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TABLE OF CONTENTS
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS IOMED, Inc.

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

IOMED, Inc.
(Exact name of registrant as specified in its charter)

(801) 975-1191
(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Exchange Act:
Common Stock, no par value

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

        Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

        The aggregate market value of the Registrant's voting stock held by non-affiliates based upon the closing price of the common stock as quoted on the American Stock Exchange on August 30, 2002, was approximately $4,185,000.

        The number of shares of Registrant's common stock outstanding on August 30, 2002, was 6,544,670.

DOCUMENTS INCORPORATED BY REFERENCE

        Certain information is incorporated into Part III of this Report on Form 10-K by reference to the Registrant's Proxy Statement for its 2002 Annual Meeting of Shareholders.

TABLE OF CONTENTS

PART I

Item 1. BUSINESS

Forward-Looking Statements

        Certain statements contained in this report on Form 10-K (the "Report") are "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Such forward-looking statements may be identified by the use of terminology such as "may," "will," "expect," "anticipate," "intend," "designed," "estimate," "should," or "continue" or the negatives thereof or other variations thereon or comparable terminology. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of IOMED, Inc. (the "Company"), or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. These risks, uncertainties and other factors include, among other things, the following: the Company's continuing uncertainty of profitability; the uncertainties related to the Company's product development programs; the Company's reliance on collaborative partners and licenses; the Company's reliance on third distribution; the risks associated with obtaining governmental approval of the Company's products; the highly competitive industry in which the Company operates and the rapid pace of technological change within that industry; the uncertainty of patented and proprietary technology protection and the Company's reliance on such patented and proprietary technology (including reliance on technology licensed from third parties); changes in or failure to comply with governmental regulation; the uncertainty of third party reimbursement for the Company's products; the Company's dependence on key employees; general economic and business conditions and other factors discussed in this Report and the Company's other Securities and Exchange Commission ("SEC") filings. The Company undertakes no obligation to update publicly any forward-looking statements for any reason, even if new information becomes available or other events or circumstances occur in the future.

Introduction

        The Company was incorporated in Utah in 1974 as Motion Control, Inc. In 1987, the Company merged with JMW Acquisition Corporation, and the name of the merged entity was changed to IOMED, Inc. The Company is a leader in the development, manufacture and sale of active drug transport systems primarily used to treat acute local inflammation in the sports and occupational medicine and physical therapy markets. The Company is seeking opportunities to market or develop new products designed to improve the quality and efficiency of medical care in its served markets. In addition, the Company is seeking collaborative opportunities to develop its non-invasive drug delivery technology to satisfy substantial unmet medical needs. The Company has proprietary technology in various stages of research and product development for the treatment of acute local inflammation and for the treatment of ophthalmic disease.

Commercial Business

        The Company currently manufactures and markets proprietary products used in the site-specific, non-invasive administration of soluble salts or other drugs into the body for medical purposes as an alternative to hypodermic injection. The Company's products are used in situations when it is advisable to avoid the pain that may accompany needle insertion and drug injection, and/or to minimize the infiltration of carrier fluids, or to avoid the damage caused by needle insertion when tissue is traumatized. The Company's active drug transport systems employ iontophoresis as a non-invasive method of enhancing and controlling the transport of water-soluble ionic drugs into and through the skin and other body tissues using a low-level electrical current. The Company currently markets two products, an iontophoretic system used to deliver a potent corticosteroid in the treatment of acute local inflammatory conditions and an iontophoretic system used to deliver Iontocaine®, the Company's brand of lidocaine HCl 2% and epinephrine 1:100,000 topical solution, for the administration of local dermal anesthesia. The Company's proprietary, patented system (the "Phoresor® System") is designed for clinical use and is comprised of a reusable dose controller and single use, disposable active transdermal patch kits. The dose controller incorporates an advanced microprocessor to precisely control drug dosage through the Company's proprietary patch kits, which include IOGEL™, TransQ® and Anestrode® patches.

        Using the Company's Phoresor System, medical professionals are able to deliver dexamethasone, a potent and effective corticosteroid, to treat local inflammatory conditions. Because of the negative side effects often associated with the oral or injectable administration of dexamethasone, it is used only as a second- or third-line therapy. However, using the Company's technology, the administration of these drugs without the occurrence of negative side effects is possible. The Company's products are used for site-specific corticosteroid therapy in clinics nationwide to treat a variety of conditions, including those suffered by top professional and semi-professional athletes in football, baseball, basketball, hockey, golf and skiing.

        The Company also markets a specialty pharmaceutical product, Numby Stuff®, for the delivery of Iontocaine. Numby Stuff offers non-invasive, needle-free local dermal anesthesia in as little as 10 minutes, and can be used prior to needle sticks, IV starts, lumbar punctures, PICC insertions, and fine needle and skin biopsies. The product is primarily used in the pediatrics market.

Business Strategy

        The Company continues to manufacture and sell the Phoresor System into the sports and physical therapy markets for use in the treatment of acute local inflammation. The Company intends to promote growth in its existing commercial business by performing the following:

•

Strengthen Distribution Networks—Enter into additional agreements to broaden the existing dealer network.



•

Leverage Low Cost Manufacturing—As the low-cost producer of iontophoretic drug delivery systems, the Company can offer distributors competitive pricing, which will enable pursuit of national accounts where pricing is key.



•

Improve Reimbursement Profile—The Company is currently working with others in its industry to improve and, in some cases, reinstate reimbursement through the third-party payor network.



•

Lead New Product Advancement and Seek New Market Opportunities—The Company will continue to pursue opportunities to expand its product offerings and identify new markets both independently and through collaborative relationships.

Products and Products Under Development

        The Company currently has potential products in pre-clinical development for the treatment of acute local inflammation and ophthalmic diseases. The following table lists the therapeutic applications of the principal products developed or currently under development by the Company. This table is qualified in its entirety by reference to the more detailed descriptions set forth elsewhere in this Report. There can be no assurance that any product under development will be developed successfully or approved in a timely manner, if at all, or even if developed or approved, be successfully manufactured or marketed. In addition, the status of development indicated below does not necessarily indicate the order in which the products shown may be submitted to or approved by the Food and Drug Administration ("FDA").

(1)

Currently marketed under a 510(k) clearance for use with "ions of soluble salts or other drugs."

(2)

Further development has been suspended as of June 30, 2002. The Company is seeking collaborative partners prior to continuing development of these development programs.

