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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
--------------------
FORM 10-Q
(X) Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the quarterly period ended September 30, 2004.
( ) Transitional report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transitional period from ________ to________
COMMISSION FILE NUMBER 0-20127
------------------------------
ESCALON MEDICAL CORP.
(Exact name of Registrant as specified in its charter)
PENNSYLVANIA 33-0272839
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization Identification Number)
575 EAST SWEDESFORD ROAD,
SUITE 100, WAYNE, PA 19087
(Address of principal executive
offices, including zip code)
(610) 688-6830
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports
required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for shorter period that the Registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
At November 8, 2004, 5,858,808 shares of common stock were outstanding.
ESCALON MEDICAL CORP.
FORM 10-Q QUARTERLY REPORT
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements 2
Condensed Consolidated Balance Sheet as of September 30, 2004
(Unaudited) and June 30, 2004 2
Condensed Consolidated Statement of Operations for the three-month
periods ended September 30, 2004 and 2003 (Unaudited) 3
Condensed Consolidated Statement of Cash Flows for the three-month
periods ended September 30, 2004 and 2003 (Unaudited) 4
Condensed Consolidated Statement of Shareholders' Equity for the
three-month period ended September 30, 2004 (Unaudited) 5
Notes to Condensed Consolidated Financial Statements (Unaudited) 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 18
Item 3. Quantitative and Qualitative Disclosures About Market Risk 35
Item 4. Controls and Procedures 36
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 37
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 38
Item 5. Other Information 38
Item 6. Exhibits 38
1
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
ESCALON MEDICAL CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
September 30, June 30,
2004 2004
------------ ------------
ASSETS (Unaudited)
Current assets:
Cash and cash equivalents $ 5,862,212 $ 12,601,971
Accounts receivable, net 4,469,782 2,492,689
Inventory, net 4,633,113 1,781,592
Note receivable 150,000 150,000
Other current assets 1,186,054 539,508
------------ ------------
Total current assets 16,301,161 17,565,760
------------ ------------
Furniture and equipment, net 1,236,606 409,187
Goodwill 19,214,098 10,591,795
Trademarks and trade names, net 616,906 616,906
Patents, net 615,942 172,078
Other assets 154,459 101,389
------------ ------------
Total assets $ 38,139,172 $ 29,457,115
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Line of credit $ 1,187,027 $ 250,000
Current portion of long-term debt
221,668 1,621,687
Accounts payable 1,798,502 499,242
Accrued expenses 3,910,326 1,229,498
------------ ------------
Total current liabilities 7,117,523 3,600,427
Long-term debt, net of current portion 594,214 2,396,019
------------ ------------
Total liabilities 7,711,737 5,996,446
Shareholders' equity:
Preferred stock, $0.001 par value; 2,000,000 shares authorized; no shares issued
Common stock, $0.001 par value; 35,000,000 shares authorized; 5,858,808 and
5,017,122 shares issued and outstanding at September 30, 2004 and June 30,
2004, respectively 5,860 5,018
Common stock warrants 1,601,346 1,601,346
Additional paid-in capital 63,270,984 56,438,903
Accumulated deficit (34,468,699) (34,584,598)
Accumulated other comprehensive income 17,944 --
------------ ------------
Total shareholders' equity 30,427,435 23,460,669
------------ ------------
Total liabilities and shareholders' equity $ 38,139,172 $ 29,457,115
============ ============
See notes to condensed consolidated financial statements
2
ESCALON MEDICAL CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(UNAUDITED)
Three Months Ended
September 30,
-------------------------------
2004 2003
----------- -----------
Product revenue $ 4,636,457 $ 2,841,127
Other revenue 655,704 570,515
----------- -----------
Revenues, net 5,292,161 3,411,642
----------- -----------
Costs and expenses:
Cost of goods sold 2,671,348 1,212,799
Research and development 315,762 207,130
Marketing, general and administrative 2,182,487 1,214,196
----------- -----------
Total costs and expenses 5,169,597 2,634,125
----------- -----------
Income from operations 122,564 777,517
----------- -----------
Other income and expenses:
Equity in Ocular Telehealth Management, LLC (29,201) --
Interest income 32,092 679
Interest expense 3,413 (118,559)
----------- -----------
Total other income and expenses 6,304 (117,880)
----------- -----------
Income before income taxes 128,868 659,637
Income taxes 12,969 36,481
----------- -----------
Net income $ 115,899 $ 623,156
=========== ===========
Basic net income per share $ 0.021 $ 0.185
=========== ===========
Diluted net income per share $ 0.019 $ 0.154
=========== ===========
Weighted average shares - basic 5,564,469 3,365,359
=========== ===========
Weighted average shares - diluted 6,141,958 4,049,298
=========== ===========
See notes to condensed consolidated financial statements
3
ESCALON MEDICAL CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(UNAUDITED)
Three Months Ended
September 30,
---------------------------------
2004 2003
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 115,899 $ 623,156
Adjustments to reconcile net income to net cash (used in)/
provided by operating activities:
Depreciation and amortization 91,885 64,377
Loss of Ocular Telehealth Management, LLC 29,201 --
Change in operating assets and liabilities:
Accounts receivable, net (552,060) 295,361
Inventory, net (294,289) (72,715)
Other current and long-term assets (306,952) (6,630)
Accounts payable, accrued and other liabilities (1,018,470) (256,801)
------------ ------------
Net cash (used in)/provided by operating activities (1,934,786) 646,748
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of Drew, net of cash 295,373 --
Investment in Ocular Telehealth Management, LLC (130,000) --
------------
Purchase of fixed assets (39,773) (15,685)
------------ ------------
Net cash (used in)/provided by investing activities 125,600 (15,685)
CASH FLOWS FROM FINANCING ACTIVITIES:
Line of credit repayment (669,269) (500,000)
Principal payments on term loans (4,258,754) (365,233)
------------ ------------
Net cash provided by/(used in) financing activities (4,928,023) (865,233)
------------ ------------
Effect of exchange rate changes on cash & cash equivalents (2,551) --
Net decrease in cash and cash equivalents (6,739,760) (234,170)
Cash and cash equivalents, beginning of period 12,601,971 298,390
------------ ------------
Cash and cash equivalents, end of period $ 5,862,211 $ 64,220
============ ============
SUPPLEMENTAL SCHEDULE OF CASH FLOW INFORMATION:
Interest paid $ 208,019 $ 130,670
============ ============
Income taxes $ 184,300 $ 92,000
============ ============
SUPPLEMENTAL SCHEDULE OF NON-CASH INFORMATION:
Accounts receivable 1,433,324 --
Inventory 2,562,848 --
Other current assets 577,140 --
Furniture and equipment 868,839 --
Patents 461,779 --
Other long-term assets 264,530 --
Line of credit 1,617,208 --
Current liabilities 4,548,746 --
Liability for shares reserved
for future exchange 597,019 --
Long-term debt 767,165 --
Exchange of common stock 6,833,420 --
See notes to condensed consolidated financial statements
4
ESCALON MEDICAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2004
(UNAUDITED)
Accumulated
Common Stock Common Additional Other Total
------------------- Stock Paid-in Accumulated Comprehensive Shareholders'
Shares Amount Warrants Capital Deficit Income Equity
--------- ------ ---------- ----------- ------------ ------------ -------------
Balance at June 30, 2004 5,017,122 $5,018 $1,601,346 $56,438,903 $(34,584,598) $ -- $23,460,669
Acquisition of Drew 841,686 842 -- 6,832,081 -- -- 6,832,923
Foreign currency translation
-- -- -- -- -- 17,944 17,944
Net income
-- -- -- -- 115,899 -- 115,899
--------- ------ ---------- ----------- ------------ -------- -----------
Balance at September 30, 2004 5,858,808 $5,860 $1,601,346 $63,270,984 $(34,468,699) $ 17,944 $30,427,435
========= ====== ========== =========== ============ ======== ===========
See notes to condensed consolidated financial statements
5
ESCALON MEDICAL CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
The Company operates in the healthcare market, specializing in the
development, manufacture and marketing of (1) ophthalmic medical devices and
pharmaceuticals; (2) instrumentation and consumables for use in human and
veterinary hematology; (3) instrumentation and consumables for the diagnosing
and monitoring of diabetes; and (4) vascular access devices.
The accompanying unaudited condensed consolidated financial statements
include the accounts of Escalon Medical Corp. and its subsidiaries, collectively
referred to as "Escalon" or the "Company."
Additionally, the Company's investment in Ocular Telehealth Management, LLC
("OTM") is accounted for under the equity method. All intercompany accounts and
transactions have been eliminated.
The accompanying condensed consolidated financial statements are unaudited
and are presented pursuant to the rules and regulations of the Securities and
Exchange Commission (the "SEC"). Accordingly, these consolidated financial
statements should be read in conjunction with the consolidated financial
statements and notes thereto contained in the Company's 2004 Annual Report on
Form 10-K. In the opinion of management, the accompanying consolidated financial
statements reflect all adjustments (which are of a normal recurring nature)
necessary for a fair presentation of the financial position, results of
operations and cash flows for interim periods presented. The results of
operations are not necessarily indicative of the results that may be expected
for the full year.
2. ACQUISITION OF DREW SCIENTIFIC GROUP, PLC
On July 23, 2004, Escalon acquired approximately 67% of the outstanding
ordinary shares of Drew Scientific Group Plc ("Drew"), a United Kingdom Company,
pursuant to the Company's exchange offer for all of the outstanding ordinary
shares of Drew, and since that date has acquired substantially all of the Drew
shares. As of September 30, 2004, Escalon had acquired approximately 94% of
their ordinary shares of Drew. During the remainder of fiscal 2005, Escalon
expects to compel Drew shareholders to tender all of the remaining outstanding
Drew shares pursuant to procedures under United Kingdom laws and regulations.
The results of Drew's operations have been included in the consolidated
financial statements since July 23, 2004, the date on which Escalon acquired
approximately 67% of the outstanding ordinary shares of Drew.
Drew is a diagnostics company specializing in the design, manufacture and
distribution of analytical systems for laboratory testing worldwide. Drew is
focused on providing instrumentation and consumables for the diagnosis and
monitoring of medical disorders in the areas of diabetes, cardiovascular
diseases and hematology. In addition, Drew supplies diagnostic systems that
perform blood component tests. Escalon expects to operate Drew as a wholly owned
separate business segment.
The aggregate purchase price of Drew was $7,857,644, net of acquired cash
of $295,373, consisting of direct acquisition costs of $722,578, consisting
primarily of investment banking, legal and accounting fees that are directly
related to the acquisition of Drew, and 900,000 shares of Escalon common stock
valued at $7,430,439. The value of the 900,000 shares issued was based on the
market price on the dates of consummation and merger. The remaining shares to be
exchanged were recorded as a liability.
6
The following table summarizes the preliminary purchase price allocation of
estimated fair values of assets acquired and liabilities assumed as of the date
of acquisition. Escalon is in the process of obtaining additional data,
identifying and valuing intangible assets acquired, obtaining third party
appraisals of tangible and intangible assets, and valuing certain
pre-acquisition legal contingencies. Therefore, the allocation of the purchase
price is subject to future refinement, which is expected to be completed no
later than June 30, 2005.
Current assets $ 4,573,312
Furniture and equipment 868,839
Patents 461,779
Other long-term assets 264,530
Goodwill 8,622,303
-----------
Total assets acquired $14,790,763
-----------
Line of credit $ 1,617,208
Current liabilities 4,258,981
Long-term debt 1,056,930
-----------
Total liabilities assumed $ 6,933,119
-----------
Net assets acquired $ 7,857,644
===========
The following pro forma results of operations information has been prepared
to give effect to the purchase as if such transaction had occurred at the
beginning of the periods being presented. The information presented is not
necessarily indicative of results of future operations of the combined
companies.
Three Months Ended
September 30,
--------------------------------
2004 2003
---------- ----------
Revenues $5,926,771 $7,231,653
Cost of goods sold 3,088,286 3,840,927
---------- ----------
Gross profit 2,838,485 3,390,726
Operating expenses 2,810,440 2,960,326
Other expense 522 191,853
---------- ----------
Net income before taxes 27,523 238,547
Provision for income taxes 12,969 12,481
---------- ----------
Net income $ 14,554 $ 226,066
========== ==========
Basic net income per share $ 0.003 $ 0.067
========== ==========
Diluted net income per share $ 0.002 $ 0.056
========== ==========
Weighted average shares - basic 5,564,469 3,365,359
========== ==========
Weighted average shares - diluted 6,141,958 4,049,298
========== ==========
7
3. STOCK-BASED COMPENSATION
The Company reports stock-based compensation through the disclosure-only
requirements of Statement of Financial Accounting Standards No. 123 ("SFAS
123"), "Accounting for Stock-Based Compensation," as amended by Statement of
Financial Accounting Standards No. 148 ("SFAS 148"), "Accounting for Stock-Based
Compensation - Transition and Disclosure - an Amendment to FASB No. 123."
Compensation expense for options is measured using the intrinsic value method in
accordance with Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees" ("APB 25"). Under APB 25, because the exercise price
of the Company's employee stock options is generally equal to the market price
of the underlying stock on the date of grant, no compensation expense is
recognized.
