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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.
___________________________________

FORM 10-Q
____________________________________

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934.

For the Quarterly Period Ended January 1, 2005

OR

TRANSITIONAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period From _________ to ________.

Commission File Number 0-11392

SPAN-AMERICA MEDICAL SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)

South Carolina
  
57-0525804
(State or other jurisdiction of
  
(I.R.S. Employer
incorporation or organization)
  
Identification Number)

70 Commerce Center
Greenville, South Carolina 29615
(Address of Principal Executive Offices) (Zip Code)

Registrant's telephone number, including area code: (864) 288-8877

Not Applicable
Former name, former address and former fiscal year, if changed since last report.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No  

APPLICABLE ONLY TO CORPORATE ISSUERS
Indicate the number of shares outstanding of each of the issuer's class of common stock, as of the latest practical date.
Common Stock, No Par Value - 2,593,768 shares as of 1/31/05

  
     
 


INDEX

SPAN-AMERICA MEDICAL SYSTEMS, INC.


PART I.
  
FINANCIAL INFORMATION
    
         
Item 1.
  
Financial Statements (Unaudited)
    
         
   
Balance Sheets - January 1, 2005 and October 2, 2004
 
3
         
   
Statements of Income - Three months ended January 1, 2005 and January 3, 2004
  
4
 
        
   
Statements of Cash Flows - Three months ended January 1, 2005 and January 3, 2004
  
5
         
   
Notes to Financial Statements - January 1, 2005
  
6
         
Item 2.
  
Management's Discussion and Analysis of Interim Financial Condition and Results of Operations
  
10
         
Item 3.
  
Market Risk
  
15
         
Item 4.
  
Controls and Procedures
  
15
         
PART II.
 
OTHER INFORMATION
  
16
         
Item 1.
  
Legal Proceedings
    
Item 2.
  
Changes in Securities
    
Item 3.
  
Defaults upon Senior Securities
    
Item 4.
  
Submission of Matters to a Vote of Security Holders
    
Item 5.
  
Other Information
    
Item 6.
  
Exhibits and Reports on Form 8-K
    
         
SIGNATURES
  
18
         
OFFICER CERTIFICATIONS
  
19


 
  2  
 

Span-America Medical Systems, Inc.
Balance Sheets
    January 1,
2005
(Unaudited)		   October 2,
2004
( Note)		  
Assets
          
Current assets:
          
Cash and cash equivalents
  
$
2,449,406
  
$
1,707,598
  
Securities available for sale
    
4,367,216
   
4,673,528
 
Accounts receivable, net of allowances of $499,000
              
(Jan. 1, 2005) and $323,000 (Oct. 2, 2004)
    
5,906,004
   
6,432,086
 
Inventories (Note 2)
    
3,104,987
   
2,717,573
 
Prepaid expenses and deferred income taxes
    
590,343
   
912,404
 
Total current assets
    
16,417,956
   
16,443,189
 
               
Property and equipment, net (Note 3)
    
6,174,825
   
6,184,786
 
Cost in excess of fair value of net assets acquired,
              
net of accumulated amortization of $1,027,765 (Jan. 1, 2005
              
and Oct. 2, 2004)
    
1,924,131
   
1,924,131
 
Other assets (Note 4)
    
2,572,315
   
2,362,819
 
   
$
27,089,227
  
$
26,914,925
  
               
Liabilities and Shareholders' Equity
              
Current liabilities:
              
Accounts payable
  
$
2,280,182
  
$
2,570,352
  
Accrued and sundry liabilities
    
2,314,344
   
2,249,898
 
Dividends declared
    
1,037,507
   
-
 
Total current liabilities
    
5,632,033
   
4,820,250
 
               
Deferred income taxes
    
776,000
   
776,000
 
Deferred compensation
    
891,610
   
899,283
 
               
Contingencies (Note 8)
              
               
Shareholders' equity
              
Common stock, no par value, 20,000,000 shares
              
authorized; issued and outstanding shares 2,593,768
              
at Jan. 1, 2005 and 2,592,218 at Oct. 2, 2004
    
570,733
   
557,856
 
Additional paid in capital
    
19,297
   
19,297
 
Retained earnings
    
19,199,554
   
19,842,239
 
Total shareholders' equity
    
19,789,584
   
20,419,392
 
   
$
27,089,227
  
$
26,914,925
  
 
See accompanying notes.
 