Acute Local Inflammation

        Acute local inflammatory conditions resulting from exercise, sports injuries, trauma or repetitive motion disorders are among the leading types of injuries occurring in the workplace and among physically active adults. The most common of these injuries include tendonitis, bursitis, carpal tunnel syndrome and epicondylitis (tennis elbow). The Company believes the electro transport of corticosteroids may provide significant advantages over other current treatment regimens for acute local inflammation.

        Commercial Products.    The Company pioneered the commercial introduction of its active transdermal drug delivery system in 1979. The product is used principally by physical therapists (under a doctor's prescription) and has been clinically administered in over 15 million patient treatments for the delivery of corticosteroids. More than 13 million of these treatments have occurred since 1990, when advancements in patch technology made by the Company led to the introduction of its present family of hydrogel patches for use with its microprocessor controlled dose controllers. The Company's products are also used by athletic trainers and physical therapists serving a number of professional and semi-professional athletes and teams, including golfers, tennis players, men's and women's Olympic ski teams, as well as by football, basketball, baseball and hockey teams. The Company believes that its active transdermal drug delivery systems have been accepted in the rehabilitation marketplace due to their ease of use, non-invasiveness, recognized efficacy and lack of significant side effects.

        Products Under Development.    IontoDex™ is an integrated version of the Company's active drug transport system designed for patient in-home use in the treatment of acute local inflammation. The drug formulation, combined with the proprietary active drug transport system, has the potential to address a significant unmet medical need by offering patients the benefits of anti-inflammatory effects of dexamethasone while avoiding all of the GI and other systemic side effects of NSAIDs and Cox-II inhibitors. The Company believes the IontoDex product offers a significant collaborative opportunity based on clinical data associated with the drug formulation and our proprietary drug delivery system.

        During fiscal 2001, the Company completed both a pivotal Phase III and a confirmatory Phase III clinical study for the delivery of dexamethasone for the treatment of acute local inflammation. In May 2001, the Company announced that the confirmatory study failed to meet the primary clinical endpoints in the treatment of epicondylitis. The study showed a positive response in patients treated with the drug; however, increased benefit in the study's placebo group prevented the statistical separation between the two patient groups necessary to achieve the desired conclusions. Due to these study results and to financial and other resource constraints, the Company has currently suspended further development efforts and may seek corporate development partners or other strategic funding sources prior to any continuation of this development program.

Local Dermal Anesthesia

        Medical care providers have long recognized the importance of the management of pain, including pain associated with certain minimally invasive medical procedures such as needle injections; venous access (including phlebotomies and intravenous catheterizations); lumbar punctures; and local dermatological, gynecological and urological procedures such as wart and mole removal, biopsies (including fine needle, punch, excisional, shave and cervical biopsies), Mohs procedures and vasectomies. To address this concern, local dermal anesthetics are widely used in medical practice.

        Commercial Products.    The Company's Iontocaine is approved by the FDA under an NDA and is specifically labeled for use with the Company's Phoresor system and its proprietary, single use, disposable active transdermal patch kits. The Company has received FDA labeling to use the system for all procedures requiring local dermal anesthesia.

        The Company sells its local dermal anesthesia product into the pediatric market under the brand name Numby Stuff. Numby Stuff is presently being used to induce local dermal anesthesia prior to pediatric intravenous starts, blood draws and other invasive procedures, and the Company believes it provides a cost effective alternative to the leading topical product.

        Due to limited distribution, to date, Numby Stuff has not generated significant revenues. However, the response by medical professionals and medical organizations has been very positive. The Company seeks to expand its sales, marketing and distribution capabilities for this product through additional distribution arrangements, but does not anticipate significant revenues to be generated from this product until such distribution capabilities have been established.

Ophthalmic Diseases

        The Company believes that its unique active drug transport system presents a significant opportunity in the ophthalmic pharmaceutical marketplace due to large patient populations with sight threatening medical needs that are unmet. Age-related macular degeneration ("AMD") and diabetic retinopathy ("DR") are the major causes of visual impairment in the United States and Europe. Both AMD and DR are conditions caused by angiogenesis (unwanted blood vessel growth) resulting in neovascularization that damages the retina and ultimately causes blindness. Posterior uveitis and retinitis secondary to glaucoma also contribute considerably to loss of sight worldwide. A common characteristic among all of these conditions is their location at the back of the eye, where drug treatment is difficult to administer. The Company believes that its specialty pharmaceutical products offer a solution or a significant improvement to currently unmet medical needs in this area.

        Currently, there are no satisfactory pharmaceutical treatments for many ophthalmic diseases and conditions. A leading obstacle in the advancement of new therapies to treat serious ophthalmic disease is the inability to both safely and effectively deliver drugs to diseased cells in the back of the eye. Current drug delivery methods, which include intravenous, oral, topical (eye drops), intraocular injections and surgical implants, all have limitations that potentially affect their technical as well as their commercial viability in the treatment of these diseases. Furthermore, the complex physiology of the human eye presents unique problems for drug delivery, which are not optimally addressed by current ocular drug delivery methods.    The Company's delivery system, trademarked OcuPhor™, allows for site-specific administration of a pharmacologic agent without the collateral tissue damage associated with surgery, lasers, needle injections or implants.

        Products Under Development.    Using its proprietary technology, the Company has developed an ocular drug delivery system that seeks to address the safe and effective administration of therapeutics to the back of the eye. OcuPhor has been designed as a platform technology to deliver drug compounds non-invasively and site-specifically to posterior segments of the eye. Through both collaborations and internal research efforts, the Company has made significant advancements with the OcuPhor System. Feasibility studies confirmed OcuPhor's ability to deliver an anti-angiogenic drug to the back of the eye. Preliminary clinical studies in human volunteers have shown that the OcuPhor System is safe and well tolerated over a wide range of both positive and negative polarity currents and does not produce any ophthalmic changes as measured by a series of standard tests. Additionally, the Company has demonstrated that the OcuPhor System is capable of delivering antiangiogenics, anti-inflammatories, antibiotics, antivirals, and neuroprotectants. The Company believes that OcuPhor's transport capabilities are within the theoretical therapeutic range of a variety of drugs, including small molecules as well as some macromolecules such as oligonucleotides and small proteins. Due to financial and other resource constraints, the Company has curtailed this product development program and is seeking opportunities to form new license agreements and collaborative partnerships to take the OcuPhor System beyond the preclinical stage.