SFAS 123 establishes an alternative method of expense recognition for
stock-based compensation awards based on fair values. The following table
illustrates the effect on net income and earnings per share if the Company had
applied the fair value recognition provisions of SFAS 123.
Three Months Ended
September 30,
----------------------------------
2004 2003
--------- ------------
Net Income, as reported $ 115,899 $ 623,156
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects (284,671) (18,103)
--------- ------------
Pro forma net income $(168,772) $ 605,053
========= ============
Earnings per share:
Basic - as reported $ 0.021 $ 0.185
========= ============
Basic - pro forma $ (0.030) $ 0.180
========= ============
Diluted - as reported $ 0.019 $ 0.154
========= ============
Diluted - pro forma $ (0.030) $ 0.149
========= ============
The Company has followed the guidelines of SFAS 123 to establish the
valuation of its stock options. The fair value of these equity awards was
estimated at the date of grant using the Black-Scholes option pricing method.
For the purposes of pro forma disclosures, the estimated fair value of the
equity awards is amortized to expense over the options' vesting period. For the
purposes of applying SFAS No. 123, the estimated per share value of the options
granted during the three-month period ended September 30, 2004 was between $4.92
and $5.06. The fair value was estimated using the following assumptions:
dividend yield of 0.0%, volatility of 0.78; risk-free interest rate of 3.30%;
and expected life of 10 years. The volatility assumption is based on volatility
seen in the Company's stock over the last five years. This assumption was made
according to the guidance of SFAS 123. There is no reason to believe that future
volatility will compare with the historical volatility. Because the Company's
stock options have characteristics significantly different from those of traded
options, and because changes in the subjective input assumptions can materially
affect the fair value estimate, in the opinion of management, the existing
models do not necessarily provide a reliable single measure of the value of its
options.
8
4. EARNINGS PER SHARE
The Company follows Financial Accounting Standards Board Statement No. 128,
"Earnings Per Share," in presenting basic and diluted earnings per share. The
following table set forth the computation of basic and diluted earnings per
share:
Three Months
Ended September 30,
--------------------------------
2004 2003
---------- ----------
Numerator:
Numerator for basic and diluted earnings per share:
Net income $ 115,899 $ 623,156
---------- ----------
Denominator:
Denominator for basic earnings per
share - weighted average shares 5,564,469 3,365,359
Effect of dilutive securities:
Stock options and warrants 519,175 683,939
Shares reserved for future exchange 58,314 --
---------- ----------
Denominator for diluted earnings
earnings per share - weighted average and
assumed conversion 6,141,958 4,049,298
---------- ----------
Basic earnings per share $ 0.021 $ 0.185
========== ==========
Diluted earnings per share $ 0.019 $ 0.154
========== ==========
5. INVENTORY
Inventory, stated at lower of cost (determined on a first-in, first-out
basis) or market, consisted of the following:
September 30, June 30,
2004 2004
----------- -----------
Raw materials $ 2,854,472 $ 1,132,331
Work in process 579,100 287,276
Finished goods 1,204,666 367,110
----------- -----------
4,638,238 1,786,717
Valuation allowance (5,125) (5,125)
----------- -----------
Total inventory $ 4,633,113 $ 1,781,592
=========== ===========
6. NOTE RECEIVABLE
Escalon entered into an agreement with an individual who was involved in
the development of a drug delivery system. The Company holds a note receivable
from the individual in the amount of $150,000 that is due in May 2005.
9
7. INTANGIBLE ASSETS
ACQUIRED LICENSE AND DISTRIBUTION RIGHTS
In connection with the Company's acquisition of assets of Escalon
Ophthalmics, Inc. ("EOI") in February 1996, a portion of the purchase price was
allocated to certain license and distribution agreements. This cost allocation
was based on an evaluation by management, with such costs being amortized over
an eight-year period using the straight-line method. The value of these assets
is reevaluated periodically to determine if the estimated lives continue to be
appropriate.
Accumulated amortization of license and distribution rights was $180,182 and
$180,182 at September 30, 2004 and June 30, 2004, respectively. Amortization
expense for the three-months ended September 30, 2004 and 2003 was $0 and
$5,631, respectively.
PATENTS
It is the Company's practice to seek patent protection on processes and
products in various countries. Patent application costs are capitalized and
amortized over their estimated useful lives, not exceeding 17 years, on a
straight-line basis from the date the related patents are issued. Costs
associated with patents no longer being pursued are expensed. Accumulated patent
amortization was $131,623 and $122,139 at September 30, 2004 and June 30, 2004,
respectively. Amortization expense for the three-months ended September 30, 2004
and 2003 was $9,484 and $2,683, respectively.
The aggregate amortization expense for each of the next five years for
acquired license and distribution rights and patents is as follows:
Year Ending
June 30,
----------
2005 $ 65,567
2006 65,714
2007 60,515
2008 56,842
2009 54,307
--------
Total $302,945
========
GOODWILL, TRADEMARKS AND TRADE NAMES
Goodwill, trademarks and trade names represent intangible assets obtained
from the EOI, Endologix, Inc. ("Endologix"), Sonomed and Drew acquisitions.
Goodwill represents the excess of purchase price over the fair market value of
net assets acquired.
10
The following table presents unamortized intangible assets by business unit as
of September 30, 2004:
Adjusted
Gross Gross
Carrying Carrying Accumulated Net Carrying
GOODWILL Amount Impairment Amount Amortization Value
----------- --------- ----------- ------------ -----------
Sonomed $10,547,488 $-- $10,547,488 $(1,021,938) $ 9,525,550
Drew 8,622,303 -- 8,622,303 -- 8,622,303
Vascular 1,149,813 -- 1,149,813 (208,595) 941,218
Medical/Trek 272,786 -- 272,786 (147,759) 125,027
----------- ---- ----------- ----------- -----------
Total $20,592,390 $-- $20,592,390 $(1,378,292) $19,214,098
=========== ==== =========== =========== ===========
Adjusted
Gross Gross
Carrying Carrying Accumulated Net Carrying
UNAMORTIZED INTANGIBLE ASSETS Amount Impairment Amount Amortization Value
----------- ---------- ------------ ------------ ------------
Sonomed $665,000 $-- $665,000 $(63,194) $601,806
Sonomed EMS
15,100 -- 15,100 -- 15,100
-------- ---- -------- -------- --------
Total $680,100 $-- $680,100 $(63,194) $616,906
======== ==== ======== ======== ========
The following table presents unamortized intangible assets by business unit as
of June 30, 2004:
Adjusted
Gross Gross
Carrying Carrying Accumulated Net Carrying
GOODWILL Amount Impairment Amount Amortization Value
----------- --------- ----------- ------------ -----------
Sonomed $10,547,488 $-- $10,547,488 $(1,021,938) $ 9,525,550
Vascular 1,149,813 -- 1,149,813 (208,595) 941,218
Medical/Trek 272,786 -- 272,786 (147,759) 125,027
----------- ---- ----------- ----------- -----------
Total $11,970,087 $-- $11,970,087 $(1,378,292) $10,591,795
=========== ==== =========== =========== ===========
Adjusted
Gross Gross
UNAMORTIZED INTANGIBLE Carrying Carrying Accumulated Net Carrying
ASSETS Amount Impairment Amount Amortization Value
----------- ---------- ------------ ------------ ------------
Sonomed $ 665,000 $-- $ 665,000 $ (63,194) $ 601,806
Sonomed EMS 15,100 -- 15,100 -- 15,100
----------- ---- ----------- ----------- -----------
Total $ 680,100 $-- $ 680,100 $ (63,194) $ 616,906
=========== ==== =========== =========== ===========
The following table presents amortized intangible assets by business unit as of
September 30, 2004:
Adjusted
AMORTIZED INTANGIBLE Gross Gross
ASSETS Carrying Carrying Accumulated Net Carrying
PATENTS Amount Impairment Amount Amortization Value
----------- --------- ----------- ------------ -----------
Drew $453,348 $-- $453,348 (6,802) $446,546
Vascular (pending issuance 36,916 -- 36,916 -- 36,916
Medical/Trek 257,301 -- 257,301 (124,821) 132,480
Sonomed EMS -- -- -- -- --
-------- --- -------- --------- --------
Total $747,565 $-- $747,565 $(131,623) $615,942
======== === ======== ========= ========
11
The following table presents amortized intangible assets by business unit as of
June 30, 2004:
Adjusted
AMORTIZED INTANGIBLE Gross Gross
ASSETS Carrying Carrying Accumulated Net Carrying
PATENTS Amount Impairment Amount Amortization Value
----------- --------- ----------- ------------ -----------
Vascular (pending issuance) $ 36,916 $-- $ 36,916 -- $ 36,916
Medical/Trek
257,301 -- 257,301 (122,139) 135,162
Sonomed EMS
-------- --- --------- --------- --------
Total $294,217 $-- $ 294,217 $(122,139) $172,078
======== === ======== ========= ========
8. ACCRUED EXPENSES
Accrued expenses consisted of the following:
September 30, June 30,
2004 2004
---------- ----------
(unaudited)
Accrued compensation $ 802,068 $ 908,568
Acquisition expense accruals 516,126 --
Severance accruals 721,029 --
Shares reserved for future exchange 597,019 --
Other accruals 1,274,084 320,930
---------- ----------
Total $3,910,326 $1,229,498
========== ==========
Accrued compensation as of September 30, 2004 primarily relates to payroll,
bonus, vacation accruals and payroll tax liabilities.
Acquisition expense accruals as of September 30, 2004 primarily relate to
professional fees (attorneys, accountants and other consultants) accruals
related directly to the acquisition of Drew.
Severance accruals as of September 30, 2004 relate to certain former
directors and officers of Drew who management had the intent to terminate as of
the consummation date of the transaction.
Shares reserved for future exchange as of September 30, 2004 relate to the
remaining 58,314 shares that Escalon expects to issue to Drew shareholders who
are compelled to exchange their Drew shares pursuant to procedures under United
Kingdom laws and regulations. This liability has been valued using the market
price of Escalon on the date Escalon could begin to compel Drew shareholders to
tender all remaining shares. This liability will be reduced as the shareholders
exchange the remaining shares.
In addition to normal accruals, other accruals as of September 30, 2004
relate to the remaining lease payments on a facility that had been exited prior
to the acquisition, accruals for litigation existing prior to the acquisition,
franchise and ad valorem tax accruals, royalty accruals and other sundry
operating expenses and accruals.
9. LINE OF CREDIT AND LONG-TERM DEBT
On December 23, 2002, a lender acquired the Company's bank debt, which
consisted of term debt of $5,850,000 and $1,475,000 outstanding on a $2,000,000
available line of credit. On February 13, 2003, the Company entered into an
Amended Agreement with the lender. The primary amendments of the amended Loan
Agreement were to reduce quarterly principal payments, extend the term of the
repayments and to alter the covenants of the original bank agreement. On
September 30, 2004, the Company paid off
12
and terminated both the remaining term debt and the outstanding balance on this
line of credit. In November 2001, the Company issued the lender 60,000 warrants
to purchase the Company's common stock at $3.66 per share in connection with
this debt. The warrants will expire in November 2006.
On January 21, 1999, the Company's Vascular subsidiary and Endologix
entered into an Assets Sale and Purchase Agreement. Pursuant to this agreement,
the Company acquired for cash the assets of Endologix's vascular access business
in exchange for cash and also agreed to pay royalties to Endologix based on
future sales of the vascular access business for a period of five years
following the closing of the sale, with a guaranteed minimum royalty of $300,000
per year. On February 1, 2001, the parties amended the agreement to eliminate
any future royalty payments to Endologix. Pursuant to this amendment, the
Company paid $17,558 in cash to Endologix, delivered a short-term note in the
amount of $64,884 that was satisfied in January 2002, a note in the amount of
$717,558 payable in 11 quarterly installments that commenced on April 15, 2002,
and the Company issued 50,000 shares of its common stock to Endologix. On
September 30, 2004, the Company paid off the balance of the term debt.
As of September 30, 2004, Drew had an overdraft line of credit with a
United Kingdom financial institution. The amount available on the line is
$651,344. The interest rate is 2.00% over the United Kingdom prime rate (4.75%
at September 30, 2004). The line is secured by Drew's assets and is personally
guaranteed by certain of Drew's current and former directors. The balance as of
September 30, 2004 is $655,791.
Drew also has long-term debt facilities through the Texas Mezzanine Fund
and through Symbiotics, Inc. The Texas Mezzanine Fund term debt is payable in
monthly installments of $14,200, which includes interest at a fixed rate of
8.00%. The note is due in April 2008 and is secured by certain assets of Drew.
The outstanding balance at September 30, 2004 is $515,880. The Symbiotics, Inc.
term debt, which originated from the acquisition of a product line from
Symbiotics, Inc., is payable in monthly installments of $8,333 with interest at
a fixed rate of 5.00%. The outstanding balance at September 30, 2004 is
$300,002. Drew has a line of credit with a domestic financial institution
secured by certain assets of Drew. The amount available on the line of credit is
$2,000,000. Interest is at the federal prime rate plus 4.00% (8.75% at September
30, 2004). The outstanding balance as of September 30, 2004 was $531,236.
