 million loss on the sale of mortgage loans in 2006 and an increase in deposit service fees of $17.9 million in 2007 compared to 2006 partially offset by a $3.6 million decrease in loan related fees.

Non-interest expenses of $484.0 million increased $47.6 million, or 10.9%, compared to 2006. The increase reflects the impact of severance and other costs of $15.6 million, debt prepayment expenses of $8.9 million and an increase in compensation and benefits of $15.0 million, $3.4 million related to the write-off of software development costs and $2.3 million of closing costs related to Peoples Mortgage Corporation (“PMC”).

Net Interest Income

Net interest income which is the difference between interest earned on loans, investments and other interest-earning assets and interest paid on deposits and borrowings, totaled $508.2 million in 2007, compared to $508.6 million in 2006, a decrease of $0.4 million. Net interest income is affected by changes in interest rates, by loan and deposit pricing strategies and competitive conditions, the volume and mix of interest-earning assets and interest-bearing liabilities and the level of non-performing assets. The decrease in net interest income is largely due to lower volumes of average interest-earning assets, mostly related to decreases in average securities partially offset by decreases in average interest-bearing liabilities related to decreases in average borrowings.

Interest Income

Interest income (on a fully tax-equivalent basis) decreased $17.5 million, or 1.7%, to $1.0 billion for 2007 as compared to 2006. A decrease in the average interest earning-assets over the prior year was partially offset by slightly higher average yields earned on the assets. The decline in the volume of interest-earning assets is a result of the balance sheet repositioning which began in the fourth quarter of 2006 and was completed by the first quarter of 2007. The average loan portfolio, excluding loans held for sale, decreased by $409.9 million, or 3.2%, compared to 2006. Average securities decreased by $704.8 million, or 23.0%, compared to 2006. Additionally higher yielding commercial and consumer loans partially replaced reductions in residential loans.

The yield earned on interest-earning assets increased 35 basis points for the year ended December 31, 2007 to 6.60% compared to 6.25% for 2006 as a result of the balance sheet repositioning actions. The loan portfolio yield increased 17 basis points to 6.76% for the year ended December 31, 2007 and comprised 81.2% of average interest-earning assets compared to the loan portfolio yield of 6.59% and 78.3% of average interest-earning assets for the year ended December 31, 2006. Additionally, the yield on securities was 5.79%, an 86 basis point improvement over 2006.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Forward-Looking Statements and Factors that Could Affect Future Results

Certain statements contained in this Quarterly Report on Form 10-Q that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”), notwithstanding that such statements are not specifically identified as such. In addition, certain statements may be contained in the Company’s future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Company that are not statements of historical fact and constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, expenses, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans, objectives and expectations of Webster or its management or Board of Directors, including those relating to products or services; (iii) statements of future economic performance; and (iv) statements of assumptions underlying such statements. Words such as “believes”, “anticipates”, “expects”, “intends”, “targeted”, “continue”, “remain”, “will”, “should”, “may” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:

Critical Accounting Policies

The Company’s significant accounting policies are described in Note 1 to the consolidated financial statements included in its 2008 Annual Report on Form 10-K. The preparation of the consolidated financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and to disclose contingent assets and liabilities. Actual results could differ from those estimates. Management has identified accounting for the allowance for credit losses, valuation and analysis for impairment of goodwill and other intangible assets, and the analysis of other-than-temporary impairment for its investment securities, income taxes and pension and other post retirement benefits as the Company’s most critical accounting policies and estimates in that they are important to the portrayal of the Company’s financial condition and results, and they require management’s most subjective and complex judgment as a result of the need to make estimates about the effects of matters that are inherently uncertain. These accounting policies, including the nature of the estimates and types of assumptions used, are described throughout this Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations and Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s 2008 Annual Report on Form 10-K.

Significant Third Quarter Event

During the third quarter, Webster strengthened its capital position through an agreement with Warburg Pincus, the global private equity firm, pursuant to which Warburg agreed to invest $115 million in Webster, as previously disclosed. An initial amount of $40 million was invested on July 27, 2009 and the remaining $75 million was invested on October 15, 2009. This investment, coupled with the successful exchange offer for convertible preferred stock and trust preferred securities completed during the second quarter, enabled Webster to significantly increase common equity with minimal dilution to tangible book value. For more information regarding Warburg’s investment in Webster and the securities purchased, see Note 12 to Webster’s condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.

(a) Calculated using SNL’s methodology-non-interest expense (excluding foreclosed property expenses, intangible amortization, goodwill impairments and other charges) as a percentage of net interest income (FTE basis) plus non-interest income (excluding gain/loss on securities and other charges).

(b) Calculated based on income from continuing operations for all periods presented.

(c) For the three and nine months ended September 30, 2009 and 2008, respectively, the effect of stock options, restricted stock, convertible preferred stock outstanding at September 30, 2009 and the outstanding warrant to purchase common stock on the computation of diluted earnings per share was anti-dilutive. Therefore, the effect of these instruments were not included in the determination of diluted shares (average).

(d) Calculated in accordance with FASB ASC Topic 260 and related updates including FASB ASU No. 2009-08 which required the Company to determine the dilutive effects of the Series A Preferred Stock tendered on June 24, 2009 separately from the remaining shares outstanding at September 30, 2009. Accordingly, the adjustments to dilutive EPS related to the Series A Preferred Stock includes the $58.8 million excess of the carrying amount of the preferred stock retired over the fair value of the common shares issued and cash delivered, net of the $7.2 million of dividends paid. These adjustments were not incorporated into the calculation of diluted EPS for the three and six months ended June 30, 2009. Had the $58.8 million excess of the carrying amount of the preferred stock retired over the fair value of the common shares issued and cash delivered, net of the $7.2 million of dividends paid been taken into consideration diluted EPS for continuing operations would have been $(0.66) and $(0.97) for the three and six months ended June 30, 2009, respectively, a decrease from the $0.30 and $(0.10), respectively, previously reported within Webster’s Form 10-Q for the three and six months ended June 30, 2009.

(e) The ratios presented are projected for the 2009 reporting periods and actual for the 2008 reporting periods.

Net Interest Income

Net interest income totaled $126.7 million and $364.2 million for the three and nine months ended September 30, 2009, respectively, a decrease of $2.5 million and $15.6 million from the comparable periods in the prior year, respectively. Average earning assets grew by 2.5% to $16.1 billion for the nine months ended September 30, 2009 from $15.7 billion for the nine months ended September 30, 2008, while the net interest margin declined from 3.32% and 3.28% for the three and nine months ended September 30, 2008, respectively, to 3.24% and 3.21% for the three and nine months ended September 30, 2009, respectively. The securities portfolio totaled $4.6 billion at September 30, 2009 compared to $3.7 billion at December 31, 2008 and $2.9 billion a year ago. The yield in the securities portfolio on a fully tax-equivalent basis for the three and nine months ended September 30, 2009 was 5.14% and 5.31%, respectively, compared with 5.62% and 5.62% for the same periods in 2008.

Net interest income can change significantly from period to period based on general levels of interest rates, customer prepayment patterns, the mix of interest earning assets and the mix of interest bearing and non-interest bearing deposits and borrowings. Webster manages the risk of changes in interest rates on its net interest income through an Asset/Liability Management Committee and through related interest rate risk monitoring and management policies. See “Asset/Liability Management and Market Risk” for further discussion of Webster’s interest rate risk position.

Interest Income

Interest income for the three months ended September 30, 2009 decreased $29.7 million, or 13.8%, from the comparable period in 2008. The decrease in short-term interest rates had an unfavorable impact on interest sensitive loans as well as lower rates on new volumes. The average balance for investment securities for the three months ended September 30, 2009 was $4.3 billion, an increase of $1.4 billion from the comparable period in 2008. The average balance for loans for the three months ended September 30, 2009 was $11.5 billion, a decrease of $1.3 billion from the comparable period in 2008.

Interest income for the nine months ended September 30, 2009 decreased $96.7 million, or 14.6%, from the comparable period in 2008. The decrease in short-term interest rates had an unfavorable impact on interest sensitive loans as well as increased non-performing loans. The average balance for investment securities for the nine months ended September 30, 2009 was $4.0 billion, an increase of $1.1 billion from the comparable period in 2008. The average balance for loans for the nine months ended September 30, 2009 was $11.9 billion, a decrease of $0.8 billion from the comparable period in 2008.

The yield on interest-earning assets decreased 94 basis points to 5.31% for the nine months ended September 30, 2009, from the comparable period in 2008. The decrease reflects the declining interest rate environment during these periods as well as increased non-performing loans.

The loan portfolio yield decreased 109 basis points to 4.58% for the nine months ended September 30, 2009 and comprised 73.5% of average interest-earning assets compared to 80.7% of average interest-earning assets for the nine months ended September 30, 2008.

CONF CALL

James Smith
Thank you, Melissa. Good morning, everyone and welcome to Webster’s third quarter earning’s call and webcast. You can find our earnings release which was issued earlier this morning and the slides for the Company of this presentation on our website at websterbank.com. As usual, I will provide an overview for the quarter and Gerry Plush, our Chief Financial Officer and Chief Risk Officer will ]]>Mon, 11 Jan 2010 05:00:56 GMThttp://www.dailystocks.com/forum/showtopic.php?tid/3732/http://www.dailystocks.com/forum/showtopic.php?tid/3732/
BUSINESS OVERVIEW

Introduction



Mesa Laboratories, Inc. (hereinafter referred to as the “Company” or “Mesa”) was incorporated as a Colorado corporation on March 26, 1982. The Company designs, manufactures and markets instruments and disposable products utilized in connection with industrial applications and healthcare. For industrial applications, which includes pharmaceutical, food, medical devices, and petrochemical, the Company presently markets the DATATRACE® data logging systems, NUSONICS® Concentration Analyzers, Pipeline Interface Detectors and Flow Meter products and RAVEN Biological Indicators. For healthcare applications, the Company markets Dialysate Meters used in kidney dialysis and RAVEN Biological Indicators, which are used by hospitals and dental offices to assure sterility. The Company is continually performing research and development to expand the application of its technology.



DATATRACE ® Data Loggers



The DATATRACE products are self-contained, wireless, high precision, data loggers that are used in critical manufacturing, quality control, and transportation applications. They are used to measure temperature, humidity and pressure inside a process or inside a product during manufacturing. In addition, the DATATRACE products can be used to validate the proper operation of laboratory or manufacturing equipment, either during its installation or for annual re-certifications. The product line consists of individual data loggers, PC interface software and various accessories. A customer typically purchases a large number of data loggers along with a single PC interface and the software package. Specifically, the customer can purchase either the wireless Micropack III (MPIII) data loggers or the Micropack Radio Frequency (MPRF) transmitting data loggers. Both DataTrace models work with the Data Trace Radio Frequency (DTRF) software package.



In practice, using the PC interface, the user programs the loggers to collect environmental data at a pre-determined interval, places the data loggers in the product or process, and then in the case of the MPIII model retrieves the data loggers and reads the data into a PC after placing them in the interface or with the MPRF models is continuously collecting the data via radio frequency transmissions. After this, the user can prepare tabular and graphical reports using the DTRF software.



The MPIII line is much smaller, has improved hardware compared to previous DataTrace loggers, has embedded software, includes a rapid optical interface, and operates over a wide temperature range. The MPRF models include all the features and performance improvements of the MPIII version and adds the capability to transmit data to a PC in real time through the proprietary DTLinc RF network. The ability to view process or validation data instantly saves valuable time, and it can prevent costly processing mistakes. The DataTrace RF system allows the user to see results immediately and make appropriate decisions as necessary.



While there are a variety of different types of wireless data loggers available on the market, there are only a few that are rated as “intrinsically safe” and can operate at elevated temperatures, like the DATATRACE products. These are important differentiating factors for the DATATRACE products in the marketplace, and consequently, they are used by companies to control their most critical processes. Due to their higher accuracy and precision, along with the importance of the processes they are used to control, an important component of the DATATRACE product line is the calibration service that is provided by Mesa. Typically, each DATATRACE data logger is calibrated by Mesa’s calibration laboratory prior to shipment and then annually, for a re-certification fee, to verify its accuracy. For instance, the MPRF temperature data loggers have an operating range of —80 o C to +400 o C and can be calibrated to an accuracy of +/- 0.1 o C over a portion of this range. This allows the DATATRACE loggers to be used to conduct quality control on critical processes, such as sterilization, one of the most important applications.



RAVEN Biological Indicators



In May 2006, the Company acquired Raven Biological Laboratories, Inc. of Omaha, Nebraska. The RAVEN product line consists of Biological Indicators (BI) and Chemical Indicators (CI) used to assess the effectiveness of sterilization processes, including steam, gas (such as ethylene oxide), and radiation. BI’s consist of resistant spores of certain microorganisms which are applied on a convenient substrate. The spores are well characterized in terms of numbers and resistance to sterilization. In use, the BI is exposed to a sterilization process and then tested to determine the presence of surviving organisms. RAVEN’s line of BI’s includes both spore strips, which require post-processing transfer to a growth media, self-contained products which have the growth media already pre-packaged in crushable ampoules, industrial use BI’s, and culture media. CI’s are similar to BI’s, except that a chemical change (generally determined by color) is used to assess the exposure to sterilization conditions. BI’s and CI’s are often used together to monitor processes. RAVEN products are used to validate equipment and monitor the effectiveness of a process in any industrial or healthcare setting which uses sterilization. Key markets for RAVEN include healthcare such as dental offices and hospitals, and industrial such as medical device and pharmaceutical manufacturing.



In addition to Biological and Chemical Indicators, the Company offers Contract and Testing Services to industrial companies for the development of sterilization processes. These testing services include organism identification, population verification, sterilization process development and custom BI production.



The RAVEN Biological Indicators are distinguished in the marketplace by their high level of quality, consistency and flexibility. A variety of different formats allows the RAVEN BI to be used in many different types of processes and products. For instance, the simple spore strips are used most often in the small table-top steam sterilizers in dental offices, while a more complex self-contained BI such as the ProTest, may be used by a medical device manufacturer to assure the sterility in a complex ethylene oxide sterilization process. In either case, the number of spores contained on the carrier and the resistance of the spores to the sterilization process must be well characterized in order to accurately assess the effectiveness of sterilization. During manufacturing, extensive quality control steps are used to insure that the microorganism spores are well characterized and their resistance is known following placement on the target carrier. The RAVEN products are registered medical devices manufactured under ISO 13485 controlled processes. They are developed and used according to the guidelines developed under the auspices of the Association for the Advancement of Medical Instrumentation (AAMI), which are adopted as the worldwide standard under the International Standards Organization (ISO).

Recently the Company has expanded its product line adding two (2) specialized biological indicator products. One of these products, ProTest BI Test Pack, is a significant addition to RAVEN’s offering for the domestic healthcare (hospital) market. It allows the user to immediately release certain types of sterilized materials saving the user time and money. A second product added in early 2007, ProAMP with Negative Controls, provides industrial (pharmaceutical and medical device) users with a unique and previously unseen option for sterilization monitoring and the effects of steam sterilization on the interpretation of a self-contained biological indicator. Having printed Negative Controls, the user can not only monitor their sterilization processes but also see the effects their process has on BIs themselves.



MEDICAL HEMODIALYSIS PRODUCTS



Patients with kidney failure (known as end stage renal disease, or ESRD) require the removal of toxic waste products and excess water through artificial means. This process is generally performed three times per week and is most often accomplished through the use of hemodialysis.



Hemodialysis requires the treatment to be conducted on a dialysis machine through the use of a disposable cartridge known as a dialyzer. Blood is brought extra corporally to the dialysis machine for control and monitoring and passes through the dialyzer where waste products and excess water are removed. This treatment generally lasts three to four hours. While these hemodialysis procedures can be conducted in home, the bulk of the treatments are conducted in over 4,500 clinics and hospital centers in the U.S. Currently, there are over 300,000 patients in the U.S. undergoing dialysis therapy.



In addition to the reimbursement policies of the United States Government and state agencies, the Company’s revenues from its dialysis products can be expected to be dependent upon the policies of insurance companies and kidney foundations.



Dialysate Meters



Mesa’s Dialysate Meters are instruments that are used to test various parameters of the dialysis fluid (dialysate), and the proper calibration and operation of the dialysis machine. Each measures some combination of temperature, pressure, pH and conductivity to ensure that the dialysate has the proper composition to promote the transfer of waste products from the blood to the dialysate. The meters provide a digital readout that the patient, physician or technician uses to verify that the dialysis machine is working within prescribed limits and delivering the properly prepared dialysate.



The Company manufactures two styles of Dialysate Meters; those designed for use by dialysis machine manufacturers and Biomedical Technicians and those used primarily by dialysis nurses or patient care technicians. The meters for technicians include the Models NEO-2 and the newer 90XL. These meters are characterized by exceptional accuracy, stability, and flexibility and are used by the industry as the primary standard for the calibration of dialysis machines. The newest 90XL meter has four independent measurement channels, allowing the user to easily perform testing and calibration of multiple dialysis machines in a clinic or on the manufacturing floor.



The 90XL meter has been well received by the marketplace and already holds a dominant position in comparison to unit sales of the NEO-2. Mesa anticipates that the marketplace will want to gradually phase out of the NEO-2 meters and further adopt the 90XL.

The dialysis meters designed for use by dialysis nurses are known primarily for their ease of use and include the pHoenix, Hydra, and NEO-STAT+ models. Incorporating a patented, built-in syringe sampling system, these meters are used as the final quality control check on the dialysate just prior to starting a treatment. Their design allows the nurse to quickly and easily draw a small sample of the dialysate into the meter for measurement, and management believes that they have become the most popular meter in the point-of care testing in dialysis clinics. The pHoenix meter is the newest meter Mesa has introduced to the marketplace and is the leading seller by far of the three (3) hand held meter choices.



In addition to the dialysate meters, the Company markets a line of calibration standard solutions for use in dialysis clinics for calibration and testing. These standard solutions are regularly consumed by the dialysis clinics and this, along with calibration services, represents a recurring revenue stream for the Medical product line.