Iontophoretic Drug Delivery Technology and Its Advantages

        Iontophoretic drug delivery systems are designed to overcome many of the limitations associated with other drug delivery methods. Iontophoresis is an active method of drug delivery in which water-soluble, ionized (electrically charged) drugs are transported through the skin or other body tissues for local or systemic therapeutic applications by applying a low-level electrical current. The amount of drug delivered is proportional to the total electrical charge applied (which is a function of time and current). Therefore, it is possible to program the system's electrical current levels to control more precisely the desired drug dose, delivery rate and the pattern of delivery.

        Among the many drug delivery methods available today, the Company believes the advantages of iontophoretic drug delivery are many and include the following:

•

Non-invasive, needle-free



•

Ability to provide site-specific drug delivery to avoid systemic side effects

•

Rapid onset and cessation kinetics



•

Controlled, programmable and titratable drug delivery capabilities



•

Ability to provide smooth, variable or bolus plasma levels, singly or in combination, all in a single delivery system



•

Enhanced delivery for a broad range of compounds, including large drug molecules such as peptides and oligonucleotides



•

Minimal variability in the delivery profiles among patients and body sites



•

Potential for enhanced patient compliance and control

        Although the fundamentals of iontophoresis have been understood for decades, the method has become commercially practicable as a means of delivering drugs only recently as a result of advances in electronics, materials science and electrochemistry. These advances have led to the development of more efficient and adaptable drug patches and more reliable, compact and programmable dose controllers. The Company has an expansive portfolio of intellectual property with which it has developed iontophoretic pharmaceutical systems that have unique and enhanced performance characteristics, which the Company believes are adaptable to a number of clinical settings and therapeutic applications.

Patents and Proprietary Rights

        The Company's proprietary technology includes patents, trademarks, trade secrets and other proprietary know-how. These technologies are used in various combinations in the testing, evaluation and formulation of optimal ionic drug solutions and in the research, development, design and manufacture of microprocessor controlled power supplies and active transdermal patches which are specifically designed and constructed for particular therapeutic applications.

        The Company has implemented a policy of actively patenting and maintaining as trade secrets and proprietary information all inventions and technologies that it believes are important to its business operations. The Company generally seeks patent protection for its key proprietary technologies in the United States and other major markets. The Company also relies on trade secrets, know-how, continuing technological innovations and licensing opportunities to develop and maintain its competitive position. The Company seeks protection of its trade secrets and proprietary know-how, in part, through confidentiality agreements. Employees, consultants, advisors, collaborators, and other individuals and entities are required to execute confidentiality agreements upon the start of employment or other contractual relationships.

        The Company has acquired exclusive worldwide rights to Elan Corporation, plc's ("Elan") broad base of United States and foreign patents, in vitro drug transport data and in vivo animal and human clinical data, in addition to other proprietary know-how in iontophoretic drug delivery and electro-transport fields.

        As of June 30, 2002, the Company held or had rights to utilize approximately 76 United States patents and 253 foreign patents and has (or has the rights to utilize) approximately 26 pending patent applications in the United States and 101 pending patent applications in foreign countries for all such technology. The Company also owns or has licensed rights to issued and pending United States patents governing the design and manufacture of certain myoelectric prosthetic devices which it has sublicensed to a third party in connection with the sale of the Company's Motion Control division in December 1996.

Collaborative Relationships and Licenses

        If the Company elects to enter into additional collaborative relationships, potential collaborative partners may provide proprietary drugs, technology, financial resources, research and pharmaceutical manufacturing capabilities or marketing infrastructure to aid in the development and commercialization of the Company's current and future products. Depending on the availability of financial, marketing and scientific resources and other factors, the Company may also license or cross-license its technology or products to others and retain profit sharing, royalty, manufacturing, co-marketing, co-promotion or similar rights. Any such arrangements could limit the Company's flexibility in pursuing alternatives for the development or commercialization of its products.

        The Company's collaborative relationships and license arrangements include the following:

        Novartis.    In July 1995, the Company entered into various research and development agreements with Novartis Pharmaceuticals Corporation ("Novartis") to evaluate the feasibility of delivering a number of Novartis compounds utilizing the Company's iontophoretic drug delivery technology. Although the Company met all of the essential development objectives under the agreements, Novartis did not renew the agreements beyond their scheduled expiration date of December 31, 1998. The Company granted Novartis a perpetual non-exclusive, royalty-bearing license to certain iontophoretic technology. Technology developed in the collaboration is jointly owned and the Company is free to apply the technologies it developed for Novartis to any available drug candidates, either independently or on behalf of other parties.

        Elan.    In March 1997, the Company acquired exclusive world-wide licenses to certain iontophoretic drug delivery technologies, including rights to Elan's broad base of United States and foreign patents, in vitro drug transport data and in vivo animal and human clinical data, in addition to other proprietary know-how in iontophoretic drug delivery and electro-transport fields. Under the terms of the license, the Company is obligated to pay Elan a royalty on net revenues, as defined in the agreement.

        Alza.    In 1993, the Company entered into a cross-license agreement with Alza Corporation ("Alza"). Under the agreement, non-exclusive, royalty free rights to certain patented technologies were exchanged. One patent sublicensed by Alza to the Company under the agreement bears a nominal royalty rate, if used.

        University of Utah.    In 1974, the Company entered into a licensing agreement with the University of Utah Research Foundation ("University"). Under the agreement, as amended, the Company obtained an exclusive license to certain iontophoretic drug delivery technologies developed at the University. Under the terms of the amended license, the Company is obligated to pay the University a royalty on all sales of its iontophoretic drug delivery products through the year 2007.

        Santen Pharmaceuticals.    In April 2001, the Company entered into a collaboration agreement with Santen Pharmaceutical Co., LTD for the joint development of a treatment for AMD using the OcuPhor System and an anti-angiogenic drug. Work under the collaborative development agreement concluded in fiscal 2002.

        Eyetech Pharmaceuticals.    In February 2001, the Company entered into a collaboration agreement with Eyetech Pharmaceutical, Inc. ("Eyetech") to assist in performing initial development experiments to establish "proof of concept" using the Company's technology and Eyetech's drug compound. To date, no work has been performed under this agreement and Eyetech is continuing Phase III clinical trials on its lead compound, Macugen™, using multiple intravitreal injections to deliver the drug. The Company's OcuPhor system may be the subject of future evaluation for new compounds under development at Eyetech; however, no additional work is planned or anticipated under this agreement at the present time.

Manufacturing

        The Company's manufacturing activities primarily relate to its manufacture of active transdermal patch kits, which are manufactured and assembled using several proprietary materials, components, processes and production technologies developed by the Company in conjunction with its equipment and materials suppliers. The Company has manufactured internally all of the drug patches it has sold, and believes its patch manufacturing capacity can be expanded to meet its needs for the foreseeable future.