Note: The Balance Sheet at October 2, 2004 has been derived from the audited financial statements at that date.

 
  3  
 
 

Span-America Medical Systems, Inc.
Statements of Income
(Unaudited)
     
Three Months Ended
  
     
 
January 1,
2005
    
 
January 3,
2004
  
               
Net sales
  
$
10,777,400
  
$
11,508,513
  
Cost of goods sold
    
7,518,708
   
8,606,742
 
Gross profit
    
3,258,692
   
2,901,771
 
               
Selling and marketing expenses
    
1,780,705
   
1,609,576
 
Research and development expenses
    
240,633
   
170,970
 
General and administrative expenses
    
625,112
   
630,871
 
     
2,646,450
   
2,411,417
 
               
Operating income
    
612,242
   
490,354
 
               
Non-operating income:
              
Investment income
    
22,542
   
17,015
 
Royalty income
    
131,834
   
141,339
 
Other
    
901
   
843
 
 
    
155,277
   
159,197
 
               
Income before income taxes
    
767,519
   
649,551
 
Provision for income taxes
    
269,000
   
228,000
 
Net income
  
$
498,519
  
$
421,551
  
               
Net income per share of common stock (Note 6):
              
Basic
  
$
0.19
  
$
0.16
  
Diluted
  
$
0.18
  
$
0.16
  
               
Dividends per common share
  
$
0.440
  
$
0.035
  
               
Weighted average shares outstanding:
              
Basic
    
2,592,591
   
2,561,556
 
Diluted
    
2,734,992
   
2,704,784
 
 
See accompanying notes.

 
  4  
 
 
Span-America Medical Systems, Inc.
Statements of Cash Flows
(Unaudited)
    Three Months Ended  
    January 1,
2005		   January 3,
2004		  
Operating activities:
          
Net income
  
$
498,519
  
$
421,551
  
Adjustments to reconcile net income to net
              
cash provided by operating activities:
              
Depreciation and amortization
    
202,169
   
161,689
 
Provision for losses on accounts receivable
    
(3,575
)
  
(12,400
)
Increase in cash value of life insurance
    
(68,049
)
  
(86,400
)
Deferred compensation
   
(7,673
)
  
(7,105
)
Changes in operating assets and liabilities:
              
Accounts receivable
    
525,968
   
656,616
 
Inventory
    
(387,414
)
  
52,675
 
Prepaid expenses and other assets
    
254,580
   
24,618
 
Accounts payable and accrued expenses
    
(213,747
)
  
(66,579
)
Net cash provided by operating activities
    
800,778
   
1,144,665
 
               
Investing activities:
              
Purchases of marketable securities
    
(1,000,000
)
  
(800,000
)
Proceeds from sale of marketable securities
    
1,310,000
   
700,000
 
Purchases of property, plant and equipment
    
(163,611
)
  
(842,698
)
Payments for other assets
    
(102,562
)
  
(87,611
)
Net cash provided by/(used for) investing activities
    
43,827
   
(1,030,309
)
               
Financing activities:
              
Dividends paid
    
(103,697
)
  
(89,818
)
Common stock issued upon exercise of options
    
900
   
89,990
 
Net cash (used for)provided by financing activities
    
(102,797
)
  
172
 
               
Increase in cash and cash equivalents
    
741,808
   
114,528
 
Cash and cash equivalents at beginning of period
    
1,707,598
   
1,811,332
 
Cash and cash equivalents at end of period
  
$
2,449,406
  
$
1,925,860
  
 
 
See accompanying notes.

 
  5  
 
 

SPAN-AMERICA MEDICAL SYSTEMS, INC.
                
NOTES TO FINANCIAL STATEMENTS
                
January 1, 2005
                
 
1. BASIS OF PRESENTATION
 
The accompanying unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three month period ended January 1, 2005 are not necessarily indicative of the results that may be expected for the year ended October 1, 2005. For further information, refer to the Company's Annual Report on Form 10-K for the year ended October 2, 2004.

