SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

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

For the quarterly period ended September 30, 2006

OR

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

For the transition period from                        to                       

Commission File Number: 0-15223

HEMACARE CORPORATION

(Exact name of registrant as specified in its charter)

 

(818) 226-1968

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer o

Accelerated Filer o

Non-Accelerated Filer x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

As of November 2, 2006, 8,495,955 shares of Common Stock of the registrant were issued and outstanding.

HEMACARE CORPORATION AND SUBSIDIARIES

INDEX TO FORM 10-Q

FOR THE THREE AND NINE MONTHS ENDED
SEPTEMBER 30, 2006

			Page
			Number
PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets as of September 30, 2006 (unaudited) and December 31, 2005			1
	Consolidated Statements of Income for the three and nine months ended September 30, 2006 and 2005 (unaudited)			2
	Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005 (unaudited)			3
	Notes to Unaudited Consolidated Financial Statements			4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations			12
Item 3.	Quantitative and Qualitative Disclosures About Market Risk			26
Item 4.	Controls and Procedures			26
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings			27
Item 1A.	Risk Factors			27
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds			28
Item 3.	Defaults Upon Senior Securities			28
Item 4.	Submission of Matters to a Vote of Security Holders			28
Item 5.	Other Information			28
Item 6.	Exhibits			29
SIGNATURES				30

 

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PART 1   FINANCIAL INFORMATION

Item 1.                          Financial Statements

HEMACARE CORPORATION
CONSOLIDATED BALANCE SHEETS

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

1

HEMACARE CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

2

HEMACARE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

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HemaCare Corporation
Notes to Unaudited Consolidated Financial Statements

Note 1—Basis of Presentation and General Information

BASIS OF PRESENTATION

In the opinion of management, the accompanying unaudited consolidated financial statements for the three and nine months ended September 30, 2006 and 2005 include all adjustments (consisting of normal recurring accruals) which management considers necessary to present fairly the financial position of the Company as of September 30, 2006, the results of its operations for the three and nine months ended September 30, 2006 and 2005, and its cash flows for the nine months ended September 30, 2006 and 2005 in conformity with accounting principles generally accepted in the United States. These financial statements have been prepared consistently with the accounting policies described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, as filed with the Securities and Exchange Commission on March 21, 2006 which should be read in conjunction with this Quarterly Report on Form 10-Q. The results of operations for the three and nine months ended September 30, 2006 are not necessarily indicative of the consolidated results of operations to be expected for the full fiscal year ending December 31, 2006. Certain information and footnote disclosures normally included in the financial statements presented in accordance with accounting principles generally accepted in the United States have been condensed or omitted.

USE OF ESTIMATES

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Estimates also affect the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-based Payment: An amendment of FASB Statements No. 123 and 95 (“SFAS 123R”), in the first quarter of fiscal year 2006, the Company started to recognize compensation expense related to stock options granted to employees based on: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of December 31, 2005, based on the grant date fair value estimated in accordance with SFAS No 123, Accounting for Stock-Based Compensation (“SFAS 123”), and (b) compensation cost for all share-based payments granted subsequent to December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R.

The Company’s assessment of the estimated fair value of the stock options granted is affected by the price of the Company’s stock, as well as assumptions regarding a number of complex and subjective variables and the related tax impact. Management utilized the Black-Scholes model to estimate the fair value of stock options granted. Generally, the calculation of the fair value for options granted under SFAS 123R is similar to the calculation of fair value under SFAS 123, with the exception of the treatment of forfeitures.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. This model also requires the input of highly subjective assumptions including:

(a)          The expected volatility of the common stock price, which was determined based on historical volatility of the Company’s common stock;

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(b)         Expected dividends, which are not anticipated; and

(c)          Expected life of the stock option, which is estimated based on the historical stock option exercise behavior of employees.

In the future, management may elect to use different assumptions under the Black-Scholes valuation model or a different valuation model, which could result in a significantly different impact on net income or loss.

CONCENTRATION OF CREDIT RISK

The Company maintains cash balances at various financial institutions. Deposits not exceeding $100,000 for each institution are insured by the Federal Deposit Insurance Corporation. At September 30, 2006 and December 31, 2005, the Company had uninsured cash and cash equivalents of $784,000 and $2,401,000, respectively.

APPLICATION OF NEW ACCOUNTING STANDARDS

In July 2006, the FASB issued FASB Interpretation Number 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109 (“FIN48”). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken in a tax return. The Company must determine whether it is “more-likely-than-not” that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. Once it is determined that a position meets the more-likely-than-not recognition threshold, the position is measured to determine the amount of benefit to recognize in the financial statements. FIN 48 applies to all tax positions related to income taxes subject to FASB Statement No. 109, Accounting for Income Taxes. The interpretation clearly scopes out income tax positions related to FASB Statement No. 5, Accounting for Contingencies. The Company will adopt the provisions of this statement beginning in the first quarter of 2007. The cumulative effect of applying the provisions of FIN 48 will be reported as an adjustment to the opening balance of retained earnings on January 1, 2007. The Company does not anticipate that the adoption of this statement will have a material effect on our financial position or results of operations.

In September 2006, the FASB issued two new pronouncements, SFAS No. 157, Fair Value Measurements, and SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—An Amendment of FASB Statements No. 87, 88, 106, and 132(R). The Company does not believe that SFAS No. 157 will have a material impact on its financial statements. SFAS 158 does not apply as the Company does not have a defined benefit pension or another post retirement plan.

Note 2—Acquisition of Teragenix Corporation

On August 29, 2006, the Company acquired all of the outstanding stock of Teragenix Corporation, subsequently renamed HemaCare BioScience, Inc. (“HemaBio”) for $4.8 million comprised of (i) $1,372,000 in cash, (ii) up to an additional $250,000 in cash, subject to the Company’s right to set-off, (iii) 285,895 shares of the Company’s common stock, (iv) secured, subordinated promissory notes issued by the Company in the aggregate principal amount of $200,000, (v) up to 248,000 additional shares of the Company’s common stock based on the “EBIT” (as defined) of HemaBio for the twelve month period ended March 31, 2007, and (vi) up to an additional $1,300,000 in cash based on the EBIT of HemaBio for the three fiscal years ended December 31, 2008, all as more fully described in the Company’s Current Report on Form 8-K filed with the SEC on September 5, 2006. The Company allocated the purchase price per SFAS 141 to the fair value of the assets acquired, net of liabilities assumed. The remaining portion of the purchase price, or $3,078,000, was allocated to goodwill representing the amount of the purchase price

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in excess of the fair value of the assets, net of liabilities acquired, subject to possible adjustment during the allocation period which will not to exceed one year.

The following table summarizes the components of the consideration paid to acquire HemaBio:

 

The following table summarizes the allocation of the consideration to the assets acquired, net of liabilities assumed:

 

HemaCare’s primary reason for acquiring Teragenix is its focus on providing blood products and support services to research-focused customers. HemaCare identified research support as a strategic growth opportunity, and believes the combination of the two companies will provide HemaCare with a market advantage by providing research customers with a wide range of biological samples and clinical research support services.

As of September 30, 2006, the balance sheet of HemaBio is consolidated with the Company’s balance sheet. The statement of income of HemaBio for the 32 day period from August 30, 2006 to September 30, 2006 is consolidated with the Company’s statement of income for the three and nine month periods ended September 30, 2006. The statement of cash flows for HemaBio for the period August 30, 2006 to September 30, 2006 is included with the Company’s statement of cash flows for the nine months ended September 30, 2006.