        The Company does not manufacture or repackage any drugs or compounds used in its delivery systems. The Company outsources the manufacture and assembly of its Phoresor dose controllers, which employ a variety of sub-assemblies and components that are designed or specified by the Company. These components and subassemblies are manufactured by third parties, and then shipped to a contract manufacturer for final assembly. The Company's manufacturing activities for the Phoresor are limited to design, labeling, inspection and packaging.

        The Company and certain of its suppliers are required to comply with FDA regulations governing manufacturing practices, including the Quality System Regulations, which mandate controls for product design, control and quality. The Company believes it is in compliance with the Quality System Regulations. The Company is also ISO 9001 and CE Mark certified and has Good Manufacturing Practices ("GMP") audits conducted on a regular basis.

Sales and Distribution

        The Company's marketing strategy is to position its pharmaceutical products in the marketplace as the preferred means of administration for a wide range of drugs. The strategy employs the use of multiple sales and distribution channels, including (i) a network of medical supply dealers; (ii) independent sales representatives; and (iii) co-marketing through collaborative marketing partners or distributors that have national or market-specific marketing capabilities. The Company intends to use these distribution channels, both singly and, for certain products, in combination, to maximize the Company's marketing resources.

        The Company currently sells the majority of its products into the physical therapy, sports medicine and related markets. The Company employs a nationwide network of distributors and independent sales representatives to sell and distribute its products in those markets. This distribution network is supported by regional business managers and internal customer service representatives who are employees of the Company. In addition to the Company's sales and distribution efforts for its local inflammation products in the United States, it maintains marketing and sales activities in international markets. These sales are made primarily through independent distributors operating in those countries.

        The Company's regional business managers and internal customer service representatives along with independent sales representatives facilitate the sales of Numby Stuff in the pediatric hospital market. The Company desires to expand its presence in this market through collaborative marketing partners or through distributors that have market-specific distribution capability.

        One distributor accounted for approximately 20%, 18% and 16% of the Company's product sales for the fiscal years ended June 30, 2002, 2001 and 2000. Although a valued distribution channel, in the event of a loss of such customer, the Company believes that it could continue to reach a substantial portion of its end user customers through alternative distribution channels. Less than 10% of product sales are to foreign customers.

Government Regulation

        Both drugs and medical devices, including the Company's iontophoretic drug delivery systems, are subject to extensive regulation by the FDA in the United States and by comparable authorities in other foreign countries.

        The Company's iontophoretic drug delivery products involve a medical device component, thereby subjecting such products to compliance with the FDA's regulations governing medical devices. Where such medical devices are labeled for use with a specific pharmaceutical product for a specific therapeutic indication, they are subject to the FDA's regulations governing both medical devices and pharmaceutical products. The Company's future iontophoretic drug delivery systems may involve a pharmaceutical component or specific labeling for use with a pharmaceutical product.

        Products regulated as medical devices may not be commercially distributed in the United States unless they have been cleared or approved by the FDA. Currently, there are two methods for obtaining FDA clearance or approval of medical devices. Devices deemed to pose less risk are placed in class I (general controls) or class II (general and special controls) and qualify for 510(k) notification, a procedure under section 510(k) of the Federal Food, Drug, and Cosmetic Act. A medical device that does not qualify for the 510(k) clearance is placed in class III, which is reserved for devices deemed by the FDA to pose the greatest risk. A preamendment class III device is one that was on the market before May 28, 1976. This status means that the device at present can be marketed through a 510(k) clearance, but it remains subject to a call for a Pre Market Approval ("PMA") application under section 515 of the Drug Act. A PMA application generally requires a more complex submission than a 510(k) notification. Typically, it requires showing that the device is safe and effective based on extensive and costly preclinical and clinical tests, as well as information about the device and its components regarding, among other things, manufacturing, labeling and promotion.

        The regulatory status of iontophoretic devices is complex. The FDA has classified them as class II devices eligible for marketing through 510(k) premarket clearance when intended for use with a drug whose labeling bears adequate directions for the device's use with that drug. However, if an iontophoretic device is intended for use with a drug that is not labeled for use with the device, the FDA considers the iontophoresis device to be a preamendment class III device.

        The Company's Phoresor received 510(k) clearance as a preamendment class III device labeled for use with ions of soluble salts or other drugs. In 1995, the FDA approved an NDA for Iontocaine to be used as a local anesthetic and delivered iontophoretically by the Phoresor, which effectively moved the Phoresor into class II for this intended use. Unlike Iontocaine, dexamethasone does not have an NDA approval allowing it to be labeled for iontophoretic delivery. Thus, at the present time, the Company's Phoresor is a preamendment class III device when used with dexamethasone (or any drug other than Iontocaine). The Company gives no assurance that it will ever obtain an approved NDA for the iontophoretic delivery of any drug other than Iontocaine.

        In August 2000, the FDA published a proposed rule to amend the physical medical device regulations to remove the class III iontophoresis device identification. Because the Company's products are all approved as class II devices, the Company does not believe that the proposed regulation would have any effect on the Company's ability to continue the manufacturing and selling of its current products.

        A lengthy and complex regulatory framework also applies to the labeling and marketing of specific drugs. Generally these pharmaceutical products require the submission of an NDA. The NDA approval process generally entails: (i) conducting preclinical laboratory and animal testing to enable FDA authorization of an Investigational New Drug ("IND") application, (ii) initial IND clinical studies to define safety and dose parameters, (iii) well controlled IND clinical trials to demonstrate product safety and efficacy, and (iv) submission to the FDA of an NDA. Preclinical studies involve laboratory evaluation of product characteristics and animal studies to assess the efficacy and safety of the drug. Human clinical trials are typically conducted in three sequential phases. Phase I trials normally consist of testing the product in a small number of healthy volunteers for safety and pharmacokinetic parameters using single and multiple dosing regimens. In Phase II trials, the manufacturer evaluates safety, initial efficacy, and dose ranging of the product for specific indications in a somewhat larger patient population. Phase III trials typically involve expanded testing for safety and clinical efficacy in a broad patient population at multiple clinical testing centers. The FDA, under Good Laboratory Practice regulations, regulates the preclinical and clinical studies. Results of the studies must be submitted to the FDA for review. The FDA may grant marketing approval, require additional testing and/or information, or deny the application. The process of obtaining FDA approval for a new product through this process may take several years and typically involves substantial risks and the expenditure of substantial resources.