The schedule below presents principal amortization for the next five years
under each of the Company's loan agreements as of September 30, 2004:
Texas
Twelve Months Ending Mezzanine Symbiotics Total
- -------------------- -------- ---------- --------
2005 $121,672 $ 99,996 $221,668
2006 143,721 99,996 243,717
2007 155,821 100,010 255,831
2008 94,666 -- 94,666
2009 -- -- --
-------- -------- --------
Total $515,880 $300,002 $815,882
======== ======== ========
10. OTHER REVENUE
Other revenue includes quarterly payments received from (1) Bausch & Lomb
in connection with the sale of their Silicone Oil product line, (2) royalty
payments received from IntraLase Corp. ("IntraLase")relating to the licensing of
the Company's intellectual laser technology, and (3) royalty payments received
from Bio-Rad Laboratories, Inc. ("Bio-Rad").
For the three-months ended September 30, 2004, and 2003, Silicone Oil
revenue totaled $417,000 and $509,000, respectively, laser technology totaled
$239,000 and $62,000, respectively, and the Bio-Rad
13
royalty was $0 for the period ended September 30, 2004. Accounts receivable at
September 30, 2004 and June 30, 2004 related to other revenue was $417,000 and
$459,000, respectively.
BAUSCH & LOMB SILICONE OIL
The agreement with Bausch & Lomb, which commenced on August 13, 2000, is
structured so that the Company receives consideration from Bausch & Lomb based
on its adjusted gross profit from its sales of Silicone Oil on a quarterly
basis. The consideration is subject to a factor, which steps down through the
termination date (August 2005) according to the following schedule:
From 8/13/00 to 8/12/01 100%
From 8/13/01 to 8/12/02 82%
From 8/13/02 to 8/12/03 72%
From 8/13/03 to 8/12/04 64%
From 8/13/04 to 8/12/05 45%
INTRALASE: LICENSING OF LASER TECHNOLOGY
The material terms of the license of the Company's laser patents to
IntraLase, which expires in 2014, provide that the Company will receive a 2.5%
royalty on product sales that are based on the licensed laser patents, subject
to deductions for royalties payable to third parties up to a maximum of 50% of
royalties otherwise due and payable to the Company, and a 1.5% royalty on
product sales that are not based on the licensed laser patents. The Company
receives a minimum annual license fee of $15,000 per year during the remaining
term of the license. The minimum annual license fee is offset against the
royalty payments. In addition, the Company owns 252,535 common shares of
IntraLase pursuant to the license agreement. See also Note 11 Commitments and
Contingencies.
The license was dated October 23, 1997, was amended and restated in October
2000 and expires on the latest of the following events:
- - The last to expire of the laser patents;
- - Ten years from the effective date of the amended and restated agreement;
- - The fifth anniversary date of the first commercial sale.
The material termination provisions of the license of the laser technology are
as follows:
- - The Company has the right to terminate if IntraLase defaults in the payment
of any royalty;
- - The Company has the right to terminate if IntraLase makes any false report;
- - The Company has the right to terminate if IntraLase defaults in the making
of any required report;
- - The commission of any material breach of any covenant or promise under the
license agreement; or
- - The termination of the license by IntraLase after 90 days notice (if
IntraLase were to terminate, they would not be permitted to utilize the
licensed technology necessary to manufacture their current products).
14
BIO-RAD ROYALTY
The royalty received from Bio-Rad relates to a certain non-exclusive
Eighth Amendment to OEM Agreement "OEM" Agreement) between the Company's Drew
business and Bio-Rad, dated July 19, 1994. Bio-Rad pays a royalty based on
sales of certain of Drew's products in certain specifically identified
geographic regions.
The material terms of the OEM Agreement which expires May 15, 2005 provide
as follows:
* Drew receives a royalty of 19.5 cents per test
* The royalty payment are due 30 days after the end of the month
* Royalty payments will be made depending on the volume of tests
provided by Bio-Rad if less than 3,750 tests per month, Bio-Rad will calculate
the number of tests used on a quarterly basis in arrears and pay Drew within
45 days of the end of the quarter. If more than 3,750 tests per month Bio-Rad
will pay an estimated month royalty and within 45 days of the end of the
quarter make final settlement upon actual number of tests per month.
11. COMMITMENTS AND CONTINGENCIES
COMMITMENTS
Escalon leases its manufacturing, research and corporate office facilities
and certain equipment under non-cancelable operating lease arrangements. The
Company has also entered into an agreement whereby the Company is obligated to
purchase a contracted minimum amount of product from the other party to the
agreement. The future minimum payments to be paid under these arrangements as of
September 30, 2004 are as follows:
Lease Purchase
Twelve Months Ending Obligations Commitments Total
- -------------------- ---------- ----------- ----------
2005 $ 773,154 $700,000 $1,473,154
2006 764,873 -- 764,873
2007 567,844 -- 567,844
2008 312,606 -- 312,606
2009 270,164 -- 270,164
Thereafter 583,381 -- 583,381
---------- -------- ----------
Total $3,272,022 $700,000 $3,972,022
========== ======== ==========
Rent expense charged to operations during the three months ended September
30, 2004 and 2003 was $141,191 and $86,424, respectively.
CONTINGENCIES
ROYALTY AGREEMENT: CLINICAL DIAGNOSTIC SOLUTIONS
Drew and Clinical Diagnostic Solutions, Inc. ("CDS") entered into a Private
Label/Manufacturing Agreement dated April 1, 2002 for the right to sell
formulations or products of CDS including reagents, controls and calibrators
("CDS products") on a private label basis. The agreement term is 15 years and
automatically renews year-to-year thereafter. Drew is obligated to pay CDS a
royalty of 7.5% on all sales of CDS products produced from Drew's United Kingdom
facility. The amount of royalties paid during the three months ended September
30, 2004 was $4,509.
LEGAL PROCEEDINGS: INTRALASE
On June 10, 2004, Escalon provided notice to Intralase of the Company's
intention to terminate the license agreement with Intralase due to Intralase's
failure to pay certain royalties that the Company believes are due under the
license agreement. On June 21, 2004, Intralase sought a preliminary injunction
and a temporary restraining order with the United States District Court for the
Central District of California, Southern District against Escalon to prevent the
termination of the license agreement with Intralase. The parties subsequently
agreed to stipulate to the temporary restraining order to prevent a termination
of the license agreement and, on July 6, 2004, as mutually agreed by Intralase
and Escalon, the same district court entered a stipulation and order to delay
the requested hearing on the preliminary injunction until November 1, 2004. The
Company does not believe that this matter has had or is likely to have a
material adverse effect on the Company's business, financial condition or future
results of operations.
15
LEGAL PROCEEDINGS: DREW
Escalon is aware of three lawsuits involving Drew. The first lawsuit
involves the principal shareholders of an entity previously acquired by Drew for
the collection of unpaid expenses. A counterclaim was filed for breach of
intellectual property rights and for breach of the principal shareholders'
covenants not to compete. This action was filed in the state courts of
Connecticut. The second lawsuit was filed in the state court of Minnesota, but
transferred to the Federal District Court of Minnesota. This action was brought
by a distributor against an entity previously acquired by Drew claiming a breach
of a marketing and distribution agreement. The parties have reached a tentative
settlement of this matter. The third action involves a suit instituted in
California in connection with a dispute from a customer claiming a refund for a
product purchase. The Company does not believe that the resolution of these
matters has had or is likely to have a material adverse effect on the Company's
business, financial condition or future results of operations.
OTHER LEGAL PROCEEDINGS
Furthermore, Escalon, from time to time is involved in various legal
proceedings and disputes that arise in the normal course of business. These
matters have included intellectual property disputes, contract disputes,
employment disputes and other matters. The Company does not believe that the
resolution of any of these matters has had or is likely to have a material
adverse effect on the Company's business, financial condition or results of
operations.
16
12. SEGMENTAL INFORMATION
During the three-month periods ended September 30, 2004 and 2003, the
Company operations were classified into four principal reportable segments that
provide different products or services. This represents a change from fiscal
2004. The Company acquired Drew on July 23, 2004, and subsequently, Drew has
been added as an additional business segment. During the first quarter of fiscal
2005, management also changed the structure of its internal organization that
caused Medical/Trek and EMI to be reported as one reportable segment. The
corresponding interim period has been restated to present comparative
information. Separate management of each segment is required because each
business unit is subject to different marketing, production and technology
strategies.
SEGMENTAL STATEMENTS OF OPERATIONS (IN THOUSANDS) -
THREE MONTHS ENDED SEPTEMBER 30,
Drew Sonomed Vascular Medical/Trek/EMI Total
---------------- -------------------- ------------------ ------------------ --------------------
2004 2003 2004 2003 2004 2003 2004 2003 2004 2003
-------- ---- -------- -------- ------- ------- ------- ------- -------- --------
Product revenue $ 1,904 $-- $ 1,644 $ 1,705 $ 695 $ 734 $ 393 $ 402 $ 4,636 $ 2,841
Other revenue -- -- -- -- -- -- 656 571 656 571
-------- ---- -------- -------- ------- ------- ------- ------- -------- --------
Total revenue 1,904 -- 1,644 1,705 695 734 1,049 973 5,292 3,412
-------- ---- -------- -------- ------- ------- ------- ------- -------- --------
Costs and expenses:
Cost of goods sold 1,251 -- 859 681 320 296 241 236 2,671 1,213
Operating expenses 937 -- 629 712 409 434 523 276 2,498 1,422
-------- ---- -------- -------- ------- ------- ------- ------- -------- --------
Total costs and
expenses 2,188 -- 1,488 1,393 729 730 764 512 5,169 2,635
-------- ---- -------- -------- ------- ------- ------- ------- -------- --------
Income from operations (284) -- 156 312 (34) 4 285 461 123 777
Other income and
expenses:
Equity in OTM -- -- -- -- -- -- (29) -- (29) --
Interest income 4 -- -- -- -- -- 137 1 141 1
Interest expense (24) -- (81) (115) (1) (4) -- -- (106) (119)
-------- ---- -------- -------- ------- ------- ------- ------- -------- --------
Total other income
and expenses (20) -- (81) (115) (1) (4) 108 1 6 (118)
-------- ---- -------- -------- ------- ------- ------- ------- -------- --------
Income before taxes (304) -- 75 197 (35) -- 393 462 129 659
Income taxes -- -- -- -- -- -- 13 36 13 36
-------- ---- -------- -------- ------- ------- ------- ------- -------- --------
Net income (loss) $ (304) $-- $ 75 $ 197 $ (35) $-- $ 380 $ 426 $ 116 $ 623
======== ==== ======== ======== ======= ======= ======= ======= ======== ========
Depreciation and
amortization $ 46 $-- $ 7 $ 6 $ 11 $ 11 $ 28 $ 48 $ 92 $ 65
Assets $ 15,128 $-- $ 12,844 $ 12,562 $ 2,226 $ 2,142 $ 7,941 $14,753 $ 38,139 $ 29,457
Expenditures for
long-lived assets $ 2 $-- $ 19 $-- $ 7 $-- $ 11 $ 16 $ 39 $ 16
13. SHAREHOLDERS' EQUITY
WARRANTS TO PURCHASE COMMON STOCK
In connection with debt issued by a former lender to Escalon in November
2001, the Company issued the lender warrants to purchase 60,000 shares of the
Company's common stock at $3.66 per share. The warrants are currently
exercisable and will expire in November 2006.
In connection with the private placement of Escalon's common stock in March
2004, the Company issued several accredited investors warrants to purchase
120,000 shares of the Company's common stock. The warrants are exercisable at
$15.60 per share and expire in five years from the placement date.
17
EXCHANGE OFFER FOR DREW SCIENTIFIC GROUP, PLC
During the three months ended September 30, 2004, the Company issued
841,686 shares of its common stock pursuant to its exchange offer for all of the
outstanding shares of Drew, and had acquired approximately 94% of the
outstanding shares of Drew as of that date. During the remainder of fiscal 2005,
Escalon expects to compel Drew shareholders to tender all of the remaining
outstanding Drew shares pursuant to procedures under United Kingdom laws and
regulations. A total of 58,314 shares are reserved for future issuance in
connection with this final exchange.
14. RELATED PARTY TRANSACTIONS
Escalon and a member of the Company's Board of Directors are founding and
equal members of Ocular Telehealth Management, LLC ("OTM"). OTM is a diagnostic
telemedicine company providing remote examination, diagnosis and management of
disorders affecting the human eye. OTM's initial solution focuses on the
diagnosis of diabetic retinopathy by creating access and providing annual
dilated retinal examinations for the diabetic population. OTM was founded to
harness the latest advances in telecommunications, software and digital imaging
in order to create greater access and a more successful disease management for
populations that are susceptible to ocular disease. Through September 30, 2004,
Escalon has invested $130,000 in OTM and has committed to invest an additional
$126,000 through March 31, 2005. As of September 30, 2004, Escalon owned 50% of
OTM. The members of OTM have agreed to review the operations of OTM after 24
months, at which time the members each have the right to sell their membership
interest back to OTM at fair market value. The Company will provide
administrative support functions to OTM. Through September 30, 2004, OTM had
revenue of $115 and incurred expenses of $58,517. This investment is accounted
for under the equity method of accounting and is included in other assets.
Commencing in July 2004, a relative of a senior executive officer of
Escalon began providing legal services to the Company in connection with various
legal proceedings. Expenses incurred through this individual were $13,062 during
the three-month period ended September 30, 2004.