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If the operating results of HemaBio had been included since the beginning of the three month and nine month periods ended September 30, 2005 and 2006, the pro forma revenues, net income and net income per share would be as follows:

 

Note 3—Line of Credit and Notes Payable

On September 26, 2006, the Company, together with the Company’s subsidiaries Coral Blood Services, Inc. and HemaCare BioScience, Inc., entered into an Amended and Restated Loan and Security Agreement (“Agreement”) with Comerica Bank (“Comerica”) to provide a working capital line of credit. The Agreement restated the terms of the prior credit agreement with Comerica, except i) the limits on the amount the Company may borrow were changed to the lesser of 75% of eligible accounts receivable or $3 million, ii) HemaBio was added as an additional borrower, iii) Comerica was given a security interest in all of the assets of HemaBio, and iv) the term of the Agreement was extended one year to June 30, 2008. The Agreement provides that interest is payable monthly at a rate of prime minus 0.25%. As of September 30, 2006, the rate associated with this credit facility was 8.00%. In addition, the Company has the option to draw against this facility for thirty (30), sixty (60) or ninety (90) days using LIBOR as the relevant rate of interest. As of September 30, 2006, the Company had borrowed $1,275,000 on this line of credit, and the Company had unused availability of $1,725,000.

The Comerica credit facility is collateralized by substantially all of the Company’s assets and requires the maintenance of certain financial covenants that among other things require minimum levels of profitability and prohibit the payment of dividends. As of September 30, 2006, the Company was in full compliance with all of the financial covenants. During the first nine months of 2006, the Company incurred $8,000 in interest expense associated with the Comerica credit facility.

The Company also has a capital equipment lease with GE Capital used to finance the acquisition of vehicles. As of September 30, 2006, the balance outstanding on this lease was $27,000, all of which is included in current obligations. This lease is scheduled to terminate in January 2007, and has a fixed interest rate of 8.0%.

Note 4—Shareholders’ Equity

Through the end of fiscal 2005, the Company measured compensation expense for stock-based incentive programs utilizing the intrinsic value method prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under this method, the Company did not record compensation expense when stock options were granted to eligible participants as long as the exercise price was not less than the fair market value of the stock when the option was granted. In accordance with SFAS 123R, the Company disclosed the pro forma net income per share as if the fair value-based method had been applied in measuring compensation expense for share-based incentive awards. No share-based compensation cost was recognized in the Condensed Consolidated Statement of Income for the three month or nine month period ended September 30, 2005 for options granted under

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the Company’s 1996 Stock Incentive Plan, as all unvested options granted had an exercise price equal to the market value of the underlying common stock on the date of grant.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS 123R. This statement requires that the cost resulting from all share-based payment transactions be recognized in the Company’s consolidated financial statements. In addition, in March 2005 the Securities and Exchange Commission (“SEC”) released SEC Staff Accounting Bulletin No. 107, “Share-Based Payment” (“SAB 107”). SAB 107 provides the SEC’s staff’s position regarding the application of SFAS 123R and certain SEC rules and regulations, and also provides the staff’s views regarding the valuation of share-based payment arrangements for public companies. Generally, the approach in SFAS 123R is similar to the approach described in SFAS 123. However, SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values. Pro forma disclosure of fair value recognition, as prescribed under SFAS 123, is no longer an alternative.

In 2006, the Company adopted the fair value recognition provisions of SFAS 123R utilizing the modified prospective transition method, as prescribed by SFAS 123R. Under that transition method, compensation cost recognized during the three months and nine months ended September 30, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of June 30, 2006, and December 31, 2005 respectively based on the grant date fair value estimated in accordance with SFAS 123, and (b) compensation cost for all share-based payments granted subsequent to June 30, 2006, and December 31, 2005 respectively, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Under the modified prospective transition method, results for the prior periods have not been restated.

For the three months and nine months ended September 30, 2006, the Company recognized non-cash share-based compensation costs of $43,000 and $404,000, respectively, as a result of the adoption of SFAS 123R, lowering income before taxes and net income by these amounts.

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123R to options granted under the Company’s stock option plans in all periods presented. The Company did not recognize any compensation expense related to the issuance of stock options in 2005. The effect of applying SFAS 123R resulted in lowering income from continuing operations, income before taxes, net income and basic and diluted earnings per share are as follows:

 

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The following summarizes the activity of the Company’s stock options for the nine months ended September 30, 2006:

 

The following summarizes the activity of the Company’s stock options that have not vested for the nine months ended September 30, 2006.

 

As of September 30, 2006, there was $475,000 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under existing stock option plans. This cost is expected to be recognized over a weighted-average period of 3.15 years. The total measurement fair value of shares vested during the nine months ended September 30, 2006 was $462,000.

The Black-Scholes option pricing model is used by the Company to determine the weighted average fair value of options. The fair value of options at date of grant and the assumptions utilized to determine such values are indicated in the following table:

 

On July 19, 2006 the Company’s 1996 Stock Option Plan expired. At the Company’s annual meeting of shareholders held on May 24, 2006, the shareholders approved the 2006 Equity Incentive Plan (“the Plan”). The Plan is to encourage ownership in the Company by key personnel whose long-term service is considered essential to the Company’s continued progress, thereby linking these employees directly to stockholder interests through increased stock ownership. A total of 1,200,000 shares of the Company’s common stock will be reserved for issuance under the Plan. Awards may be granted to any employee,

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director or consultant, or those of the Company’s affiliates. As of November 1, 2006, no awards had been granted under the Plan.

Note 5—Earnings per Share

The following table provides the calculation methodology for the numerator and denominator for diluted earnings per share:

 

Warrants issued in the third quarter of 2002 to the Company’s prior President and CEO for 270,000 shares of the Company’s common stock expired on September 26, 2006 unexercised. Therefore, the shares associated with these warrants were excluded from the calculation of diluted shares outstanding for any reported period ended September 30, 2006.

Options for 490,000 shares of common stock for both the three and nine months ended September 30, 2006 have been excluded from the above calculation because their effect would have been anti-dilutive.

Options and warrants outstanding of 150,000 shares and 175,000 shares of common stock for the three and nine months ended September 30, 2005, respectively, have been excluded from the above calculation because their effect would have been anti-dilutive.

Note 6—Provision for Income Taxes

The Company has substantial net operating losses from prior periods that will be available in 2006 to eliminate most of any potential federal tax liability. The Company has recognized income in each of the last twelve quarters, and as a result, and to the degree that the Company incurs any tax liability, the Company will reduce the valuation reserve against its deferred tax assets to reflect some potential future benefit from the future utilization of the Company’s net operating losses. The Company will continue to evaluate the deferred tax asset valuation reserve each quarter based on the reportable income for each quarter. At this time, the Company will not reduce the 100% deferred tax valuation reserve, but may choose to reduce this reserve in future periods.

As a result of federal alternative minimum taxes and other state taxes, the Company estimates that $7,000 in taxes has been incurred as a result of reportable income during the third quarter of 2006. As described in Note 3, in 2006, the Company adopted the fair value recognition provisions of SFAS 123R pertaining to share-based compensation transactions. This adoption creates temporary differences between GAAP based net income and tax based net income because the compensation deduction permitted under SFAS 123R is not deductible for taxes. When option holders exercise their rights to purchase the Company’s shares, the Company is entitled to take a tax deduction, eliminating the temporary difference created when the option rights vested.

The Company recognized $43,000 in compensation expense related to SFAS 123R in the third quarter of 2006. As a result of the temporary difference created, the Company’s deferred tax asset balance increased $8,000. Since the Company maintains a 100% valuation reserve for its deferred tax reserve, none of the increase in deferred taxes is reflected in the income statement.

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Note 7—Business Segments

HemaCare operates two business segments as follows:

·       Blood Products—Collection, processing and distribution of blood products and donor testing.

·       Blood Services—Therapeutic apheresis, stem cell collection procedures and other therapeutic services to patients.

Management considers the operations of HemaBio to be similar to the Company’s existing blood products business segment. HemaBio sources, processes and distributes human biological samples, manufactures quality control products and provides clinical trial services. Management does not consider this operation to be sufficiently material or significant to require separate reporting of HemaBio as a new business segment. Therefore, the financial information for HemaBio is reported as part of the Company’s blood products business segment.

Management uses more than one measure to evaluate segment performance. However, the dominant measurements are consistent with HemaCare’s consolidated financial statements, which present revenue from external customers and operating income for each segment.

There were no intersegment revenues for either the three month or nine month period ended September 30, 2006 or ended September 30, 2005.