        The FDA regulates the Company's quality control and manufacturing procedures by requiring it and its contract manufacturers to comply with certain standards, including compliance with the Quality System Regulations (for devices) and current GMP regulations (for drugs).

        The Company may be subject to certain user fees that the FDA is authorized to collect under the Public Health Security and Bioterrorism Preparedness and Response Act of 2002, which includes the reauthorization of user fees under the Prescription Drug User Fee Amendments of 2002 (PDUFA III).

        Agencies similar to the FDA regulate medical devices and pharmaceutical products in most foreign countries. The International Standards Organization (ISO) has established regulations for medical devices in the European Union. Currently, the Company is in compliance with these ISO 9001 regulations and its products are CE Marked. The Company will be required to meet the regulations of any foreign country where it markets its products. In addition, various aspects of the Company's business and operations are also regulated by a number of other governmental agencies including the Drug Enforcement Agency, U.S. Department of Agriculture, the Environmental Protection Agency, the Occupational Safety and Health Administration as well as by other federal, state and local authorities.

        Noncompliance with these various government regulatory requirements could result in enforcement actions that could include fines, plant closure, a recall of the Company's products or other civil or criminal sanctions. Noncompliance as well as unanticipated changes in existing regulatory requirements or adoption of new requirements could have a material adverse effect on the Company.

Competition

        The drug delivery, pharmaceutical and biotechnology industries are highly competitive and rapidly evolving, with significant developments expected to continue at a rapid pace. The Company's success depends upon maintaining a competitive position and developing products and technologies for efficient and cost effective drug delivery. The Company's products compete with other formulations of drugs and with other drug delivery systems, including other iontophoretic delivery systems. The Company believes its products compete on the basis of quality, efficacy, cost, convenience, safety and patient compliance.

        The Company is aware of many other competitors in the general field of drug delivery, including competitors developing injectable or implantable drug delivery systems, oral drug delivery technologies, passive transdermal systems, oral transmucosal systems and intranasal and inhalation systems. The Company is also aware of other companies that have developed or are currently developing iontophoretic and other active transdermal drug delivery systems.

        Alza, Vyteris, Inc., and Empi, Inc. are engaged in the development and/or marketing of iontophoretic devices. Alza, a licensee of the Company, and Vyteris are both undertaking the development of iontophoretic drug delivery systems, but neither currently markets any iontophoretic products. Empi is the Company's primary competitor in the sale of iontophoretic drug delivery systems for the treatment of acute local inflammation in the physical therapy market and, the Company estimates, controls a majority of that market.

        Currently, no other company has FDA approval to market an iontophoretic system for the inducement of local anesthesia. Therefore, the Company's iontophoretic system for delivering Iontocaine for the inducement of local dermal anesthesia primarily competes with traditional methods of delivering local dermal anesthetics by needle injection or is used in circumstances where either no anesthesia is used, due to the pain associated with needle injection (including needle injections themselves), or where topical anesthetic creams are used. The most effective and widely used topical anesthetic cream, EMLA, is manufactured and sold by AstraZeneca International, a large international pharmaceutical company. There can be no assurance that the Company can effectively compete with these products or any other drug delivery system.

Employees

        As of June 30, 2002, the Company had 54 full-time employees, 7 of whom hold either an advanced business or technical degree. Of the Company's full-time employees on that date, 7 were engaged in engineering and product development, 25 in manufacturing and quality control, and 22 in marketing and general administration. None of the Company's employees is represented by a labor union. The Company has not experienced any employee related work stoppages and considers its relations with employees to be good.

Item 2. PROPERTIES

        The Company's administrative, manufacturing operations, and research office space is housed in a single facility, consisting of approximately 34,000 square feet of useable space, located at 2441 South 3850 West in Salt Lake City, Utah. The facility is leased to the Company until April 30, 2006.    The Company believes its facilities will be adequate and suitable for its present needs and that additional space will be available as needed.

Item 3. LEGAL PROCEEDINGS

        The Company is not involved in, nor is it aware of, any material litigation or impending litigation. However, the Company is subject to various claims and legal proceedings covering matters that arise in the ordinary course of business. The Company believes that the resolution of these cases will not have a material adverse effect on its business, financial position, or future results of operations.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

        No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this Report.

PART II

Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

        The Company's common stock has traded on the American Stock Exchange (the "AMEX") since April 24, 1998, under the symbol "IOX". The following table sets forth, for the periods indicated, the high and low sales prices as reported by the AMEX. These prices represent quotations between dealers and do not include retail mark-up, markdown or commission, and do not necessarily represent actual transactions.

        As of June 30, 2002, there were 111 shareholders of record of the Company's common stock. Included in the number of shareholders of record are shares held in "nominee" or "street" names. Because many of such shares are held by brokers and other institutions on behalf of individual investors, the Company is unable to estimate the total number of shareholders represented by these record holders.

        The Company has not paid dividends to date and does not anticipate or contemplate paying cash dividends in the foreseeable future. It is the present intention of management to utilize all available funds for the development and growth of the Company's business.

Item 6. SELECTED CONSOLIDATED FINANCIAL DATA

        The following selected statement of operations data for the years ended June 30, 2002, 2001 and 2000, and the balance sheet data as of June 30, 2002 and 2001 are derived from the audited consolidated financial statements included in this report and should be read in conjunction with those consolidated financial statements and the notes thereto. The selected statement of operations data for the years ended June 30, 1999 and 1998, and the balance sheet data as of June 30, 2000, 1999 and 1998 are derived from the audited consolidated financial statements of the Company, which are not included herein and are qualified by reference to such financial statements and the notes thereto. Certain reclassifications have been made to prior year balances to conform to the financial statement presentation included herein.

(1)

Reflects a $1,190,000 non-recurring, non-cash charge for the impairment of long-lived assets and a $505,000 non-recurring restructuring charge.

(2)

Reflects a non-recurring restructuring charge.

(3)

Reflects a lease abandonment charge for facilities relocation.

(4)

See Notes to Consolidated Financial Statements for information concerning the computation of per share amounts.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the Consolidated Financial Statements and the related Notes thereto included elsewhere in this Report. The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, that involve risks and uncertainties. The Company's actual results of operations could differ significantly from those anticipated in such forward-looking statements as a result of numerous factors discussed under Item 1 "Business" and elsewhere in this Report.