NUSONICS PRODUCTS



The Company’s sonic fluid measurement product line consists of two major components: Sonic Flow Meters and Concentration Monitors. While the total market for flow meters is very large, the NUSONICS® Sonic Flow Meters best serve applications where cleanliness and resistance to corrosives are required. Specific applications where the NUSONICS® products are particularly well suited include water treatment, chemical processing and heating ventilation and air conditioning (HVAC) applications. The Concentration Monitor component of the product line consists of Pipeline Interface Detectors and Concentration Analyzers. The Pipeline Interface Detector serves a smaller market niche while the Concentration Analyzers serve a wider variety of industry application, such as chemical, food, pharmaceutical and polymerization processes.



The NUSONICS products have been subject to strong competition in the marketplace in recent years primarily from larger, well established process control companies. Consequently, sales of NUSONICS products have decreased and currently represent less than 4% of the Company’s total revenue. Today, most sales are made to existing NUSONICS customers who are replacing or adding to their current infrastructure.



Manufacturing



The Company assembles its products at its facilities in Lakewood, Colorado and Omaha, Nebraska. The Company’s electronic products are manufactured primarily by assembling products from purchased components and testing the final products prior to release. The RAVEN products are manufactured by growing microbiological spores from raw materials, assembling the finished products through a series of process steps, and testing the finished Biological Indicators using established quality control tests.



Most of the materials and components used in the Company’s product lines are available from a number of different suppliers. Mesa generally maintains multiple sources of suppliers for most items but is dependent on a single source for certain items. Mesa believes that alternative sources could be developed, if required, for present single supply sources. Although the Company’s dependence on these single supply sources may involve a degree of risk, to date, Mesa has been able to acquire sufficient stock to meet its production requirements.



Marketing and Distribution



The Company’s domestic sales of its MEDICAL and DATATRACE products are generated by its direct sales and marketing staff, while outside the U.S., a number of distributors are utilized. The Company’s RAVEN products are distributed both directly, through a sales and marketing staff to end users and through a series of distributors both domestically and outside the U.S. International sales for all products are conducted through over 100 distributors. During the fiscal year ended March 31, 2009, approximately 72% of sales have been domestic and 28% have been international to countries throughout Europe, Africa, Australia, Asia and South America, as well as Canada and Mexico.

Sales promotions include attendance by Mesa representatives at trade shows, direct mail campaigns, internet advertising and other digital forms of advertising.



Customers of Mesa’s MEDICAL products primarily include dialysis centers and dialysis equipment manufacturers. The primary emphasis of the Company’s marketing effort is to offer quality products to the healthcare market which will aid in cost containment and improved patient well-being.



DATATRACE® customers include numerous industrial users in the food, pharmaceutical and medical device markets who utilize the products within a variety of manufacturing, quality control and validation applications. The emphasis of the Company’s marketing effort is to offer a quality product that provides a unique and flexible solution to monitoring temperature, pressure or humidity without interfering with the processing of the product.



RAVEN customers include various companies providing sterility assurance testing to the dental office market, hospitals, contract sterilizing services and various industrial users involved in pharmaceutical and medical device manufacturing. The Company’s marketing focuses on providing high quality test products in a variety of different formats, which minimize incubation and test result time.



NUSONICS® customers include various industries such as water treatment, manufacturing, HVAC and petroleum product transportation. The Company’s marketing efforts are focused on offering flow measurement and concentration monitoring in difficult environments where noninvasive monitoring techniques are required.



During the fiscal year ended March 31, 2009, one customer represented approximately 14% of the Company’s revenues and approximately 12% of the Company’s accounts receivable balance. During the fiscal year ended March 31, 2008, one customer represented approximately 13% of the Company’s revenues and approximately 12% of the Company’s accounts receivable balance.



Competition



Mesa competes with major medical and instrumentation companies as well as a number of smaller companies, many of which are well established, with substantially greater capital resources and larger research and development capabilities. Furthermore, many of these companies have an established product line and a significant operating history. Accordingly, the Company may be at a competitive disadvantage due to such factors as its limited resources and limited marketing and distribution network.



Companies with which Mesa’s dialysis products compete include Myron L Company and IBP Medical GmbH. Companies with which Mesa’s DATATRACE® data logger products compete include GE Kaye, Ellab and TMI Orion. Companies with which RAVEN’s biological indicator products compete include 3M, SGM and Steris. Companies with which Mesa’s NUSONICS® products compete include Controlotron, Badger Meter, Rosemount, and GE Panametrics.



Government Regulation



Medical devices marketed by Mesa are subject to the provisions of the Federal Food, Drug and Cosmetic Act, as amended by the Medical Device Amendments of 1976 (hereinafter referred to as the “Act”). A medical device which was not marketed prior to May 28, 1976, or is not substantially equivalent to a device marketed prior to that date, may not be marketed until certain data is filed with the FDA and the FDA has affirmatively determined that such data justifies marketing under conditions specified by the FDA. A medical device is defined by the Act as an instrument which (1) is intended for use in the diagnosis or the treatment of disease, or is intended to affect the structure of any function of the human body; (2) does not achieve its intended purpose through chemical action; and (3) is not dependent upon being metabolized for the achievement of its principal intended purpose. The Act requires any company proposing to market a medical device to notify the FDA of its intention at least ninety days before doing so, and in such notification must advise the FDA as to whether the device is substantially equivalent to a device marketed prior to May 28, 1976. As of the date hereof, the Company has received permission from the FDA to market all of its products requiring such permission.



Some of Mesa’s products are subject to FDA regulations and inspections, which may be time-consuming and costly. This includes on-going compliance with the FDA’s current Good Manufacturing Practices regulations which require, among other things, the systematic control of manufacture, packaging and storage of products intended for human use. Failure to comply with these practices renders the product adulterated and could subject the Company to an interruption of manufacture and sale of its medical products and possible regulatory action by the FDA.



The manufacture and sale of medical devices is also regulated by some states. Although there is substantial overlap between state regulations and the regulations of the FDA, some state laws may apply. Mesa, however, does not anticipate that complying with state regulations will create any significant problems. Foreign countries also have laws regulating medical devices sold in those countries, which may cause us to expend additional resources on compliance.



Employees



On March 31, 2009, the Company had a total of 111 employees, of which 108 were full-time employees. Currently, 24 persons are employed for marketing and sales, six for research and development, 70 for manufacturing and quality assurance and 11 for administration.



Additional Information



For the fiscal years ended March 31, 2009 and 2008, Mesa spent $636,000 and $532,000, respectively, on Company-sponsored research and development activities.



Compliance with federal, state and local provisions which have been enacted regarding the discharge of materials into the environment or otherwise relating to the protection of the environment has not had, and is not expected to have, any adverse effect upon capital expenditures, earnings or the competitive position of the Company. Mesa is not presently a party to any litigation or administrative proceedings with respect to its compliance with such environmental standards. In addition, the Company does not anticipate being required to expend any significant capital funds in the near future for environmental protection in connection with its operations.



The Company has been issued patents for its DATATRACE® temperature recording devices, its NUSONICS® sonic flow measurement and sonic concentration monitoring products and its pHoenix, Hydra and NeoStat+ dialysis meters and its RAVEN biological indicators. Several of these patents have now expired. Failure to obtain patent protection on the Company’s remaining products may have a substantially adverse effect upon the Company since there can be no assurance that other companies will not develop functionally similar products, placing the Company at a competitive disadvantage. Further, there can be no assurance that patent protection will afford protection against competitors with similar inventions, nor can there be any assurance that the patents will not be infringed or designed around by others. Moreover, it may be costly to pursue and to prosecute patent infringement actions against others, and such actions could interfere with the business of the Company.

CEO BACKGROUND

Nominees for Election as Directors


Name and Address


Age



Office


Term Expires(1)


Luke R. Schmieder


66



Chairman of the


2009

12100 West Sixth Avenue


Board of Directors



Lakewood, Colorado



John J. Sullivan, Ph.D.


56

Chief Executive Officer,


2009

12100 West Sixth Avenue

President and Director

Lakewood, Colorado

Paul D. Duke


67
Director (2)(3)(4)


2009

12100 West Sixth Avenue

Lakewood, Colorado


H. Stuart Campbell



79


Director (2)(3)(4)


2009

12100 West Sixth Avenue

Lakewood, Colorado

MANAGEMENT DISCUSSION FROM LATEST 10K

Mesa Laboratories, Inc. manufactures and distributes electronic measurement systems and disposable products for various niche applications, including renal treatment, food processing, medical sterilization, pharmaceutical processing and other industrial applications. Our Company follows a philosophy of manufacturing a high quality product and providing a high level of on-going service for those products. In order to optimize the performance of our Company and to build the value of the Company for its shareholders, we continually follow the trend of various key financial indicators. A sample of some of the most important of these indicators is presented in the following table.

(1) Average return on stockholder investment is calculated by dividing total net income by the average of end of year and beginning of year total stockholder’s equity.

(2) Average return on invested capital (invested capital = total assets — current liabilities — cash and short-term investments) is calculated by dividing total net income by the average of end of year and beginning of year invested capital.



While we continually try to optimize the overall performance and trends, the table above does highlight various exceptions. Most of the indicators above are improving in the most recent fiscal year. Exceptions to the improving trends are days sales outstanding, the average return calculations, and net profit margin. Longer times to payment for our foreign customers have increased the total days sales outstanding average for the total Company in fiscal 2009. A small decrease in net profit margin combined with increasing balance sheet levels during fiscal 2009 caused the average return calculations to decrease slightly in the current fiscal year. Our company saw a small decrease in net profit margin in fiscal 2009 due to a small decrease in gross profit margins and decreased interest income on invested cash due to lower interest rates.



Results of Operations



Net Sales



Net sales for fiscal 2009 increased 10 percent from fiscal 2008, and net sales for fiscal 2008 increased 13 percent from fiscal 2007. In dollars, net sales of $21,536,000 in fiscal 2009 increased $1,978,000 from $19,558,000 in 2008, and net sales of $19,558,000 in fiscal 2008 increased $2,316,000 from $17,242,000 in 2007.



Our revenues come from two main sources, which include product revenues and parts and service revenues. Parts and service revenues are derived from on-going repair and recalibration or certification of our products. The certification or recalibration of product is usually a key component of the customer’s own quality system and many of our customers operate in regulated industries, such as food processing or medical and pharmaceutical processing. For this reason, these revenues tend to be fairly stable and grow slowly over time. During fiscal years 2009, 2008 and 2007 our Company had parts and service revenue of $3,642,000, $3,499,000 and $3,333,000. As a percentage of total revenue, parts and service revenues were 17% in 2009, 18% in 2008 and 19% in 2007.



The performance of new product sales is dependent on several factors, including general economic conditions in the United States and abroad, capital spending trends and the introduction of new products. Until the current fiscal year, general economic conditions had been improving, and more specifically, capital spending had been improving, but these trends have reversed during fiscal 2009. New products released to the market over the past five fiscal years include the Datatrace Micropack III temperature loggers during the middle of fiscal 2003, the Datatrace Micropack III humidity and pressure loggers at the end of fiscal 2004, the 90XL Dialysate Meter for kidney dialysis was introduced late in fiscal 2006, and the Datatrace RF System was introduced in early fiscal 2009. For fiscal years 2009, 2008 and 2007 product sales for our company were $17,894,000, $16,059,000 and $13,909,000.



During fiscal 2009, sales of the Company’s medical products and services increased 16% for the fiscal year compared to the prior year period. For the year, Medical saw increased sales of meter products, disposables and service, which were partially off-set by lower sales of the discontinued dialyzer reprocessor. Sales of our new 90XL Meter continued to progress well during fiscal 2009. In addition, we continue to maintain strong relationships with our major customers in this market.



During fiscal 2009, sales of Datatrace data logger products preformed at the same level as the prior year. For the year, DataTrace products did not experience an increase in sales due to existing economic trends which influenced some industrial customers to delay their capital equipment purchases. Sales for the twelve month period saw small declines though the various categories of Micropack III products which were off-set by sales of the new Micropack RF products. We are optimistic and look forward to improving trends in both new product shipments and service sales in both the domestic and international markets for the later part of fiscal 2010. Introduction of the new Micropack RF products, with their real-time reporting capabilities, is expected to further add to Datatrace product line sales in the new fiscal year.



Fiscal 2009 sales of Raven biological indicator products increased 15 percent compared to the prior year period. In fiscal 2009, Raven experienced an increase in biological indicator and chemical indicator sales. Sales

during fiscal 2009 benefited from increased production capabilities and automation, which is allowing our company to better penetrate the market with additional product size configurations and increased production of key products.



During fiscal 2009, sales of the Nusonics line of ultrasonic fluid measurement systems increased by three percent. Sales of these products remain stable, but Nusonics products currently contribute less than four percent of the Company’s total sales and are not expected to grow in the future.



During fiscal 2008, sales of the Company’s medical products and services increased five percent for the fiscal year compared to the prior year period. For the year, Medical saw increased sales of meter products, disposables and service, which were partially off-set by lower sales of the discontinued dialyzer reprocessor line and lower repair part sales. Sales of our new 90XL Meter continued to progress well during fiscal 2008. In addition, we continued to maintain strong relationships with our major customers in this market.



During fiscal 2008, sales of Datatrace data logger products increased 13% compared to the prior year. For the year, DataTrace products continued to see improving trends in both new product shipments and service sales in both the domestic and international markets. Introduction of the new Micropack RF products, with their real-time reporting capabilities, was expected to further add to Datatrace product line sales in the fiscal 2009.



Fiscal 2008 sales of Raven biological indicator products increased 29 percent compared to the prior year period. The Raven biological indicator products were acquired on May 4, 2006. For this reason, sales of the company’s Raven biological indicator products benefited from an extra five weeks of sales for the full year when compared to the prior year period.



During fiscal 2008, sales of the Nusonics line of ultrasonic fluid measurement systems decreased by three percent. Sales of these products remain stable, but Nusonics products currently contribute less than four percent of the Company’s total sales and are not expected to grow in the future.



Cost of Sales



Cost of sales as a percent of net sales in fiscal 2009 increased 1.5 percent from fiscal 2008 to 35.8 percent, and in fiscal 2008 decreased 2.5 percent from fiscal 2007 to 34.3 percent from 36.8 percent. Most of our products enjoy gross margins in excess of 50 percent. Due to the fact that the dialysis products have sales concentrated with several companies that maintain large chains of treatment centers, the products that are sold to the renal market tend to be slightly more price sensitive than the data logging products. Also, due to the nature of the market for biological indicators, the RAVEN products produce gross margins lower than DATATRACE and MEDICAL. Therefore, shifts in product mix toward higher sales of DATATRACE and MEDICAL products will tend to produce lower cost of goods sold expense and higher gross margins while shifts toward higher sales of RAVEN products will normally produce the opposite effect on cost of goods sold expense and gross margins.



During fiscal 2009, our Company saw increases in costs of sales due to flat DATATRACE sales as result of the economic down turn, and increases in RAVEN and MEDICAL products with a resulting increase in cost of sales. The Company continues to monitor and implement cost reduction programs, price increases and improvements in freight cost recovery.



During fiscal 2008, our Company saw reductions in costs of sales year over year with the exception of the DATATRACE line which saw a small increase of one half of one percent as a percent of DATATRACE sales. Most of the decline in costs of sales percent in the current fiscal year was attributable to an improvement in the Medical line, where cost reduction programs, price increases and improvements in freight cost recovery all contributed to the gain.

Selling, General and Administrative



General and administrative expenses tend to be fairly fixed and stable from year-to-year. To the greatest extent possible, we work at containing and minimizing these costs. Total administrative costs were $2,522,000 in fiscal 2009, $2,420,000 in fiscal 2008 and $2,075,000 in fiscal 2007, which represents a $102,000 increase from fiscal 2008 to fiscal 2009 and a $345,000 increase from fiscal 2007 to fiscal 2008. The increase in general and administrative costs for 2009 can be attributed to general increases in operating costs and the addition of the Controller position. Fiscal 2008 general and administrative costs increased due to five additional weeks of RAVEN related costs compared to the prior year along with higher accounting and consulting costs, which mostly can be attributed to the Company’s efforts to comply with the demands of Section 404 of the Sarbanes-Oxley Act of 2002.



Our selling and marketing costs tend to be far more variable in relation to sales, although there are various exceptions. Some of these exceptions include the introduction of new products and the mix of international sales to domestic sales. For a product line experiencing introduction of a new product, costs will tend to be higher as a percent of sales due to higher advertising development and sales training programs. Our Company’s international sales are usually discounted and recorded at the net discounted price, so that a change in mix between international and domestic sales may influence sales and marketing costs. One other major influence on sales and marketing costs is the mix of domestic dialysis product sales to all other domestic sales. Domestic dialysis product sales are made by direct telemarketing representatives, which gives us a lower cost structure, when compared to the field salesman and independent representative sales channels utilized by our other products. Through fiscal 2009 and fiscal 2008 the Company continued to focus additional resources on its sales and marketing efforts. In June of fiscal 2006, the company began a transition from independent manufacturer’s representatives to direct sales personnel for domestic sales of its Datatrace products. This change to our sales channels increased our selling costs in recent years, but our domestic sales levels have been rising to compensate for these cost increases. The past year’s continuing transition to direct selling was focused on overall sales management and telemarketing resources for both the DATATRACE and RAVEN lines.



In dollars, selling costs were $3,051,000 in fiscal 2009, $2,845,000 in fiscal 2008 and $2,769,000 in fiscal 2007. As a percent of sales, selling cost were 14.2 percent in fiscal 2009, 14.5 percent in fiscal 2008 and 16.1 percent in fiscal 2007. During both fiscal 2009 and 2008, sales and marketing costs as a percent of sales declined. In real dollars, the DATATRACE and RAVEN costs increased during fiscal 2009 due to the expansion of our selling staff and additional sales and marketing expenses to increase the Company’s customer base, and during fiscal 2008, we experienced an additional five weeks of costs for RAVEN products when compared with fiscal 2007.



Research and Development



Company sponsored research and development cost was $636,000 in fiscal 2009, $532,000 in fiscal 2008 and $392,000 in fiscal 2007. We are currently executing a strategy of increasing the flow of internally developed products. Late in the first quarter of fiscal 2009, the Datatrace Micropack RF product was introduced, and on-going research to introduce this technology into the environmental monitoring segment of the market continued during the remainder of the fiscal year. Most of our work during fiscal 2008 and 2007 was focused on the development of the new Micropack RF products as part of our Datatrace line.