Note 8—Commitments and Contingencies

State and federal laws set forth anti-kickback and self-referral prohibitions and otherwise regulate financial relationships between blood banks and hospitals, physicians and other persons who refer business to them. While the Company believes its present operations comply with applicable regulations, there can be no assurance that future legislation or rule making, or the interpretation of existing laws and regulations will not prohibit or adversely impact the delivery by HemaCare of its services and products.

Healthcare reform is continuously under consideration by lawmakers, and it is not certain as to what changes may be made in the future regarding health care policies. However, policies regarding reimbursement, universal health insurance and managed competition may materially impact the Company’s operations.

The Company is party to various claims, actions and proceedings incidental to its normal business operations. The Company believes the outcome of such claims, actions and proceedings, individually and in the aggregate, will not have a material adverse effect on the business and financial condition of the Company.

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Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the Company’s financial statements and the related notes provided under “Item 1-Financial Statements” above.

The matters discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Quarterly Report on Form 10-Q that are not historical are forward-looking statements. These statements may also be identified by the use of words such as “anticipate,” “believe,” “continue,” “estimate,” “expect,” “intend,” “may,” “project,” “will” and similar expressions, as they relate to the Company, its management and its industry. Investors and prospective investors are cautioned that these forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual results could differ materially from those described in this report because of numerous factors, many of which are beyond the Company’s control. These factors include, without limitation, those described below under the heading “Risk Factors Affecting the Company.” The Company does not undertake to update its forward-looking statements to reflect later events and circumstances or actual outcomes.

General

HemaCare Corporation (“HemaCare” or the “Company”) collects, processes and distributes human blood products for transfusion and research primarily in the United States. The blood products distributed consist of those produced by the Company and purchased from other suppliers. Additionally, the Company provides blood related services, principally therapeutic apheresis procedures and stem cell collection to patients with a variety of disorders. Blood related services are provided on an in-patient and out-patient basis under contract, as an outside purchased service.

The Company has operated in Southern California since 1979. In 1998, the Company expanded operations, through the acquisition of a similar business, into portions of the eastern U.S. In late 2003, new management, following a comprehensive evaluation of the Company’s operations, implemented a restructuring plan reducing the number of geographic areas served and improving the revenue potential from the remaining geographic areas served by the Company.

On August 29, 2006, the Company acquired all of the outstanding stock of Teragenix Corporation, subsequently renamed HemaCare BioScience, Inc. (“HemaBio”) for (i) $1,372,000 in cash, (ii) up to an additional $250,000 in cash, subject to the Company’s right to set-off, (iii) 285,895 shares of the Company’s common stock, (iv) secured, subordinated promissory notes issued by the Company in the aggregate principal amount of $200,000, (v) up to 248,000 additional shares of the Company’s common stock based on the “EBIT” (as defined) of HemaBio for the fiscal year ended March 31, 2007, and (vi) up to an additional $1,300,000 in cash based on the EBIT of HemaBio for the three fiscal years ended December 31, 2008, all as more fully described in the Company’s Current Report on Form 8-K filed with the SEC on September 5, 2006. This wholly owned subsidiary sources, processes and distributes human biological samples, manufactures quality control products and provides clinical trial services from its facility in Fort Lauderdale, Florida.

Results of Operations

Three months ended September 30, 2006 compared to the three months ended September 30, 2005

Overview

The Company generated revenue for the third quarter of 2006 of $9,177,000, an increase of $1,409,000, or 18.1%, compared to the same period of 2005. Blood products revenue increased $1,185,000, or 19.7%, as a result of increased blood product sales in California, increases in selected product prices from the prior year, and the addition of 32 days of revenue from HemaBio subsequent to the acquisition of

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HemaBio on August 29, 2006. Blood services revenue increased $224,000, or 12.6%, mostly as a result of a 17.3% increase in the number of procedures performed.

Gross profit in the third quarter of 2006 increased $285,000, or 19.7%, compared to the third quarter of 2005. The increase is attributable to higher revenue and gross profit margins for both the blood products and blood services business segments.

General and administrative expenses increased $127,000, or 11%, in the third quarter of 2006 compared to the same quarter of 2005. The Company recognized $43,000 of non-cash share-based compensation expense in the third quarter of 2006, $39,000 of which is included in general and administrative expenses. The Company did not recognize this expense in the same quarter in 2005, per SFAS 123R.

The Company generated $448,000 of net income for the third quarter of 2006, representing an $153,000, or 52.2%, increase from the same period in 2005. The increase is primarily attributable to the increase in gross profit as described above, the addition of 32 days of operating results from HemaBio, and management’s efforts to control general and administrative expenses during a period of increasing revenue.

Blood Products

For the three months ended September 30, 2006, blood product revenues increased $1,185,000, or 19.7%, compared with the same quarter of 2005. This increase is attributable to an increase in sales volume of blood products in California, an increase in the prices charged for selected products over the prior year and the addition of 32 days of revenue from HemaBio subsequent to the acquisition on August 29, 2006.

For the three months ended September 30, 2006, gross profit for the blood products segment increased $60,000, or 5.8%, to $1,107,000 from $1,047,000 generated in third quarter of 2005. The increase is primarily attributable to the increase in the sales volume of blood products, primarily from the Company’s California operations and the addition of HemaBio. The gross profit percentage for blood products decreased to 15.4% in the third quarter of 2006, from 17.4% for the same quarter of 2005. This is primarily the result of lower margins from the Company’s Maine operations due to higher staff compensation costs in Maine is the primary cause for the decrease in margins.

Blood Services

Revenues from blood services increased $224,000, or 12.6%, to $1,991,000 in the third quarter of 2006 from $1,767,000 generated in the same period of 2005. The increase was mainly due to a 17.3% increase in the number of therapeutic apheresis procedures performed during the quarter compared to the same quarter in 2005, mostly from the Company’s Mid-Atlantic operations.

Gross profit for the blood services segment increased $225,000, or 56.3%, from $399,000 in the third quarter of 2005 to $624,000 during the same period of 2006, reflecting higher procedure volumes. For the quarter, this business segment produced a gross profit percentage of 31.3%, compared with 22.6% for the same quarter in 2005. This increase is primarily the result of operational efficiencies derived from the increase in the number of procedures performed which did not require a significant increase in support infrastructure for this business segment.

General and Administrative Expenses

General and administrative expenses increased $127,000, or 11%, to $1,276,000 in the third quarter of 2006 from $1,149,000 in the same period of 2005. This increase was the result of i) a $39,000 in non-cash shared-based compensation expense, ii) a $39,000 increase in bad debt expense, iii) a $32,000 increase in interest and banking expenses, iv) a $30,000 increase in compensation and benefits expense, and v) a $12,000 increase in insurance expense. These increases were partially offset by a $46,000 reduction in the

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cost of outside services and temporary personnel. The increase in share-based compensation reflects the adoption of SFAS 123R in 2006 associated with options issued under the Company’s 1996 Stock Incentive Plan. Bad debt expense increased in the quarter due to an increase in the age of selected customer accounts. Interest and banking expenses increased as a result of the recent utilization of the Company’s line of credit with Comerica Bank. The increase in employee compensation is mostly the result of higher salaries and health related benefit expenses. Finally, insurance expense increased as a result of increased premiums associated with the Company’s liability insurance renewal that occurred in May of 2006. The reduction in outside services and temporary personnel is due to reduced reliance on outside resources to assist management with various projects.

Income Taxes

The Company has sufficient net operating loss carryforwards to avoid most federal income tax expense for the third quarter of 2006. However, management anticipates that the Company will be subject to federal alternative minimum tax in 2006. In addition, management anticipates that the Company will be subject to various state and local taxes which are unaffected by the net operating loss carryforward. Management has calculated an estimated tax liability that includes the potential for federal alternative minimum tax, and has calculated estimated tax liability for each state and local jurisdiction using the tax basis each jurisdiction uses to assess taxes. During the third quarter of 2006, the Company recorded $7,000 to the provision for income taxes based on these estimates. In the first quarter of 2006, the Company adopted the fair value recognition provisions of SFAS 123R pertaining to share-based compensation transactions. This adoption creates temporary differences between GAAP based net income and tax based net income because the compensation deduction permitted under SFAS 123R is not deductible for taxes. When option holders exercise their rights to purchase the Company’s shares, the Company is entitled to take a tax deduction, eliminating the temporary difference created when the option rights vested.