15. SUBSEQUENT EVENT - INTRALASE INITIAL PUBLIC OFFERING
In October 1997, Escalon licensed its intellectual laser properties to
IntraLase in exchange for an equity interest of 252,535 shares of common stock
(as adjusted for splits), as well as royalties on future product sales. On
October 7, 2004, IntraLase announced the initial public offering of shares of
its common stock at a price of $13.00 per share. The shares of common stock are
restricted for a period of less than one year and may be sold after April 4,
2005 pursuant to a certain Fourth Amended Registration Rights Agreement between
the Company and IntraLase. The shares have been classified as
available-for-sale-securities. The Company has historically accounted for these
shares at $0 basis because a readily determinable market value was not
available.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS
Certain statements contained in, or incorporated by reference in, the
Quarterly Report on Form 10-Q, are forward-looking statements, made pursuant to
the safe harbor provisions of the Private Securities Litigation Reform Act of
1995, which provide current expectations or forecasts of future events. Such
statements can be identified by the use of terminology such as "anticipate,"
"believe," "could," "estimate," "expect," "forecast," "intend," "may," "plan,"
"possible," "project," "should," "will" and similar words or expressions. The
Company's forward-looking statements include certain information relating to
general business strategy, growth strategies, financial results, liquidity,
product development, the introduction of new products, the potential markets and
uses for the Company's products, the Company's regulatory filings with the
United States Food and Drug Administration (the "FDA"), acquisitions, the
development of joint venture opportunities, the effect of competition on the
structure of the markets in which the Company competes and defending the Company
in litigation matters. One must carefully consider forward-looking
18
statements and understand that such statements involve a variety of risks and
uncertainties, known and unknown, and may be affected by assumptions that fail
to materialize as anticipated. Consequently, no forward-looking statement can be
guaranteed, and actual results may vary materially. It is not possible to
foresee or identify all factors affecting the Company's forward-looking
statements, and one therefore should not consider the following list of such
factors to be an exhaustive statement of all risks, uncertainties or potentially
inaccurate assumptions. The Company undertakes no obligation to update any
forward-looking statement. Although it is not possible to create a comprehensive
list of all factors that may cause actual results to differ from the Company's
forward-looking statements, the most important factors include without
limitation, the following:
THE COMPANY'S PRODUCTS ARE SUBJECT TO STRINGENT ONGOING REGULATION BY THE
FDA AND SIMILAR HEALTH AUTHORITIES, AND IF THE FDA'S APPROVALS OR
CLEARANCES OF THE COMPANY'S PRODUCTS ARE RESTRICTED OR REVOKED, THE COMPANY
COULD FACE DELAYS THAT WOULD IMPAIR THE COMPANY'S ABILITY TO GENERATE FUNDS
FROM OPERATIONS.
The FDA and similar health authorities in foreign countries extensively
regulate Escalon's activity. The Company must obtain either 510(K) clearances or
pre-market approvals and new drug application approvals prior to marketing a
product in the United States. Foreign regulation also requires that Escalon
obtain other approvals from foreign government agencies prior to the sale of
products in those countries. Also, Escalon may be required to obtain FDA
approval before exporting a product or device that has not received FDA
marketing clearance or approval.
Escalon has received the necessary FDA approvals for all products that the
Company currently markets. Any restrictions on or revocation of the FDA
approvals and clearances that the Company has obtained, however, would prevent
the continued marketing of the impacted products and other devices. The
restrictions or revocations could result from the discovery of previously
unknown problems with the product. Consequently, FDA revocation would impair the
Company's ability to generate funds from operations.
The FDA and comparable agencies in state and local jurisdictions and in
foreign countries impose substantial requirements upon the manufacturing and
marketing of pharmaceutical and medical device equipment and related
disposables, including the obligation to adhere to the FDA's Good Manufacturing
Practice regulations. Compliance with these regulations requires time-consuming
detailed validation of manufacturing and quality control processes, FDA periodic
inspections and other procedures. If the FDA finds any deficiencies in the
validation processes, for example, the FDA may impose restrictions on marketing
the specific products until such deficiencies are corrected.
Escalon has received CE approval on several of the Company's products that
allows the Company to sell the products in the countries comprising the European
community. In addition to the CE mark, however, some foreign countries may
require separate individual foreign regulatory clearances. Escalon cannot assure
that the Company will be able to obtain regulatory clearances for other products
in the United States or foreign markets.
The process for obtaining regulatory clearances and approvals underlying
clinical studies for any new products or devices and for multiple indications
for existing products is lengthy and will require substantial commitments of
Escalon's financial resources and Escalon's management's time and effort. Any
delay in obtaining clearances or approvals or any changes in existing regulatory
requirements would materially adversely affect the Company's business.
Escalon's failure to comply with the applicable regulations would subject
the Company to fines, delays or suspensions of approvals or clearances, seizures
or recalls of products, operating restrictions, injunctions or civil or criminal
penalties, which would adversely affect the Company's business, financial
condition and results of operations.
19
FAILURE OF THE MARKET TO ACCEPT THE COMPANY'S PRODUCTS COULD ADVERSELY
IMPACT THE COMPANY'S BUSINESS AND FINANCIAL CONDITION.
The Company's business and financial condition will depend upon the market
acceptance of the Company's products. The Company cannot assure that the
Company's products will achieve market acceptance. Market acceptance depends
upon a number of factors:
- The price of the products;
- The receipt of regulatory approvals for multiple indications;
- The establishment and demonstration of the clinical safety and
efficacy of the Company's products; and
- The advantages of the Company's products over those marketed by the
Company's competitors.
Any failure to achieve significant market acceptance of the Company's
products will have a material adverse effect on the Company's business.
THE SUCCESS OF COMPETITIVE PRODUCTS COULD HAVE AN ADVERSE EFFECT ON THE
COMPANY'S BUSINESS.
The Company faces intense competition in the medical device and
pharmaceutical markets, which are characterized by rapidly changing technology,
short product life cycles, cyclical oversupply and rapid price erosion. Many of
the Company's competitors have substantially greater financial, technical,
marketing, distribution and other resources. The Company's strategy is to
compete primarily on the basis on technological innovation, reliability, quality
and price of the Company's products. Without timely introductions of new
products and enhancements, the Company's products will become technologically
obsolete over time, in which case the Company's revenues and operating results
would suffer. The success of the Company's new product offerings will depend on
several factors, including the Company's ability to:
- Properly identify customer needs;
- Innovate and develop new technologies, services and applications;
- Establish adequate product distribution coverage;
- Obtain and maintain required regulatory approvals from the FDA and
other regulatory agencies;
- Protect the Company's intellectual property;
- Successfully commercialize new technologies in a timely manner;
- Manufacture and deliver the Company's products in sufficient volumes
on time;
- Differentiate the Company's offerings from the offerings of the
Company's competitors;
- Price the Company's products competitively;
- Anticipate competitors' announcements of new products, services or
technological innovations; and
- General market and economic conditions.
20
The Company cannot assure that the Company will be able to compete effectively
in the competitive environments in which it operates.
THE COMPANY'S PRODUCTS EMPLOY PROPRIETARY TECHNOLOGY, AND THIS TECHNOLOGY
MAY INFRINGE ON THE INTELLECTUAL PROPERTY RIGHTS OF THIRD PARTIES.
The Company holds several United States and foreign patents for the
Company's products. Other parties, however, hold patents relating to similar
products and technologies. If patents held by others were adjudged valid and
interpreted broadly in an adversarial proceeding, the court or agency could deem
them to cover one or more aspects of the Company's products or procedures. Any
claims for patent infringements or claims by the Company for patent enforcement
would consume time, result in costly litigation, divert technical and management
personnel or require the Company to develop non-infringing technology or enter
into royalty or licensing agreements. The Company cannot be certain that the
Company will not be subject to one or more claims for patent infringement, that
the Company would prevail in any such action or that the Company's patents will
afford protection against competitors with similar technology.
If a court determines that any of the Company's products, infringes,
directly or indirectly, on a patent in a particular market, the court may enjoin
the Company from making, using or selling the product. Furthermore, the Company
may be required to pay damages or obtain a royalty-bearing license, if
available, on acceptable terms.
THE COMPANY WILL NO LONGER RECEIVE REVENUE FROM THE SALE OF SILICONE OIL BY
BAUSCH & LOMB SUBSEQUENT TO AUGUST 13, 2005.
The Company realized 7.88% and 14.91% of its net revenue during the
three-month periods ended September 30, 2004 and 2003, respectively, from Bausch
& Lomb's sales of Silicone Oil. The Company is entitled to receive this revenue
from Bausch & Lomb, in varying amounts, through August 2005. The agreement with
Bausch & Lomb, which commenced on August 13, 2000, is structured such that the
Company receives consideration from Bausch & Lomb based on its adjusted gross
profit from its sales of Silicone Oil on a quarterly basis. The consideration is
subject to a factor, which steps down according to the following schedule:
From 8/13/00 to 8/12/01 100%
From 8/13/01 to 8/12/02 82%
From 8/13/02 to 8/12/03 72%
From 8/13/03 to 8/12/04 64%
From 8/13/04 to 8/12/05 45%
The revenue associated with the sale of Silicone Oil by Bausch & Lomb has
no associated expense and consequently provides a gross margin of 100%. Any
significant reduction in this revenue can have a significant negative impact on
gross margin. Any significant decrease in Silicone Oil revenue received by the
Company would have an impact on the Company's financial position, results of
operations and cash flows and the Company's stock price could be negatively
impacted.
LACK OF AVAILABILITY OF KEY SYSTEM COMPONENTS COULD RESULT IN DELAYS,
INCREASED COSTS OR COSTLY REDESIGN OF THE COMPANY'S PRODUCTS.
Although some of the parts and components used to manufacture the Company's
products are available from multiple sources, the Company currently purchases
most of the Company's components from single sources in an effort to obtain
volume discounts. Lack of availability of any of these parts and components
could result in production delays, increased costs, or costly redesign of the
Company's products. Any loss of availability of an essential component could
result in a material adverse change to Escalon's business, financial condition
and results of operations. Some of the Company's suppliers are also subject to
the FDA's Good Manufacturing Practice regulations. Failure of these suppliers to
comply
21
with these regulations could result in the delay or limitation of the supply of
parts or components to the Company, which would adversely affect the Company's
financial condition and results of operations.
THE COMPANY'S ABILITY TO MARKET OR SELL THE COMPANY'S PRODUCTS MAY BE
ADVERSELY AFFECTED BY LIMITATIONS ON REIMBURSEMENTS BY GOVERNMENT PROGRAMS,
PRIVATE INSURANCE PLANS AND OTHER THIRD PARTY PAYORS.
The Company's customers bill various third party payors, including
government programs and private insurance plans, for the health care services
provided to their patients. Third party payors may reimburse the customer,
usually at a fixed rate based on the procedure performed, or may deny
reimbursement if they determine that the use of the Company's products was
elective, unnecessary, inappropriate, not cost-effective, experimental or used
for a non-approved indication. Third party payors may deny reimbursement
notwithstanding FDA approval or clearance of a product and may challenge the
prices charged for the medical products and services. The Company's ability to
sell the Company's products on a profitable basis may be adversely impacted by
denials of reimbursement or limitations on reimbursement, compared with
reimbursement available for competitive products and procedures. New legislation
that further reduces reimbursements under the capital cost pass-through system
utilized in connection with the Medicare program could also adversely affect the
marketing of the Company's products.
FUTURE LEGISLATION OR CHANGES IN GOVERNMENT PROGRAMS MAY ADVERSELY AFFECT
THE MARKET FOR THE COMPANY'S PRODUCTS.
In the past several years, the federal government and Congress have made
proposals to change aspects of the delivery and financing of health care
services. The Company cannot predict what form any future legislations may take
or its effect on the Company's business. Legislation that sets price limits and
utilization controls may adversely affect the rate of growth of ophthalmic and
vascular access product markets. If any future health care legislation were to
adversely impact those markets, the Company's product marketing could also
suffer, which would adversely impact the Company's business.
THE COMPANY MAY BECOME INVOLVED IN PRODUCT LIABILITY LITIGATION, WHICH MAY
SUBJECT THE COMPANY TO LIABILITY AND DIVERT MANAGEMENT ATTENTION.
The testing and marketing of the Company's products for applications in
ophthalmology and vascular access, the Company's pharmaceutical products and
vascular access products entail and inherent risk of product liability,
resulting in claims based upon injuries or alleged injuries associated with a
defect in the products' performance. Some of these injuries may not become
evident for a number of years. Although the Company is not currently involved in
any product liability litigation, the Company may be party to litigation in the
future as a result of an alleged claim. Litigation, regardless of the merits of
the claim or outcome, could consume a great deal of the Company's time and money
and would divert management time and attention away from the Company's core
businesses. The Company maintains limited product liability insurance coverage
of $1,000,000 per occurrence and $2,000,000 in the aggregate, with umbrella
policy coverage of up to $5,000,000 in excess of such amounts. A successful
product liability claim in excess of any insurance coverage may adversely impact
the Company's financial condition and results of operations. The Company cannot
assure you that product liability insurance coverage will continue to be
available to the Company in the future on reasonable terms or at all.