RECENTLY ISSUED ACCOUNTING STANDARDS

In December 2004, the FASB reissued Statement of Financial Accounting Standards (“SFAS”) No. 123 as SFAS No. 123R, “Share Based Compensation.” Under SFAS No. 123R, public entities will be required to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and recognize the cost over the period during which an employee is required to render services in exchange for the award. In addition, the adoption of SFAS No. 123R will require additional accounting and disclosure related to the income tax and cash flow effects resulting from share-based payment arrangements. SFAS No. 123R will be effective for interim or annual reporting periods beginning on or after June 15, 2005. The Company is currently evaluating the impact that adoption of SFAS No. 123R will have on its financial position, results of operations and cash flows. (See Stock-Based Compensation below.)

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs,” which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of this statement is not expected to have a material impact on the financial condition or operating results of the Company.
 
STOCK-BASED COMPENSATION
 
The Company accounts for stock options under Accounting Principles Board Opinion 25, “Accounting for Stock Issued to Employees.” Accordingly, no compensation expense has been charged to operations. Had compensation expense for the plans been determined based on the fair value at the grant dates for awards under the plans consistent with the accounting method available under Statement of Financial Accounting Standards, (SFAS) No. 123 “Accounting for Stock Based Compensation,” the Company's net income and net income per common share would have been reduced to the proforma amounts indicated below:
   
Jan. 1, 2005
  
Jan. 3, 2004
  
Net income
          
As reported
  
$
498,519
  
$
421,551
  
Stock option expense, net of taxes
    
37,308
   
33,417
 
Pro forma
  
$
461,211
  
$
388,134
  
               
Basic net income per common share
              
As reported
  
$
0.19
  
$
0.16
  
Stock option expense, net of taxes
    
0.01
   
0.01
 
Pro forma
  
$
0.18
  
$
0.15
  
               
Diluted net income per common share
              
As reported
  
$
0.18
  
$
0.16
  
Stock option expense, net of taxes
    
0.01
   
0.01
 
Pro forma
  
$
0.17
  
$
0.15
  
 
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for grants made in 2004 and 2003, respectively: risk-free interest rates of 4.14% and 3.26%; dividend yields of 1.1% and 1.6%; volatility factors of the expected market price of the Company's common stock of 38.9% and 38.4%; and a weighted average expected life of the option of eight years for both periods.

 
  6  
 

 
2. INVENTORIES
 
The components of inventories are as follows:
 
     
Jan. 1, 2005
    
Oct. 2, 2004
  
Raw materials
  
$
2,350,092
  
$
1,900,433
  
Finished goods
    
754,895
   
817,140
 
   
$
3,104,987
  
$
2,717,573
  
 
3. PROPERTY AND EQUIPMENT
 
Property and equipment, at cost, is summarized by major classification as follows:
  
     
Jan. 1, 2005
    
Oct. 2, 2004
  
               
Land
  
$
317,343
  
$
317,343
  
Land improvements
    
246,172
   
246,172
 
Buildings
    
4,041,391
   
4,041,391
 
Construction in process
    
276,018
   
130,000
 
Machinery and equipment
   
8,658,081
   
8,647,093
 
Furniture and fixtures
    
439,733
   
433,128
 
Automobiles
    
9,520
   
9,520
 
Leasehold improvements
    
12,330
   
12,330
 
     
14,000,588
   
13,836,977
 
Less accumulated depreciation
    
7,825,763
   
7,652,191
 
   
$
6,174,825
  
$
6,184,786
  
 
Construction in progress at Jan. 1, 2005 and Oct. 2, 2004 represents roof replacement in process.
 
4. OTHER ASSETS
 
Other assets consist of the following:
 
   
Jan. 1, 2005
  
Oct. 2, 2004
  
Patents, net of accumulated amortization
          
of $1,291,377 (Jan. 1, 2005) and
          
$1,262,781 (Oct. 2, 2004)
  
$
742,698
  
$
706,232
  
Cash value of life insurance policies
    
1,646,518
   
1,578,469
 
Other
    
183,099
   
78,118
 
   
$
2,572,315
  
$
2,362,819
  
 
5. PRODUCT WARRANTIES
 
The Company offers warranties of various lengths to its customers depending on the specific product sold. The Company's warranties require it to repair or replace defective products during the warranty period at no cost to the customer. At the time revenue is recognized for covered products, the Company records a liability for estimated costs that may be incurred under its warranties. The costs are estimated based on historical experience and any specific warranty problems that have been identified. (Although historical warranty costs have been within expectations, there can be no assurance that future warranty costs will not exceed historical amounts.) The Company periodically assesses the adequacy of its recorded liability and adjusts the balance as necessary.
 