The Company recognized $43,000 in compensation expense related to SFAS 123R in the third quarter of 2006. As a result of the temporary difference created, the Company’s deferred tax asset balance increased $8,000. Since the Company maintains a 100% valuation reserve for its deferred tax reserve, none of the increase in deferred taxes is reflected in the income statement.

Nine months ended September 30, 2006 compared to the nine months ended September 30, 2005

Overview

The Company reported revenue for the nine months ended September 30, 2006 of $25,797,000, a $3,425,000, or 15.3%, increase, from $22,372,000 generated during the same period in 2005. Blood products revenue increased $2,871,000, or 16.4%, as a result of increased sales in the Company’s California market, and the addition of revenue from HemaBio for the period August 30, 2006 to September 30, 2006. Blood services revenue increased $554,000, or 11.3%, mostly as a result of an increase in the number of procedures performed.

Gross profit for the first nine months of 2006 increased $192,000, or 4.1%, compared with the first nine months of 2005, mostly as a result of higher revenue, as well as the gross profit generated by the Company’s HemaBio subsidiary for the period August 30, 2006 to September 30, 2006.

General and administrative expenses increased $283,000, or 7.7%, due mostly to the Company’s adoption of SFAS 123R in 2006.

Net income for the period decreased $118,000, or 11.7%, to $893,000 from $1,011,000 in the first nine months of 2005. This decrease is attributable to $404,000 in non-cash share-based compensation expense recognized during the first nine months of 2006. No such expense was recognized in the first nine months of 2005 per the modified prospective transition method provided in SFAS 123R.

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Blood Products

For the nine months ended September 30, 2006, revenues for this business segment increased $2,871,000, or 16.4%, compared to the same period of 2005. The increase in revenue is directly attributable to higher sales volumes at the Company’s California operations, year-over-year increases in selected product pricing, and the addition of 32 days of revenue generated by the Company’s new HemaBio subsidiary.

For the nine months ended September 30, 2006, gross profit for the blood products segment decreased $44,000, or 1.2%, compared with the same period of 2005. This is primarily the result of decreased gross profit from the Company’s Maine operations compared to the same period of the prior year. The gross profit percentage for the blood products segment decreased to 17.3%, from 20.4% recorded during the first nine months of 2005. The decline is attributable to an increase in staff compensation expense at the Company’s Maine operations.

Blood Services

Revenues from blood services increased $554,000, or 11.3%, to $5,445,000 in the first nine months of 2006 from $4,891,000 in the same period of 2005. The increase was mainly due to a 10.4% increase in the number of therapeutic apheresis procedures performed.

Gross profit for the blood services segment increased $235,000, or 21%, to $1,354,000 in the first nine months of 2006 from $1,118,000 during the same period in 2005, reflecting higher procedure volumes. For the first nine months of 2006, this business segment produced a gross profit percentage of 24.9%, compared with 22.9% for the same period in 2005. The increase is primarily the result of efficiencies derived from the increase in the volume of therapeutic apheresis procedures.

General and Administrative Expenses

General and administrative expenses increased by $284,000, or 7.7%, to $3,943,000 in the first nine months of 2006 from $3,660,000 in the same period of 2005 due to the Company’s adoption of SFAS 123R in 2006, which resulted in the Company recognizing $404,000 in non-cash share-based compensation expense in the first nine months of 2006, of which $381,000 is in general and administrative expenses. The Company did not recognize any non-cash share-based compensation expense in the same period of 2006 under the transition method of SFAS 123R. The increase was offset by a $159,000 decrease in outside service expense attributable to a reduction in the utilization of outside consultants and temporary personnel.

Income Taxes

The Company has sufficient net operating loss carryforwards to avoid most federal income tax expense for the first nine months of 2006. However, management anticipates that the Company will be subject to federal alternative minimum tax in 2006. In addition, management anticipates that the Company will be subject to various state and local taxes which are unaffected by the net operating loss carryforward. Management has calculated an estimated tax liability that includes the potential for federal alternative minimum tax, and has calculated estimated tax liability for each state and local jurisdiction using the tax basis each jurisdiction uses to assess taxes. During the first nine months of 2006, the Company recorded $33,000 to the provision for income taxes based on these estimates. In the first nine months of 2006, the Company adopted the fair value recognition provisions of SFAS 123R pertaining to share-based compensation transactions. This adoption creates temporary differences between GAAP based net income and tax based net income because the compensation deduction permitted under SFAS 123R is not deductible for taxes. When option holders exercise their rights to purchase the Company’s shares, the Company is entitled to take a tax deduction, eliminating the temporary difference created when the option rights vested.

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The Company recognized $404,000 in compensation expense related to SFAS 123R in the first nine months of 2006. As a result of the temporary difference created, the Company’s deferred tax asset balance increased $101,000. Since the Company maintains a 100% valuation reserve for its deferred tax reserve, none of the increase in deferred taxes is reflected in the income statement.

Critical Accounting Policies and Estimates

Use of Estimates

The Company’s discussion and analysis of its financial condition and results of operations are based on the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to valuation reserves, income taxes and intangibles. The Company bases its estimates on historical experience and on various other assumptions that management believes are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Accounting for Share-Based Incentive Programs

In accordance with SFAS 123R, in the first nine months of 2006 the Company recognized compensation expense related to stock options granted to employees based on: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of, December 31, 2005, based on the grant date fair value estimated in accordance with SFAS 123, adjusted for an estimated future forfeiture rate, and (b) compensation cost for all share-based payments granted subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R.

The Company’s assessment of the estimated fair value of the stock options granted is affected by the price of the Company’s stock, as well as assumptions regarding a number of complex and subjective variables and the related tax impact. Management utilized the Black-Scholes model to estimate the fair value of stock options granted. Generally, the calculation of the fair value for options granted under SFAS 123R is similar to the calculation of fair value under SFAS 123, with the exception of the treatment of forfeitures.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. This model also requires the input of highly subjective assumptions including:

(a)          The expected volatility of the common stock price, which was determined based on historical volatility of the Company’s common stock;

(b)         Expected dividends, which are not anticipated; and

(c)          Expected life of the stock option, which is estimated based on the historical stock option exercise behavior of employees.

In the future, management may elect to use different assumptions under the Black-Scholes valuation model or a different valuation model, which could result in a significantly different impact on net income or loss.

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Allowance for Doubtful Accounts

The Company makes ongoing estimates relating to the collectibility of accounts receivable and maintains a reserve for estimated losses resulting from the inability of customers to meet their financial obligations to the Company. In determining the amount of the reserve, management considers the historical level of credit losses and makes judgments about the creditworthiness of significant customers based on ongoing credit evaluations. Since management cannot predict future changes in the financial stability of customers, actual future losses from uncollectible accounts may differ from the estimates. If the financial condition of customers were to deteriorate, resulting in their inability to make payments, a larger reserve may be required. In the event it is determined that a smaller or larger reserve was appropriate, the Company would record a credit or a charge to general and administrative expense in the period in which such a determination is made.

Inventory Valuation Reserve

The Company’s inventory, which is comprised primarily of various components of blood, is valued at the lower of cost or market. The Company estimates the market value of inventory at the current sales price, but management must assess the likelihood that the inventory is saleable, and to the extent management believes the inventory is not saleable, a valuation allowance is required. Management has based the valuation reserve for slow moving inventory on the previous twelve month period of historical sales quantity for each inventory item. Inventory quantity in excess of the historical sales volume is reserved at 100%. The charge or credit to cost of goods sold for inventory valuation adjustments, may cause fluctuations in gross profit.