Net Income



Net income increased to $4,790,000 or $1.48 per share on a diluted basis in fiscal 2009 from $4,610,000 or $1.41 per share on a diluted basis in fiscal 2008 and $3,958,000 or $1.22 per share on a diluted basis in fiscal 2007. For the fiscal year 2009, Mesa experienced net income growth of four percent, which was behind the sales growth rate of 10 percent for the fiscal year. The slower profitability growth was a result of static DATATRACE sales, and an increase in cost of sales

In 2008 the acceleration of profitability for the fiscal year can be attributed to a gain in gross profits as a percent of net sales, but was partially off-set by an increase in the income tax rate as a percent of earnings before income tax.



Liquidity and Capital Resources



On March 31, 2009, we had cash and cash equivalents of $9,111,000. In addition, we had other current assets totaling $9,482,000 and total current assets of $18,593,000. Current liabilities of our Company were $1,484,000 which resulted in a current ratio of 13:1. For comparison purposes at March 31, 2008, we had cash and short term investments of $5,770,000, other current assets of $8,641,000, total current assets of $14,411,000, current liabilities of $1,587,000 and a current ratio of 9:1.



Our Company has made capital acquisitions of $676,000 in fiscal 2009, and $207,000 in fiscal 2008. Fiscal 2009 included approximately $444,000 expended on equipment to automate certain manufacturing processes for our Raven products.



We have instituted a program to repurchase up to 300,000 shares of our outstanding common stock. Under the plan, the shares may be purchased from time to time in the open market at prevailing prices or in negotiated transactions off the market. Shares purchased will be canceled and repurchases will be made with existing cash reserves. We do not maintain a set policy for our buyback program. Most of our stock buybacks have occurred during periods when the price to earnings multiple has been near historical low points, or during times when selling activity in the stock is out of balance with buying demand. On February 27, 2007, the Company entered into an agreement to purchase 30,000 shares of Mesa Laboratories, Inc. common stock from one of its current Board of Directors members, Mr. Paul D. Duke. Under the terms of the agreement, Mesa Laboratories, Inc. would purchase 3,000 shares of Mesa Laboratories, Inc. common stock from Mr. Duke each month beginning in March 2007 through December 2007 at a per share price equal to the volume weighted average price (VWAP) of the common stock for the previous calendar month. While Mr. Duke’s commitment to sell was binding through the entire term of the buyback period, the company and its Board retained the right to rescind the agreement at anytime during the period depending upon the circumstances existing at the time.



During fiscal 2009 the Company paid regular quarterly dividends of $.10 per share of common stock. For fiscal year 2009, dividends totaled $.40 per common share of stock. During the first half of fiscal 2008, the Company maintained the regular quarterly dividend of $.08 per share of common stock and raised the quarterly dividend to $.10 per common share of stock during the second half of the fiscal year. For fiscal year 2008, dividends totaled $.36 per common share of stock.



Our Company invests its surplus capital in various interest bearing instruments, including money market funds and short-term treasuries. All investments are fixed dollar investments with variable rates in order to minimize the risk of principal loss.



The Company does not currently maintain a line of credit or any other form of debt. Nor does the Company guarantee the debt of any other entity. The Company has maintained a long history of surplus cash flow from operations. This surplus cash flow has been used in the past to fund acquisitions and stock buybacks and has been partially utilized to fund past special dividends. We are actively investigating opportunities to acquire new product lines or companies, for which we may utilize cash in the future.



Contractual Obligations



At March 31, 2009 we had routine contractual obligations for open purchase orders for purchases of supplies and inventory, which would be payable in less than one year.



Forward Looking Statements



All statements other than statements of historical fact included in this annual report regarding our Company’s financial position and operating and strategic initiatives and addressing industry developments are forward-looking statements. Where, in any forward-looking statement, the Company, or its management, expresses an expectation or belief as to future results, such expectation or belief is expressed in good faith and believed to have a reasonable basis, but there can be no assurance that the statement of expectation or belief will result or be achieved or accomplished. Factors which could cause actual results to differ materially from those anticipated, include but are not limited to general economic, financial and business conditions; competition in the data logging market; competition in the kidney dialysis market; competition in the fluid measurement market, competition in the biological indicator market; the business abilities and judgment of personnel; the impacts of unusual items resulting from ongoing evaluations of business strategies; and changes in business strategy. We do not intend to update these forward looking statements. You are advised to review the “Item 1A. Risk Factors” of this report for more information about risks that could affect the financial results of Mesa Laboratories, Inc.



Critical Accounting Policies and Estimates



The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Actual results could differ materially from those estimates.



We believe that there are several accounting policies that are critical to understanding the Company’s historical and future performance, as these policies affect the reported amounts of revenue and the more significant areas involving management’s judgments and estimates. These significant accounting policies relate to revenue recognition, research and development costs, valuation of inventory, valuation of long-lived assets and stock based compensation. These policies, and the Company’s procedures related to these policies, are described in detail below.



Revenue Recognition



We sell our products directly through our sales force and through distributors. Revenue from direct sales of our product is recognized upon shipment to the customer. Revenue from ongoing product service and repair is fully recognized upon completion and shipment of serviced product.



Accounts Receivable



At the time the accounts are originated, the Company considers a reserve for doubtful accounts based on the creditworthiness of the customer. The provision for uncollectible amounts is continually reviewed and adjusted to maintain the allowance at a level considered adequate to cover future losses. The allowance is management’s best estimate of uncollectible amounts and is determined based on historical performance that is tracked by the Company on an ongoing basis. The losses ultimately incurred could differ materially in the near term from the amounts estimated in determining the allowance.



Research & Development Costs



Research and development activities consist primarily of new product development and continuing engineering on existing products. Costs related to research and development efforts on existing or potential products are expensed as incurred.



Valuation of Inventories



Inventories are stated at the lower of cost or market, using the first-in, first-out method (FIFO) to determine cost. The Company’s policy is to periodically evaluate the market value of the inventory and the stage of product life cycle, and record a reserve for any inventory considered slow moving or obsolete. As of March 31, 2009 and 2008 the Company had recorded a reserve of $175,000 each year.

MANAGEMENT DISCUSSION FOR LATEST QUARTER


Overview



Mesa Laboratories, Inc. manufactures and distributes electronic measurement systems and disposables for various niche applications, including renal treatment, food processing, medical sterilization, pharmaceutical processing and other industrial applications. Our Company follows a philosophy of manufacturing a high quality product and providing a high level of on-going service for those products. In order to optimize the performance of our Company and to build the value of the Company for its shareholders, we continually follow the trend of various key financial indicators. A sample of some of the most important of these indicators is presented in the following table.

(1) Average return on stockholder investment is calculated by dividing total annualized net income by the average of end of period and beginning of year total stockholder’s equity.



(2) Average return on invested capital (invested capital = total assets - current liabilities - cash and short-term investments) is calculated by dividing total annualized net income by the average of end of period and beginning of year invested capital.



While we continually try to optimize the overall performance and trends, the table above does highlight various exceptions. These exceptions are usually influenced by a more important need. Most of the indicators above for the period ended June 30, 2009 are showing variation from the trends of the past years. Our balance sheet trends are improving due to cost reductions and only a small decline in sales. Our return trends are showing some decline due to the growth of assets. Factors currently impacting profitability include higher sales of Raven products, lower sales of Datatrace products, lower interest income on the Company’s invested surplus cash, and a higher anticipated income tax rate for fiscal 2010.



Results of Operations



Net Sales



Net sales for the first quarter of fiscal 2010 decreased two percent from fiscal 2009. In real dollars, net sales of $4,977,000 in fiscal 2010 decreased $77,000 from $5,054,000 in 2009.



Our revenues come from two main sources, which include product revenues and parts and service revenues. Parts and service revenues are derived from on-going repair and recalibration or certification of our products. The certification or recalibration of product is usually a key component of the customer’s own quality system and many of our customers operate in regulated industries, such as food processing or medical and pharmaceutical manufacturing. For this reason, these revenues tend to be fairly stable and grow slowly over time. Also, it is important to note that the Raven products are disposables and thus do not contribute to the Company’s parts and service revenues. During the first quarter of fiscal years 2010 and 2009 our Company had parts and service revenue of $889,000 and $932,000, respectively. As a percentage of total revenue, parts and service revenues were 18% in 2010 and 18% in 2009.



The performance of new product sales is dependent on several factors, including general economic conditions in the United States and abroad, capital spending trends and the introduction of new products. Over the past three quarters, both general economic conditions and capital spending patterns have been declining. Although overall economic conditions have softened this year we have seen little impact in our sales performance in total so far. We attribute this to the industries we serve which include various medical related markets, food processing and pharmaceuticals. While the medical markets have continued to improve, we have seen a decline in sales to our food and pharmaceutical markets. For fiscal first quarter 2010 and 2009, product sales for our company were $4,088,000 and $4,122,000, respectively.

Over the fiscal first quarter, our medical revenues increased 12 percent compared to the prior period. This increase was due to higher sales of dialysis meters, calibration solutions and dialysis meter service.



During the fiscal first quarter, sales of the Datatrace brand of products decreased 26 percent from the prior year. The decrease in DataTrace sales during the quarter is the result of declining economic and capital spending trends which influenced some industrial customers to delay their capital equipment purchases. The first fiscal quarter saw declines through the various categories of Micropack III products which were only partially off-set by sales of the new Micropack RF products. We are cautiously optimistic and look forward to improving Datatrace sales trends in both new product shipments and service sales in both the domestic and international markets for the later part of fiscal 2010.



Raven sales for the first quarter increased 16 percent compared to the first quarter of the prior year. The Raven biological indicator products saw sales gains in its core biological indicator strip business. Sales of Prospore and Protest products continue to increase, and we have expanded our manufacturing capacity for these products during the past fiscal year to allow the company to pursue additional opportunities for growth of these products. We also saw a substantial increase in sales of our chemical indicator products during the first quarter.



Cost of Sales



Cost of sales as a percent of net sales during the first fiscal quarter increased 3.5 percent from fiscal 2009 to 40.1 percent. Over the past two years we have made significant strides in lowering the cost to manufacture our medical products and currently both Medical and Datatrace products enjoy margins higher than the Raven products. Therefore, shifts in product mix toward higher sales of Medical and Datatrace products will tend to produce lower cost of goods sold expense and higher gross margins while shifts toward higher sales of Raven products will normally produce the opposite effect on cost of goods sold expense and gross margins.



Higher Raven sales this quarter are a contributing factor to the lower gross margins. The Company continues to monitor and implement cost reduction programs, price increases and improvements in freight cost recovery to improve gross margins.



Selling, General and Administrative



General and administrative expenses tend to be fairly fixed and stable from year-to-year. To the greatest extent possible, we work at containing and minimizing these costs. In the first fiscal quarter of 2010, we have not incurred additional costs to address the regulatory requirements of the Sarbanes — Oxley Act, although we do expect additional costs over the remainder of the year. For the fiscal first quarter, total administrative costs were $617,000 in the current quarter compared to $738,000 for the same quarter last year.



Our selling and marketing costs tend to be far more variable in relation to sales, although there are various exceptions. Some of these exceptions include the introduction of new products and the mix of international sales to domestic sales. For a product line experiencing introduction of a new product, costs will tend to be higher as a percent of sales due to higher advertising costs and sales training programs. Our Company’s international sales are usually discounted and recorded at the net discounted price, so that a change in mix between international and domestic sales may influence sales and marketing costs. In dollars, selling costs were $606,000 in the first fiscal quarter of 2010 and $757,000 in the same prior year quarter. As a percent of sales, selling cost was 12.2% in the current quarter and 15.0% in the prior year quarter.



Research and Development



Company sponsored research and development cost was $152,000 during the first fiscal quarter and $173,000 during the previous year period. We are currently executing a strategy of increasing the flow of internally developed products. Late in the first quarter of the previous fiscal year we introduced our new Datatrace Micropack RF product. Unlike previous versions of the Micropack line, this product allows real time radio transmission of data in addition to logging of data as the instrument moves through a process. Currently, we continue to experience some on-going development cost for the Micropack RF and are continuing work that expands this radio frequency technology into new markets.



Net Income



Net income remained stable at $1,026,000 or $.31 per share on a diluted basis during the quarter compared to $1,016,000 or $.31 per share on a diluted basis in the previous year period. As previously discussed, margins decreased during the quarter. Other factors impacting net income during the quarter included the decreases in general and administrative costs, sales and marketing costs, and research and development costs which we also discussed earlier in this report. A final factor impacting net income this quarter is lower interest income on the Company’s surplus cash due to a softening of interest rates over the past three quarters, and an increase in the estimate of income tax expense as a percent of earnings before income tax.



Liquidity and Capital Resources



On June 30, 2009, we had cash and short term investments of $10,759,000. In addition, we had other current assets totaling $8,719,000 and total current assets of $19,478,000. Current liabilities of our Company were $1,473,000 which resulted in a current ratio of 13:1.



Our Company has made capital acquisitions during the first fiscal quarter of $29,000.



We have instituted a program to repurchase up to 300,000 shares of our outstanding common stock. Under the plan, the shares may be purchased from time to time in the open market at prevailing prices or in negotiated transactions off the market. Shares purchased will be canceled and repurchases will be made with existing cash reserves. We do not maintain a set policy or schedule for our buyback program.



On November 12, 2003 our Board of Directors instituted a policy of paying regular quarterly dividends. On June 15, 2009, a quarterly dividend of $.10 per common share was paid to shareholders of record on June 2, 2009.



Our Company invests its surplus capital in various interest bearing instruments, including money market funds. All investments are fixed dollar investments with variable rates in order to minimize the risk of principal loss.

The Company does not currently maintain a line of credit or any other form of debt. Nor does the Company guarantee the debt of any other entity. The Company has maintained a long history of surplus cash flow from operations. This surplus cash flow has been used in the past to fund acquisitions and stock buybacks and is currently being partially utilized to fund our on-going dividend. If interesting candidates come to our attention, we may choose to pursue new acquisitions.



Contractual Obligations



At June 30, 2009 we had contractual obligations for open purchase orders for routine purchases of supplies and inventory, which would be payable in less than one year. Additionally, the Company has committed to purchase approximately $140,000 of bottling equipment to automate the bottling of its dialysis solutions products, which is currently done by an outside vendor.



Forward Looking Statements



All statements other than statements of historical fact included in this annual report regarding our Company’s financial position and operating and strategic initiatives and addressing industry developments are forward-looking statements. Where, in any forward-looking statement, the Company, or its management, expresses an expectation or belief as to future results, such expectation or belief is expressed in good faith and believed to have a reasonable basis, but there can be no assurance that the statement of expectation or belief will result or be achieved or accomplished. Factors which could cause actual results to differ materially from those anticipated, include but are not limited to general economic, financial and business conditions; competition in the data logging market; competition in the kidney dialysis market; competition in the fluid measurement market; competition in the biological indicator market; the business abilities and judgment of personnel; the impacts of unusual items resulting from ongoing evaluations of business strategies; and changes in business strategy. We do not intend to update these forward looking statements. You are advised to review Item 1A. “Risk Factors” provided in our Company’s most recent Form 10-K filing with the SEC for more information about risks that could affect the financial results of Mesa Laboratories, Inc.



Critical Accounting Policies and Estimates



The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Actual results could differ materially from those estimates.



We believe that there are several accounting policies that are critical to understanding the Company’s historical and future performance, as these policies affect the reported amounts of revenue and the more significant areas involving management’s judgments and estimates. These significant accounting policies relate to revenue recognition, research and development costs, valuation of inventory, and valuation of long-lived assets. These policies, and the Company’s procedures related to these policies, are described in detail below.

Revenue Recognition



We sell our products directly through our sales force and through distributors. Revenue from direct sales of our product is recognized upon shipment to the customer. Revenue from ongoing product service and repair is fully recognized upon completion and shipment of serviced product.


Accounts Receivable


At the time the accounts are originated, the Company considers a reserve for doubtful accounts based on the creditworthiness of the customer. The provision for uncollectible amounts is continually reviewed and adjusted to maintain the allowance at a level considered adequate to cover future losses. The allowance is management’s best estimate of uncollectible amounts and is determined based on historical performance that is tracked by the Company on an ongoing basis. The losses ultimately incurred could differ materially in the near term from the amounts estimated in determining the allowance.


Research & Development Costs



Research and development activities consist primarily of new product development and continuing engineering on existing products. Costs related to research and development efforts on existing or potential products are expensed as incurred.



Valuation of Inventories



Inventories are stated at the lower of cost or market, using the first-in, first-out method (FIFO) to determine cost. The Company’s policy is to periodically evaluate the market value of the inventory and the stage of product life cycle, and record a reserve for any inventory considered slow moving or obsolete.



Valuation of Long-Lived Assets, Goodwill and Intangibles



The Company assesses the realizable value of long-lived assets, goodwill and intangibles for potential impairment at least annually or when events and circumstances warrant such a review. The carrying value of a long-lived asset is considered impaired when the anticipated fair value is less than its carrying value. In assessing the recoverability of our long-lived assets, goodwill and intangibles, we must make assumptions regarding estimated future cash flows and other factors to deter]]>Fri, 08 Jan 2010 05:12:49 GMThttp://www.dailystocks.com/forum/showtopic.php?tid/3725/http://www.dailystocks.com/forum/showtopic.php?tid/3725/
BUSINESS OVERVIEW

We are an emerging specialty pharmaceutical company in the business of development, licensing and commercialization of pharmaceutical products utilizing our validated drug delivery technology. We have U.S. and international patents and other proprietary rights to technologies that facilitate the absorption of drugs. Our platform drug delivery technology enhances permeation and absorption of pharmaceutical molecules across the skin, nasal mucosa and eye through formulation development with proprietary molecules such as CPE-215. We have licensed an application of our proprietary CPE-215 drug delivery technology to Auxilium, which led to the launch of Testim in the United States in February 2003, the first product incorporating our CPE-215 drug delivery technology. We have additional licensed applications and are in discussions with other pharmaceutical and biotechnology companies to form additional strategic alliances to facilitate the development and commercialization of other products using our drug delivery technologies.