THE COMPANY'S INTERNATIONAL OPERATIONS COULD BE ADVERSELY IMPACTED BY
CHANGES IN LAWS OR POLICIES OR FOREIGN GOVERNMENTAL AGENCIES AND SOCIAL AND
ECONOMIC CONDITIONS IN THE COUNTRIES IN WHICH THE COMPANY OPERATES.
The Company derives a portion of its revenues from sales outside the United
States. Changes in the laws or policies of governmental agencies, as well as
social and economic conditions, in the countries in which the Company operates
could affect the Company's business in these countries and the Company's results
of operations. Also, economic factors, including inflation and fluctuations in
interest rates and foreign currency exchange rates, and competitive factors such
as price competition, business combinations
22
of competitors or a decline in industry sales from continued economic weakness,
both in the United States and other countries in which the Company conducts
business, could adversely affect the Company's results of operations.
THE COMPANY IS DEPENDENT ON ITS MANAGEMENT AND KEY PERSONNEL TO SUCCEED.
The Company's principal executive officers and technical personnel have
extensive experience with the Company's products, the Company's research and
development efforts, the development of marketing and sales programs and the
necessary support services to be provided to the Company's customers. Also, the
Company competes with other companies, universities, research entities and other
organizations to attract and retain qualified personnel. The loss of the
services of any of the Company's executive officers or other technical
personnel, or the Company's failure to attract and retain other skilled and
experienced personnel, could have a material adverse effect on the Company's
ability to maintain or expand its businesses.
ANY ACQUISITIONS, STRATEGIC ALLIANCES, JOINT VENTURES AND DIVESTITURES THAT
THE COMPANY EFFECTS COULD RESULT IN FINANCIAL RESULTS THAT DIFFER FROM
MARKET EXPECTATIONS.
In the normal course of business, the Company engages in discussions with
third parties regarding possible acquisitions, strategic alliances, joint
ventures and divestitures. As a result of any such transactions, the Company's
financial results may differ from the investment community's expectations in a
given quarter. In addition, acquisitions and alliances may require the Company
to integrate a different company culture, management team and business
infrastructure. The Company may have difficulty developing, manufacturing and
marketing the products of a newly acquired company in a way that enhances the
performance of the Company's combined businesses or product lines to realize the
value from expected synergies. Depending on the size and complexity of an
acquisition, the Company's successful integration of the entity depends on a
variety of factors including the retention of key employees and the management
of facilities and employees in separate geographical areas. These efforts
require varying levels of management resources, which may divert the Company's
attention from other business operations. The Company acquired Drew during the
first quarter of fiscal 2005. Drew does not have a history of producing positive
operating cash flows and, as a result, at the time of acquisition, was operating
under financial constraints and was under-capitalized and is expected to
negatively impact the Company's financial results in the short term. If the
Company does not realize the expected benefits or synergies of such
transactions, the Company's consolidated financial position, results of
operations and stock price could be negatively impacted.
THE MARKET PRICE OF THE COMPANY'S STOCK HAS HISTORICALLY BEEN VOLATILE, AND
THE COMPANY HAS NOT PAID CASH DIVIDENDS.
The volatility of the Company's common stock imposes a greater risk of
capital losses on shareholders as compared to less volatile stocks. In addition,
such volatility makes it difficult to ascribe a stable valuation to a
shareholder's holdings of the Company's common stock. The following factors have
and may continue to have a significant impact on the market price of the
Company's common stock:
- Announcements of technological innovations;
- Changes in marketing, product pricing and sales strategies or new
products by the Company's competitors;
- Any acquisitions, strategic alliances, joint ventures and divestitures
that the Company effects;
- Changes in domestic or foreign governmental regulations or regulatory
requirements; and
- Developments or disputes relating to patent or proprietary rights and
public concern as to the safety and efficacy of the procedures for
which the Company's products are used.
23
Moreover, the possibility exists that the stock market, and in
particular the securities of technology companies such as Escalon, could
experience extreme price and volume fluctuations unrelated to operating
performance. The Company has not paid any cash dividends on its common stock and
does not anticipate paying any cash dividends in the foreseeable future.
THE COMPANY'S RESULTS FLUCTUATE FROM QUARTER TO QUARTER
The Company has experienced quarterly fluctuations in operating
results and anticipates continued fluctuations in the future. A number of
factors contribute to these fluctuations:
- Acquisitions (such as Drew) and subsequent integration of the
acquired company,
- Changes in the mix of products sold;
- The timing and expense of new product introductions by the Company
or its competitors;
- Fluctuations in royalty income;
- Announcements of new strategic relationships by the Company or its
competitors;
- The cancellation or delays in the purchase of the Company's
products;
- The gain or loss of significant customers;
- Fluctuations in customer demand for the Company's products; and
- Competitive pressures on prices at which the Company can sell its
products.
The Company sets its spending levels in advance of each quarter
based, in part, on the Company's expectations of product orders and shipments
during that quarter. A shortfall in revenue, therefore, in any particular
quarter as compared to the Company's plan could have a material adverse effect
on the Company's results of operations and cash flows. Also, the Company's
quarterly results could fluctuate due to general conditions in the healthcare
industry or global economy generally, or market volatility unrelated to the
Company's business and operating results.
THE IMPACT OF TERRORISM OR ACTS OF WAR COULD HAVE A MATERIAL ADVERSE
EFFECT ON THE COMPANY'S BUSINESS.
Terrorist acts or acts of war, whether in the United States or
abroad, could cause damage or disruption to the Company's operations, its
suppliers, channels to market or customers, or could cause costs to increase, or
create political or economic instability, any of which could have a material
adverse effect on the Company's business.
THE COMPANY'S CHARTER DOCUMENTS AND PENNSYLVANIA LAW MAY INHIBIT A
TAKEOVER.
Certain provisions of Pennsylvania law and our Bylaws could delay or
impede the removal of incumbent directors and could make it more difficult for a
third party to acquire, or could discourage a third party from attempting to
acquire, control of the Company. These provisions could limit the price that
certain investors might be willing to pay in the future for shares of the
Company's common stock. The Company's Board of Directors is divided into three
classes, with directors in each class elected for three-year terms. The bylaws
impose various procedural and other requirements that could make it more
difficult for shareholders to effect certain corporate actions. The Company's
Board of Directors may issue shares of preferred stock without shareholder
approval on such terms and conditions, and having such rights, privileges and
preferences, as the Board may determine. The rights of the holders of common
stock will be
24
subject to, and may be adversely affected by, the rights of the holders of any
preferred stock that may be issued in the future. The Company has no current
plans to issue any shares of preferred stock.
The reader must carefully consider forward-looking statements and
understand that such statements involve a variety of risks and uncertainties,
known an unknown, and may be affected by inaccurate assumptions. It is not
possible to foresee or identify all factors that may affect the Company's
forward-looking statements, and the reader should not consider any list of such
factors to be an exhaustive list of all risks, uncertainties or potentially
inaccurate assumptions affecting such forward-looking statements.
The Company cautions the reader to consider carefully these factors
as well as the specific factors discussed with each specific forward-looking
statement in this quarterly report and in the Company's other filings with the
Securities and Exchange Commission. In some cases, these factors have affected,
and in the future (together with other unknown factors) could affect the
Company's ability to implement the Company's business strategy and may cause
actual results to differ materially from those contemplated by such
forward-looking statements. No assurance can be made that any expectation,
estimate or projection contained in a forward-looking statement can be achieved.
The Company also cautions the reader that forward-looking statements
speak only as of the date made. The Company undertakes no obligation to update
any forward-looking statement, but investors are advised to consult any further
disclosures by the Company on this subject in the Company's filings with the
Securities and Exchange Commission, especially on Forms 10-K, 10-Q and 8-K, in
which the Company discusses in more detail various important factors that could
cause actual results to differ from expected or historical results. The Company
intends to take advantage of the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995 regarding the Company's forward-looking
statements, and are including this sentence for the express purpose of enabling
the Company to use the protections of the safe harbor with respect to all
forward-looking statements.
EXECUTIVE OVERVIEW - THREE-MONTH PERIOD ENDED SEPTEMBER 30, 2004
The following highlights are discussed in further detail within this
Form 10-Q. The reader is encouraged to read this Form 10-Q in its entirety to
gain a more complete understanding of factors affecting Company performance and
financial condition.
- On July 23, 2004, Escalon acquired approximately 67% of the
outstanding ordinary shares of Drew pursuant to the Company's
exchange offer for all of the outstanding ordinary shares of Drew,
and since that date has acquired substantially all of the Drew
shares. During the remainder of fiscal 2005, Escalon expects to
compel Drew shareholders to tender all of the remaining outstanding
Drew shares pursuant to procedures under United Kingdom laws and
regulations. Drew's revenue during the period from July 24, 2004
through September 30, 2004 was $1,904,000 and Drew's operations
resulted in a net loss of $304,000. Prior to acquisition, Drew's
ability to obtain raw materials and components was severely
restricted due to prolonged liquidity constraints. These constraints
were pervasive through all of Drew's locations and affected all
aspects of Drew's operations. Escalon's immediate operational
priorities with respect to Drew have been to stabilize and increase
Drew's revenue base and to infuse Drew with the working capital in
the areas of manufacturing, sales and marketing and product
development in order to remove the pre-acquisition liquidity
constraints.
- In connection with the acquisition of Drew, the Company issued
841,686 shares of its common stock during the three-month period
ended September 30, 2004. As of September 30, 2004, 58,314 shares of
the Company's common stock remain reserved for future exchange for
Drew shares.
- During the three-month period ended September 30, 2004, the Company
paid off all of its term debt that existed prior to the acquisition
of Drew as well as the outstanding line of credit that existed prior
to the acquisition. The total pre-acquisition debt paid off during
the three-month period ended September 30, 2004 was $4,268,000.
- When Drew is excluded, product revenue decreased 3.84% during the
three-month period ended September 30, 2004 as compared to the same
period last fiscal year. The decrease is primarily related to the
Sonomed business unit. The decrease in Sonomed product revenue was
primarily caused by a decrease in demand for the Company's
pachymeter product.
25
- Other revenue increased 14.93% during the three-month period ended
September 30, 2004 as compared to the same period last fiscal year.
The increase relates to an increase in royalty payments received
from Intralase. During the three-month period ended September 30,
2004, 63.56% of the Company's other revenue was received from Bausch
& Lomb in connection with the Silicone Oil product line. The Bausch
& Lomb contract for this revenue expires in August 2005.
- When Drew is excluded, cost of goods sold as a percentage of product
revenue increased to 52.01% of product revenue during the
three-month period ended September 30, 2004, as compared to 42.70%
of product revenue, for the same period last fiscal year. The
increase is primarily related to the Sonomed business unit. The
primary factors affecting Sonomed were product mix, most notably the
decrease in pachymeter sales, in addition to an increase in
international sales, where the Company generally experiences lower
price per unit on its products.
- When Drew is excluded, operating expenses increased 9.87% during the
three-month period ended September 30, 2004 as compared to the same
period last fiscal year. The increase primarily relates to the
Company's continuing efforts to strengthen its sales channels
domestically and overseas as well as increases in administrative
headcount.
- Interest expense decreased during the three-month period ended
September 30, 2004 as compared to the same period last fiscal year.
The Company paid off several of its debt facilities to several
entities in advance of their maturity dates. Additionally, the
Company reversed accrued loan commitment fees pursuant to the
satisfaction of the debt and release by the lender of those fees.
The fees were originally accrued based on contractual terms.
COMPANY OVERVIEW
The following discussion should be read in conjunction with interim
condensed consolidated financial statements and the notes thereto, which are set
forth elsewhere in this report on Form 10-Q.
The Company operates in the healthcare market, specializing in the
development, manufacture, marketing and distribution of medical devices and
pharmaceuticals in the areas of ophthalmology, diabetes, cardiovascular disease,
hematology and vascular access. The Company and its products are subject to
regulation and inspection by the FDA. The FDA requires extensive testing of new
products prior to sale and has jurisdiction over the safety, efficacy and
manufacturing of products, as well as product labeling and marketing. The
Company's Internet address is www.escalonmed.com.
In February 1996, the Company acquired substantially all of the
assets and certain liabilities of EOI a developer and distributor of ophthalmic
surgical products. Prior to this acquisition, the Company devoted substantially
all of its resources to the research and development of ultrafast laser systems
designed for the treatment of ophthalmic disorders. As a result of the EOI
acquisition, Escalon changed its market focus and is no longer developing laser
technology. In October 1997, the Company licensed its intellectual laser
property to IntraLase, in return for an equity interest and future royalties on
sales of products relating to the laser technology. IntraLase undertook the
responsibility for funding and developing the laser technology through to
commercialization. IntraLase began selling products related to the laser
technology during fiscal 2002. The Company is in dispute with IntraLase over
royalty payments owed to the Company. See Part II, Item 1. Legal Proceedings,
for further information. IntraLase completed its initial public offering in
October 2004. See the Notes to Condensed Consolidated Financial Statements for
further information.
To further diversify its product portfolio, in January 1999, the
Company's Vascular subsidiary acquired the vascular access product line from
Endologix, formerly Radiance Medical Systems, Inc. Vascular's products use
Doppler technology to aid medical personnel in locating arteries and veins in
difficult circumstances. Currently, this product line is concentrated in the
cardiac catheterization market. In January 2000, the Company purchased Sonomed,
a privately held manufacturer of ophthalmic ultrasound diagnostic equipment.