Income Taxes

As part of the process of preparing the financial statements, the Company is required to estimate income taxes in each of the jurisdictions that the Company operates. This process involves estimating actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in the balance sheet. Management must then assess the likelihood that the deferred tax assets will be recovered from future taxable income, and to the extent management believes that recovery is not likely, must establish a valuation allowance. To the extent a valuation allowance is created or adjusted in a period, the Company must include an expense, or benefit, within the tax provision in the statements of income.

Significant management judgment is required in determining the provision for income taxes, deferred tax asset and liabilities and any valuation allowance recorded against net deferred tax assets. Management continually evaluates if the deferred tax asset is likely to be realized. If management determines that the deferred tax asset is not likely to be realized, a write-down of that asset would be required and would be reflected in the provision for taxes in the accompanying period.

Liquidity and Capital Resources

As of September 30, 2006, the Company’s cash and cash equivalents were $1,088,000, and the Company had working capital of $2,839,000.

On September 26, 2006, the Company, together with the Company’s subsidiaries Coral Blood Services, Inc. and HemaCare BioScience, Inc., entered into an Amended and Restated Loan and Security Agreement (“Agreement”) with Comerica Bank (“Comerica”) to provide a working capital line of credit. The Agreement restated the terms of the prior credit agreement with Comerica, except i) the limits on the amount the Company may borrow were changed to the lesser of 75% of eligible accounts receivable or $3 million, ii) HemaBio was added as an additional borrower, iii) Comerica was given a security interest in all of the assets of HemaBio, and vi) extended the term of the Agreement one year to June 30, 2008. The

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Agreement provides that interest is payable monthly at a rate of prime minus 0.25%. As of September 30, 2006, the rate associated with this credit facility was 8.00%. In addition, the Company has the option to draw against this facility for thirty (30), sixty (60) or ninety (90) days using LIBOR as the relevant rate of interest. As of September 30, 2006, the Company had borrowed $1,275,000 on this line of credit, and the Company had unused availability of $1,725,000.

The Comerica credit facility is collateralized by substantially all of the Company’s assets and requires the maintenance of certain financial covenants that among other things require minimum levels of profitability and prohibit the payment of dividends. As of September 30, 2006, the Company was in full compliance with all of the financial covenants. During the third quarter of 2006, the Company incurred $8,000 of interest expense associated with the Comerica credit facility.

The Company also has a capital equipment lease with GE Capital used to finance the acquisition of vehicles. As of September 30, 2006, the balance outstanding on this lease was $27,000, all of which is included in current obligations. This lease is scheduled to terminate in January 2007, and has a fixed interest rate of 8.0%.

The following table summarizes our contractual obligations by year (in thousands):

 

For the nine months ended on September 30, 2006, net cash provided by operating activities was $442,000, compared to $881,000 of cash provided by operating activities for the nine months ended September 30, 2005. The decrease of $439,000 in cash provided between the two periods is primarily due to an increase in cash used for accounts receivable of $843,000, compared to $345,000 for this category in 2005. As of September 30, 2006, the days sales outstanding were 47 days, compared to 41 days outstanding as of December 31, 2005. The Company has experienced some increase in the age of selected customer receivable balances during the first nine months of 2006. In addition, the Company used $805,000 in cash for accounts payable, accrued expenses and other liabilities during the first nine months of 2006 compared to $31,000 of cash provided in this same category for the same period of 2005 due to coincidental timing differences for payroll and vendor payments between the two periods. Offsetting these two categories, is $68,000 in cash provided from a decrease in inventories, supplies and prepaid expenses, compared to a $320,000 increase for this same category in 2005.

For the nine months ended on September 30, 2006, net cash used in investing activities was $3,193,000, compared to $333,000 for the same period in 2005. The increase is the result of the consideration paid to acquire Teragenix Corporation, and document control and financial reporting systems.

For the nine months ended September 30, 2006, net cash provided by financing activities was $1,227,000, compared to cash provided of $720,000 of cash used by financing activities for the nine months ended September 30, 2005. Most of the difference is due to a $1,275,000 advance against the Company’s line of credit with Comerica Bank.

The Company entered into a lease to occupy a building located in Van Nuys, California for new corporate headquarters and to relocate the Company’s blood processing and distribution operations from Sherman Oaks, California. The Company expects to incur approximately $1.5 million in capital expenditures for improvements and relocation costs, mostly in the fourth quarter of 2006. The Company previously decided to initiate a new information technology project to enhance the automation of its blood

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product operations. The Company has identified a preferred blood bank information system developer to provide this system, and is currently in contract negotiations. This project is expected to take approximately two years to complete, and will involve considerable financial and managerial resources. Management expects approximately $2 million will be needed to complete this project.

Management anticipates that cash generated by operations and available borrowing on the bank line of credit, will be sufficient to provide funding for the Company’s needs during the next year, including working capital requirements, equipment purchases, operating lease commitments and to fund the new information technology project and facility improvements.

The Company’s primary sources of liquidity include cash on hand, available borrowing on the line of credit and cash generated from operations. Liquidity depends, in part, on timely collections of accounts receivable. Any significant delays in customer payments could adversely affect the Company’s liquidity. Liquidity also depends on maintaining compliance with the various loan covenants.

Risk Factors Affecting the Company

The Company’s short and long-term success is subject to many factors that are beyond management’s control. Shareholders and prospective shareholders of the Company should consider carefully the following risk factors, in addition to other information contained in this report. The matters discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Quarterly Report on Form 10-Q that are not historical are forward-looking statements. These statements may also be identified by the use of words such as “anticipate,” “believe,” “continue,” “estimate,” “expect,” “intend,” “may,” “project,” “will” and similar expressions, as they relate to the Company, its management and its industry. Investors and prospective investors are cautioned that these forward-looking statements are not guarantees of future performance and involve risks and uncertainties, many of which will be beyond the control of the Company. Actual results could differ materially from those anticipated in these forward-looking statements as a result of various risks and uncertainties, including those described below or in other filings by the Company with the Securities and Exchange Commission. The Company does not undertake to update its forward-looking statements to reflect later events and circumstances or actual outcomes.

Steady or declining market prices could reduce profitability

The cost of collecting, processing and testing blood products has risen significantly in recent years and will likely continue to increase. These cost increases are related to new and improved testing procedures, increased regulatory requirements related to blood safety, and increased costs related to collecting and processing blood products. Competition and fixed price contracts may limit the Company’s ability to maintain existing operating margins. Some competitors have greater resources than the Company to sustain periods of marginally profitable or unprofitable sales. Steady or declining market prices, and increased costs may reduce profitability and may have a material adverse effect on the business and results of operations.

Changes in demand for blood products could affect profitability

The Company’s operations are structured to produce particular blood products based on customers’ existing demand, and perceived potential changes in demand, for these products. Sudden or unexpected changes in demand for these products could have an adverse impact on the Company’s profitability. Increasing demand could harm relationships with customers if the Company is unable to alter production capacity, or purchase products from other suppliers, adequately to fill orders. This could result in a decrease in overall revenues and profits. Decreases in demand may require the Company to make sizeable investments to restructure operations away from declining products to the production of new products. Lack of access to sufficient capital, or lack of adequate time to properly respond to such a change in demand, could result in declining revenue and profits as customers transfer to other suppliers.

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Declining blood donations could affect profitability

The business depends on the availability of donated blood. Only a small percentage of the population donates blood, and regulations intended to reduce the risk of introducing infectious diseases in the blood supply have decreased the pool of potential donors. If the level of donor participation declines, the Company may not be able to reduce costs sufficiently to maintain profitability in blood products.

Competition may cause a loss of customers and an increase in costs and impact profitability

Competition within the blood services and blood products industries is constantly changing. Recent consolidations of blood services providers has changed the competitive environment for the Company’s blood services segment. Competition for customers and trained apheresis nurses is increasing. This has caused the Company to incur significant recruitment costs to replace nurses, dramatically increase nurses’ compensation and incur higher marketing related expenses in order to attract and retain customers. In addition, consolidations and affiliations within the hospital industry have changed the market for the blood products segment. The newly consolidated or affiliated hospitals have started to negotiate with the Company as a group, and therefore exert greater price pressure on the Company. These changes may have a negative impact on the Company’s future revenue, and may negatively impact future profitability.