Our research and development programs for our drug delivery technologies are primarily focused on the development of Nasulin, our intranasal insulin product candidate. We have completed two Phase 2a studies for Nasulin in patients with Type 1 diabetes patients using our CPE-215 technology, one in the U.S. and one in India. In early 2009, we initiated a Phase 2a, randomized, parallel, double-blind, placebo-controlled, multi-center study in the U.S. to determine the effect of Nasulin versus Placebo on blood glucose control in patient volunteers with moderately controlled Type 2 diabetes mellitus currently treated with basal insulin and oral antidiabetic medications, excluding secretagogues. During 2009 we also expect to initiate a Phase 1 Nasulin pharmacokinetic study. Additional studies may be required to advance the Nasulin clinical program. We expect to incur increased costs from the advancement of our clinical programs and from continued product development and testing efforts. Clinical trials are subject to numerous risks and uncertainties. Many factors can delay or result in termination of future clinical trials. Slow patient enrollment or results from ongoing or completed clinical trials could cause the Company to adjust its current clinical plan. See “Risk Factors” section, page 20.

We believe, based upon our extensive experience with Testim and Nasulin, that our CPE-215 formulation technology constitutes a broad platform that has the ability to significantly enhance the permeation of a wide range of therapeutic molecules. To expand the development and commercialization of products using our CPE-215 drug delivery technology, we are pursuing strategic alliances with potential partners including large pharmaceutical, specialty pharmaceutical and biotechnology companies.

We were incorporated in the State of Delaware in 2007, and our principal executive offices are located in Exeter, New Hampshire.

Separation from Bentley Pharmaceuticals, Inc.

Our business was initially the drug delivery business of Bentley Pharmaceuticals, Inc. (referred to as “Bentley”) which was spun off in June 2008 in connection with the sale of Bentley’s remaining business. Shares of our stock were distributed to Bentley stockholders after the close of business on June 30, 2008 (the “Separation Date”) by means of a stock dividend, a transaction that was taxable to Bentley and Bentley’s stockholders (the “Separation”). Each Bentley stockholder of record on June 20, 2008, the record date, received on the Separation Date one CPEX share for every ten shares of Bentley common stock. Bentley has no ownership interest in CPEX subsequent to the Separation.

Prior to our separation from Bentley, we entered into a Separation and Distribution Agreement, Tax Sharing Agreement, Employment Members Agreement and Transition Services Agreement (together referred to as the “Separation Agreements”), which have governed our relationship with Bentley since the Separation Date. The Transition Services Agreement, whereby Bentley agreed to provide us with certain executive and administrative services, expired under its terms in December 2008.

Our financial statements reflect the historical financial position, results of operations and cash flows of the business transferred to us from Bentley as part of the separation and distribution. Our financial statements have been prepared and are presented as if we had been operating as a separate entity using the historical cost basis of the assets and liabilities of Bentley and including the historical operations of the business transferred to us from Bentley as part of the separation. Prior to the Separation Date, we were fully integrated with Bentley and the accompanying financial statements reflect the application of certain estimates and allocations. Our statements of operations include all revenues and costs that are directly attributable to the business of CPEX. In addition, certain expenses of Bentley have been allocated to us using various assumptions that, in the opinion of management, are reasonable. These expenses include an allocated share of executive compensation, public company costs and other administrative costs. The allocated costs totaled $4.4 million, $4.2 million and $4.1 million for the years ended December 31, 2008, 2007 and 2006, respectively. There have been no allocations of expenses of Bentley charged to CPEX since the Separation Date. The financial information included herein may not necessarily reflect our financial position, results of operations and cash flows in the future or what our financial position, results of operations and cash flows would have been had we been a stand-alone company during the periods presented.

Industry Overview

Specialty Pharmaceutical Companies Addressing Limitations of Current Therapies

Our goal is to become a leading specialty pharmaceutical company by leveraging our permeation enhancement technology to create a diverse and renewable pipeline of therapeutic compounds that address a wide variety of unmet medical needs. Specialty pharmaceutical companies like ours develop products to address the limitations of current therapies in selected established markets (endocrinology, urology, dermatology, neurology, etc.). These specialty markets can usually be addressed by smaller sales forces, but have the same market potential. Our pipeline products, through the application of our permeation enhancement technology, are designed to enhance safety, efficacy, ease-of-use and patient compliance. Our pipeline products also provide novel opportunities for pharmaceutical and biotechnology companies to partner with us to develop new and innovative products and extend their therapeutic franchises.

It has been reported the global specialty pharmaceutical market reached an overall value of $61.6 billion in 2007 (an increase of 15.7% from 2006) and is projected to continue to grow for the foreseeable future.

Developing safer and more efficacious methods of delivering existing drugs is generally subject to less risk than attempting to discover new drugs, because of lower development costs. On average, it takes 10 to 15 years for an experimental new drug to progress from the laboratory to commercialization in the U.S., with an average cost of approximately $800 million to $900 million. Typically, only one in 5,000 compounds entering preclinical testing advances into human testing and only one in five compounds tested in humans is approved for commercialization. By contrast, we typically consider drugs for our pipeline that already have been approved and are commercially available, have a track record of safety and efficacy and have established markets for which there is an unmet medical need. In addition, for some of our products, we may be able to pursue an accelerated 505(b)2 path to the market that will translate into less time spent in the clinic and less money spent on clinical development. The 505(b)2 development path in turn translates into a faster time to market launch and more overall patent life for the marketed drug.

The vast majority of the drugs currently on the market are administered orally or by injection. Oral drug delivery methods, while simple to use, typically subject drugs to degradation initially by the stomach and secondarily by first-pass metabolism in the liver before reaching the bloodstream. In order to achieve efficacy, higher drug dosages are often used, which can increase the risk of side effects.

Injectable pharmaceuticals, while avoiding first-pass metabolism in the liver, possess several disadvantages, which can lead to decreased patient acceptance and compliance with prescribed therapy. A decline in patient acceptance and compliance can delay the initiation of treatment and increase the risk of medical complications and could lead to higher healthcare costs. Injectable drugs are more painful for the patient and often require medical personnel to administer. In addition, injectable drugs are typically also more expensive

due to the added cost associated with their manufacturing under sterile conditions and added costs for their administration, including medical personnel, syringes, needles and other supplies.

Pharmaceutical and biotechnology companies recognize the benefits of alternative delivery technologies as a way of gaining a competitive advantage. In particular, alternative technologies that avoid first-pass hepatic metabolism and which are also are less invasive than injectable options and enable product line and patent position extension, provide an attractive combination of advantages to pharmaceutical and biotechnology companies and to patients. Further, these pharmaceutical and biotechnology companies often benefit from specialty pharmaceutical companies that apply their technologies to off-patent products, formulating their own proprietary products, which are then typically commercialized by larger pharmaceutical companies capable of promoting the products.

Permeation Enhancement Technology — The Path to Improved Drug Benefits

Permeation enhancement with CPE-215 is the patented drug delivery technology of CPEX. It has been proven to enhance the absorption of drugs through the nasal mucosa, skin and eye. It can be adapted to products formulated as creams, ointments, gels, solutions, sprays or patches. CPE-215 also has maintained a record of safety as a direct and indirect food additive and fragrance, and is listed on the FDA’s inactive ingredient list for approved use in drug applications.

We believe that potential key benefits of the patented drug permeation technology of CPEX using CPE-215 may include the following therapeutic and commercial opportunities and advantages:


• Improved compliance and convenience to patients requiring ongoing injection therapies and the potential for earlier acceptance of prophylactic treatment for patients reluctant to use injections;

• Application to injectable peptides that could be administered intranasally with CPE-215;

• Application to therapeutic molecules that are degraded by passage through the liver or would benefit from intra-nasal administration to eliminate first-pass metabolism;

• Application to a variety of metabolic, neurological and other serious medical conditions;

• Opportunities for life-cycle extension strategies for existing marketed products;

• Opportunities for allowing product differentiation based on benefits of administration.

Licensed Products

Testim, Licensed Topical Testosterone Gel

We earn royalty revenues on sales of Testim, a testosterone gel that incorporates the CPE-215 drug delivery technology. The product is licensed to Auxilium and was successfully launched in the U.S. in early 2003 as a testosterone replacement therapy. Testim has been approved for marketing in Canada and 15 countries in Europe. Royalties received from Testim sales were $15.1 million, $11.1 million and $8.3 million for the years ended December 31, 2008, 2007 and 2006, respectively. Auxilium uses its sales force to market Testim in the U.S. and has partnered with Paladin Labs Inc. to market the drug in Canada and with Ferring International S.A. to market the drug in Europe.

The testosterone replacement market has expanded as more baby-boomers enter middle age and more attention is focused on male hormonal deficiency and the benefits of replacement therapy. Hypogonadism, a condition in men where insufficient amounts of testosterone are produced is thought to affect one out of every five men in the U.S. and Europe aged over 50. Symptoms associated with low testosterone levels in men include depression, decreased libido, erectile dysfunction, muscular atrophy, loss of energy, mood alterations, increased body fat and reduced bone density. This condition is currently significantly under-treated and growing patient awareness together with education continue to spur demand for testosterone replacement therapy.

Currently marketed testosterone replacement therapies deliver hormones through injections, transdermal patches or gels. Gels provide commercially attractive and efficacious alternatives to the other current methods of delivery by providing a more steady state of absorption rather than the bolus surge of injections or the irritation caused by patches resulting in a less desirable dosage regimen.

In October 2008, Upsher-Smith Laboratories filed an Abbreviated New Drug Application, or ANDA, in which it has certified that it believes that its testosterone gel product is a generic version of Testim that does not infringe our patent covering Testim. On December 4, 2008 we and Auxilium filed a lawsuit against Upsher-Smith under the Hatch Waxman Act for infringement of our patent. As described more fully under Item 3 — “Legal Proceedings” in this report, any U.S. Food and Drug Agency (FDA) approval of Upsher-Smith’s proposed generic product will be stayed until the earlier of 30 months or resolution of our patent infringement lawsuit. Currently, the primary competition for Testim is AndroGel ® , marketed by Solvay Pharmaceuticals, Inc., and its potential generic competitors. Watson Pharmaceuticals Inc., and Par Pharmaceuticals Inc., have filed ANDAs against AndroGel but the timing of the entry of these generics is uncertain at this time. There are several other compounds in various stages of clinical development which may compete with Testim. Indevus Pharmaceuticals, Inc., (“Indevus”) which was acquired in February 2009 by Endo Pharmaceuticals, Inc., has developed NEBIDO tm , a novel, long-acting injectable testosterone product. NEBIDO is approved and launched in Europe and has received a conditional approval letter in the U.S. Indevus has stated they plan to resubmit their New Drug Application (“NDA”) in the first quarter of 2009. Additional competition may come from Prostrakan Group plc, who has developed Tostrex tm , a 2% testosterone gel currently sold in Europe and are awaiting approval on this product, under the brand name Fortigel tm , in the U.S., by Acrux Limited, an Australian company that has developed Testosterone MD-Lotion which is currently in Phase 3 clinical trials and by BioSante Pharmaceuticals, Inc., and Teva Pharmaceuticals USA, Inc., who have developed Bio-T-Gel tm , a once-daily transdermal testosterone gel currently in Phase 2 clinical trials. Other delivery formats of testosterone are also under development. Clarus Therapeutics is developing an oral form of testosterone called OriTex tm . Other new treatments are being sought for testosterone replacement therapy; these products are in development and their future impact on the treatment of testosterone deficiency is unknown.

Product in Development

Nasulin tm , Proprietary Intranasal Insulin Product

Nasulin is the patented intranasal insulin spray of CPEX which incorporates CPE-215 as a permeation facilitator that addresses the need for an insulin product that more closely resembles the body’s normal physiological response and provides a more patient-friendly delivery method. These potential benefits could reshape the insulin market. Based on market reports and projections, we have estimated the insulin market to be approximately $8.0 billion. In general, drugs delivered via the nasal cavity have the potential to be readily absorbed across the highly vascularized nasal mucosa and directly into the circulatory system, thereby avoiding first-pass metabolism in the liver. When absorbed the speed of absorption affords a faster onset of action compared to the most rapid-acting, injectable insulin formulations. A series of studies have confirmed that Nasulin delivers insulin quickly through the nasal mucosa, even more rapidly than subcutaneous injection.

According to new 2007 prevalence data released by the United States Centers for Disease Control and Prevention, or CDC, approximately 24 million people in the United States, or 8% of the population, suffer from diabetes. A study published by Diabetes Care in 2006 projects that the number of diagnosed diabetics in the U.S. will reach 48.3 million by 2050 due to an aging population, rising obesity rates and poor health habits. Prescription trends show a preference for combining rapid-acting injections during mealtimes with a once daily basal insulin injection. Due to the time-action profiles of the rapid-acting mealtime injectable insulins, patients are at increased risk for hypoglycemic events and for gaining weight. The ultra-rapid time-action profile of Nasulin has the potential to reduce the risk of hypoglycemic events and of weight gain. In addition, because Nasulin delivers needle-free insulin, it has the potential to improve the acceptability of mealtime insulin among patients with diabetes and has the potential to improve adherence to insulin treatment regimens.

Nasulin is currently in Phase 2 clinical trials in the United States for the treatment of hyperglycemia in patients with Type 1 and Type 2 diabetes. We believe an intranasal route of administration will yield an ultra-rapid time action profile which will reduce hyperglycemia with less risk of hypoglycemia and weight gain. In addition, this needle-free route of delivery avoids the potential pulmonary disadvantages of competitive candidates that use an inhalation route of administration. Our expectation is to finish key efficacy Phase 2 trials in patients with Type 2 diabetes in 2011 while simultaneously seeking a pharmaceutical partner to support Phase 3 clinical trials and product commercialization upon regulatory approval. We originally intended to have these Phase 2 efficacy trials completed in 2010 however slower than anticipated enrollment in our current Phase 2 clinical trial has caused us to revise our clinical trial timeline. While the terms of any future alliance will be determined through negotiation, we would look to license the product in return for upfront payments, milestones and royalties that reflect our research investment, innovation and potential market size.

Products Available for Licensing

Antifungal Nail Lacquer

We have developed a topical nail lacquer for treating fingernail and toenail fungal infections (onychomycosis). We completed two Phase 1/2 clinical trials for the treatment of nail fungal infections in 2002 and 2003 utilizing a clotrimazole lacquer formulation containing CPE-215. According to the National Onychomycosis Society, nail fungus affects almost 30 million people in the U.S., primarily between the ages of 40 and 65. Patients electing to take oral therapy must undergo blood monitoring during the course of treatment to monitor for liver damage. The Company continues to pursue licensing opportunities for this product.

Topical Hormonal Therapy

Our topical hormonal therapy incorporates the use of metabolic steroids that regulate most of the hormonal action in adult males. Hormone replacement therapies using these metabolic steroids may have significant benefits in treating a number of medical afflictions, including osteoporosis and sexual dysfunction. In May 2001 we granted to Auxilium an exclusive worldwide license to develop, market and sell a topical hormonal therapy containing our CPE-215 technology. We have received immaterial revenues and incurred some nominal expenses under this license.

Intranasal Pain Management

Under a research agreement with Auxilium, we formulated the intranasal delivery of a pain management chemical agent using our CPE-215 technology. Auxilium has the exclusive right to license this product application pursuant to our research agreement, but has not activated the license to date. We have received immaterial revenues and incurred some nominal expenses under this license.

Key Markets and Trends

Testosterone

Substantially all of our revenues are derived through royalty income from the only commercialized product licensed with our CPE-215 technology, Testim, which is sold by Auxilium.

Overview of Testosterone Replacement Market

The testosterone replacement market has expanded as more baby-boomers enter middle age and more attention is focused on male hormonal deficiency and the benefits of replacement therapy. A recent study published in the July 2006 International Journal of Clinical Practice indicates that 39% of U.S. males over 45 have hypogonadism, a condition in men where insufficient amounts of testosterone are produced. Symptoms associated with low testosterone levels in men include depression, decreased libido, erectile dysfunction, muscular atrophy, loss of energy, mood alterations, increased body fat and reduced bone density. This condition is currently significantly under-treated and growing patient awareness together with education continue to spur demand for testosterone replacement therapy.

Currently marketed testosterone replacement therapies deliver hormones through injections, transdermal patches or gels. Gels provide commercially attractive and efficacious alternatives to the other current methods of delivery by providing a more steady state of absorption rather than the bolus surge of injections or the irritation caused by patches resulting in a less desirable dosage regimen.

Diabetes

Our most advanced product in development, Nasulin, is an intranasal formulation of insulin being developed to treat hyperglycemia in patients suffering from Type 1 and Type 2 diabetes.

Overview of Diabetes

Diabetes is a major disease characterized by the body’s inability to properly regulate levels of blood glucose, or blood sugar. The cells of the body use glucose as fuel, which is consumed 24 hours a day. Between meals, when glucose is not being supplied from food, the liver releases glucose into the blood to sustain adequate levels. Insulin is a hormone produced by the pancreas that regulates the body’s blood glucose levels. Patients with diabetes develop abnormally high levels of glucose, a state known as hyperglycemia, either because they produce insufficient levels of insulin or because they fail to respond adequately to insulin produced by the body. Over time, poorly controlled levels of blood glucose can lead to major complications, including high blood pressure, blindness, amputations, kidney failure, heart attack, stroke and death.

According to new 2007 prevalence data released by the United States Centers for Disease Control and Prevention, or CDC, approximately 24 million people in the United States, or 8% of the population, suffer from diabetes. This represents an increase of more than 3 million people in approximately two years. In addition to the 24 million people with diabetes, approximately 57 million people are estimated to have pre-diabetes, putting them at increased risk for developing diabetes. In addition the incidence of diabetes is also increasing. A study published by Diabetes Care in 2006 projected that in 2050 there would be 48.3 million people with diagnosed diabetes in the United States. Diabetes extracts a heavy toll from those who suffer from it. The CDC reported that diabetes was the seventh leading cause of death listed on death certificates in 2006, but that diabetes was likely to be underreported as a cause of death. Overall, the CDC found that the risk of death among people with diabetes is about twice that of people without diabetes of similar age. The economic costs of diabetes are high as well. The American Diabetes Association estimates that in 2007, the total cost of diabetes in the United States was $174 billion. This amount includes $116 billion of direct medical expenditure costs which comprised of $27 billion for diabetes care, $58 billion for chronic diabetes-related complications and $31 billion for excess general medical costs.