Overview

        The Company is a leader in the development, manufacture and sale of active drug transport systems used to treat local inflammation in the sports and occupational medicine and physical therapy markets. The Company's current product line is based on proprietary iontophoretic drug delivery technology. The majority of the Company's revenues have been generated through the sale of the Phoresor system and related products that employ its proprietary technology. The Company is seeking opportunities to market or develop new products designed to improve the quality and efficiency of medical care it its served markets. In addition, the Company is seeking collaborative opportunities to develop its non-invasive drug transport technology to satisfy substantial unmet medical needs. The Company has proprietary technologies in various stages of research and product development for the treatment of acute local inflammation and for the treatment of ophthalmic disease. Since its inception, the Company has generally incurred operating losses as a result of costs associated with internally funded research and development activities. As of June 30, 2002, the Company's accumulated deficit was approximately $33.9 million. The Company's ability to achieve and sustain profitability will depend on its ability to achieve market acceptance and successfully expand sales of its existing products and successfully complete the development of, receive regulatory approvals for, and successfully manufacture and market its products under development, as to which there can be no assurance.

Fiscal Years Ended June 30, 2002 and 2001

        Revenues.    The Company achieved record annual product sales of $11.2 million in fiscal 2002 compared to $11.1 million in fiscal 2001. The increased product sales in the last three fiscal quarters of 2002, including record sales in the fourth quarter, helped offset the negative impact on sales orders in the first quarter resulting from a market shortage of an anti-inflammatory drug often used with its iontophoretic drug delivery products. The Company believes that the long-term effects of this drug shortage have since been mitigated and its sales orders have returned to normal levels following the drug shortage.

        Contract research revenues, royalties and license fees were $591,000 in fiscal 2002 compared to $192,000 in fiscal 2001. The increase in contract research revenue reflects the recognition of a $350,000 one-time payment for work performed under a collaborative research agreement with Santen Pharmaceuticals Co., Ltd. The Company and Santen have concluded work under their collaborative development agreement. The amount of future revenue levels will be dependent upon the Company's ability to expand its existing relationships and establish new collaborative research and product development programs.

        Costs of Products Sold.    Costs of products sold increased 9% to $4.2 million in fiscal 2002 from $3.8 million in fiscal 2001. Gross margins on product sales were 63% in fiscal 2002 compared to 66% in fiscal 2001, reflecting higher fixed costs, including depreciation expense, associated with the Company's new manufacturing and research facility.

        Research and Development Expense.    Research and development expenditures decreased $5.1 million, or 66%, to $2.6 million in fiscal 2002 from $7.7 million in fiscal 2001. The Company's research and development expenditures in the current periods reflect its investment in its ophthalmic and other product development programs. The decrease in fiscal 2002 was a result of cost reduction measures, including the suspension or curtailment of certain product development programs. During fiscal 2003, the Company intends to concentrate research and development efforts on its commercial business for the development of treatments for acute local inflammation in the sports and occupational medicine and physical therapy markets.

        Selling, General and Administrative Expenses.    Selling, general and administrative expenses decreased 31% to $5.6 million in fiscal 2002 compared to $8.0 million in 2001. This decrease relates primarily to the suspension of the Company's local inflammation development program, which resulted in a decrease of certain pre-market research and other costs associated with the program.

        Non-recurring charges.    Consistent with current accounting standards and according to its policy, the Company reviews long-lived assets for impairment whenever events occur or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Following the suspension of certain research and development activities, a change in strategic focus, and the implementation of a new patent management strategy, the Company performed a review for impairment of its intangible assets. Based on the review, the Company recorded a non-cash charge of $1,190,000 for the impairment of long-lived assets for the period ended June 30, 2002. The impairment charge represents the write-off of unamortized acquisition costs of certain patents and other intellectual property rights related to certain product development programs that have either been suspended or curtailed.

        The Company accrued for and recorded restructuring charges of $505,000 and $353,000 in fiscal 2002 and 2001 for certain involuntary employee termination benefits related to the suspension or curtailment of certain product development programs. During fiscal 2002 and 2001, 13 and 5 employees, respectively, were terminated and received involuntary termination benefits. Of the 18 total employees terminated, 11 were engaged in research and product development activities, and 7 in sales and general administration. As of June 30, 2002, substantially all of these termination benefits had been paid.

        Other Costs and Expenses.    Interest expense increased to $263,000 in fiscal 2002 from $78,000 in fiscal 2001. The increase is attributed to higher interest expense resulting from the increased equipment and furniture purchased under the Company's lease line and the term loan related to the building consolidation and relocation. Interest income and other miscellaneous income was $186,000 in fiscal 2002, compared to $777,000 in fiscal 2001. Amounts in both periods reflect interest earnings on invested cash balances. The decrease is due to lower interest rates on a lower invested cash balance.

        Income Taxes.    The Company has substantial net operating loss carryforwards, which, under the current "change of ownership" rules of the Internal Revenue Code of 1986, as amended, may be subject to substantial annual limitation. No income tax benefit was recognized for fiscal 2002 or 2001.

        Net Loss.    A net loss of $2,362,000 in fiscal 2002 compares to a net loss of $7,876,000 in fiscal 2001. The improved net loss position in fiscal 2002 was a result of significant cost control measures, including the suspension or curtailment of certain development programs, taken by the Company. The net loss in fiscal 2002 includes non-recurring charges of $1,695,000. The majority of the fiscal 2001 net loss can be attributed to internally funded research and development programs, including approximately $6.0 million for Phase III clinical studies and other expenses associated with the local inflammation program.

Fiscal Years Ended June 30, 2001 and 2000

        Revenues.    Product sales increased 5% to $11.1 million in fiscal 2001 from $10.6 million in fiscal 2000. Growth in the Company's IOGEL line of iontophoretic patches and increased market acceptance of iontophoresis contributed to the increase in product sales.

        Contract research revenues, royalties and license fees were $192,000 in fiscal 2001 compared to $171,000 in fiscal 2000.

        Costs of Products Sold.    Costs of products sold increased 3% to $3.8 million in fiscal 2001 from $3.7 million in fiscal 2000. Gross margins on product sales improved to 66% in fiscal 2001 compared to 65% in fiscal 2000. During the second half of fiscal 2001 the Company experienced downward pressure on its product margins due to higher fixed costs resulting from its relocation to a new facility and from costs associated with the installation of automated manufacturing equipment.

        Research and Development Expense.    Research and development expenditures increased 140% to $7.7 million in fiscal 2001 from $3.2 million in fiscal 2000, which reflected the Company's investment in key internal research and product development programs. During fiscal 2001 and 2000, the Company invested $4.4 million and $1.2 million, respectively, in product development and Phase III clinical studies related to its local inflammation program. In addition, during fiscal 2001, the Company invested further into the pre-clinical development of its proprietary ophthalmic pharmaceutical systems.