Changes in the Company's product warranty liability for the three months ended January 1, 2005 and January 3, 2004 are as follows:
 
     
Jan. 1, 2005
    
Jan. 3, 2004
 
Accrued liability at beginning of year
  
$
212,564
  
$
141,723
  
Increases in reserve
    
11,700
   
-
 
Expenses
    
(7,544
)
  
(2,035
)
Accrued liability at end of year
  
$
216,720
  
$
139,688
  
 

 
  7  
 

6. EARNINGS PER COMMON SHARE
 
The following table sets forth the computation of basic and diluted earnings per share in accordance with SFAS No. 128, "Earnings Per Share."
 
   
Jan. 1, 2005
  
Jan. 3, 2004
  
Numerator for basic and diluted earnings per share:
          
Net income
  
$
498,519
  
$
421,551
  
               
Denominator:
              
Denominator for basic earnings per share:
              
Weighted average shares
    
2,592,591
   
2,561,556
 
Effect of dilutive securities:
              
Employee stock options
    
142,401
   
143,228
 
Denominator for diluted earnings per share:
              
Adjusted weighted average shares
              
and assumed conversions
    
2,734,992
   
2,704,784
 
               
Net income per share:
              
Basic
  
$
0.19
  
$
0.16
  
Diluted
  
$
0.18
  
$
0.16
  
 
7. OPERATIONS AND INDUSTRY SEGMENTS
 
The company reports on three segments of business: medical, custom products, and safety catheters. This industry segment information corresponds to the markets in the United States for which the Company manufactures and distributes its polyurethane foam and safety catheter products and therefore complies with the requirements of SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information."
 
The following table summarizes certain information on industry segments:
 
   
Jan. 1, 2005
  
Jan. 3, 2004
  
Net Sales:
          
Medical
  
$
6,509,759
  
$
5,394,037
  
Custom products
    
4,267,641
   
6,114,476
 
Safety catheters
    
-
   
-
 
Total
    
10,777,400
   
11,508,513
 
               
Operating profit (loss):
              
Medical
  
$
1,030,206
  
$
594,229
  
Custom products
    
76,839
    
222,816
 
Safety catheters
    
(374,266
)
  
(160,235
)
Total
    
732,779
    
656,810
 
               
Corporate expense
    
(120,537
)
  
(166,456
)
Other income
    
155,277
   
159,197
 
Income before income taxes
  
$
767,519
  
$
649,551
  
 
Total sales by industry segment include sales from unaffiliated customers, as reported in the Company's statements of income. In calculating operating profit, non-allocable general corporate expenses, interest expense, other income, and income taxes are not included, but certain corporate operating expenses incurred for the benefit of all segments are included on an allocated basis.

 
  8  
 

 
8. COMMITMENTS AND CONTINGENCIES
 
In December 2004, the Company signed a letter of intent with a construction company to expand the Greenville, SC plant by approximately 60,000 square feet for approximately $2.6 million. The project is expected to be financed either from the Company’s existing cash and investments or conventional bank debt.
 
The Company has negotiated new supply terms with its contract manufacturer for its Secure I.V. product line, including the payment of approximately $35,000 per month in labor charges until approximately May 2005 while design changes are being completed.
 
From time to time the company is a defendant in legal actions involving claims arising in the normal course of business. The company believes that, as a result of legal defenses and insurance arrangements, none of these actions should have a material adverse effect on its operations or financial condition
 

 
  9  
 




ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF
INTERIM FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The statements contained in "Results of Operations" and “Liquidity and Capital Resources” which are not historical facts are forward-looking statements that involve risks and uncertainties. Management wishes to caution the reader that these forward-looking statements such as the Company's expectations for future sales increases or expense changes compared with previous periods are only predictions. Actual events or results may differ materially as a result of risks and uncertainties facing the Company. Such risks include but are not limited to: (a) the loss of a key distributor of the Company's medical or custom products, (b) the inability to achieve anticipated sales volume of medical or custom products, (c) raw material cost increases, (d) the degree of success achieved in manufacturing and selling the Secure I.V. safety catheter product line, (e) potential problems arising from having a sole source contract manufacturer for the Secure I.V. product line, (f) the potential for lost sales due to competition from low-cost foreign imports, (g) changes in relationships with large customers, (h) the impact of competitive products and pricing, (i) government reimbursement changes in the medical market, (j) FDA regulation of medical device manufacturing, and other risks referenced in the Company's Securities and Exchange Commission Filings. The Company disclaims any obligation to update any forward-looking statement whether as a result of new information, future events or otherwise.