There are two major forms of diabetes, Type 1 and Type 2. Type 1 diabetes is an autoimmune disease characterized by a complete lack of insulin secretion by the pancreas, so insulin must be supplied from outside the body. In Type 2 diabetes, the pancreas continues to produce insulin; however, insulin-dependent cells become resistant to the effects of insulin. Over time, the pancreas becomes increasingly unable to secrete adequate amounts of insulin to support metabolism. According to the CDC, Type 2 diabetes is the more prevalent form of the disease, affecting approximately 90% to 95% of people diagnosed with diabetes.

Challenges of treating Type 2 Diabetes

Typically, the treatment of Type 2 diabetes starts with management of diet and exercise and progresses to treatment with various oral medications and then to treatment with insulin. Treatment with diet and exercise alone is not an effective long-term solution for most patients with Type 2 diabetes. Oral medications — which act predominantly by increasing the amount of insulin produced by the pancreas, by increasing the sensitivity of insulin-dependent cells or by reducing the glucose output of the liver — may have significant adverse effects and are limited in their ability to manage the disease effectively.


CEO BACKGROUND

Business Experience
Director
Name and Age

and Other Directorships

Since

Director Nominees:
Class I Director nominees
(to be elected at the 2009 Annual Meeting)

John W. Spiegel
Age: 68 John W. Spiegel served as Vice Chairman and Chief Financial Officer of SunTrust Banks, Inc. from August 2000 until he retired as Chief Financial Officer in August 2004 and as Vice Chairman in 2005. Prior to August 2000, Mr. Spiegel was an Executive Vice President and Chief Financial Officer of SunTrust Banks since 1985. Mr. Spiegel also serves on the Board of Directors of Rock-Tenn Company, S1 Corporation and Colonial Properties Trust. Mr. Spiegel is also a trustee of Children’s Healthcare of Atlanta, and is a member of the Dean’s Advisory Council of the Goizueta Business School at Emory University. Mr. Spiegel received an MBA from Emory University. 2008
John A. Sedor
Age: 64 John A. Sedor has been our Chief Executive Officer and President since the spin-off from Bentley in 2008. Mr. Sedor was President of Bentley from 2005 until the spin-off. From 2001 to May 2005, he was President and CEO of Sandoz, Inc. (a division of Novartis AG). From 1998-2001 Mr. Sedor was President and Chief Executive Officer at Verion, Inc., a drug delivery company. Previously, Mr. Sedor served as President and Chief Executive Officer at Centeon, LLC, a joint venture between two major multinational corporations, Rhône-Poulenc Rorer and Hoechst AG. Previously, Mr. Sedor served as Executive Vice President at Rhône-Poulenc Rorer, Revlon Health Care and Parke-Davis. Mr. Sedor holds a Bachelor of Science degree in Pharmacy/Chemistry from Duquesne University, and has studied strategic marketing at both Northwestern University’s Kellogg Graduate School of Management and Harvard Business School. He has also attended Harvard’s Executive Forum. N/A


MANAGEMENT DISCUSSION FROM LATEST 10K

The following discussion and analysis should be read in conjunction with the Financial Statements and related Notes to the Condensed Combined and Consolidated Financial Statements, or Notes, included in Item 15 of this Annual Report. Except for the historical information contained herein the foregoing discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those projected in the forward-looking statements discussed herein.

Words such as “expect”, “anticipate”, “intend”, “believe”, “may”, “could”, “project”, “estimate” and similar words are used to identify forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements, including, but not limited to, the statements in “Business”, “Legal Proceedings”, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Risk Factors” and other sections in this Annual Report, are not based on historical facts, but rather reflect our current expectations concerning future results and events. The forward-looking statements include statements about our strategy, the prospects of our technologies and research and development efforts, our plans to enter into more collaborative relationships, the prospects for clinical development of our product candidates, our prospects for revenue growth, anticipated financial results and the prospects for growth of our business. Although we believe that the expectations reflected in the forward-looking statements are reasonable, such statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be different from any future results, performance and achievements expressed or implied by these statements, including the risks outlined in the Risk Factors section and elsewhere in this report. You are cautioned not to place undue reliance on these forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether as the result of new information, future events or otherwise, except as may be required by law.

Overview

We are an emerging specialty pharmaceutical company that employs 18 people as of March 17, 2009 at our principal executive offices in Exeter, New Hampshire. Our business is the research, development, licensing and commercialization of pharmaceutical products utilizing our validated drug delivery platform technology. We have U.S. and international patents and other proprietary rights to technologies that facilitate the absorption of drugs. Our platform drug delivery technology enhances permeation and absorption of pharmaceutical molecules across the skin, nasal mucosa and eye through formulation development with proprietary molecules such as CPE-215. Our first product is Testim ® , a gel for testosterone replacement therapy, which is a formulation of CPE-215 with testosterone. Testim is licensed to Auxilium Pharmaceuticals, Inc. who is currently marketing the product in the United States, Europe and other countries. Our second product, Nasulin tm , currently in Phase 2 clinical trials, is an intranasal spray formulation of CPE-215 with insulin.

We believe, based upon our experience with Testim and Nasulin, that our CPE-215 technology is a broad platform technology that has the ability to enhance significantly the permeation of a wide range of therapeutic molecules. To expand the development and commercialization of products using our CPE-215 drug delivery technology, we are pursuing strategic alliances with partners including large pharmaceutical, specialty pharmaceutical and biotechnology companies. The alliance opportunities may include co-development of products, in-licensing of therapeutic molecules, out-licensing of delivery technology or partnering late-stage candidates for commercialization.

Separation from Bentley

Our business was initially the drug delivery business of Bentley Pharmaceuticals, Inc. (referred to as “Bentley”) which Bentley spun-off in June 2008 in connection with the sale of Bentley’s remaining businesses. Shares of our stock were distributed to Bentley stockholders after the close of business on June 30, 2008 (the “Separation Date”) by means of a stock dividend, a transaction that was taxable to Bentley and Bentley’s stockholders (the “Separation”). Each Bentley stockholder of record on June 20, 2008, the record date, received on the Separation Date one CPEX share for every ten shares of Bentley common stock. Bentley has no ownership interest in CPEX subsequent to the Separation.

Our financial statements reflect the historical financial position, results of operations and cash flows of the business transferred to us from Bentley as part of the Separation. Our financial statements have been prepared and are presented as if we had been operating as a separate entity using the historical cost basis of the assets and liabilities of Bentley and including the historical operations of the business transferred to us from Bentley as part of the Separation. For each of the periods presented, we were fully integrated with Bentley and the accompanying financial statements reflect the application of certain estimates and allocations. Our statements of operations include all revenues and costs that are directly attributable to our business. In addition, certain expenses of Bentley have been allocated to us using various assumptions that, in the opinion of management, are reasonable. These expenses include an allocated share of executive compensation, public company costs and other administrative costs. The allocated costs totaled $4.4 million, $4.2 million and
$4.1 million for the years ended December 31, 2008, 2007 and 2006, respectively. There have been no allocations of expenses charged to us since the Separation Date. The financial information included herein may not necessarily reflect our financial position, results of operations and cash flows in the future or what our financial position, results of operations and cash flows would have been had we been a stand-alone company during the periods presented.

Consolidated Results of Operations

The following is a discussion of the results of our operations for the years ended December 31, 2008, 2007 and 2006. Included in the financial disclosures are direct costs associated with our business and certain allocated costs from Bentley related to executive compensation, public company costs and other administrative costs. As these costs only represent an allocation of the costs incurred by Bentley before the Separation, they are not necessarily indicative of the costs that would have been incurred if we were an independent public company in the periods presented. Inflation and changing prices have not had a significant impact on our revenues or loss from operations in the three years ended December 31, 2008.

Royalties and other revenue increased 40% to $15.6 million in 2008 from $11.1 million in 2007 due primarily to increased royalties earned on sales of Testim. For the year ended December 31, 2008, Testim prescriptions were reported to have grown approximately 27% compared to the same period in 2007. In addition, it is also reported that Testim’s market share of the testosterone replacement gel market in December 2008 had increased to more than 22% versus approximately 21% in December 2007. The long-term prospects for Testim sales are subject to resolutions of our patent infringement suit against Upsher-Smith, which has made an ANDA filing for a generic version of Testim, as described above in “Legal Proceedings”. Clinical and other revenue was $513,000 in 2008 which includes revenue from our development and license agreement with Serenity Pharmaceuticals, Inc. which we signed in 2008 and for which there is no comparable revenue in 2007.

General and administrative costs increased 25% to $6.5 million in 2008 compared to $5.2 million in 2007, primarily due to a non-cash charge of approximately $980,000 resulting from the modification of equity awards associated with the spin-off from Bentley.

Research and development expenses consist primarily of costs associated with the development of Nasulin, our lead product candidate. These costs include costs of clinical trials, manufacturing supplies and other development materials, compensation and related benefits for research and development personnel, costs for consultants, and various overhead costs. Research and development costs are expensed as incurred. Research and development costs decreased to $9.1 million in 2008 compared to $9.6 million in 2007 due mostly to the timing of our pre-clinical and clinical activities. Spending on clinical trials was $1.5 million in 2008 compared to $2.1 million in 2007.

We expect our research and development costs to increase in 2009 to between $15 million and $18 million. We have initiated a Phase 2a trial in the U.S. and our expectation is to initiate an additional Phase 2 trial in the U.S. in 2010 while continuing the development of products in our pipeline. Additional expenses for the full development of Nasulin cannot be estimated at this time. The risks and uncertainties associated with the planning and execution of a clinical development program includes, among other things, uncertainties about results that at any time could require us to abandon or greatly modify the program. Accordingly, we cannot estimate the period in which material net cash inflows from Nasulin might commence, if ever.

Separation costs, consisting of legal, tax and other strategic consulting costs specifically related to the separation from Bentley explained above, were $2.5 million in 2008 compared to $1.0 million in 2007. No additional separation costs have been incurred since the Separation Date and we do not expect to incur any additional separation costs in the future.

Royalties and other revenues increased 33% from $8.4 million in 2006 to $11.1 million in 2007 from increased royalties earned on sales of Testim. Testim’s market share increased from 19% in 2006 to 21% in 2007. In 2006, Testim royalties included a one-time increase of approximately $0.5 million due to a change in estimate which, based on historical experience, allowed us to reasonably estimate future product returns on sales of Testim.

Total operating expenses increased 26% from $13.2 million in 2006 to $16.6 million in 2007, primarily from research and development expenses and separation costs.


• Research and development expenses increased $1.8 million or 22% to $9.6 million in 2007, primarily from increased costs to support our Nasulin clinical program and an increase in compensation and benefit costs.

• The year ended December 31, 2007 included costs incurred for legal, tax and other strategic consulting specifically associated with the spin-off from Bentley. These separation costs totaled $1.0 million in the year ended December 31, 2007.

The net loss increased from $4.2 million in 2006 to $4.9 million in 2007, due to increased operating expenses primarily increased research and development expenses and separation costs. These increases were partially offset by increased Testim royalty revenues.

Liquidity and Capital Resources

Overview

We had approximately $15.2 million in cash and cash equivalents at December 31, 2008, which, along with Testim royalties, we believe will be sufficient to fund our operations and our cash requirements for at least the next twelve months. Our cash includes balances maintained in commercial bank accounts, amounts invested in overnight sweep investments and cash deposits in money market accounts. Although cost estimates and timing of our trials are subject to change, we expect research and development expenses for 2009 to range between $15 million and $18 million. There can be no assurance that changes in our research and development plans or other events affecting our revenues or operating expenses will not result in the earlier depletion of our funds. However, we will continue to explore alternative sources for financing our business activities. In appropriate situations, which will be strategically determined, we may seek funding from other sources, including, but not limited to, contribution by others to joint ventures and other collaborative or licensing arrangements for the development, testing, manufacturing and marketing of Nasulin and other products currently under development.

Operating Activities

Net cash used in operating activities was $553,000 for the year ended December 31, 2008 largely resulting from the net loss of $2.9 million, an increase in accounts receivable of $1.2 million and a reduction in accounts payable and accrued expenses of $591,000, which were partially offset by non-cash share-based compensation of $3.2 million and depreciation and amortization of $682,000. Net cash used in 2007 was $2.2 million resulting from the net loss of $4.9 million and an increase in accounts receivable of $1.0 million, which were partially offset by non-cash share-based compensation expense of $1.5 million, an increase in accounts payable and accrued expenses of $1.1 million and depreciation and amortization expenses of $752,000. Net cash used in 2006 was $1.3 million resulting from the net loss of $4.2 million partially offset by non-cash share-based compensation expense of $1.3 million, depreciation and amortization of $679,000 and decreases in accounts receivable of $603,000 and in prepaid expenses and other current assets of $384,000.



Investing Activities

Net cash used in investing activities was $307,000 for the year ended December 31, 2008 due to the purchase of necessary equipment to scale-up our manufacturing capabilities. Net cash used in the twelve months ended December 31, 2007 was $430,000, which includes $303,000 for laboratory expansion and equipment and $157,000 for costs to acquire intellectual property rights. We expect to invest approximately $800,000 in capital expenditures in 2009, primarily for research and development equipment. Net cash used in the twelve months ended December 31, 2006 was $1.4 million, which includes $826,000 related to machinery and equipment purchased for research and development activities and $583,000 for costs to acquire intellectual property rights.

Financing Activities

Net cash used by financing activities was $5.6 million for the year ended December 31, 2008 due largely to the change in Bentley’s net investment in our business of $7.3 million, which was partially offset by proceeds of $1.7 million from the exercise of stock options. Financing activities for 2007 and 2006 reflect the net change in Bentley’s net investment in our business, consisting primarily of the funding of our net loss and other operating and investing activities for CPEX. Additionally, the change in Bentley’s net investment included a cash transfer of $5.5 million to us from Bentley.

Off-Balance Sheet Arrangements

We do not have any significant off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

Critical Accounting Policies and Estimates

Certain of our accounting policies are particularly important to the portrayal of our financial position, results of operations and cash flows and require the application of significant judgment by our management. As a result they are subject to an inherent degree of uncertainty. In applying those policies, our management uses judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical experience, terms of existing contracts, our observance of trends in the industry, information provided by our customers and information available from other outside sources, as appropriate. Our critical accounting policies and estimates include:

Revenue recognition and accounts receivable

We earn royalty revenues on Auxilium’s sales of Testim, which incorporates our CPE-215 permeation enhancement technology. Since 2003, Auxilium has sold Testim to pharmaceutical wholesalers and chain drug stores. Revenue is recognized when products are shipped or services are performed. At the time revenue is recognized, estimates for revenue deductions are recorded, including discounts, rebates and product returns. Estimates related to revenue deductions are predominately based on historical experience.

Accounts receivable are recorded at their net realizable value as products are shipped or services are performed. Receivable balances are reported net of an estimated allowance for uncollectible accounts. Estimated uncollectible receivables are based on the amount and status of past due accounts, contractual terms with customers, the credit worthiness of customers and the history of our uncollectible accounts.

Intellectual property costs

Costs incurred in connection with acquiring licenses, patents and other proprietary rights are capitalized. Capitalized costs are amortized on a straight-line basis for periods not exceeding 15 years from the dates of acquisition. Carrying values of such assets are reviewed at least annually by comparing the carrying amounts to their estimated undiscounted cash flows and adjustments are made for any diminution in value.

MANAGEMENT DISCUSSION FOR LATEST QUARTER


The following discussion and analysis should be read in conjunction with all financial and non-financial information appearing elsewhere in this report and with our consolidated and combined financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2008 filed with the Securities and Exchange Commission on March 25, 2009, referred to as the 2008 Form 10-K. Except for the historical information contained herein, the foregoing discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those projected in the forward-looking statements discussed herein due to competitive factors and other risks discussed in the 2008 Form 10-K under Item 1A “Risk Factors”.
Overview
We are an emerging specialty pharmaceutical company in the business of research, development, licensing and commercialization of pharmaceutical products utilizing our validated drug delivery platform technology. We have U.S. and international patents and other proprietary rights to technology that facilitates the absorption of drugs. Our platform drug delivery technology enhances permeation and absorption of pharmaceutical molecules across the skin, nasal mucosa and eye through development of proprietary formulations with molecules such as CPE-215 ® . Our first product is Testim ® , a gel for testosterone replacement therapy, which is a formulation of our technology with testosterone. Testim is licensed to Auxilium Pharmaceuticals which is currently marketing it in the United States, Europe and other countries. Our second product, Nasulin tm , currently in Phase 2 clinical trials, is a proprietary intranasal spray formulation of insulin with our permeation enhancement technology. In addition, Serenity Pharmaceuticals, Inc., our licensing and development partner, has commenced enrollment in a Phase 3 clinical trial for an undisclosed urology drug delivered using CPEX’s intranasal technology.
We believe, based upon our experience with Testim and Nasulin, that our technology is a broad platform technology that has the ability to significantly enhance the permeation of a wide range of therapeutic molecules. To expand the development and commercialization of products using our technology, we are pursuing strategic alliances with partners including large pharmaceutical, specialty pharmaceutical and biotechnology companies. The alliance opportunities may include co-development of products, in-licensing of therapeutic molecules, out-licensing of delivery technology or partnering late-stage candidates for commercialization.
Separation from Bentley
On June 12, 2008, the Board of Directors of Bentley Pharmaceuticals approved the spin-off of its drug delivery business into CPEX. Shares of CPEX were distributed to Bentley stockholders after the close of business on June 30, 2008 by means of a stock dividend, which we refer to as the Separation. Each Bentley stockholder of record on June 20, 2008 received one CPEX share for every ten shares of Bentley common stock it owned. Bentley retained no ownership interest in CPEX subsequent to the Separation.
We have incurred legal, tax and other strategic consulting costs specifically associated with the Separation. These costs, which are reported as Separation costs within operating expenses in the Condensed Consolidated and Combined Statements of Operations, totaled $2.5 million for the nine months ended September 30, 2008. No separation costs have been incurred by CPEX subsequent to the Separation.
Nasulin Clinical Program
The following is a list of studies for which data analysis was recently completed:
• BNT INS-US-0100-PK006: A Randomized, Single Site, Single Blind 6-Way Crossover Study of Intranasal Insulin and Humalog in Patients with Type 2 Diabetes Mellitus to Determine Optimum Dose Timing. We completed this Phase 1 study in subjects with Type 2 diabetes over a period of 6 months in the U.S. A total of 13 patients participated in this study. Final data demonstrated that the preferred timing of intranasal insulin administration with Nasulin is at the start or immediately following a meal.