        Selling, General and Administrative Expenses.    Selling, general and administrative expenses increased 44% to $8.0 million in fiscal 2001 compared to $5.6 million in 2000. This increase relates primarily to pre-marketing activity associated with the Company's acute local inflammation program, as well as increased patent prosecution and maintenance costs.

        Non-recurring Charge.    The Company incurred a non-recurring charge in fiscal 2000 of $360,000 associated with the planned consolidation of its research, administrative and manufacturing operations.

        Other Costs and Expenses.    Interest expense increased to $78,000 in fiscal 2001 from $26,000 in fiscal 2000. This increase can be attributed to higher interest expense associated with higher long-term obligations. Interest income and other miscellaneous income was $777,000 in fiscal 2001, compared to $986,000 in fiscal 2000. Amounts in both periods reflect interest earnings on the invested cash balances.

        Net Loss.    A net loss of $7,876,000 in fiscal 2001 compares to a net loss of $1,155,000 in fiscal 2000. The majority of the net loss in fiscal 2001 and 2000 can be attributed to internally funded research and development programs, including Phase III clinical studies associated with the local inflammation program. Approximately $6.0 million of fiscal 2001 operating expenses were attributed to the local inflammation program compared to approximately $1.2 million in fiscal 2000. During both periods, net interest earnings on invested cash balances offset a loss from operations, in part.

Liquidity and Capital Resources

        During fiscal 2002, 2001, and 2000, the Company's operating losses, which resulted primarily from investment in research and development programs, were funded largely by cash flow from its commercial operating business and its cash reserves from its initial public offering in April 1998.

        As of June 30, 2002, the Company had cash and cash equivalents totaling approximately $4.4 million. Additionally, the Company had approximately $2.3 million of long-term restricted cash, invested in mutual funds and used to secure long-term financing. Cash in excess of immediate requirements is invested in a manner which is intended to maximize liquidity and return while minimizing investment risk, and, whenever possible, the Company seeks to minimize the potential effects of concentration of credit risk.

        The Company consumed $1,705,000, $5,545,000, and $491,000 in cash from operating activities during fiscal 2002, 2001, and 2000, respectively. The Company's efforts to stabilize its cost structure resulted in an improved net loss position and a decrease in cash consumption for operating activities in fiscal 2002. The increased consumption of cash for operating activities in fiscal 2001 can be attributed to the Company's investment in research and product development and the resulting net operating losses.

        Historically, the Company's operations have not been capital intensive. However, during fiscal 2001 the Company invested approximately $3.3 million for the relocation and consolidation of its research and manufacturing facilities and for new equipment to automate its manufacturing process. The Company used long-term financing agreements to fund these investments.

        As of June 30, 2002, the Company had approximately $3.1 million outstanding under financing agreements, all of which was recorded as long-term obligations, including the current portion. The Company intends to enter into additional financing agreements to fund the majority of its capital equipment needs during the next 12 months, but does not anticipate a significant investment in capital equipment during that time. The Company's equipment and furniture expenditures in excess of equipment acquired under capital lease agreements were $110,000, $289,000, and $234,000 in fiscal 2002, 2001, and 2000, respectively.

        Other sources and uses of cash during the periods included the following: During fiscal 2002, the Company used $575,000 for payments on long-term obligations and its restricted cash requirements decreased $376,000. During fiscal 2001, the Company used $217,000 for payments on long-term obligations; received $45,000 in proceeds from exercise of stock options; and secured long-term financing with $2,655,000 of restricted cash. During fiscal 2000, the Company purchased all rights to the iontophoretic intellectual property owned by Laboratories Fournier, including patented technology, know-how and a 10-year non-compete clause, at a cost of $1.4 million, including transaction expenses; used $84,000 for payments on long-term capital lease obligations; and received $43,000 in proceeds from exercise of stock options.

        In an effort to meet anticipated future growth and to consolidate its research and administrative functions and manufacturing operations, the Company executed a lease agreement in fiscal 2000 for an approximate 34,000 square foot facility. Accordingly, the Company recorded a non-recurring charge of $360,000 relating to the abandonment of certain facilities. The Company funded the facilities modification and consolidation with a term loan and available credit under its lease lines.

        The Company will continue to incur costs associated with its research and product development activities. During fiscal 2003, these costs will be funded internally from the Company's established commercial business; term loan and capital lease financing agreements; and from existing cash balances. The Company anticipates that at its current operating levels, existing cash balances and cash generated from operations will be sufficient to fund its operating needs through fiscal 2004 and beyond. However, the Company may be required to or elect to raise additional capital before that time. The Company's actual capital requirements will depend on numerous factors, many of which are outside the Company's control.

Critical Accounting Policies

        Financial Reporting Release No. 60, which was recently released by the Securities and Exchange Commission, requires all companies to include a discussion of critical accounting policies or methods used in the preparation of financial statements. The following list is not intended to be a comprehensive list of all of our accounting policies. Our significant accounting policies are more fully described in Note 1 of our consolidated financial statements. In many cases, the accounting treatment of a particular transaction is dictated by accounting principles generally accepted in the United States, with no need for management's judgment or estimation in its application. There are also areas in which management's judgment in selecting an available alternative would not produce a materially different result. The following is a brief discussion of the more significant accounting policies and methods used by us:

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

        Revenue Recognition—Revenues on product sales are recognized when there is persuasive evidence that an arms length transfer has occurred, generally upon shipment, when title has passed, and the price is fixed or determinable. The Company recognizes revenue from contract research based upon performance of its obligations, making qualifying expenditures and delivery of reports and data. Revenues from royalty and license agreements are based on third-party sales and are recognized in the quarter in which payment is either received or may be reasonably estimated.

        Long Lived Assets—The carrying amounts of long-lived assets, and the related amortization periods, are reviewed for impairment whenever events occur or changes in circumstances indicate that the carrying amount of an asset may not be recoverable within the estimated useful life. When the Company determines the existence of impairment indicators, the impairment loss is measured based on the excess of carrying value over the estimated fair value of the impaired assets. The carrying value of the underlying assets is reduced, with the reduction charged to expense, so that the carrying value is equal to fair value.

        Inventories—Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. The Company evaluates the carrying value of its inventories at least quarterly, taking into account such factors as historical and anticipated future sales compared with quantities on hand, the price the Company expects to obtain for its products in their respective markets compared with historical cost, and the remaining shelf life of goods on hand.