RESULTS OF OPERATIONS

Net sales for the first quarter of fiscal 2005 declined by 6% to $10.8 million compared with $11.5 million in the first quarter of fiscal 2004. The sales decline was mainly the result of lower volume in the custom products segment due to a decrease in sales of mattress pads and pillows for the consumer market. Net income for the first quarter rose 18% to $499,000, or $0.18 per diluted share, compared with net income of $422,000, or $0.16 per diluted share, in the first quarter of fiscal 2004. The increase in earnings was the result of a more profitable product mix as sales in the medical segment increased during the quarter while sales in the lower-margin custom products segment declined.

The Company's sales in the medical segment grew 21% to $6.5 million in the first quarter of fiscal 2005 compared with $5.4 million in the same quarter last year. Medical sales represented 60% of this year’s total first quarter sales compared with 47% in the first quarter of fiscal 2004. Most of the sales growth in the medical segment came from the PressureGuard line of therapeutic mattresses, which are sold to hospitals, long-term care facilities and home care dealers throughout the United States and Canada. Sales of medical mattresses in the first quarter of fiscal 2005 were up 46% compared with the first quarter of last year mostly due to a large shipment of powered mattresses to a key customer in the long-term-care market and an increase in sales of private label mattress products in the acute care market. In other medical product lines, sales of seating products grew by 17%, Selan® skin care products increased 10%, patient positioners were up 1% and mattress overlays declined by 17%. The decline in mattress overlays continues a long-term trend of overlays loosing market share to replacement mattresses. We expect total medical sales for fiscal 2005 to be higher than those of fiscal 2004, but the rate of increase for the remainder of the fiscal year will likely be lower than the 21% rate achieved in the first quarter.

 
  10  
 


In the custom products segment, sales declined by 30% to $4.3 million compared with $6.1 million in the same period last year. Most of this decline resulted from lower volumes of consumer bedding products, which fell by 32% compared to the first quarter of fiscal 2004. The decline was caused by several factors. First, the year-earlier quarter included sales from a promotion with a large retailer that was not repeated in the first quarter this fiscal year. Second, one of our customers switched from a branded sales program to a private label program offered by a competing supplier. Finally, we lost a portion of our pillow business to a competing product manufactured in China. We expect sales of consumer bedding products to increase over first quarter levels during the remainder of fiscal 2005. However, we expect consumer bedding sales for the full fiscal year 2005 to be lower than last year’s levels.

Sales of industrial products, which are also part of our custom products segment, declined by 20% during the first quarter mostly as a result of lower volume to existing customers. The fourth calendar (our first fiscal quarter) quarter tends to be a seasonally weaker quarter for industrial sales. We expect sales of industrial products to increase during the remainder of fiscal 2005, but they will likely be slightly lower than last year’s level.

In the safety catheter segment, we had no net sales of our newly developed Secure I.V. safety catheter. We began shipping market test samples of the product in the latter part of fiscal 2004. However, in late December 2004 we decided to delay the full release of Secure I.V. as a result of initial customer feedback that revealed the potential benefits of making three design improvements to the product. Consequently, we have postponed further shipments of Secure I.V. for approximately five months while we make and test the design changes. We expect the design enhancements will improve the performance and marketability of Secure I.V. We believe that making the changes at this early stage in the product’s life cycle will give Secure I.V. the best chance for future growth and success.

As a result of the production delay and design changes, our first quarter costs in the safety catheter segment were higher than in previous quarters. Total expenses related to Secure I.V. in the first quarter were $374,000 ($0.09 per diluted share after taxes) compared with $160,000 ($0.04 per diluted share after taxes) in the first quarter last year. Of the $374,000 in this year’s first quarter expenses, approximately $180,000 was directly related to the design changes as we set up reserves for potential customer returns and obsolete inventory. We believe that total quarterly expenses in the safety catheter segment for the remainder of fiscal 2005 will be lower than first quarter levels because of the one-time charges included in the first quarter. However, as we re-start production of Secure I.V., we expect our manufacturing costs to be higher than fiscal 2004 levels because of a price increase from our contract manufacturer. We expect to offset a portion of the cost increase through higher unit sales prices. As a result of the design changes and the production cost increase, our operating loss in the safety catheter segment for the full fiscal year of fiscal 2005 is expected to be higher than the $684,000 pre-tax loss incurred in fiscal 2004.