Operations depend on services of qualified professionals and competition for their services is strong

The Company is highly dependent upon obtaining the services of qualified professionals. In particular, the Company’s operations depend on the services of registered nurses, medical technologists, regulatory and quality assurance professionals, and others with knowledge of the blood industry. Nationwide, the demand for these professionals exceeds the supply and competition for their services is strong. If the Company is unable to attract and retain a staff of qualified professionals, operations may be adversely affected.

Industry regulations could impact operations

The business of collecting, processing and distributing blood products is subject to extensive and complex regulation by the state and federal governments. The Company is required to obtain and maintain numerous licenses in different legal jurisdictions regarding the safety of products, facilities and procedures, and regarding the purity and quality of blood products. In January 2006, the Food and Drug Administration (“FDA”) performed an inspection of the Company’s California operations. On May 5, 2006, the Company received a warning letter from the FDA pertaining to specific observations during the inspection. The Company has responded and implemented an action plan to address each issue.

On November 3, 2006, the AABB provided recommendations to reduce the risk of transfusion-related acute lung injury (“TRALI”). This recommendation, to be fully implemented for high-plasma volume blood products and platelets by November 2007 and 2008, respectively, may reduce the volume of products available to customers, which may negatively impact the Company’s operations and profitability.

State and federal laws include anti-kickback and self-referral prohibitions and other regulations that affect the shipping of blood products and the relationships between blood banks, hospitals, physicians and other persons who refer business to each other. Health insurers and government payers, such as Medicare and Medicaid, also limit reimbursement for products and services, and require compliance with certain regulations before reimbursement will be made.

The Company devotes substantial resources to complying with laws and regulations; however, the possibility cannot be eliminated that interpretations of existing laws and regulations will result in findings that the Company has not complied with significant existing regulations. Such a finding could materially

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harm the business. Moreover, healthcare reform is continually under consideration by regulators, and the Company does not know how laws and regulations will change in the future.

Decrease in reimbursement rates may affect profitability

Reimbursement rates for blood products and services provided to Medicaid, Medicare and commercial patients, impact the fees that the Company is able to negotiate with hospitals. In addition, to the degree that the Company’s hospital customers receive lower reimbursement for the products and services provided by the Company, these customers may reduce their demand for these goods and services, and adversely affect the Company’s revenue. If the Company is unable to increase prices for goods and services, the Company’s profitability may be adversely affected.

Targeted partner blood drives involve higher collection costs

Part of the Company’s current operations involves conducting blood drives in partnership with hospitals. Blood drives are conducted under the name of the hospital partner and require that all promotional materials and other printed material include the name of the hospital partner. This strategy lacks the efficiencies associated with blood drives that are not targeted to benefit particular hospital partners. As a result, collection costs might be higher than those experienced by the Company’s competition and may affect profitability and growth plans.

Not-For-Profit status gives advantages to competitors

HemaCare is the only significant blood products supplier to hospitals in the U.S. that is operated for profit and investor owned. The not-for-profit competition is exempt from federal and state taxes, and has substantial community support and access to tax-exempt financing. The Company may not be able to continue to compete successfully with not-for-profit organizations and the business and results of operations may suffer material adverse harm.

Reliance on relatively few vendors for significant supplies and services could affect the Company’s ability to operate

The Company currently relies on a relatively small number of vendors to supply important supplies and services. Significant price increases, or disruptions in the ability of these vendors to provide products and services, may force the Company to find alternative vendors. Alternative vendors may not be available, or may not provide their products and services at favorable prices. If the Company cannot obtain the products and services it currently uses, or alternatives at reasonable prices, the Company’s ability to produce products and provide services may be severely impacted and result in a reduction of revenue and profitability.

Potential adverse effect from changes in the healthcare industry, including consolidations, could affect access to customers

Competition to gain patients on the basis of price, quality and service is intensifying among healthcare providers who are under pressure to decrease the costs of healthcare delivery. There has been significant consolidation among healthcare providers seeking to enhance efficiencies, and this consolidation is expected to continue. As a result of these trends, the Company may be limited in its ability to increase prices for products in the future, even if costs increase. Further, customer attrition as a result of consolidation or closure of hospital facilities may adversely impact the Company.

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Future technological developments or alternative treatments could jeopardize business

As a result of the risks posed by blood-borne diseases, many companies are currently seeking to develop alternative treatments for blood product transfusions or synthetic substitutes for human blood products. HemaCare’s business consists of collecting, processing and distributing human blood products and providing blood related therapeutic services. The introduction and acceptance in the market of alternative treatments or synthetic blood substitutes may cause material adverse harm to the business. In addition, recent technological developments to extend the shelf-life of products currently offered by the Company, could increase the available supply in the market, and put downward pressure on the price for these products. This may cause a material adverse impact on the future profitability for these products.

Potential inability to meet future capital needs could affect plans to finance future expansion

Currently, the Company believes it has sufficient cash available through its cash on hand, bank credit facilities and funds from operations to finance its operations for the next year. The Company generated $1,655,000 in net income in 2005; however, there is no assurance this performance will be sustainable, and the Company may need to raise additional capital in the debt or equity markets. There can be no assurance that the Company will be able to obtain such financing on reasonable terms or at all. Additionally, there is no assurance that the Company will be able to obtain sufficient capital to finance future expansion.

Limited access to insurance could affect ability to defend against possible claims

The Company currently maintains insurance coverage consistent with the industry; however, if the Company experiences losses or the risks associated with the blood industry increase in the future, insurance may become more expensive or unavailable. The Company also cannot give assurance that as the business expands, or the Company introduces new products and services, that additional liability insurance on acceptable terms will be available, or that the existing insurance will provide adequate coverage against any and all potential claims. Also, the limitations on liability contained in various agreements and contracts may not be enforceable and may not otherwise protect the Company from liability for damages. The successful assertion of one or more large claims against the Company that exceed available insurance coverage, or changes in insurance policies, such as premium increases or the imposition of large deductibles or co-insurance requirements, may materially and adversely affect the business.

Ability to attract, retain and motivate management and other skilled employees

The Company’s success depends significantly on the continued services of key management and skilled personnel. Competition for qualified personnel is intense and there are a limited number of people with knowledge of, and experience in, the blood product and blood service industries. The Company does not have employment agreements with most key employees, nor maintain life insurance policies on them. The loss of key personnel, especially without advance notice, or the Company’s inability to hire or retain qualified personnel, could have a material adverse affect on revenue and on the Company’s ability to maintain a competitive advantage. The Company cannot guarantee that it can retain key management and skilled personnel, or that it will be able to attract, assimilate and retain other highly qualified personnel in the future.

Product safety and product liability could provide exposure to claims and litigation

Blood products carry the risk of transmitting infectious diseases, including but not limited to hepatitis, HIV and Creutzfeldt-Jakob disease. HemaCare screens donors, uses highly qualified testing service providers to test its blood products for known pathogens in accordance with industry standards, and complies with all applicable safety regulations. Nevertheless, the risk that screening and testing processes might fail, or that new pathogens may be undetected by them, cannot be completely eliminated. There is currently no test to detect the pathogen responsible for Creutzfeldt-Jakob disease. If patients are infected

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by known or unknown pathogens, claims may exceed insurance coverage and materially and adversely affect the Company’s financial condition.

Environmental risks could cause the Company to incur substantial costs to maintain compliance

HemaCare’s operations involve the controlled use of bio-hazardous materials and chemicals. Although the Company believes that its safety procedures for handling and disposing of such materials comply with the standards prescribed by state and federal regulations, the risk of accidental contamination or injury from these materials cannot be completely eliminated. In the event of such an accident, the Company could be held liable for any damages that result, and any such liability could exceed the resources of the Company and its insurance coverage. The Company may incur substantial costs to maintain compliance with environmental regulations as it develops and expands its business.