26
On July 23, 2004, Escalon acquired approximately 67% of the
outstanding ordinary shares of Drew, a United Kingdom company, pursuant to the
Company's exchange offer for all of the outstanding ordinary shares of Drew, and
since that date has acquired substantially all of the Drew shares. During the
remainder of fiscal 2005, Escalon expects to compel Drew shareholders to tender
all of the remaining outstanding Drew shares pursuant to procedures under United
Kingdom laws and regulations. Drew is a diagnostics company specializing in the
design, manufacture and distribution of analytical systems for laboratory
testing worldwide. Drew is focused on providing instrumentation and consumables
for the diagnosis and monitoring of medical disorders in the areas of diabetes,
cardiovascular diseases and hematology. In addition, Drew supplies diagnostic
systems that perform blood component tests.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements requires management to make
estimates and assumptions that affect amounts reported therein. The most
significant of those involve the application of SFAS 142, discussed further in
the Notes to the Condensed Consolidated Financial Statements included in this
Form 10-Q. The financial statements are prepared in conformity with accounting
principles generally accepted in the United States of America, and, as such,
include amounts based on informed estimates and judgments of management. For
example, estimates are used in determining valuation allowances for deferred
income taxes, uncollectible receivables, obsolete inventory, sales returns and
rebates and purchased intangible assets. Actual results achieved in the future
could differ from current estimates. The Company used what it believes are
reasonable assumptions and, where applicable, established valuation techniques
in making its estimates.
REVENUE RECOGNITION
The Company recognizes revenue from the sale of its products at the
time of shipment, when title and risk of loss transfer. The Company provides
products to its distributors at agreed wholesale prices and to the balance of
its customers at set retail prices. Distributors can receive discounts for
accepting high volume shipments. The discounts are reflected immediately in the
net invoice price, which is the basis for revenue recognition. No further
material discounts are given.
The Company's considerations for recognizing revenue upon shipment of
product to a distributor are based on the following:
- Persuasive evidence that an arrangement (purchase order and sales
invoice) exists between a willing buyer (distributor) and the
Company that outlines the terms of the sale (company information,
quantity of goods, purchase price and payment terms). The buyer
(distributor) does not have an immediate right of return.
- Shipping terms are ex-factory shipping point. At this point the
buyer (distributor) takes title to the goods and is responsible for
all risks and rewards of ownership, including insuring the goods as
necessary.
- The Company's price to the buyer (distributor) is fixed and
determinable as specifically outlined on the sales invoice. The
sales arrangement does not have customer cancellation or termination
clauses.
- The buyer (distributor) places a purchase order with the Company;
the terms of the sale are cash, COD or credit. Customer credit is
determined based on the Company's policy and procedures related to
the buyer's (distributor's) creditworthiness. Based on this
determination, the Company believes that collectibility is
reasonably assured.
Escalon assesses collectibility based on creditworthiness of the customer
and past transaction history. The Company performs ongoing credit evaluations of
its customers and does not require collateral from its
27
customers. For many of Escalon's international customers, the Company requires
an irrevocable letter of credit to be issued by the customer before the purchase
order is accepted.
VALUATION OF INTANGIBLE ASSETS
Escalon annually evaluates for impairment its intangible assets and
goodwill in accordance with SFAS 142, "Goodwill and Other Intangible Assets," or
whatever events or changes in circumstances indicate that the carrying value may
not be recoverable. These intangible assets include goodwill, trademarks and
trade names. Factors the Company considers important that could trigger an
impairment review include significant under-performance relative to historical
or projected future operating results or significant negative industry or
economic trends. If these criteria indicate that the value of the intangible
asset may be impaired, an evaluation of the recoverability of the net carrying
value of the asset is made. If this evaluation indicates that the intangible
asset is not recoverable, the net carrying value of the related intangible asset
will be reduced to fair value. Any such impairment charge could be significant
and could have a material adverse effect on the Company's financial statements
if and when an impairment charge is recorded. No impairment losses were recorded
for goodwill, trademarks and trade names during any of the periods presented
based on these evaluations.
TAXES
Estimates of taxable income of the various legal entities and
jurisdictions are used in the tax rate calculation. Management uses judgment in
estimating what the Company's income will be for the year. Since judgment is
involved, there is risk that the tax rate may significantly increase or decrease
in any period.
In determining income (loss) for financial statement purposes,
management must make certain estimates and judgments. These estimates and
judgments occur in the calculation of certain tax liabilities and in the
determination of the recoverability of certain of the deferred tax assets, which
arise from temporary differences between the tax and financial statement
recognition of revenue and expense. SFAS 109 also requires that the deferred tax
assets be reduced by a valuation allowance, if based on the weight of available
evidence, it is more likely than not that all or some portion of the recorded
deferred tax assets will not be realized in future periods.
In evaluating Escalon's ability to recover the Company's deferred tax
assets, management considers all available positive and negative evidence
including the Company's past operating results, the existence of cumulative
losses and near-term forecasts of future taxable income. Management develops
assumptions that require significant judgment about the near-term forecasts of
future taxable income that is consistent with the plans and estimates management
is using to manage the underlying businesses.
Through September 30, 2004, Escalon has recorded a full valuation
allowance against the Company's net operating losses due to the uncertainty of
their realization as a result of the Company's earnings history, the number of
years the Company's operating losses and tax credits can be carried forward, the
existence of taxable temporary differences and near-term earnings expectations.
The amount of the valuation allowance could decrease if facts and circumstances
change that materially increase taxable income prior to the expiration of the
loss carryforwards. Any reduction would reduce (increase) the income tax expense
(benefit) in the period such determination is made by the Company.
28
THREE-MONTH PERIODS ENDED SEPTEMBER 30, 2004 AND 2003
The following table shows consolidated product revenue by business
segment as well as identifying trends in business segment product revenues for
the three-month periods ended September 30, 2004 and 2003.
Three-Month Periods Ended September 30,
------------------------------------------
2004 2003 % Change
-------- ------- ---------
Product revenue:
Drew $1,904 $ - 100.00%
Sonomed 1,644 1,705 -3.58%
Vascular 695 734 -5.31%
Medical/Trek/EMI 393 402 -2.24%
-------- ------- ---------
$4,636 $2,841 63.18%
======== ======= =========
Product revenue increased $1,795,000, or 63.18%, to $4,636,000 during
the three-month period ended September 30, 2004 as compared to the same period
last fiscal year. The increase in revenue is attributed to the acquisition of
Drew on July 23, 2004. If Drew is excluded, product revenue decreased $109,000,
or 3.84%, to $2,732,000 during the three-month period ended September 30, 2004
as compared to the same period last fiscal year. In the Sonomed business unit,
revenue decreased $61,000, or 3.58%, to $1,644,000 during the three-month period
ended September 30, 2004 as compared to the same period last fiscal year. The
decrease in Sonomed product revenue was primarily caused by a decrease in demand
for the Company's pachymeter product. Unit sales of the pachymeter decreased by
90.99% as compared to the same period last fiscal year. The domestic market for
pachymeters had previously expanded due to enhanced techniques in glaucoma
screening performed by optometrists. Historically, the typical optometrist had
not been a user of the pachymeter. Domestic demand for the Company's pachymeter
returned to historic levels in the fourth quarter of fiscal 2004. Sales of
Sonomed's new EZ-Scan product line have partially offset the aforementioned
declines. In the Vascular business unit, revenue decreased $39,000, or 5.31%, to
$695,000 during the three-month period ended September 30, 2004 as compared to
the same period last fiscal year. The decrease in product revenues in the
Vascular business unit was primarily the result of the Company providing relief
from the contracted minimum monthly purchase requirements to several of its
distributors. The Company provided this relief to prevent the distributors from
becoming overstocked with the Company's product. In the Medical/Trek/EMI
business unit, revenue decreased $9,000, or 2.24%, to $393,000 during the
three-month period ended September 30, 2004. Please see the executive overview
for further information regarding the operating results of Drew.
Other revenue increased $85,000, or 14.93%, to $656,000 during the
three-month period ended September 30, 2004 as compared to the same period last
fiscal year. The increase relates to a $177,000 increase in royalty payments
received from Intralase related to the licensing of the Company's intellectual
laser technology. The royalty received from Bausch & Lomb in connection with
their sales of Silicone Oil decreased $92,000. The Company's contract with
Bausch & Lomb calls for annual step-downs in the calculation of Silicone Oil
revenue to be received by the Company from 64% from August 13, 2003 to August
12, 2004 to 45% from August 13, 2004 to August 12, 2005. The step-downs occur
during the first quarter of each fiscal year through the remainder of the
contract, which ends in August 2005. For the three-month period ended September
30, 2004, the step-down caused a $176,000 decrease in Silicone Oil revenue that
the Company would have otherwise received had the step-down not occurred. The
offsetting $84,000 increase in Silicone Oil revenue is due to market demand for
the product. The Company does not have any further knowledge as to what factors
have affected Bausch & Lomb's sales of Silicone Oil. See the Notes to
Consolidated Financial Statements for a description of the step-down provisions
under the contract with Bausch & Lomb.
29
The following table presents consolidated cost of goods sold by
reportable business segment and as a percentage of related segment product
revenues for the three-month periods ended September 30, 2004 and 2003.
Three-Month Periods Ended September 30,
---------------------------------------------
Cost of goods sold: 2004 2003
-------------------------- -----------------------------
Dollars % Dollars %
------- ----- ------- ------
(in thousands) (in thousands)
Drew $1,251 65.70% $ -- 0.00%
Sonomed 859 52.25% 681 39.94%
Vascular 320 46.04% 296 40.33%
Medical/Trek/EMI 242 61.58% 236 58.71%
------ ------ ----- ------
$2,672 57.64% $1,213 42.70%
====== ====== ====== ======
Cost of goods sold totaled $2,672,000, or 57.64% of product revenue,
for the three-month period ended September 30, 2004 as compared to $1,213,000,
or 42.70% of product revenue, for the same period last fiscal year. The increase
in cost of goods sold is primarily attributed to the acquisition of Drew on July
23, 2004. If Drew is excluded, cost of goods sold increased $208,000, to
$1,421,000, or 52.01% of product revenue during the three-month period ended
September 30, 2004, as compared to $1,213,000, or 42.70% of product revenue, for
the same period last fiscal year. Cost of goods sold in the Sonomed business
unit totaled $859,000, or 52.25% of product revenue for the three-month period
ended September 30, 2004 as compared to $681,000, or 39.94% of product revenue
for the same period last fiscal year. The primary factors affecting the increase
in cost of goods sold as a percentage of product revenue were product mix, most
notably the decrease in pachymeter sales, in addition to an increase in
international sales, where the Company generally experiences lower price per
unit on its products. Cost of goods sold in the Vascular business totaled
$320,000, or 46.04% of revenue, for the three-month period ended September 30,
2004 as compared to $296,000, or 40.33% of revenue for the same period last
fiscal year. The Company experienced increases in overtime and temporary labor
during the three-month period ended September 30, 2004 as compared to the same
period last fiscal year. Cost of goods sold in the Medical/Trek/EMI business
unit totaled $242,000, or 61.58%, during the three-month period ended September
30, 2004 as compared to $236,000, or 58.71% for the same period last fiscal
year. Fluctuations in Medical/Trek/EMI cost of goods sold primarily emanates
from product mix, which was primarily controlled by market demand. Please see
the executive overview for further information regarding the operating results
of Drew.
The following table presents consolidated marketing, general and
administrative expenses as well as identifying trends in business segment
marketing, general and administrative expenses for the three-month periods ended
September 30, 2004 and 2003.
Three-Month Periods Ended September 30,
-------------------------------------------------
2004 2003 % Change
--------- --------- ----------
Marketing, general and
administrative expenses:
Drew $ 792 $ -- 100.00%
Sonomed 324 259 25.10%
Vascular 339 314 7.96%
Medical/Trek/EMI 727 641 13.42%
-------- ------- -------
$2,182 $1,214 79.74%
======== ======= ========
Marketing, general and administrative expenses increased $968,000, or
79.74%, to $2,182,000 during the three-month period ended September 30, 2004 as
compared to the same period last fiscal year. The increase in marketing, general
and
30
administrative expenses was primarily attributed to incremental expenditures due
to the acquisition of Drew on July 23, 2004. If Drew is excluded, marketing,
general and administrative expenses increased $176,000, or 14.50%, to $1,390,000
during the three-month period ended September 30, 2004 as compared to the same
period last fiscal year. Marketing, general and administrative expenses in the
Sonomed business unit increased $65,000, or 25.10%, to $324,000 as compared to
the same period last fiscal year. Salaries and other personnel-related expenses
increased $24,000 as a result of increased headcount. Consulting expenses
increased $16,000 primarily due to increased marketing expenditures in the
European market. Advertising expenses also increased $17,000. In the Vascular
business unit, marketing, general and administrative expenses increased $25,000,
or 7.96%, to $339,000 as compared to the same period last fiscal year. The
Company agreed to pay royalties for a period of five years following the
acquisition of the vascular access division of Endologix. That five-year period
ended in December 2003. This resulted in a $60,000 decrease in royalty expense.