 
  11  
 


The gross profit margin percentage for the total Company rose to 30.2% compared with 25.2% in the first quarter last year. Our gross profit level increased 12% to $3.3 million in the first quarter of fiscal 2005 compared with $2.9 million in the first quarter last year. The improvements in gross profit were due to higher sales volume of medical products offset in part by lower sales of custom products and higher expenses in the safety catheter segment. Medical sales typically have a higher margin than custom product sales because many of the Company’s medical products are patented and proprietary. Management expects the Company's gross margin percentage for the full year of fiscal 2005 to be higher than that of fiscal 2004.

Sales and marketing expenses were up 11% in the first quarter of fiscal 2005 to $1.8 million compared with $1.6 million in the prior year. The increase was due mainly to higher commissions and samples expense in the medical segment as result of higher sales volume. Total sales and marketing expenses for fiscal 2005 are expected to be higher than those of fiscal 2004.

Research and development expenses were up $70,000 (41%) to $241,000 compared with $171,000 in the first quarter of fiscal 2004. Of the $70,000 increase, $21,000 occurred in the medical segment and was related to ongoing new product development efforts. The remaining $49,000 portion of the increase occurred in the safety catheter segment and was related to the design changes in Secure I.V. as discussed above. Approximately 60% of the total R&D expense for the first quarter was related to the safety catheter segment. We expect that total research and development expenses for fiscal 2005 will be higher than those of fiscal 2004.

General and administrative expenses decreased by $6,000 to $625,000 in the first quarter of fiscal 2005 compared with the first quarter of last year. The decrease was due mostly to lower professional fees which were partially offset by an increase in insurance costs and a decrease in the income from officer life insurance policies. The year-earlier quarter (first quarter of fiscal 2004) included approximately $91,000 in expenses related to the lawsuit and potential tender offer activity by shareholder Jerry Zucker. General and administrative expenses for fiscal 2005 are expected to be similar to those of 2004.

Operating profit increased by 25% to $612,000 in the first quarter from $490,000 in the same quarter last year. The increase was due primarily to higher medical sales volume during the quarter.

Non-operating income declined by $4,000 to $155,000 in the first quarter of fiscal 2005 from $159,000 in the same quarter last year because of lower royalty income. Royalty income from a syringe product licensed to Becton, Dickinson and Company declined 7% to $132,000 compared with the first quarter of fiscal 2004. The royalty income will end in December 2005 due to the expiration of the related patents. No further royalty income will be received after that date. Royalty income during the first quarter of fiscal 2005 represented 17% of the Company’s total pre-tax income compared with 22% in the same quarter last year. Management expects total non-operating income for fiscal 2005 to be lower than 2004 levels.

Net income for the first quarter of 2004 increased 18% to $499,000 or $0.18 per diluted share compared with $422,000 or $0.16 per diluted share in the same quarter of last year.

 
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During the first quarter of fiscal 2005, the Company paid dividends of $104,000, or 21% of net income. This payment represented one quarterly dividend of $0.04 per share. In December 2004, the Company declared a special cash dividend of $0.40 per share payable on January 12, 2005 to shareholders of record on December 22, 2004.

LIQUIDITY AND CAPITAL RESOURCES

The Company generated cash from operations of approximately $801,000 during the first quarter of fiscal 2005 compared with $1,145,000 in the first quarter of fiscal 2004. The decrease in cash flow during the period was due mostly to an increase in raw material inventory levels for the Secure I.V. product line and a decrease in total accounts payable due to lower sales levels in the custom products segment. The Company’s working capital decreased by $837,000 (7%) to $10.8 million during the three months ended January 1, 2005 from $11.6 million at October 2, 2004. The decrease was mainly the result of the declaration of a special, one-time dividend of approximately $1.0 million as noted above, which was payable on January 12, 2005. The decrease in working capital was also impacted by a reduction in accounts receivables as a result of lower sales in the quarter. The current ratio declined during the quarter to 2.9 from 3.4 at October 2, 2004.