Business interruption due to terrorism and increased security measures in response to terrorism

HemaCare’s business depends on the free flow of products and services through the channels of commerce and freedom of movement for patients and donors. Delays or stoppages in the transportation of perishable blood products and interruptions of mail, financial or other services could have a material adverse effect on the Company’s results of operations and financial condition. Furthermore, the Company may experience an increase in operating costs, such as costs for transportation, insurance and security, as a result of the terrorist activities and potential activities, which may target health care facilities or medical products. The Company may also experience delays in receiving payments from payers that have been affected by terrorist activities and potential activities. The U.S. economy in general is adversely affected by terrorist activities, and potential activities, and any economic downturn may adversely impact the Company’s results of operations, impair its ability to raise capital or otherwise adversely affect its ability to grow its business.

Evaluation and consideration of strategic alternatives, and other significant projects, may distract management from reacting appropriately to business challenges and lead to reduced profitability

As a publicly traded Company, management must constantly evaluate and consider new strategic alternatives, and other significant projects, in an attempt to maximize shareholder value. The Company does not possess a large management team that can both consider strategic alternatives and manage daily operations. Therefore, management distractions associated with the evaluation and consideration of strategic alternatives, could prevent management from dedicating appropriate time to immediate business challenges or other significant business decisions. This may cause a material adverse impact on the future profitability of the Company.

Strategy to acquire companies may result in unsuitable acquisitions or failure to successfully integrate acquired companies, which could lead to reduced profitability

The Company may embark on a growth strategy through acquisitions of companies or operations that compliment existing product lines, customers or other capabilities. The Company may be unsuccessful in identifying suitable acquisition candidates, or may be unable to consummate a desired acquisition. To the extent any future acquisitions are completed, the Company may be unsuccessful in integrating acquired companies or their operations, or if integration is more difficult than anticipated, the Company may experience disruptions that could have a material adverse impact on future profitability. Some of the risks that may affect the Company’s ability to integrate, or realize any anticipated benefits from, acquisitions include:

·       unexpected losses of key employees or customer of the acquired company;

·       difficulties integrating the acquired company’s standards, processes, procedures and controls;

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·       difficulties coordinating new product and process development;

·       difficulties hiring additional management and other critical personnel;

·       difficulties increasing the scope, geographic diversity and complexity of the Company’s operations;

·       difficulties consolidating facilities, transferring processes and know-how;

·       difficulties reducing costs of the acquired company’s business;

·       diversion of management’s attention from the management of the Company; and

·       adverse effects on existing business relationships with customers.

Articles of Incorporation and Rights Plan could delay or prevent an acquisition or sale of HemaCare

HemaCare’s Articles of Incorporation empower the Board of Directors to establish and issue a class of preferred stock, and to determine the rights, preferences and privileges of the preferred stock. This gives the Board of Directors the ability to deter, discourage or make more difficult for a change in control of HemaCare, even if such a change in control would be in the interest of a significant number of shareholders or if such a change in control would provide shareholders with a substantial premium for their shares over the then-prevailing market price for the Company’s common stock.

In addition, the Board of Directors has adopted a Shareholder’s Rights Plan designed to require a person or group interested in acquiring a significant or controlling interest in HemaCare to negotiate with the Board. Under the terms of our Shareholders’ Rights Plan, in general, if a person or group acquires more than 15% of the outstanding shares of common stock, all of the other shareholders would have the right to purchase securities from the Company at a discount to the fair market value of the common stock, causing substantial dilution to the acquiring person or group. The Shareholders’ Rights Plan may inhibit a change in control and, therefore, may materially adversely affect the shareholders’ ability to realize a premium over the then-prevailing market price for the common stock in connection with such a transaction. For a description of the Shareholders’ Rights Plan see the Company’s Current Report on Form 8-K filed with the SEC on March 5, 1998.

Quarterly revenue and operating results may fluctuate in future periods, and the Company may fail to meet investor expectations

The Company’s quarterly revenue and operating results have fluctuated significantly in the past, and are likely to continue to do so in the future due to a number of factors, many of which are not within the Company’s control. If quarterly revenue or operating results fall below the expectations of investors, the price of the Company’s common stock could decline significantly. Factors that might cause quarterly fluctuations in revenue and operating results include the following:

·       changes in demand for the Company’s products and services, and the ability to attain the required resources to satisfy customer demand;

·       ability to develop, introduce, market and gain market acceptance of new products or services in a timely manner;

·       ability to manage inventories, accounts receivable and cash flows;

·       ability to control costs; and

·       ability to attract qualified blood donors.

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The amount of expenses incurred depends, in part, on expectation regarding future revenue. In addition, since many expenses are fixed in the short term, the Company cannot significantly reduce expenses if there is a decline in revenue to avoid losses.

Stocks traded on the OTC Bulletin Board are subject to greater market risks than those of exchange-traded and Nasdaq stocks since they are less liquid

HemaCare’s common stock was delisted from the Nasdaq Small Cap Market on October 29, 1998 because of the failure to maintain Nasdaq’s requirement of a minimum bid price of $1.00. Since November 2, 1998 the common stock has traded on the OTC Bulletin Board, an electronic, screen-based trading system operated by the National Association of Securities Dealers, Inc. Securities traded on the OTC Bulletin Board are, for the most part, thinly traded and generally are not subject to the level of regulation imposed on securities listed or traded on the Nasdaq Stock Market or on a national securities exchange. As a result, an investor may find it difficult to dispose of the Company’s common stock or to obtain accurate quotations as to its price.

Stock price could be volatile

The price of HemaCare’s common stock has fluctuated in the past and may be more volatile in the future. Factors such as the announcements of government regulation, new products or services introduced by the Company or by the competition, healthcare legislation, trends in health insurance, litigation, fluctuations in operating results and market conditions for healthcare stocks in general could have a significant impact on the future price of HemaCare’s common stock. In addition, the stock market has from time to time experienced extreme price and volume fluctuations that may be unrelated to the operating performance of particular companies. The generally low volume of trading in HemaCare’s common stock makes it more vulnerable to rapid changes in price in response to market conditions.

Future sales of equity securities could dilute the Company’s common stock

The Company may seek new financing in the future through the sale of its securities. Future sales of common stock or securities convertible into common stock could result in dilution of the common stock currently outstanding. In addition, the perceived risk of dilution may cause some shareholders to sell their shares, which may further reduce the market price of the common stock.

Lack of dividend payments

The Company intends to retain any future earnings for use in its business, and therefore does not anticipate declaring or paying any cash dividends in the foreseeable future. The declaration and payment of any cash dividends in the future will depend on the Company’s earnings, financial condition, capital needs and other factors deemed relevant by the Board of Directors. In addition, the Company’s credit agreement prohibits the payment of dividends during the term of the agreement.

Evaluation of internal control and remediation of potential problems will be costly and time consuming and could expose weaknesses in financial reporting

The regulations implementing Section 404 of the Sarbanes-Oxley Act of 2002 require an assessment of the effectiveness of the Company’s internal control over financial reporting beginning with our Annual Report on Form 10-K for the fiscal year ending December 31, 2007. The Company’s independent auditors will be required to confirm in writing whether management’s assessment of the effectiveness of the internal control over financial reporting is fairly stated in all material respects, and separately report on whether they believe management maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008.

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This process will be expensive and time consuming, and will require significant attention of management. Management can give no assurance that material weaknesses in internal controls will not be discovered. Management also can give no assurance that the process of evaluation and the auditor’s attestation will be completed on time. If a material weakness is discovered, corrective action may be time consuming, costly and further divert the attention of management. The disclosure of a material weakness, even if quickly remedied, could reduce the market’s confidence in the Company’s financial statements and harm the Company’s stock price, especially if a restatement of financial statements for past periods is required.

If the Company is unable to adequately design its internal control systems, or prepare an “internal control report” to the satisfaction of the Company’s auditors, the Company’s auditors may issue a qualified opinion on the Company’s financial statements.