Offsetting this decrease was an increase in consulting expense primarily due to
increased marketing expenditures in the European market as well as a $22,000
increase in salaries and other personnel-related expenses as a result of
increased headcount. In Medical/Trek/EMI, marketing, general and administrative
expenses increased $86,000, or 13.42%, to $727,000 as compared to the same
period last fiscal year. Salaries and other personnel-related expenses increased
$42,000 due to increased headcount. Administrative travel-related expenses
increased $36,000 primarily due to the Drew acquisition. Please see the
executive overview for further information regarding the operating results of
Drew.
Research and development expenses increased $109,000, or 52.45%, to
$316,000 during the three-month period ended September 30, 2004 as compared to
the same period last fiscal year. The increase in research and development
expenses was attributed to incremental expenditures due to the acquisition of
Drew on July 23, 2004. Please see the executive overview for further information
regarding the operating results of Drew.
Escalon recognized a net loss of $29,201 related to its investment in
OTM. The share of OTM's loss recognized by the Company is in direct proportion
to the Company's ownership equity in OTM. OTM began operations during the
three-month period ended September 30, 2004. See Related Party Transactions.
Interest income was $32,000 and $1,000 for the three-month periods
ended September 30, 2004 and 2003, respectively. The increase relates to
increased average cash balances in the current fiscal year.
Interest expense was $(3,000) and $119,000 for the three-month
periods ended September 30, 2004 and 2003, respectively. The Company paid off
several of its debt facilities to several entities in advance of their maturity
dates. Additionally, the Company reversed accrued loan commitment fees pursuant
to the satisfaction of the debt and release by the lender of said fees. The fees
were originally accrued based on contractual terms.
31
LIQUIDITY AND CAPITAL RESOURCES
Changes in Escalon's overall liquidity and capital resources from
continuing operations during the three-month period ended September 30, 2004 are
reflected in the following table:
September 30, June 30,
(Dollars are in thousands) 2004 2004
-------------- -------------
Current assets $ 16,301 $ 17,566
Less: Current liabilities 7,712 3,600
-------------- -------------
Working capital $ 8,589 $ 13,966
Current ratio 2.1 to 1 4.9 to 1
- -------------------------------------------------------------------------------------------
Notes payable and current maturities $ 1,409 $ 1,872
Long-term debt 594 2,396
-------------- -------------
Total debt $ 2,003 $ 4,268
Total equity 30,427 23,461
-------------- -------------
Total capital $32,430 $ 27,729
Total debt to total capital 6.18% 15.39%
WORKING CAPITAL POSITION
Working capital decreased $5,377,000 as of September 30, 2004 and the
current ratio decreased to 2.1 to 1 when compared to June 30, 2004. The decrease
in working capital was caused primarily by the pay-off of all of the Company's
pre-acquisition debt. Accrued expenses, accounts payable and line of credit
increased $2,681,000, $1,299,000 and $937,000, respectively. As of September 30,
2004, $2,348,000 of the accrued expenses relates to Drew, or is related to the
acquisition of Drew, $1,106,000 of accounts payable relates to Drew and the
entire $1,187,000 line of credit relates to Drew.
CASH FLOWS USED IN OPERATING ACTIVITIES
Cash flows from operating activities decreased by $2,582,000 for the
three months ended September 30, 2004 as compared to the same period last fiscal
year. Apart from year-over-year decreased net profitability of $507,000, the
Company also put an additional $2,131,000 into working capital (related to
purchase of inventory and payment of accounts payable for Drew) during the
three-month period ended September 30, 2004 as compared to the same period last
fiscal year.
CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES
Cash flows from investing activities relate to net cash received from the
acquisition of Drew offset by the Company's $130,000 investment in OTM and the
purchase of fixed assets. Any necessary capital expenditures have generally been
funded out of cash from operations, and the Company is not aware of any factors
that would cause historical capital expenditure levels not to be indicative of
capital expenditures in the future and, accordingly, does not believe that it
will have to commit material resources to capital investment for the foreseeable
future.
Cash flows used in financing activities were $4,928,000 during the
three-month period ended September 30, 2004. The Company paid off all of the
pre-acquisition term debt it had outstanding prior to the Drew acquisition as
well as the line of credit it had outstanding prior to the acquisition. The
outstanding balance of these debt facilities was a combined $4,268,000.
32
FORWARD-LOOKING STATEMENT ABOUT SIGNIFICANT ITEMS LIKELY TO
AFFECT LIQUIDITY
On July 23, 2004, Escalon acquired approximately 67% of the
outstanding ordinary shares of Drew, pursuant to the Company's exchange offer
for all of the outstanding ordinary shares of Drew, and since that date has
acquired substantially all of the Drew shares. As of September 30, 2004, the
Company has acquired approximately 94% of the outstanding ordinary shares of
Drew. During the remainder of fiscal 2005, Escalon expects to compel Drew
shareholders to tender all of the remaining outstanding Drew shares pursuant to
procedures under United Kingdom laws and regulations. Drew does not have a
history of producing positive operating cash flows and, as a result, at the time
of acquisition, was operating under financial constraints and was
under-capitalized. As of November 9, 2004, as Drew is not yet wholly owned,
Escalon loaned $3,253,000 to Drew. The funds have been primarily used to procure
components to build up inventory to support the manufacturing process as well as
to pay off accounts payable of Drew. As Drew is integrated into the Company,
management will be working to reverse the situation, while at the same time
strengthening Drew's market position. Escalon anticipates that further working
capital will be required by Drew.
In October 1997, Escalon licensed its intellectual laser properties
to IntraLase in exchange for an equity interest of 252,535 shares of common
stock (as adjusted after splits), as well as royalties on future product sales.
On October 7, 2004, IntraLase announced the initial public offering of shares of
its common stock at a price of $13.00 per share. The shares of common stock are
restricted for a period of less than one year and may be sold after April 4,
2005 pursuant to a certain Fourth Amended Registration Rights Agreement between
the Company and IntraLase. The shares have been classified as
available-for-sale-securities. The Company's net proceeds will be the market
price of the shares, multiplied by the number of shares sold, less any broker
commissions. As of November 9, 2004, IntraLase's common stock closed at $18.32
per share on the Nasdaq National Market. At that price, Escalon's shares of
IntraLase were valued at $4,626,441. The Company cannot assure that it will be
able to liquidate its shares of IntraLase at the current market price.
Escalon realized 7.88% and 14.91% of its net revenue during the
three-month period ended September 30, 2004 and 2003, respectively, from Bausch
& Lomb's sale of Silicone Oil. Silicone Oil revenue is based on sales of the
product by Bausch & Lomb multiplied by a contractual factor that reduces on an
annual basis due to a contractual step-down provision. While the Company does
not expect total Silicone Oil revenue to decline rapidly during the remainder of
the contract, any such decrease would have an impact on the Company's financial
position, results of operations and cash flows and the Company's stock price
could be negatively impacted. The Company is entitled to receive this revenue
from Bausch & Lomb, in varying amounts, through August 2005, when all revenues
will cease. See the Notes to Consolidated Financial Statements for a description
of the step-down provisions under the contract with Bausch & Lomb.
The Company issued 120,000 common stock purchase warrants in
connection with the private placement on March 17, 2004. The warrants are
exercisable at $15.60 per share and expire in five years from the placement
date. If all 120,000 warrants were to be exercised, it would provide gross
proceeds to the Company of $1,872,000. Escalon cannot assure, however, that the
warrant exercise price will be less than the market price of the Company's
common stock or that even if the exercise price is less than the market price
that any of the warrants will be exercised. These warrants are not currently in
the money and will not be exercised, and the Company will not receive any
proceeds as long as the exercise price is greater than the market price. See the
Notes to Condensed Consolidated Financial Statements for a description of the
private placement of the Company's common stock and common stock purchase
warrants. Additionally, the Company issued 60,000 common stock purchase warrants
in connection with the renegotiation of the Company's term debt in November
2001. The warrants are exercisable at $3.66 per share and expire in November
2006. If all 60,000 warrants were to be exercised, it would provide gross
proceeds to the Company of $219,600. Escalon cannot assure, however, that the
warrant exercise price will be less than the market price of the Company's
common stock or that even if the exercise price is less than the market price
that any of the warrants will be exercised.
33
BALANCE SHEET
The components of the balance sheet of the Company were increased as
of July 23, 2004 by the acquisition of Drew as follows:
Cash $ 295,373
Accounts receivable 1,433,324
Inventory 2,562,848
Other current assets 577,140
Furniture and equipment 868,839
Goodwill 8,622,303
Patents 461,779
Other long-term assets 264,530
Line of credit 1,617,208
Current liabilities 4,548,746
Liability for shares reserved
for future exchange 597,019
Long-term debt 767,165
Exchange of common stock 6,833,420
DEBT HISTORY
On December 23, 2002, a lender acquired the Company's bank debt,
which consisted of term debt of $5,850,000 and $1,475,000 outstanding on a
$2,000,000 available line of credit. On February 13, 2003, the Company entered
into an amended agreement with the lender. The primary amendments of the amended
loan agreement were to reduce quarterly principal payments, extend the term of
the repayments and to alter the covenants of the original bank agreement. On
September 30, 2004, the Company paid off and terminated both the remaining term
debt and the outstanding balance on this line of credit. In November 2001, the
Company issued the lender 60,000 warrants to purchase the Company's common stock
at $3.66 per share in connection with this debt. The warrants will expire in
November 2006.
On January 21, 1999, the Company's Vascular subsidiary and Endologix
entered into an Assets Sale and Purchase Agreement. Pursuant to this agreement,
the Company acquired for cash the assets of Endologix's vascular access business
in exchange for cash and also agreed to pay royalties to Endologix based on
future sales of the vascular access business for a period of five years
following the closing of the sale, with a guaranteed minimum royalty of $300,000
per year. On February 1, 2001, the parties amended the agreement to eliminate
any future royalty payments to Endologix. Pursuant to this amendment, the
Company paid $17,558 in cash to Endologix, delivered a short-term note in the
amount of $64,884 that was satisfied in January 2002, a note in the amount of
$717,558 payable in 11 quarterly installments that commenced on April 15, 2002,
and the Company issued 50,000 shares of its common stock to Endologix. On
September 30, 2004, the Company paid off the balance of the term debt.
As of September 30, 2004, Drew has an overdraft line of credit with a
United Kingdom financial institution. The amount available on the line is
$651,344. The interest rate is 2.00% over the United Kingdom prime rate (4.75%
at September 30, 2004). The line is secured by Drew's assets and is personally
guaranteed by certain of Drew's current and former directors. The balance as of
September 30, 2004 is $655,791.
Drew also has long-term debt facilities through the Texas Mezzanine Fund
and through Symbiotics, Inc. The Texas Mezzanine Fund term debt is payable in
monthly installments of $14,200, which includes interest at a fixed rate of
8.00%. The note is due in April 2008 and is secured by certain assets of Drew.
The outstanding balance at September 30, 2004 is $515,880. The Symbiotics, Inc.
term debt, which originated from the acquisition of a product line from
Symbiotics, Inc., is payable in monthly installments of $8,333 with interest at
a fixed rate of 5.00%. The outstanding balance at September 30,
34
2004 is $300,002. Drew has a line of credit with a U.S. financial institution
secured by certain assets of Drew. The amount available on the line of credit is
$2,000,000. Interest is at the prime rate plus 4.00% (8.75% as of September 30,
2004). The outstanding balance as of September 30, 2004 was $531,236.
OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS
Escalon was not a party to any off-balance sheet arrangements as of
and for the three-month periods ending September 30, 2004 and 2003.
The following table presents the Company's contractual obligations as
of September 30, 2004:
Less than More than
Total 1 Year 1-3 Years 3-5 Years 5 Years
---------- ----------- ----------- ------------ ------------
Long-term debt $ 815,882 $ 221,668 $ 499,548 $ 94,666 $ --
Line of credit 1,187,027 1,187,027 -- -- --
Operating lease agreements 3,272,022 773,154 1,332,717 582,770 583,381
OTM commitment 126,000 126,000 -- -- --
Purchase obligations 700,000 700,000 -- -- --
---------- ----------- ----------- ------------ ------------
$6,100,931 $3,007,849 $1,832,265 $ 677,435 $ 583,381
========== =========== =========== ============ ============
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The table below provides information about the Company's financial
instruments, consisting primarily of debt obligations that are sensitive to
changes in interest rates. For debt obligations, the table represents principal
cash flows and related interest rates by expected maturity dates. Interest rates
at September 30, 2004 are fixed at 8.00% on the Texas Mezzanine Fund term debt,
fixed at 5.00% on the Symbiotics, Inc. term debt, 4.00% over the Federal prime
rate (4.75% at September 30, 2004) on the U.S. line of credit and 2.00% over the
United Kingdom prime rate (4.75% at September 30, 2004) on the overdraft line of
credit. See the Notes to Condensed Consolidated Financial Statements for further
information regarding the Company's debt obligations.