Accounts receivable, net of allowances, declined by $526,000 (8%) to $5.9 million at the end of the first quarter of fiscal 2005 compared with $6.4 million at the end of fiscal 2004. The decline in accounts receivable during the first quarter of fiscal 2005 was due to the decline in custom products sales. The average days sales outstanding in accounts receivable was 48.5 days in the first quarter of fiscal 2005 compared with 43.1 days for fiscal 2004. The increase in days sales outstanding is the result of the increase in the percentage of medical sales compared with custom products sales during the quarter. All of the Company's accounts receivable are unsecured.

Inventories increased by $387,000 (14%) to $3.1 million at the end of the first quarter of fiscal 2005 compared with fiscal year end 2004. The increase was primarily the result of a change in supply terms with the contract manufacturer of the Secure I.V. product line resulting in the purchase of approximately $400,000 of raw materials and finished goods inventory for that product line. We expect inventory levels during fiscal 2005 to be slightly higher than those of fiscal 2004.

Net property and equipment decreased by $10,000 to $6.2 million at the end of the first quarter of fiscal 2005. Management expects that capital expenditures during fiscal 2005 will be higher than those of fiscal 2004 due to the expansion of the Company’s manufacturing plant in Greenville S.C. In December 2004, the Company signed a letter of intent with a construction company to expand the Greenville plant by approximately 60,000 square feet at an estimated cost of $2.6 million. The project is expected to be financed either from the Company’s existing cash and investments or conventional bank debt.

From time to time, the Company purchases forward contracts for foreign currency to lock in exchange rates for future payments on manufacturing equipment ordered by the Company. The foreign exchange contracts are used to eliminate foreign currency fluctuations during the 6-9 month period between the time the order is placed and the final payment date upon delivery of the equipment. Realized gains and losses, if any, are included in the cost of the related equipment. Unrealized gains and losses on open contracts are not material to the Company’s results of operations or financial condition. The Company held no forward contracts on foreign currency as of January 1, 2005.

 
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Other assets increased by $209,000 (9%) to $2.6 million during the first quarter of fiscal 2005 compared with $2.4 million at fiscal year end 2004. The increase was due to outlays for patents, licensing rights, deposits for raw material purchases and an increase in the cash surrender value of life insurance policies.

The Company's trade accounts payable decreased by $290,000 or 11% compared with fiscal year end 2004. The decrease in accounts payable level was mainly due to fewer purchases related to the sales decline in the custom products segment. Accrued and sundry liabilities increased by $64,000 or 3% compared with fiscal year end 2004 due to accruals for incentive compensation, commissions and property taxes.

Management believes that funds on hand and funds generated from operations are adequate to finance operations and expected capital requirements during fiscal 2005. As noted previously, the Company paid a special cash dividend of $0.40 per share payable on January 12, 2005 totaling $1,037,507. Also in December 2004, the Company signed a letter of intent with a construction company to expand the Greenville, SC plant by approximately 60,000 square feet at an estimated cost of $2.6 million. The project is expected to be financed either from the Company’s existing cash and investments or conventional bank debt. At the end of the first fiscal quarter, the Company renegotiated certain terms of the supply agreement with the contract manufacturer for its Secure I.V. product line. The new terms require the Company to pay approximately $35,000 per month in labor charges from January 2005 through approximately May 2005 while design changes are being completed on the Secure I.V. product line.

OFF-BALANCE SHEET ARRANGEMENTS

The Company does not have any off-balance sheet arrangements.

IMPACT OF INFLATION

Inflation was not a material factor for the Company during the first quarter of fiscal 2005. However, we received a price increase on certain of our polyurethane foam raw materials on October 1, 2004 and another increase on February 1, 2005. We will attempt to recover the cost of these increases by raising sales prices, improving manufacturing efficiencies and other cost reduction efforts. However, because of market competition and annual pricing contracts, it is unlikely that we will be able to fully offset the higher costs through sales price increases alone. Consequently, the Company’s profit margin could be adversely affected to the extent that we are unable to pass these increased costs along to our customers or to otherwise offset cost increases.