• BNT INS-US-0100-PK008: A Single Site, 3 Cohort Study to Determine the Optimal Methodology of Nasulin (BNT-INS-0100) in Normal Non-Smoking Subjects. We completed this Phase 1 study in healthy volunteers over a period of 1 month in the U.S. A total of 24 healthy volunteers participated in this study. Final data demonstrated that when dosing two sprays of



Nasulin, delivering the second administration in the same nostril results in higher systemic exposure than delivery in the other nostril. The data also demonstrated that intrasubject variability is comparable to injectable insulins.
Ongoing Clinical Trials
• Nasulin TM -US-0100-CPEX011: We are currently conducting a Phase 2a clinical trial of Nasulin, our intranasal insulin candidate, in patients with Type 2 diabetes. This study is designed to randomize 90 patients who are currently being treated with basal, or long-acting, insulin and oral anti-diabetes agents. This study is designed to assess the efficacy and safety of Nasulin versus a placebo over a 6-week treatment period and is being conducted at multiple centers in the U.S. Recently, we made amendments to the study protocol which have resulted in an increased enrollment rate. In October 2009, the Company determined that it had screened enough patients to randomize the target of 90 patients and as a result stopped enrolling new patients. As of November 9, 2009, we have randomized 72 patients in the study and we expect to complete randomization in late-November 2009. Although we previously announced plans to initiate sites in the Ukraine, due to the increase in the enrollment rate in the U.S., such additional sites were not initiated. We expect to complete this study early next year under our current operating plan.

• CPEX INS-US-0100-PK012: Earlier this year we initiated and completed enrollment in this single-site Phase 1 study, in 24 healthy volunteers, to determine the pharmacokinetic parameters of various formulation strengths of Nasulin. The results were presented as a poster at the 2009 Annual Diabetes Technology Meeting and demonstrated that as the dose of Nasulin increased, the maximum concentrations of insulin in the blood (C max ) and overall exposure to insulin over time (AUC) increased proportionally. This finding supports the use of six reliable doses for future clinical studies and will enable dose titration according to individual patient postprandial glucose reductions and risk of hypoglycemia.
Planned Clinical Trials
Following the completion of the ongoing Phase 2a study described above, we expect to initiate a Phase 2b study to assess the safety and efficacy of Nasulin in patients with Type 2 diabetes. We expect to design this trial to randomize 220 patients, we will measure the patients’ change in HbA1c, or average glucose control over the previous three to four months, after initiating Nasulin into their treatment regimen. This trial is expected to be completed in the second half of 2011. Upon completion of this trial we expect to request an end of Phase 2 meeting with the U.S. Food and Drug Administration.
Other Clinical Developments
Following the completion of an End-of-Phase-2 meeting earlier this year, Serenity Pharmaceuticals, our licensing and development partner, recently began recruiting patients in multiple Phase 3 clinical trials with their undisclosed urology drug delivered using CPEX’s intranasal technology for the treatment of nocturia. These randomized, double blind, placebo controlled studies are being conducted at multiple sites in the United States.
RESULTS OF OPERATIONS:
The following is a discussion of the results of our operations for the three and nine months ended September 30, 2009 and 2008. Included in the financial disclosures for the three and nine months ended September 30, 2008 are direct costs associated with our business and certain allocated costs from Bentley related to executive compensation, public company costs and other administrative costs. As these costs only represent an allocation of the costs incurred by Bentley before the Separation, they are not necessarily indicative of the costs that would have been incurred if we were an independent public company during the periods presented.

Royalties and other revenues increased 26% to $5.0 million for the three months ended September 30, 2009, from $3.9 million for the three months ended September 30, 2008, primarily due to increased royalties earned on sales of Testim. This growth is due to continued increases in prescriptions for Testim and to its increased market share of the testosterone replacement gel market. It has been reported that prescriptions for Testim increased 17% during the third quarter of 2009 compared to the same period in 2008. Our royalty income is subject to several risks, including potential competition from generic products. See Liquidity and Capital Resources — Liquidity Risk for further discussion.
General and administrative expenses decreased 9% to $2.3 million for the three months ended September 30, 2009, from $2.6 million for the three months ended September 30, 2008, largely due to a decrease in share-based compensation expense. General and administrative expense for the three months ended September 30, 2008 includes an $838,000 non-cash charge resulting from the modification of equity awards associated with the Separation. Employee-related expenses and professional fees also decreased during the three months ended September 30, 2009 compared to the same period last year. Partially offsetting these decreases was an increase in legal costs primarily due to our patent infringement suit against Upsher-Smith Laboratories described in Commitments, contingencies and concentrations in the accompanying Notes to the Unaudited Condensed Consolidated and Combined Financial Statements.
Research and development expenses increased 48% to $3.3 million for the three months ended September 30, 2009, from $2.2 million for the three months ended September 30, 2008, primarily due to increased clinical trial expenses related to the ongoing Nasulin clinical trials. This increase was partially offset by decreased share-based compensation expense. Research and development expense for the three months ended September 30, 2008 includes a $232,000 non-cash charge resulting from the modification of equity awards associated with the Separation. Although cost estimates and timing of our trials are subject to change and fluctuation from quarter to quarter, we expect research and development expenses for 2009 to range between $13.0 million and $15.0 million.

Royalties and other revenues increased 18% to $13.4 million for the nine months ended September 30, 2009, from $11.3 million for the nine months ended September 30, 2008, primarily due to increased royalties earned on sales of Testim. This growth is due to continued increases in prescriptions for Testim and to its increased market share of the testosterone replacement gel market. Royalty income is subject to several risks, including potential competition from generic products. See Liquidity and Capital Resources — Liquidity Risk for further discussion. Royalties and other revenue for the nine months ended September 30, 2008 includes $444,000

related to a development license agreement with Serenity Pharmaceuticals, Inc. for which there is no comparable revenue in 2009.
General and administrative expenses increased 25% to $6.3 million for the nine months ended September 30, 2009, from $5.0 million for the nine months ended September 30, 2008, primarily due to patent infringement and general legal costs, which increased $1.9 million. The legal costs relate to our patent infringement suit against Upsher-Smith Laboratories described in Commitments, contingencies and concentrations in the accompanying Notes to the Unaudited Condensed Consolidated and Combined Financial Statements. This increase was partially offset by a $678,000 reduction in share-based compensation expense due to the non-cash charge, in 2008, resulting from the modification of equity awards associated with the Separation.
Research and development expenses increased 38% to $9.3 million for the nine months ended September 30, 2009, from $6.8 million for the nine months ended September 30, 2008. Clinical trial expenses increased $3.4 million, primarily due to the ongoing Phase 1 and 2 Nasulin clinical trials, partially offset by a decrease of $740,000 in employee-related expenses, including a $455,000 reduction in share-based compensation expense related to the Separation.
Operating expenses for the nine months ended September 30, 2008 include $2.5 million in separation costs.


]]>Thu, 07 Jan 2010 09:16:53 GMThttp://www.dailystocks.com/forum/showtopic.php?tid/3722/http://www.dailystocks.com/forum/showtopic.php?tid/3722/
BUSINESS OVERVIEW

OUR BUSINESS



WSFS Financial Corporation is parent to WSFS Bank (‘the Bank”), one of the ten oldest banks in the United States continuously operating under the same name. A permanent fixture in this community, WSFS has been in operation for more than 175 years. In addition to its focus on stellar customer service, the Bank has continued to fuel growth and remain relevant. The Bank is a relationship-focused, locally-managed, community banking institution that has grown to become the largest thrift holding company in the State of Delaware, the second largest commercial lender in the state and the fourth largest bank in terms of Delaware deposits.



WSFS’ core banking business is commercial lending funded by customer-generated deposits. We have built a $1.7 billion commercial loan portfolio by recruiting the best seasoned commercial lenders in our markets and offering a high level of service and flexibility typically associated with a community bank. We fund this business primarily with deposits generated through commercial relationships and retail deposits in our 35-branch retail banking franchise located in Delaware and southeastern Pennsylvania. We also offer a broad variety of consumer loan products, retail securities and insurance brokerage through our retail branches.



In 2005, we established WSFS Wealth Strategies, our wealth management services division. Wealth Strategies was formed in response to our commercial customers’ demand for the same high level service in their investment relationships that they enjoyed as banking customers of WSFS. We found that many competitors are not devoting human capital to clients with less than $5 million in investable assets, thereby creating an opportunity. WSFS Wealth Strategies is complemented by Cypress Capital Management, a Registered Investment Adviser, acquired by WSFS in 2004 and WSFS Investment Group, a brokerage firm and insurance agency.



Our Cash Connect division is a premier provider of ATM Vault Cash and related services in the United States. Cash Connect manages more than $265 million in vault cash in approximately 10,000 ATMs nationwide and also provides online reporting and ATM cash management, predictive cash ordering, armored carrier management, ATM processing and equipment sales. Cash Connect also operates over 300 ATMs for WSFS Bank, which owns the largest branded ATM network in Delaware.

During the second quarter of 2008, we acquired a majority interest in 1 st Reverse Financial Services, LLC (1 st Reverse), specializing in reverse mortgage lending nationwide.



WSFS POINTS OF DIFFERENTIATION



While all banks offer similar products and services, we believe that WSFS has set itself apart from other banks in our market and the industry in general. Also, community banks have been able to distinguish themselves from large weakened banks with too many big problems and not enough emphasis on the customer in the current environment. The following factors summarize what we believe are those points of differentiation.



Community Banking Model



Our size and community banking model play a key role in our success. Our approach to business combines a service-oriented culture (which we call Stellar Service) with a strong complement of products and services, all aimed at meeting the needs of our retail and business customers. We believe the essence of being a community bank means that we are:

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Small enough to offer customers responsive, personalized service and direct access to decision makers,

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Large enough to provide all the products and services needed by our target market customers.

As the financial services industry has consolidated, many independent banks have been acquired by national companies that have centralized their decision-making authority away from their customers and focused their mass-marketing to a regional or even national customer base. We believe this trend has frustrated smaller business owners who have become accustomed to dealing directly with their bank’s senior executives and discouraged retail customers who often experience deteriorating levels of service in the branches. Additionally, it frustrates bank Associates who are no longer empowered to provide good and timely service to their customers.



WSFS Bank offers:



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Rapid response. Our customers tell us this is a critical differentiator from larger, in-market competitors.

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One point of contact. Our Relationship Managers are responsible for understanding his or her customers’ needs and bringing together the right resources in the Bank to meet those needs.

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A customized approach to our clients. We believe this gives us an advantage over our competitors who are too large or centralized to offer customized products or services.

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Products and services that our customers value. This includes a broad array of banking and cash management products, as well as a legal lending limit high enough to meet the credit needs of our customers, especially as they grow.



Building Associate Engagement and Customer Advocacy



Our business model is built on a concept called Human Sigma, a concept we have implemented using the statement “Engaged Associates delivering Stellar Service to create Customer Advocates”. The Human Sigma model, identified by Gallup, Inc., begins with Associates who have taken ownership of their jobs because their strengths have been identified and they have been matched with the right position and strong management. This strategy motivates Associates, and unleashes innovation and productivity to engage our most valuable asset, our customers, by providing them what we refer to as Stellar Service. As a result, we create Customer Advocates, or customers who have built an emotional attachment to the Bank. Research

Surveys conducted for us by a nationally recognized polling company indicate:



•


Our Associate Engagement scores consistently rank in the top quartile of companies polled. In 2008, there were 13.4 engaged Associates for every disengaged Associate. This compares to a 2.6:1 ratio in 2003 and a national average of 1.5:1.

•


Customer surveys rank us in the top 10% of all companies, a “world class” rating. More than 40% of our customers ranked us a “five” out of “five,” strongly agreeing with the statement “I can’t imagine a world without WSFS.”

We believe that by fostering the energy of engaged and empowered Associates, we have become an employer of choice in our market. During each of the past three years, WSFS was ranked “Best Place to Work” by The Wilmington News Journal .



Strong Market Demographics



Delaware is situated in the middle of the Washington, DC - New York corridor which includes the urban markets of Philadelphia and Baltimore. The state benefits from this urban concentration as well as from a unique political environment that has created favorable law and legal structure, a business-friendly environment and a fair tax system. In its 2007 overview, the Corporation for Enterprise Development ranked Delaware as one of only two states to receive “Straight A’s” in its assessment of economic development throughout the U.S. Additionally, Delaware is one of only seven states with a AAA bond rating. Delaware’s Demographics consistently compare favorably to US economic and demographic averages.

Balance Sheet Management



We put a great deal of focus on actively managing our balance sheet. This management manifests itself in:



•


Strong capital levels. Maintaining strong capital levels is key to our operating philosophy. All regulatory capital levels exceed well-capitalized levels. Our Tier 1 capital ratio was nearly 10% as of December 31, 2008, more than $100 million in excess of the 6% “well-capitalized” level. Our year end capital ratios do not include the additional capital raised in January 2009 through our participation in the Treasury’s Capital Purchase Program (described later).

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We maintain discipline around our lending, including planned portfolio diversification. Additionally, we take a proactive approach to identifying trends in our business and lending market and have responded proactively to areas of concern. For instance, we have limited our exposure to construction and land development (CLD) loans as we anticipated an end to the expansion in housing prices. We have also increased our portfolio monitoring and reporting sophistication. We maintain diversification in our loan portfolio to limit our exposure to any single type of credit. Such discipline supplements careful underwriting and the benefits of knowing our customers.

•


We seek to avoid credit risk in our investment portfolio and use this portion of our balance sheet primarily to help us manage liquidity and interest rate risk, while providing some marginal income. As a result, we have no exposure to Freddie Mac or Fannie Mae preferred securities, Trust Preferred securities or any securities backed by sub-prime assets. Our securities purchases have been almost exclusively AAA-rated credits. To date, we have had no other-than-temporary impairment losses to report.



We have been subject to many of the same pressures facing the banking industry, including an increase in our delinquent loans, problem loans and charge-offs from the unsustainably low levels in recent years. The measures we have taken strengthen the Bank’s credit position by diversifying risk and limiting exposure.



Disciplined and Aggressive Capital Management



We understand that our capital (or shareholders’ equity) belongs to our shareholders. They have entrusted this capital to us with the expectation that it will be kept safe, but with the equal expectation that it will earn an adequate return. As a result, we prudently but aggressively manage our shareholders’ capital. It is our intention to return some of our earnings to shareholders through share repurchases, which is now subject to approval by the U.S. Treasury, while maintaining adequate levels of capital.



Strong Performance Expectations



We are focused on high-performing long term financial goals. We define “high performing” as the top quintile of a relevant peer group in return on assets (ROA), return on equity (ROE) and earnings per share (EPS) growth. While industry headwinds have depressed these measures for the industry in recent years, long term, we believe these targets should translate to approximately 1.5% ROA, 18% ROE and a 12% EPS growth rate. Management incentives are paid, in large part, based on driving performance in these areas. A “Target” payment level is only achieved by reaching performance at the 60 th percentile of a peer group of all publicly traded banks and thrifts in our size range. More details on this plan are included in our proxy statement.



Growth



Our successful long-term trend in lending, deposit gathering and EPS have been the result of our focused strategy that provides the service and responsiveness of a community bank in a consolidating marketplace. We will continue to grow by:



•


Recruiting and developing talented, service-minded Associates. We have successfully recruited Associates with strong community ties to strengthen our existing markets and provide a strong start in new communities. We also focus efforts on developing talent and leadership in our current Associate base to better equip those Associates for their jobs and prepare them for leadership roles at WSFS.

•


Embracing the Human Sigma concept. We are committed to building Associate engagement and customer advocacy as a way to develop our culture and grow our franchise. We firmly believe franchise and shareholder value are directly linked to our Human Sigma model.

•


Continuing strong growth in commercial lending by:




o


Selectively building a presence in contiguous markets.




o


Providing product solutions like Remote Deposit Capture to facilitate commercial banking outside of our primary market.




o


Offering our community banking model that combines Stellar Service with the banking products and services our business customers demand.



•


Aggressively growing deposits. In 2003, we energized our retail branch strategy by combining Stellar Service with an expanded and updated branch network. We have also implemented a number of additional measures to accelerate our deposit growth. We will continue to grow deposits by:




o


Expanding and renovating our retail branch network.




o


Further expanding our commercial customer relationships with deposit products.




o


Finding creative ways to build deposit market share such as hiring deposit-focused relationship managers, and targeted marketing programs.




o


Potential acquisitions such as the branch acquisition we completed in 2008.



•


Growing our wealth management services division by leveraging the strong relationships we have with our current customer base and providing unparalleled service to modestly wealthy clients in our market.

Results



Our focus on these points of differentiation has allowed us to grow our core franchise and build value for our shareholders. Since 2004, our commercial loans have grown from $903 million to $1.8 billion, a strong 18% compound annual growth rate (CAGR). Over the same period, customer deposits have grown from $1.1 billion to $1.7 billion, a 13% CAGR. More importantly, over the last decade, shareholder value has increased at a far greater rate than our banking peers and the market in general, as is evident in the table below.

SUBSIDIARIES



We have two consolidated subsidiaries, WSFS Bank and Montchanin Capital Management, Inc.



WSFS Bank has one wholly owned subsidiary, WSFS Investment Group, Inc., which markets various third-party investment and insurance products, such as single-premium annuities, whole life policies and securities primarily through the Bank’s retail banking system and directly to the public.