2004 2005 2006 Thereafter Total
------------ ---------- --------- ---------- ----------
Texas Mezzanine Fund Note $ 121,672 $ 143,721 $ 155,821 $ 94,666 $ 515,880
Interest rate 8.00% 8.00% 8.00% 8.00%
Symbiotics, Inc. Note 99,996 99,996 100,010 -- 300,002
Interest rate 5.00% 5.00% 5.00% --
U.S. Line of Credit 531,236 -- -- -- 531,236
Interest rate 8.75% -- -- --
Overdraft Line of Credit 655,791 -- -- -- 655,791
Interest rate 6.75% -- -- --
------------ ---------- --------- ---------- ----------
$ 1,408,695 $ 243,717 $ 255,832 $ 94,665 $2,002,909
============ ========== ========== ========== ==========
EXCHANGE RATE RISK
During the three-month periods ended September 30, 2004 and 2003,
approximately 35.90% and 15.80%, respectively, of Escalon's consolidated net
revenue was derived from international sales. Prior to the acquisition of Drew,
the price of all product sold overseas was denominated in United States Dollars
and consequently the Company incurred no exchange rate risk on revenue. However,
a portion of Drew's product revenue is denominated in United Kingdom pounds.
During the period from July 24 through September 30, 2004, Drew recorded
$518,000 of product revenue denominated in United Kingdom Pounds. Additionally,
Drew incurs a portion of its expenses denominated in United Kingdom Pounds.
During the
35
period from July 24 through September 30, Drew incurred $632,000 of expense
denominated in United Kingdom Pounds. The Company's Sonomed business unit incurs
a portion of its marketing expenses in the European market that are transacted
in Euros. These expenses totaled $41,000 and $27,000 for the three-month periods
ended September 30, 2004 and 2003, respectively. The Company's Vascular business
unit began incurring marketing expenses in the European market during the second
quarter of fiscal 2004, the majority of which are transacted in Euros. These
expenses were $45,000 for the three-month period ended September 30, 2004. The
Company may begin to experience fluctuations, beneficial or adverse, in the
valuation of the currencies in which the Company transacts its business, namely
the United States Dollar, the United Kingdom Pound and the Euro.
ITEM 4. CONTROLS AND PROCEDURES
(A) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
The Company's management, with the participation of the Company's Chief
Executive Officer and Senior Vice President of Finance, has evaluated the
effectiveness of the Company's disclosure controls and procedures (as such term
is defined in Rule 13a-15(e) and 15(d)-15(e) under the Exchange Act) as of the
end of the period covered by this report. Based on such evaluation, the
Company's Chief Executive Officer and Senior Vice President of Finance have
concluded that, as of the end of such period, the Company's disclosure controls
and procedures are effective in recording, processing, summarizing and
reporting, on a timely basis, information required to be disclosed by the
Company in the reports that it files or submits under the Exchange Act.
(B) INTERNAL CONTROLS OVER FINANCIAL REPORTING
There have been changes in the Company's internal control over financial
reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the
Exchange Act) during the Company's first fiscal quarter ended September 30, 2004
that have materially affected, or are reasonably likely to materially affect,
the Company's internal control over financial reporting. The Company's
management notes that there have not been any changes in the Company's internal
control over financial reporting in the Company's historical business; however,
the Company's recent acquisition of Drew did cause a change in the Company's
internal control as it relates to that business. The improvement of internal
controls surrounding the acquired Drew business is a continuing focus of Company
management.
In connection with their review of the Company's September 30, 2004 interim
financial statements the Company's independent registered public accounting firm
identified certain material weaknesses and other deficiencies in our internal
control related to the Drew business that was acquired during the quarter. The
Public Company Accounting Oversight Board, Standard No. 2 states a material
weakness is "a significant deficiency, or a combination of significant
deficiencies, that results in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be prevented
or detected."
The Company's independent registered public accounting firm identified the
following material weaknesses in the Company's acquired Drew businesses related
to:
1. the Company's financial reporting closing and
review process;
2. inadequate documentation, untimely account
reconciliations and account analysis of certain
balance sheet accounts; and
3. untimely and inadequate communication of Escalon
policies and procedures to personnel of newly
acquired business.
36
In connection with the non-negotiated acquisition of Drew on
July 23, 2004 and the related material control weaknesses
discussed above, we have or expect to take the following
actions:
1. The Company's in the process of remediating the
specific material control weaknesses identified
above,
2. shortly after the acquisition of Drew, Escalon
began relocating and consolidating the financial
accounting and reporting function of Drew to
Dallas, Texas from the United Kingdom,
3. the accounting personnel in the United Kingdom
have all been replaced with employees that will
remain until the final transition of the financial
and reporting function to Dallas, Texas,
4. we are currently undertaking a detailed review of
the internal control requirements under the newly
organized financial accounting and reporting
function of Drew and will implement changes as
deemed necessary,
5. we have instituted temporary controls that require
the direct involvement of the Company's corporate
financial management team and, accounting
consultants that actively engaged in integrating
Escalon policies and procedures with all of Drew's
operating entities.
6. During the quarter an independent accounting firm
performed an investigation on the Drew UK
operations to determine if there had been any
fraudulent activity related to cash receipts on
disbursements. The accounting firm did not find
any evidence of fraud.
Our analysis is continuing and we will attempt to have it
completed by the end of the current fiscal year. This
additional work and testing may identify other deficiencies in
our internal control over financial reporting for Drew. After
completing our full analysis, we may conclude that any
additional deficiencies rise to the level of significant
deficiencies or material weaknesses in internal control over
financial reporting.
The Company has performed additional procedures to evaluate
the extent to which the internal control weaknesses discussed
above could have led to material misstatements in the
Company's consolidated financial statements. Based on this
evaluation, the Company do not believe that the control
weaknesses and deficiencies noted above led to any material
misstatements in the consolidated financial statements
included in this report.
A control system, no matter how well-designed and operated,
cannot provide absolute assurance that the objectives of the
control systems are met, and no evaluation of internal
controls can provide absolute assurance that all control
issues and instances of fraud, if any, within a company have
been detected.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On June 10, 2004, Escalon provided notice to Intralase of the
Company's intention to terminate the license agreement with Intralase due to
Intralase's failure to pay certain royalties that the Company believes are due
under the license agreement. On June 21, 2004, Intralase sought a preliminary
injunction and a temporary restraining order with the United States District
Court for the Central District of California, Southern District against Escalon
to prevent the termination of the license agreement with Intralase. The parties
subsequently agreed to stipulate to the temporary restraining order to prevent a
termination of the license agreement and, on July 6, 2004, as mutually agreed by
Intralase and Escalon, the same district court entered a stipulation and order
to remove from the trial list the hearing on the preliminary injunction. The
litigation will continue in accordance with the court order. The Company does
not believe that this matter has had or is likely to have a material adverse
effect on the Company's business, financial condition or future results of
operations.
Escalon is aware of three lawsuits involving Drew. The first lawsuit
involves the principal shareholders of an entity previously acquired by Drew for
the collection of unpaid expenses. A counterclaim was filed by Drew for breach
of intellectual property rights and for breach of the principal
37
shareholders' covenants not to compete. This action was filed in the state
courts of Connecticut. The second lawsuit was filed in the state court of
Minnesota, but transferred to the Federal District Court of Minnesota. This
action was brought by a distributor against an entity previously acquired by
Drew claiming a breach of a marketing and distribution agreement. The parties
have reached a tentative settlement of this matter. The third action involves a
suit instituted in California in connection with a dispute from a customer
claiming a refund for a product purchase. The Company does not believe that
these matters have had or are likely to have a material adverse effect on the
Company's business, financial condition or future results of operations.
Escalon, from time to time is involved in various legal proceedings
and disputes that arise in the normal course of business. These matters have
included intellectual property disputes, contract disputes, employment disputes
and other matters. The Company does not believe that the resolution of any of
these matters have had or are likely to have a material adverse effect on the
Company's business, financial condition or results of operations.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
On July 23, 2004, Escalon acquired approximately 67% of the
outstanding ordinary shares of Drew, a United Kingdom company, pursuant to the
Company's exchange offer for all of the outstanding ordinary shares of Drew, and
since that date has acquired substantially all of the Drew shares. During the
remainder of fiscal 2005, Escalon expects to compel Drew shareholders to tender
all of the remaining outstanding Drew shares pursuant to procedures under United
Kingdom laws and regulations. During the quarter ended September 30, 2004, the
Company has issued 841,686 shares of its common stock and reserved 58,314 shares
for future issuance pursuant to the exchange offer.
The issuances of shares of Escalon common stock in the exchange offer
for the acquisition of Drew were made in accordance with Rule 802 under the
Securities Act of 1933, as an exchange offer for a class of securities of a
foreign private issuer in which the conditions regarding the limitation on
United States ownership of Drew, the equal treatment of any United States
holders and Form CB filings were satisfied.
The Company did not effect any repurchases of its common stock during
the quarter ended September 30, 2004.
ITEM 5. OTHER INFORMATION
In October 1997, Escalon licensed its intellectual laser properties
to IntraLase in exchange for an equity interest of 252,535 shares of common
stock (as adjusted after splits), as well as royalties on future product sales.
On October 7, 2004, IntraLase announced the initial public offering of shares of
its common stock at a price of $13.00 per share. The shares of common stock are
restricted for a period of less than one year an may be sold after April 4, 2005
pursuant to a certain Fourth Amended Registration Rights Agreement between the
Company and IntraLase. The shares have been classified as
available-for-sale-securities. The Company has historically accounted for these
shares at $0 basis because a readily determinable market value was not
available. The Company cannot assume that it will be able to Liquidate its
shares of Intralase at the current market price.
ITEM 6. EXHIBITS
EXHIBITS
Exhibit No. Exhibit
----------- -------
Exhibits
10.34 Nat West Multi Currency Overdraft Facility dated February 12, 2003
between Drew Scientific and Nat West..
10.35 Security Agreement between Danam Acquisition Corp and Symbiotics
Corporation dated August 31, 2002.
10.36 Secured Promissory Note between Danam Acquisition Corp and
Symbiotics Corporation dated August 31, 2002.
10.37 Sixth Amendment to Amended and Restated Loan Agreement - Dated
November 30, 2003 - between Drew Scientific, Inc. and Bank of
America.
10.38 Eight Amended and Restated Revolving Promissory Note - Date November
30, 2003 - between Bank of America and Drew Scientific, Inc.
10.39 Ratification of Guaranty - November 30, 2003 - between Bank of
America and Drew Scientific, Inc.
10.40 Ratification of Guaranty - November 30, 2003 - between CDC
Acquisition Corp and Bank of America
10.41 Post Closing Agreement - Dated November 30, 2003 - between Drew
Scientific, Inc. and Danam Electronics
10.42 Second Amendment to Intercreditor Agreement - Dated November 20,
2003 - between Texas Mezzanine and Bank of America
10.43 Loan Agreement - Dated June 1, 2000 - by the Bank of America and
MWI, Inc d/b/a Danam Electronics
10.44 Guaranty - June 1, 2000 - borrower MWI, Inc d/b/a Danam Electronics
to Bank of America - Grantor Jerry West
10.45 Guaranty - June 1, 2000 - borrower MWI, Inc d/b/a Danam Electronics
to Bank of America - Grantor - Infolab Inc.
10.46 Revolving Promissory Note - June 1, 2000 - Bank of America and MWI,
Inc d/b/a Danam Electronics
10.47 Intercreditor Agreement - June 1, 2000 - between Texas Community
Bank and Trust, The Texas Mezzanine Fund, Inc. and Bank of America
10.48 Promissory Note - November 20, 2003 - between Drew Scientific, Inc.
and Texas Mezzanine Fund, Inc.
10.49 Revenue Participation Agreement - - November 20, 2003 - between Drew
Scientific, Inc. and Texas Mezzanine Fund, Inc.
10.50 Security Agreement - - November 20, 2003 - between Drew Scientific,
Inc. and Texas Mezzanine Fund, Inc.
10.51 Loan Agreement - November 20, 2003 - between Drew Scientific, Inc.
and Texas Mezzanine Fund, Inc
10.52 Guaranty Agreement - November 20, 2003 - between Drew Scientific,
Inc. and Texas Mezzanine Fund, Inc.
10.53 Guaranty Agreement - November 20, 2003 - between Keith Raymond Drew
Scientific, Inc. and Texas Mezzanine.
10.54 Subornation Agreement - November 20, 2003 - between Drew Scientific,
Inc. and Texas Mezzanine Fund, Inc.
10.55 Post Closing Agreement - November 20, 2003 - between Drew
Scientific, Inc., Drew Scientific, plc, Keith Drew. and Texas
Mezzanine Fund, Inc.
10.56 First Amendment to Post Closing Agreement dated December 20, 2003
between Drew Scientific, Inc. Drew Scientific, plc, Keith Drew and
Texas Mezzanine Fund, Inc.
31.1 Certificate of Chief Executive Officer under Rule 13a-14(a)
31.2 Certificate of Senior Vice President of Finance under Rule 13a-14(a)
32.1 Certificate of Chief Executive Officer under Section 1350 of Title
18 of the United States Code
32.2 Certificate of Senior Vice President of Finance under Section 1350
of Title 18 of the United States Code
* All the above Filed herewith.
38
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.
ESCALON MEDICAL CORP.
(Registrant)
Date: November 22, 2004 By: /s/ Richard J. DePiano
-----------------------
Richard J. DePiano
Chairman and Chief
Executive Officer
Date: November 22, 2004 By: /s/ Harry M. Rimmer
--------------------
Harry M. Rimmer
Senior Vice President - Finance
39