Item 3.                          Quantitative and Qualitative Disclosures About Market Risk

The Company has $1,275,000 of debt, in the form of draws against the Company’s working line of credit with Comerica and capitalized leases with fixed interest rates. As of September 30, 2006, $1,275,000 of the Company’s debt was subject to changes in interest rates. As a result, the Company’s interest expense can fluctuate with changes in interest rates in the U.S. A 100 basis point change in interest rates could result in an approximately $13,000 change in the Company’s interest expense. The notes assumed and issued by the Company associated with the acquisition of Teragenix have fixed interest rates and are not subject to changes in prevailing interest rates.

Item 4.                          Controls and Procedures

The Company’s management, with the participation of the Company’s chief executive officer and the principal financial officer, carried out an evaluation of the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)). Based upon that evaluation, the chief executive officer and the principal financial officer believe that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were not effective at the reasonable assurance level in making known to them in a timely manner material information relating to the Company (including its consolidated subsidiaries, required to be included in this report) for the reasons described below.

Disclosure controls and procedures, no matter how well designed and implemented, can provide only reasonable assurance of achieving an entity’s disclosure objectives. The likelihood of achieving such objections is affected by limitations inherent in disclosure controls and procedures. These include the fact that human judgment in decision-making can be faulty and that breakdowns in internal control can occur because of human failures such as simple errors, mistakes or intentional circumvention of the established process.

There was no change in the Company’s internal control over financial reporting, that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

The Company has conducted an extensive evaluation of the existing internal control structure, and several internal control weaknesses have been identified. Of these, the Company has either altered procedures to eliminate the weakness, or implemented alternative controls which management believes prevents any material misstatement of the Company’s financial statements. Nevertheless, management intends to modify the existing internal control structure further to eliminate any significant weaknesses with the objective of eliminating or reducing reliance on alternative controls.

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PART II.   OTHER INFORMATION

Item 1.                          Legal Proceedings

From time to time, the Company is involved in various routine legal proceedings incidental to the conduct of its business. Management does not believe that any of these legal proceedings will have a material adverse impact on the business, financial condition or results of operations of the Company, either due to the nature of the claims, or because management believes that such claims should not exceed the limits of the Company’s insurance coverage.

Item 1A.                  Risk Factors

The risk factors disclosed in the “Risk Factors” section of the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 have not materially changed other than as set forth below.

The following risk factors were not part of the “Risk Factors” section of the Company’s Annual Report on Form 10-K for the year ended December 31, 2005:

Strategy to acquire companies may result in unsuitable acquisitions or failure to successfully integrate acquired companies, which could lead to reduced profitability

The Company may embark on a growth strategy through acquisitions of companies or operations that compliment existing product lines, customers or other capabilities. The Company may be unsuccessful in identifying suitable acquisition candidates, or may be unable to consummate a desired acquisition. To the extent any future acquisitions are completed, the Company may be unsuccessful in integrating acquired companies or their operations, or if integration is more difficult than anticipated, we may experience disruptions that could have a material adverse impact on future profitability. Some of the risks that may affect the Company’s ability to integrate, or realize any anticipated benefits from, acquisitions include:

·       unexpected losses of key employees or customer of the acquired company;

·       difficulties integrating the acquired company’s standards, processes, procedures and controls;

·       difficulties coordinating new product and process development;

·       difficulties hiring additional management and other critical personnel;

·       difficulties increasing the scope, geographic diversity and complexity of the Company’s operations;

·       difficulties consolidating facilities, transferring processes and know-how;

·       difficulties reducing costs of the acquired company’s business;

·       diversion of management’s attention from the management of the Company; and

·       adverse effects on existing business relationships with customers.

The following risk factors were part of the “Risk Factors” section of the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, but have been updated to reflect recent events:

Industry regulations could impact operations

The business of collecting, processing and distributing blood products is subject to extensive and complex regulation by the state and federal governments. The Company is required to obtain and maintain numerous licenses in different legal jurisdictions regarding the safety of products, facilities and procedures, and regarding the purity and quality of blood products. In January 2006, the Food and Drug Administration (“FDA”) performed an inspection of the Company’s California operations.

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On May 5, 2006, the Company received a warning letter from the FDA pertaining to specific observations during the inspection. The Company has responded and implemented an action plan to address each issue.

On November 3, 2006, the AABB provided recommendations to reduce the risk of transfusion-related acute lung injury (“TRALI”). This recommendation, to be fully implemented for high-plasma volume blood products and platelets by November 2007 and 2008, respectively, may reduce the volume of products available to customers, which may negatively impact the Company’s operations and profitability.

State and federal laws include anti-kickback and self-referral prohibitions and other regulations that affect the shipping of blood products and the relationships between blood banks, hospitals, physicians and other persons who refer business to each other. Health insurers and government payers, such as Medicare and Medicaid, also limit reimbursement for products and services, and require compliance with certain regulations before reimbursement will be made.

The Company devotes substantial resources to complying with laws and regulations; however, the possibility cannot be eliminated that interpretations of existing laws and regulations will result in findings that the Company has not complied with significant existing regulations. Such a finding could materially harm the business. Moreover, healthcare reform is continually under consideration by regulators, and the Company does not know how laws and regulations will change in the future.

Item 2.                          Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3.                          Defaults Upon Senior Securities

None.

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

None.

Item 5.                          Other Information

The proxy materials for the 2006 annual meeting of shareholders held on May 24, 2006 were mailed to shareholders of the Company on April 21, 2006. Under certain circumstances, shareholders are entitled to present proposals at stockholder meetings. Any such proposal to be included in the proxy statement for the 2007 annual meeting of shareholders must be received at the Company’s executive offices at 21101 Oxnard Street, Woodland Hills, CA, 91367, addressed to the attention of the Corporate Secretary by February 27, 2007 in a form that complies with applicable regulations. The Securities and Exchange Commission’s rules provide that, in the event a stockholder proposal is not submitted to the Company prior to February 27, 2007, the proxies solicited by the Board for the 2007 annual meeting of shareholders will confer authority on the holders of the proxy to vote the shares in accordance with their best judgment and discretion if the proposal is presented at the 2007 annual meeting of stockholder without any discussion of the proposal in the proxy statement for such meeting.

If the date of the 2007 annual meeting of shareholders is advanced or delayed more than 30 days from the date of the 2006 annual meeting, stockholder proposals intended to be included in the proxy statement for the 2007 annual meeting must be received by the Company within a reasonable time before the Company begins to print and mail the proxy statement for the 2007 annual meeting. Upon any determination that the date of the 2007 annual meeting will be advanced or delayed by more than 30 days from the date of the 2006 annual meeting, the Company will disclose the change in the earliest practicable Quarterly Report on Form 10-Q.

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Item 6.                          Exhibits

a.      Exhibits

3.1                       Restated Articles of Incorporation of the Registrant incorporated by reference to Exhibit 3.1 to Form 10-K of the Registrant for the year ended December 31, 2002.

3.2                       Amended and Restated Bylaws of the Registrant, as amended, incorporated by reference to Exhibit 3.1 to Form 8-K of the Registrant dated February 20, 2003.

10.1                Stock Purchase Agreement dated August 29, 2006, among HemaCare Corporation, Joseph Mauro, Valentin Adia and Teragenix Corporation, incorporated by reference to Exhibit 99.1 to Form 8-K of the Registrant filed on September 5, 2006.

10.2                Amended and Restated Loan and Security Agreement among HemaCare Corporation, Coral Blood Services, Inc. and HemaCare BioScience, Inc. dated September 26, 2006, incorporated by reference to Exhibit 99.1 to Form 8-K of the Registrant filed on September 29, 2006

11                          Net Income per Common and Common Equivalent Share

31.1                Certification Pursuant to Rule 13a-14(a) Under the Securities Exchange Act

31.2                Certification Pursuant to Rule 13a-14(a) Under the Securities Exchange Act

32                          Certification Pursuant to 18 U.S.C. 1350 and Rule 13a-14(b) Under the Securities Exchange Act of 1934

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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.

Date	November 14, 2006		HEMACARE CORPORATION
			(Registrant)
			By:	/s/ JUDI IRVING
				Judi Irving, Chief Executive Officer
			By:	/s/ ROBERT S. CHILTON
				Robert S. Chilton, Chief Financial Officer

 

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EXHIBIT INDEX

 

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