In addition, WSFS Bank has one majority owned subsidiary, 1 st Reverse Financial Services, LLC (1 st Reverse). 1 st Reverse, a 51% owned subsidiary, is an Illinois-based reverse mortgage company that originates and subsequently sells reverse mortgage loans nationwide.



Montchanin Capital Management, Inc. (“Montchanin”) provides asset management services in our primary market area. Montchanin has one wholly owned subsidiary, Cypress Capital Management, LLC (“Cypress”). Cypress is a Wilmington-based investment advisory firm servicing high net-worth individuals and institutions and had approximately $410 million in assets under management at December 31, 2008.

DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS’ EQUITY



Condensed average balance sheets for each of the last three years and analyses of net interest income and changes in net interest income due to changes in volume and rate are presented in “Results of Operations” included in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”



INVESTMENT ACTIVITIES



At December 31, 2008, WSFS’ total securities portfolio had a carrying value of $547.9 million. The Company’s strategy has been to avoid credit risk in our securities portfolio. Therefore, securities purchases have been limited to AAA-rated securities, except for $12.4 million in BBB+ rated MBS purchased in conjunction with a 2002 reverse mortgage securitization.



• WSFS owns no CDOs, Bank Trust Preferred, Agency Preferred securities or equity securities in other FDIC insured banks or thrifts.

The portfolio is comprised of:

• $44.6 million in Federal Agency debt securities with a maturity of four years or less.

•$194.7 million in “plain vanilla” Agency MBS. Of these, $103.4 million are sequential pay CMOs with no contingent cash flows and $91.3 million are Agency MBS with 10-15 year original final maturities.

•$292.7 million in Non-Agency MBS. The quality of this portfolio is evidenced by:

oDiversification among more than 75 different pools.

o
Significant seasoning, with 85% of underlying loans originated in 2005 or earlier, and 15% originated in 2006.

oHeavy continuing principal amortization, as more than 95% of these bonds were originally 15-year pass-through cash flows.

oStrong fundamental characteristics, with an average loan-to-value of 42% (based on scheduled amortization and initial appraised value) with an average FICO score (at origination) well above 700. Only 11% of the collateral is classified as Alt-A loans and none are classified as sub-prime.

Only four of the 75 bonds, with a market value of $11.3 million, were downgraded in 2008. Based on stress tests of these four bonds using proprietary models of two independent companies, management believes the collection of the contractual principal and interest is probable and therefore the unrealized losses are considered to be temporary.

CEO BACKGROUND

Named Executive Officers (NEOs)

There was one change, shown below, to our list of NEOs from those reported in last year’s proxy.



Named Executive Officers

2007


2008

Mark A. Turner – President and Chief Executive Officer


Mark A. Turner – President and Chief Executive Officer

Marvin N. Schoenhals – Chairman of the Board


Marvin N. Schoenhals – Chairman of the Board

Stephen A. Fowle – Executive Vice President and Chief Financial Officer


Stephen A. Fowle – Executive Vice President and Chief Financial Officer

Rodger Levenson - Executive Vice President and Director of Commercial Banking


Rodger Levenson - Executive Vice President and Director of Commercial Banking

Barbara J. Fischer – Executive Vice President and Chief Administrative Officer


Richard M. Wright – Executive Vice President and Director of Retail Banking and Marketing

MANAGEMENT DISCUSSION FROM LATEST 10K

OVERVIEW



WSFS Financial Corporation (“the Company,” “our Company,” “we,” “our” or “us”) is a thrift holding company headquartered in Wilmington, Delaware. Substantially all of our assets are held by our subsidiary, Wilmington Savings Fund Society, FSB (“WSFS Bank” or the “Bank”). Founded in 1832, we are one of the ten oldest banks in the United States continuously-operating under the same name. As a federal savings bank, which was formerly chartered as a state mutual savings bank, we enjoy broader investment powers than most other financial institutions. We have served the residents of the Delaware Valley for over 175 years. We are the largest thrift institution headquartered in Delaware and the third largest financial institution in the state on the basis of total deposits traditionally garnered in-market. Our primary market area is the mid-Atlantic region of the United States, which is characterized by a diversified manufacturing and service economy. Our long-term strategy is to serve small and mid-size businesses through loans, deposits, investments, and related financial services, and to gather retail core deposits. Our strategic focus is to exceed customer expectations, deliver stellar service and build customer advocacy through highly trained, relationship oriented, friendly, knowledgeable, and empowered Associates.



We provide residential and commercial real estate, commercial and consumer lending services, as well as retail deposit and cash management services. In addition, we offer a variety of wealth management and personal trust services through WSFS Wealth Strategies, which was formed during 2005. Lending activities are funded primarily with retail deposits and borrowings. The Federal Deposit Insurance Corporation (“FDIC”) insures our customers’ deposits to their legal maximum. We serve our customers primarily from our main office, 35 retail banking offices, loan production offices and operations centers located in Delaware, southeastern Pennsylvania and Virginia and through our website at www.wsfsbank.com.



We have two consolidated subsidiaries, WSFS Bank and Montchanin Capital Management, Inc. (“Montchanin”). We also have one unconsolidated affiliate, WSFS Capital Trust III (“the Trust”). WSFS Bank has a fully-owned subsidiary, WSFS Investment Group, Inc., which markets various third-party insurance products and securities through the Bank’s retail banking system. WSFS Bank also owns a majority interest in 1 st Reverse Financial Services, LLC (1 st Reverse), specializing in reverse mortgage lending.



Montchanin has one consolidated subsidiary, Cypress Capital Management, LLC (“Cypress”). Cypress is a Wilmington-based investment advisory firm serving high net-worth individuals and institutions. Cypress had approximately $410 million in assets under management at December 31, 2008.



FORWARD-LOOKING STATEMENTS



Within this annual report and financial statements, management has included certain “forward-looking statements” concerning our future operations. Statements contained in this annual report which are not historical facts, are forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. It is management’s desire to take advantage of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. This statement is for the express purpose of availing the Corporation of the protections of such safe harbor with respect to all “forward-looking statements.” Management has used “forward-looking statements” to describe future plans and strategies including expectations of our future financial results. Management’s ability to predict results or the effect of future plans and strategy is inherently uncertain. Factors that could affect results include interest rate trends, competition, the general economic climate in Delaware, the mid-Atlantic region and the country as a whole, asset quality, loan growth, loan delinquency rates, operating risk, uncertainty of estimates in general, and changes in federal and state regulations, among other factors. These factors should be considered in evaluating the “forward-looking statements,” and undue reliance should not be placed on such statements. Actual results may differ materially from management expectations. We do not undertake, and specifically disclaim any obligation to publicly release the result of any revisions

that may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.



RESULTS OF OPERATIONS



WSFS Financial Corporation recorded net income of $16.1 million or $2.57 per diluted share for the year ended December 31, 2008, compared to $29.6 million or $4.55 per share and $30.4 million or $4.41 per share in 2007 and 2006, respectively.



Net Interest Income. Net interest income increased $7.2 million, or 9%, to $89.2 million in 2008 compared to $82.0 million in 2007. The net interest margin for 2008 was 3.13%, up 0.04% from 2007. These increases were the result of a slightly liability sensitive balance sheet combined with active management of deposit pricing. In comparison to 2007, the yield on interest-bearing liabilities declined by 1.41%, while the yield on interest-earning assets only declined by 1.27%. The improvement in the net interest margin also reflects growth, and the improved mix of our balance sheet. The investment category on our average balance sheet includes income from reverse mortgages, which declined substantially in 2008 compared to 2007, consistent with decreases in home prices over the past year. During 2008 we lost $1.1 million on reverse mortgages compared to income of $2.0 million in 2007. For further discussion of reverse mortgages, see the “Reverse Mortgages” discussion included in this Management’s Discussion and Analysis and Note 4 to the Consolidated Financial Statements.



Net interest income increased $4.1 million, or 5%, to $82.0 million in 2007 compared to $77.9 million in 2006. The net interest margin for 2007 was 3.09%, up 0.11% from 2006. The overall improvement in the net interest margin over the previous year reflects loan growth and our continued efforts to refocus the mix of our balance sheet. Loans, with an average yield of 7.55%, increased $168.7 million on average while mortgage-backed securities, with an average yield of 4.93%, declined $99.4 million on average mostly due to scheduled repayments. In addition, interest-bearing deposits, with an average rate of 3.76%, increased $219.3 million on average while FHLB advances, with an average rate of 4.97%, decreased $210.1 million on average. The yield on earning assets increased 0.37% on average in comparison to 2006 while the rate on interest-bearing liabilities increased by 0.27% on average. Additionally, income from reverse mortgages increased $1.3 million in comparison to 2006.

The following table sets forth certain information regarding changes in net interest income attributable to changes in the volumes of interest-earning assets and interest-bearing liabilities and changes in the yields for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on the changes that are attributable to: (i) changes in volume (change in volume multiplied by prior year rate); (ii) changes in rates (change in rate multiplied by prior year volume on each category); and (iii) net change (the sum of the change in volume and the change in rate). Changes due to the combination of rate and volume changes (changes in volume multiplied by changes in rate) are allocated proportionately between changes in rate and changes in volume.

Provision for Loan Losses . We maintain an allowance for loan losses at an appropriate level based on management’s assessment of the estimable and probable losses in the loan portfolio, pursuant to accounting literature, which is discussed further in the “Nonperforming Assets” section of this Management’s Discussion and Analysis. Management’s evaluation is based upon a review of the portfolio and requires significant judgment. For the year ended December 31, 2008, we recorded a provision for loan losses of $23.0 million compared to $5.0 million in 2007 and $2.7 million in 2006. The $23.0 million included $14.7 million recorded in the fourth quarter of 2008. The larger provision amount was due to the rapid deterioration in the economic environment during the fourth quarter. The $14.7 million includes the following: $7.3 million was related to four large construction loans and land development projects; $6.2 million was attributed to reserves for new loans, updated loss rate expectations on the consumer and mortgage portfolios, as well as credit risk migration in the commercial loan portfolio due to economic conditions; and $1.2 million was a result of consumer credit losses taken during the fourth quarter of 2008. The increase in the provision for loan loss reflects our proactive approach in confronting the reality of the deepening economic recession.



Noninterest Income . Noninterest income decreased $2.2 million to $46.0 million in 2008, or 5%, from $48.2 million in 2007. The majority of the decrease was due to a $2.5 million decrease in credit card/debit card and ATM income due to reduced prime based ATM bailment fees. Although noninterest income was negatively impacted by lower bailment fees, the net interest margin benefited due to lower funding costs for these borrowings. In addition, 2007 had included a $1.1 million non-recurring gain related to the sale of our former headquarters building and an $882,000 gain from the sale of our credit card portfolio. Also during the year, income from Bank-Owned Life Insuarance (BOLI) decreased $483,000 from the prior year due to lower yields in underlying investments funding this program. These decreases were partially offset by an increase in loan fee income of $1.3 million. The majority of the increase in loan fee income was due to $851,000 in fees from 1 st Reverse Financial Services, LLC (“1 st Reverse”). During the second quarter of 2008 we acquired a majority interest in 1 st Reverse, specializing in both reverse mortgage lending directly to consumers and business-to-business reverse mortgage lending through banks, brokers and financial institutions throughout the United States. Deposit service charges also increased $1.1 million. This increase was a result of overall growth in deposits. In 2008 we also recorded a $1.8 million gain on the sale of shares related to the completion of Visa’s initial public offering, and a $1.6 million charge related to a mark-to-market adjustment on the $12.4 million BBB+ rated mortgage-backed security (“MBS”) issued in connection with a 2002 reverse mortgage securitization.



Noninterest income increased $7.9 million to $48.2 million in 2007, or 20%, from $40.3 million in 2006. This was attributable to a $3.2 million increase in deposit service charges as we continued to benefit from increased deposit accounts and offered additional fee-based services. The increase also included a $1.1 million non-recurring gain related to the sale of our former headquarters building and an $882,000 gain from the sale of our credit card portfolio. Credit/debit card and ATM income also increased $915,000 as a result of increased volumes of cash in non-owned ATMs and higher bailment fess earned on this cash. In 2007 we also recorded two offsetting $6.0 million items. Both occurred during the fourth quarter and resulted in a gain and an expense recognized from the donation of a N.C. Wyeth mural, Apotheosis of the Family, which was located in our former headquarters.



Noninterest Expenses . Noninterest expenses increased $7.1 million to $89.1 million in 2008, or 9%, from $82.0 million in 2007. Excluding $2.8 million of expenses related to 1 st Reverse, acquired in the second quarter of 2008, expenses increased $4.3 million or 5% over 2007. As a result of continued growth efforts salaries, benefits, and other compensation increased $1.1 million while other operating expenses increased $1.2 million. Included in other operating expenses was a $453,000 increase in FDIC charges due to increased assessment rates. During 2008 the investment in WSFS franchise included the opening of one branch in Selbyville, Delaware, the relocation of another branch in Smyrna, Delaware, and the previously mentioned acquisition of branches. Further, during 2008 professional fees increased $1.3 million as a result of legal fees reflecting increased costs relating to problem credits, reflecting credit costs associated with the challenging credit environment.

Noninterest expenses increased $12.7 million to $82.0 million in 2007, or 18%, from $69.3 million in 2006. WSFS showed strong growth in 2007 which included the opening of three branch offices, one branch renovation, and the relocation of our corporate headquarters. As a result of this growth, the number of full-time associates grew to 599, resulting in increased salaries, benefits and other compensation of $4.3 million. This growth also affected both occupancy expense, which increased by $2.8 million, and other operating expenses, which increased by $1.9 million. During 2007 our marketing expenses increased $1.2 million, as a multi-year brand campaign was launched with the intent to leverage our Stellar Service model with the message “ W e S tand F or S ervice.” Also during 2007, we recorded a $1.2 million expense related to the Visa antitrust lawsuit settlement with American Express and Discover.



Income Taxes. We recorded a $7.0 million tax provision for the year ended December 31, 2008 compared to $13.5 million and $15.7 million for the years ended December 31, 2007 and 2006, respectively. The effective tax rates for the years ended December 31, 2008, 2007 and 2006 were 30.1%, 31.2% and 34.0%, respectively. The reduction in the 2008 effective tax rate is primarily the result of volatility in effective tax rates. The reduction in the 2007 effective tax rate is primarily the result of a $1.7 million tax benefit related to the previously discussed donation of the N.C. Wyeth mural. The provision for income taxes includes federal, state and local income taxes that are currently payable or deferred because of temporary differences between the financial reporting bases and the tax reporting bases of the assets and liabilities.



We analyze our projection of taxable income and make adjustments to our provision for income taxes accordingly. For additional information regarding our tax provision and net operating loss carryforwards, see Note 12 to the Consolidated Financial Statements.



FINANCIAL CONDITION



Total assets increased $232.4 million, or 7%, during 2008 to $3.4 billion. This increase was predominantly due to growth in net loans, which grew $209.9 million, or 9%, during 2008. Total liabilities increased $227.1 million during the year to $3.2 billion at December 31, 2008. This increase was primarily the result of an increase in customer deposits of $227.9 million, or 15% and brokered deposits of $62.2 million, or 25% during 2008. Partially offsetting these increases was an $82.3 million, or 9% decrease in FHLB advances.



Cash in non-owned ATMs. During 2008, cash in non-owned ATMs managed by CashConnect, our ATM unit, increased $7.4 million, or 4%. This increase was the result of an increase in the number of ATMs serviced by CashConnect from 9,976 at December 31, 2007 to 10,031 at December 31, 2008. Of these, 301 ATMs were WSFS owned and operated during 2008.



Mortgage-backed Securities . Our mortgage-backed securities are predominantly “plain-vanilla”, AAA-rated and of short duration. Investments in mortgage-backed securities increased $1.4 million during 2008 to $498.2 million. There were no sales of mortgage-backed securities during 2008. The weighted average duration of the mortgage-backed securities was 2.9 years at December 31, 2008.



Investment Securities. Our investment securities are comprised mostly of Federal Agency debt securities with a maturity of four years or less. We own no Collateralized Debt Obligations, Bank Trust Preferred, Agency Preferred securities or equity securities in other FDIC insured banks or thrifts.



Loans, net . Net loans increased $209.9 million, or 9%, during 2008. This included increases of $155.4 million, or 20%, in commercial loans, $67.6 million, or 9%, in commercial real estate loans, and $18.5 million, or 7%, in consumer loans. This increase was partially offset by a decrease of $24.7 million, or 6%, in residential mortgage loans.



Customer Deposits . Customer deposits increased $227.9 million, or 15%, during 2008 to $1.7 billion. During 2008 we acquired six Delaware branches from Sun National Bank, including $95.3 million in customer deposit accounts and paid a 12% premium on the balances. For additional information regarding this transaction, see Note 20 to the Consolidated Financial Statements. Customer time deposits (CDs) increased $129.0 million, or 25%, in 2008. In addition, core deposit relationships (demand deposits, money market and savings

Borrowings and Brokered Certificates of Deposit. Borrowings and brokered certificates of deposit decreased by $6.2 million, or less than 1%, during 2008. This decrease was primarily the result of a decrease in FHLB advances of $82.3 million, or 9%. Partially offsetting this decrease was a $62.2 million, or 25%, increase in brokered deposits. In addition, other borrowed funds increased $14.0 million, or 15%.



Stockholders’ Equity . Stockholders’ equity increased $5.3 million to $216.6 million at December 31, 2008. This increase included an increase of $7.4 million in comprehensive income and $3.0 million from the result of the exercise of common stock options. Partially offsetting these decreases was the purchase of 73,500 shares of treasury stock for $3.6 million. At December 31, 2008, we held 9.6 million shares of our common stock as treasury stock. Long-term, it is our intention to return some of our earnings to shareholders through share repurchases, which is subject to approval by the U.S. Treasury, while maintaining adequate levels of capital. In addition, we declared cash dividends totaling $2.8 million during 2008.



ASSET/LIABILITY MANAGEMENT



Our primary asset/liability management goal is to maximize net interest income opportunities within the constraints of managing interest rate risk, while ensuring adequate liquidity and funding and maintaining a strong capital base.