 
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ITEM 3. MARKET RISK

The Company is exposed to market risk in two areas: short term investments and cash value of life insurance. As of January 1, 2005, the Company held $4.4 million in securities available for sale. These securities consisted primarily of bonds called “variable rate demand notes” or “low floaters,” which are issued by corporations or municipalities and are backed by bank letters of credit. The interest rates on the bonds are floating rates, which are reset weekly based on market rates for comparable securities. The bonds have varying maturities but can be liquidated by the Company at anytime with seven day’s notice. Using the level of securities available for sale at quarter end, a 100 basis point increase or decrease in interest rates for a full year would increase or decrease after tax earnings by approximately $44,000.

In addition, the Company’s other assets at January 1, 2005 included $1.6 million in cash value of life insurance, which is subject to market risk related to equity pricing and interest rate changes. The cash value is invested either in a fixed income life insurance contract or in portfolios of The Prudential Series Fund, Inc. (the “Fund”). The fixed account options are similar to fixed income bond funds and are therefore subject to interest rate and company risk. The Fund portfolios invest in common stocks and bonds in accordance with their individual investment objectives. These portfolios are exposed to stock market and interest rate risk similar to comparable mutual funds. Management believes that substantial fluctuations in equity markets and interest rates and the resulting changes in cash value of life insurance would not have a material adverse effect on the financial position of the Company. During the quarter ended January 1, 2005, the Company’s cash value of life insurance increased by 4%, creating income of approximately $65,000.


ITEM 4. CONTROLS AND PROCEDURES

Under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures within 90 days of the filing date of this quarterly report, and, based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that these controls and procedures are effective. There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
 
Disclosure controls and procedures are the Company’s controls and other procedures that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

 
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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The Company is from time to time party to various legal actions arising in the normal course of business. However, management believes that as a result of legal defenses and insurance arrangements with parties believed to be financially capable, there are no proceedings threatened or pending against the Company that, if determined adversely, would have a material adverse effect on the business or financial position of the Company.

Item 2. Changes in Securities -        

None

Item 3. Defaults Upon Senior Securities -

None

Item 4. Submission of Matters to a Vote of Security Holders -

The Company held its Annual Meeting of Shareholders on February 10, 2005. At this meeting, Richard C. Coggins, Thomas F. Grady, Jr. and Peter S. Nyberg were elected to three-year terms as directors. In addition, the 2005 Non-Employee Director Stock Plan was approved. The voting details are as follows:
 
     
For
    
Against
    
Abstain
    
Not Voted
  
Richard C. Coggins
    
2,494,057
    
15,438
    
0
    
84,273
  
Thomas F. Grady, Jr.
    
2,245,256
    
264,239
    
0
    
84,273
  
Peter S. Nyberg
    
2,245,006
    
264,489
    
0
    
84,273
  
2005 Non-Employee Director Stock Plan
    
1,602,089
    
44,564
    
4,065
    
943,050
  

Item 5. Other Information

At the Company’s 2005 annual meeting of shareholders held on February 10, 2005, the Company’s shareholders voted to adopt the Company’s 2005 Non-Employee Director Stock Plan authorizing the issuance of up to 60,000 shares of the Company’s common stock to the Company’s non-employee directors over a five year period. The description of the 2005 Non-Employee Director Stock Plan set forth on pages 21 to 23 of the Company’s proxy statement for the 2005 annual meeting of shareholders is incorporated herein by reference.

 
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Item 6.  Exhibits

10.18
  
2005 Non-Employee Director Stock Plan: incorporated by reference to Appendix B to the Company’s Proxy Statement dated January 7, 2005 (Commission File No. 000-11392).
     
31.1
  
Chief Executive Officer certification pursuant to Section 302 of the Sarbanes-Oxley Act.
31.2
  
Chief Financial Officer certification pursuant to Section 302 of the Sarbanes-Oxley Act.
     
32.1
  
Chief Executive Officer certification pursuant to Section 906 of the Sarbanes-Oxley Act.
32.1
  
Chief Financial Officer certification pursuant to Section 906 of the Sarbanes-Oxley Act.



 
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SIGNATURES


Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


     
  SPAN-AMERICA MEDICAL SYSTEMS, INC.
 
 		  
 		  
 
By:   /s/ Richard C. Coggins
 
Richard C. Coggins
  Chief Financial Officer

     
 
By:   /s/  James D. Ferguson
 
James D. Ferguson
  President and Chief Executive Officer
   
Date: February 14, 2005  

 
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