In general, interest rate risk is mitigated by closely matching the maturities or repricing periods of interest-sensitive assets and liabilities to ensure a favorable interest rate spread. We regularly review our interest-rate sensitivity, and use a variety of strategies as needed to adjust that sensitivity within acceptable tolerance ranges established by management and the Board of Directors. Changing the relative proportions of fixed-rate and adjustable-rate assets and liabilities is one of our primary strategies to accomplish this objective.



The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are “interest-rate sensitive” and by monitoring an institution’s interest-sensitivity gap. An interest-sensitivity gap is considered positive when the amount of interest-rate sensitive assets exceeds the amount of interest-rate sensitive liabilities repricing within a defined period, and is considered negative when the amount of interest-rate sensitive liabilities exceeds the amount of interest-rate sensitive assets repricing within a defined period.

Generally, during a period of rising interest rates, a positive gap would result in an increase in net interest income while a negative gap would adversely affect net interest income. Conversely, during a period of falling rates, a positive gap would result in a decrease in net interest income while a negative gap would augment net interest income. However, the interest-sensitivity table does not provide a comprehensive representation of the impact of interest rate changes on net interest income. Each category of assets or liabilities will not be affected equally or simultaneously by changes in the general level of interest rates. Even assets and liabilities which contractually reprice within the rate period may not, in fact, reprice at the same price or the same time or with the same frequency. It is also important to consider that the table represents a specific point in time. Variations can occur as we adjust our interest-sensitivity position throughout the year.



To provide a more accurate position of our one-year gap, certain deposit classifications are based on the interest-rate sensitive attributes and not on the contractual repricing characteristics of these deposits. Management estimates, based on historical trends of our deposit accounts, that 35% of money market and 13% of interest-bearing demand deposits are sensitive to interest rate changes and that 22% to 36% of savings deposits are sensitive to interest rate changes. Accordingly, these interest-sensitive portions are classified in the less than one-year category with the remainder in the over five-year category.



Deposit rates other than time deposit rates are variable, and changes in deposit rates are generally subject to local market conditions and management’s discretion and are not indexed to any particular rate.

REVERSE MORTGAGES



We hold an investment in reverse mortgages of $(61,000) at December 31, 2008 representing a participation in reverse mortgages with a third party. The loans supporting this balance were originated in the early 1990’s.



Reverse mortgage loans are contracts that require the lender to make monthly advances throughout the borrower’s life or until the borrower relocates, prepays or the home is sold, at which time the loan becomes due and payable. Reverse mortgages are nonrecourse obligations, which means that the loan repayments are generally limited to the net sale proceeds of the borrower’s residence.



We account for our investment in reverse mortgages by estimating the value of the future cash flows on the reverse mortgages at a rate deemed appropriate for these mortgages, based on the market rate for similar collateral. Actual cash flows from the maturity of these mortgage loans can result in significant volatility in the recorded value of reverse mortgage assets. As a result, income varies significantly from reporting period to reporting period. For the year ended December 31, 2008, we lost $1.1 million in interest income on reverse mortgages as compared to posting income of $2.0 million in 2007 and $684,000 in 2006. The loss in 2008 primarily resulted from the decrease in the values of the properties securing these mortgages, based on annual re-evaluations and consistent with the decrease in home values over the past year.



The projected cash flows depend on assumptions about life expectancy of the mortgagee and the future changes in collateral values. Projecting the changes in collateral values is the most significant factor impacting the volatility of reverse mortgage values. Our current assumptions include a short-term annual appreciation rate of -8.0% in the first year, and a long-term annual appreciation rate of 0.5% in future years. If the long-term appreciation rate was increased to 1.5%, the resulting impact on income would have been $26,000. Conversely, if the long-term appreciation rate was decreased to -0.5%, the resulting impact on income would have been $(22,000).



We also hold $10.8 million in BBB+ rated mortgage-backed securities classified as trading and have options to acquire up to 49.9% of Class “O” Certificates issued in connection with securities consisting of a portfolio of reverse mortgages we previously owned. The Class “O” Certificates are currently recorded on our financial statements at a zero value. At the time of the securitization, the third-party securitizer (Lehman Brothers) retained 100% of the Class “O” Certificates from the securitization. These Class “O” Certificates have no priority over other classes of Certificates under the Trust and no distributions will be made on the Class “O” Certificates until, among other conditions, the principal amount of each other class of notes has been reduced to zero. The underlying assets, the reverse mortgages, are very long-term assets. Therefore, any cash flow that might inure to the holder of the Class “O” Certificates is not expected to occur until many years in the future. Additionally, we can exercise our option on 49.9% of the Class “O” Certificates in up to five separate increments for an aggregate purchase price of $1.0 million any time between January 1, 2004 and the termination of the Securitization Trust. The option to purchase the Class “O” Certificates does not meet the definition of a derivative under SFAS No. 133, Accounting for Derivative and Hedging Activities and is carried in our financial statements at cost. During the third quarter of 2008 Lehman Brothers filed for bankruptcy. We are currently in discussions with legal counsel to determine our legal rights with respect to the Class “O” certificates.



During 2006, we formed a new reverse mortgage initiative. While our activity during the past two years has been limited to acting as a correspondent for these loans, it is our intention to originate and underwrite our own reverse mortgages in the future. We expect to sell most of these loans and do not intend to hold them in our portfolio. These reverse mortgages are government approved and insured.



NONPERFORMING ASSETS



Nonperforming assets, which include nonaccruing loans, nonperforming real estate investments and assets acquired through foreclosure, can negatively affect our results of operations. Nonaccruing loans are those on which the accrual of interest has ceased. Loans are placed on nonaccrual status immediately if, in the opinion of management, collection is doubtful, or when principal or interest is past due 90 days or more and the value of the collateral is insufficient to cover principal and interest. Interest accrued but not collected at the date a loan is placed on nonaccrual status is reversed and charged against interest income. In addition, the amortization of net deferred loan fees is suspended when a loan is placed on nonaccrual status. Subsequent cash receipts are applied either to the outstanding principal balance or recorded as interest income, depending on management’s assessment of the ultimate collectibility of principal and interest. Past due loans are defined as loans contractually past due 90 days or more as to principal or interest payments but which remain in accrual status because they are considered well secured and in the process of collection.

MANAGEMENT DISCUSSION FOR LATEST QUARTER.

GENERAL



WSFS Financial Corporation (“the Company”, “our Company”, “we”, “our” or “us”) is a thrift holding company headquartered in Wilmington, Delaware. Substantially all of our assets are held by our subsidiary, Wilmington Savings Fund Society, FSB (“WSFS Bank” or the “Bank”). Founded in 1832, we are one of the ten oldest banks in the United States continuously-operating under the same name. As a federal savings bank, which was formerly chartered as a state mutual savings bank, we enjoy broader investment powers than most other financial institutions. We have served the residents of the Delaware Valley for over 175 years. We are the largest thrift institution headquartered in Delaware and the fourth largest financial institution in the state on the basis of total deposits traditionally garnered in-market. Our primary market area is the mid-Atlantic region of the United States, which is characterized by a diversified manufacturing and service economy. Our long-term strategy is to serve small and mid-size businesses through loans, deposits, investments, and related financial services, and to gather retail core deposits. Our strategic focus is to exceed customer expectations, deliver stellar service and build customer advocacy through highly trained, relationship oriented, friendly, knowledgeable, and empowered Associates.



We have two consolidated subsidiaries, WSFS Bank and Montchanin Capital management, Inc. (“Montchanin”). We also have one unconsolidated affiliate, WSFS Capital Trust III (“the Trust”). WSFS Bank has a fully-owned subsidiary, WSFS Investment Group, Inc., and also owns a majority interest in 1 st Reverse Financial Services, LLC (“1 st Reverse”). Montchanin has one consolidated subsidiary, Cypress Capital Management, LLC (“Cypress”). For additional information on the Company or any of our subsidiaries, see Note 1, Basis of presentation, to the Consolidated Financial Statements.



FORWARD-LOOKING STATEMENTS



The following discussion may contain statements which are not historical facts and are forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. Such forward-looking statements, which are based on various assumptions, some of which may be beyond the company’s control, are subject to risks and uncertainties and other factors which could cause actual results to differ materially from those currently anticipated. Such risks and uncertainties include, but are not limited to, those related to the economic environment, particularly in the market areas in which the company operates, the volatility of the financial and securities markets, including changes with respect to the market value of our financial assets, changes in government laws and regulations affecting financial institutions, including potential expenses associated therewith, changes resulting from our participation in the CPP, including additional conditions that may be imposed in the future on participating companies, and the costs associated with resolving any problem loans and other risks and uncertainties discussed in documents filed by WSFS Financial Corporation with the Securities and Exchange Commission from time to time. The Corporation does not undertake to update any forward-looking statements, whether written or oral, that may be made from time to time by or on behalf of the Corporation.



CRITICAL ACCOUNTING POLICIES



The discussion and analysis of the financial condition and results of operations are based on the Consolidated Financial Statements, which are prepared in conformity with U.S. generally accepted accounting principles. The preparation of these Consolidated Financial Statements requires management to make estimates and assumptions affecting the reported amounts of assets, liabilities, revenue and expenses. We regularly evaluate these estimates and assumptions including those related to the allowance for loan losses, contingencies (including indemnifications), and deferred taxes. We base our estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances. These form the basis for making judgments on 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.



The following are critical accounting policies that involve more significant judgments and estimates:



Allowance for Loan Losses



We maintain allowances for credit losses and charge losses to these allowances when realized. The determination of the allowance for loan losses requires significant judgment reflecting our best estimate of probable loan losses related to specifically identified loans as well as those in the remaining loan portfolio. Our evaluation is based upon a continuing review of these portfolios, with consideration given to evaluations resulting from examinations performed by regulatory authorities.

Contingencies (Including Indemnifications)



In the ordinary course of business we are subject to legal actions, which involve claims for monetary relief. Based upon information presently available to us and our counsel, it is our opinion that any legal and financial responsibility arising from such claims will not have a material adverse effect on our results of operations.



We maintain a loss contingency for standby letters of credit and charge losses to this reserve when such losses are realized. The determination of the loss contingency for standby letters of credit requires significant judgment reflecting management’s best estimate of probable losses.



The Bank, as successor to originators of reverse mortgages is, from time to time, involved in arbitration or litigation with various parties including borrowers or the heirs of borrowers. Because reverse mortgages are a relatively new and uncommon product, there can be no assurances about how the courts or arbitrators may apply existing legal principles to the interpretation and enforcement of the terms and conditions of the Bank’s reverse mortgage obligations.



Deferred Taxes



We account for income taxes in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 740, Income Taxes (“ASC 740”), which requires the recording of deferred income taxes that reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. We continually assess the need for valuation allowances on deferred income tax assets that may result from, among other things, limitations imposed by Internal Revenue Code and uncertainties, including the timing of settlement and realization of these differences. No valuation allowance is required as of September 30, 2009.



Fair Value Measurements



We adopted FASB ASC 820-10, Fair Value Measurements and Disclosures (“ASC 820”), which defines fair value, establishes a framework for measuring fair value under GAAP, and expands disclosures about fair value measurements. See Note 10, Fair Value of Financial Assets.



FINANCIAL CONDITION, CAPITAL RESOURCES AND LIQUIDITY



Financial Condition



Our total assets increased $141.0 million, or 4%, during the nine months ended September 30, 2009. Total loans increased $66.1 million, or 3%, attributable to a $131.5 million, or 8%, increase in commercial and commercial real estate loans offset by a decrease in residential mortgage loans of $50.4 million, or 13%, and an additional allowance for loan losses of $21.0 million, or 67%. Mortgage-backed securities increased $27.3 million, or 5%. Finally, cash and cash equivalents increased $41.0 million, or 17%. This included a $7.0 million, or 12% increase in cash and due from banks, and a $33.7 million, or 18%, increase in cash in non-owned ATMs.



Total liabilities increased $54.5 million, or 2%, between December 31, 2008 and September 30, 2009 to $3.3 billion. This increase was mainly due to an increase in deposits of $354.5 million, or 17%. This included increases of $357.0 million, or 21%, in customer deposits and $22.9 million, or 7%, in brokered certificates of deposit. These increases in customer deposits improved our funding mix as deposit growth reduced our need for more costly wholesale funding. As a result, both Federal Home Loan Bank (FHLB) advances and other jumbo certificates of deposits decreased by $310.4 million, or 38%, and $25.4 million, or 24%, respectively.



At September 30, 2009, we had approximately $10.9 million in goodwill, primarily the result of a multi-branch purchase in 2008. At September 30, 2009, we considered whether there were any occurrences of a triggering event which would require us to test the goodwill for impairment before our annual test in December, as required under GAAP. Our review concluded there were no such occurrences and therefore we did not test our goodwill for impairment.



Capital Resources



Stockholders’ equity increased $86.4 million between December 31, 2008 and September 30, 2009. This increase was mainly due to the sale of senior preferred stock to the U.S. Department of the Treasury under its Capital Purchase Program (“CPP”) totaling $52.6 million and the sale of $25.0 million of common stock to Peninsula Investment Partners, L.P (“Peninsula”). Also, accumulated other comprehensive loss decreased $10.5 million during the first nine months of 2009 mainly due to an increase in the fair value of securities available-for-sale. Partially offsetting these increases was the declaration of common and preferred dividends totaling $2.2 million and $1.5 million, respectively, during the nine months ended September 30, 2009.



Under Office of Thrift Supervision (“OTS”) capital regulations, savings institutions such as the Bank must maintain “tangible” capital equal to 1.5% of adjusted total assets, “core” capital equal to 4.0% of adjusted total assets, “Tier 1” capital equal to 4.0% of risk weighted assets and “total” or “risk-based” capital (a combination of core and “supplementary” capital) equal to 8.0% of risk-weighted assets. Failure to meet minimum capital requirements can initiate certain mandatory actions and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our bank’s financial statements. At September 30, 2009 the Bank was in compliance with regulatory capital requirements and is considered a “well-capitalized” institution.

Liquidity



We manage our liquidity risk and funding needs through our treasury function and our Asset/Liability Committee. We have a policy that separately addresses liquidity, and management monitors our adherence to policy limits. Also, liquidity risk management is a primary area of examination by the OTS. We comply with guidance promulgated under Thrift Bulletin 77 that requires thrift institutions to maintain adequate liquidity to assure safe and sound operations.



As a financial institution, the Bank has ready access to several sources to fund growth and meet its liquidity needs. Among these are: net income, deposit programs, loan repayments, borrowing from the FHLB, repurchase agreements and the brokered deposit market. The Bank’s branch expansion is intended to enter us into new, but contiguous, markets, attract new customers and provide funding for its business loan growth. In addition, we have a large portfolio of high-quality, liquid investments, primarily short-duration, AAA-rated, mortgage-backed securities and Agency notes that provide a near-continuous source of cash flow to meet current cash needs, or can be sold to meet larger discrete needs for cash. Management believes these sources are sufficient to maintain the required and prudent levels of liquidity.



During the nine months ended September, 2009, cash and cash equivalents increased $41.0 million to $289.6 million. The increase was a result of the following: a $293.5 million increase in cash provided through increases in demand, savings and time deposits; the sale of 52,625 shares of senior preferred stock, resulting in an increase in cash of $52.6 million; increase in cash of $35.6 million provided by operating activities; the issuance of $30.0 million of unsecured debt under the FDIC’s Temporary Liquidity Guarantee Program (“TLGP”); and an increase in cash of $25.0 million from the completion of the common stock sale to Peninsula in September 2009. Partially offsetting these increases was net borrowings from the FHLB, which decreased $310.4 million during the nine months ended September 30, 2009, resulting in a decrease in cash. In addition, net loan growth resulted in the use of $100.2 million in cash, which was primarily the result of the successful implementation of specific strategies designed to increase corporate and small business lending.



NONPERFORMING ASSETS



The following table shows our nonperforming assets and past due loans at the dates indicated. Nonperforming assets include nonaccruing loans, nonperforming real estate investments, assets acquired through foreclosure and restructured mortgage and home equity consumer debt. Nonaccruing loans are those on which the accrual of interest has ceased. Loans are placed on nonaccrual status immediately if, in the opinion of management, collection is doubtful, or when principal or interest is past due 90 days or more and the value of the collateral is insufficient to cover principal and interest. Interest accrued but not collected at the date a loan is placed on nonaccrual status is reversed and charged against interest income. In addition, the amortization of net deferred loan fees is suspended when a loan is placed on nonaccrual status. Subsequent cash receipts are applied either to the outstanding principal balance or recorded as interest income, depending on management’s assessment of the ultimate collectability of principal and interest. Past due loans are loans contractually past due 90 days or more as to principal or interest payments but which remain on accrual status because they are considered well secured and in the process of collection.

Nonperforming assets increased $57.4 million between December 31, 2008 and September 30, 2009. As a result, nonperforming assets, as a percentage of total assets, increased from 1.04% at December 31, 2008 to 2.61% at September 30, 2009. The increase was largely attributable to nine residential construction projects totaling $33.5 million and four commercial construction projects totaling $10.9 million. Nonperforming commercial loans increased due to three commercial relationships placed on nonaccrual status and an increase in nonperforming small business loans during the nine months ended September 30, 2009. There was also a $5.0 million increase in properties acquired through foreclosures (REO) due to two residential construction projects now held by us. Other notable increases were in troubled debt restructuring (TDR) and residential mortgages which increased $4.7 million and $3.7 million, respectively.



Total past due loans increased $5.1 million to $6.4 million at September 30, 2009. This increase was mainly due to one owner occupied commercial mortgage we are in the process of modifying. This loan has a partia]]>Wed, 06 Jan 2010 05:24:36 GMThttp://www.dailystocks.com/forum/showtopic.php?tid/3719/http://www.dailystocks.com/forum/showtopic.php?tid/3719/
BUSINESS OVERVIEW


General

The Group is a publicly-owned financial holding company incorporated on June 14, 1996 under the laws of the Commonwealth of Puerto Rico, providing a full range of financial services through its subsidiaries. The Group is subject to the provisions of the U.S. Bank Holding Company Act of 1956, as amended, (the “BHC Act”) and, accordingly, subject to the supervision and regulation of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”).

The Group provides comprehensive financial services to its