New Accounting Pronouncements

        In October 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 144, "Accounting for the Impairment or Disposal of Long-lived Assets," which addresses financial accounting and reporting for the disposal of long-lived assets. SFAS 144 is required to be adopted for all fiscal years beginning after December 15, 2001. The Company does not expect the adoption of SFAS 144 to have a significant impact on its financial position or results of operation.

        In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," which requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The Company does not expect the adoption of SFAS 146 to have a significant impact on its financial position or results of operation.

Additional Risk Factors

        Future results could differ materially from those currently anticipated by the Company due to a number of factors, including those identified in this section and elsewhere in this Form 10-K, any of which could have a material adverse impact on the Company's business, financial condition or results of operations.

        Continuing Operating Losses; Uncertainty of Future Profitability.    Since 1991, the Company has sustained losses in each fiscal year, except fiscal years 1999 and 1996. The Company had an accumulated deficit of $33.9 million as of June 30, 2002. The Company's ability to achieve and sustain profitability will depend on its ability to achieve market acceptance, successfully expand sales of its existing products, and successfully complete the development of, receive regulatory approvals for, and successfully manufacture and market, its products under development. The success of the Company's current products and products under development may also depend on the timing of new product introductions by the Company relative to its competitors and other factors.

        Uncertainties Related to Product Development.    The Company may be required to undertake time-consuming and costly product development activities, including clinical trials, and seek regulatory approval for new applications and products. Product revenues may not be realized from the sale of any such products for several years, if at all. The Company can give no assurance that its product development efforts, either alone or in collaboration with other parties, will ever be successfully completed, that it can obtain required regulatory approvals of its products, that products under development can be manufactured at acceptable cost or with appropriate quality, or that its products can meet market needs or achieve market acceptance.

        Before seeking regulatory approval for the commercial sale of its products, the Company must demonstrate through preclinical studies and clinical trials that those products are safe and effective for use in the target indications. There can be no assurances the Company will be able to complete its clinical trials in a timely manner, if at all. The results from preclinical studies and early clinical trials may not be indicative of results the Company will obtain in large-scale testing. There can be no assurance the Company's clinical trials will demonstrate sufficient safety and efficacy to obtain requisite regulatory approvals or that those clinical trials will result in additional marketable products. The use of any product the Company develops may produce undesirable side effects that could result in the interruption, delay or suspension of clinical trials, or the failure to obtain FDA or other regulatory approval for targeted indications. If the Company's products under development are not shown to be safe and effective in clinical trials, the resulting delays in developing other compounds and conducting related preclinical testing and clinical trials, as well as the need for additional financing to complete such testing and trials, could have a material adverse effect on the Company's business, financial condition, and results of operations.

        Reliance on Collaborative Partners.    The Company has previously entered into arrangements with corporate partners, licensors, licensees and other parties for the development, clinical testing, manufacture, marketing or commercialization of certain of its products or products in development. The process of establishing collaborative partners is difficult, time-consuming, and involves significant uncertainty. Discussions with potential collaborators may not lead to the establishment of new collaborative relationships on favorable terms, if at all. If successful in establishing a collaborative agreement, such agreement may never result in the successful development of products or the generation of significant revenue. Until the Company elects to and enters into additional collaborative agreements, it will be required to internally fund all of its research and development expenditures. Such agreements could limit the Company's flexibility in pursuing alternatives for the development or commercialization of its products. To the extent the Company chooses not, or is not able, to establish such collaborations, it could experience significantly increased business risk and capital requirements in the development, clinical testing, manufacturing, marketing and commercialization of its products. The Company could also encounter significant delays in introducing products into markets or find that the development, manufacture or sale of proposed products in such markets is adversely affected by the absence of those collaborative arrangements.

        Intense Competition and Rapid Technological Change.    The drug delivery, pharmaceutical and biotechnology industries are highly competitive and rapidly evolving, with significant developments expected to continue at a rapid pace. Many competitors, including public and private corporations, academic institutions, governmental agencies and other public and private research organizations, are involved in the development of drug delivery systems, including competing electrotransport-related drug delivery technologies. Many of these competitors have substantially greater financial and other resources, are more experienced, and are larger, more established organizations than the Company. In addition, these competitors may offer broader product lines, have greater name recognition, and offer discounts as a competitive tactic. Accordingly, competitors may succeed in developing competing technologies, and obtaining FDA approval or gaining market share for products, more rapidly than the Company. Many of these competitors currently have drug delivery products that are approved or in development. There can be no assurance the Company's competitors will not succeed in more rapidly developing or marketing products that are more effective or commercially attractive than the Company's current or future products, or that would render the Company's products obsolete or noncompetitive. There can also be no assurance the Company will have the financial resources, technical or management expertise, or manufacturing or support capability to compete in the future.

        The first pharmaceutical product to reach the market in a therapeutic area or using a certain drug delivery technology generally obtains and maintains a significant market share relative to later entrants to the market. The Company's success will depend on its ability to maintain a competitive position and develop new products and technologies for efficient and cost effective drug delivery. There can be no assurance any of the Company's products will have advantages that will be significant enough to cause medical professionals to prefer or even use them. New drugs or further development of alternative drug delivery methods may provide greater therapeutic benefits for a specific drug or indication, or may offer comparable performance at lower cost, than that offered by the Company's products.

        Reliance on Third Party Distribution.    The Company presently markets its drug delivery systems for the treatment of acute local inflammation primarily to physical therapists through a nationwide network of distributors and independent sales representatives. The Company is currently marketing its local dermal anesthesia products in the United States hospital market through a limited number of sales personnel who work directly for the Company and independent manufacturers' representatives.

        In order to achieve broad distribution and market penetration of its current and future products, the Company intends to expand its marketing presence through direct sales and marketing or through co-marketing of its products with collaborative marketing partners or distributors that have national or market-specific marketing capabilities. There can be no assurance that the Company will be able to maintain existing, or establish new, marketing arrangements on terms favorable to the Company, if at all.

        Dependence on Patents and Proprietary Technology.    The Company's ability to commercialize many of the products it has under development will depend, in part, on its or its licensors' ability, both in the United States and in other countries, to obtain patents, enforce those patents, preserve trade secrets and operate without infringing on the proprietary rights of third parties.

        The patent positions of drug delivery, pharmaceutical and biotechnology companies are highly uncertain and involve complex legal and factual questions. There can be no assurance the patents currently owned and licensed by the Company, or any future patents, will prevent other companies from developing similar or therapeutically equivalent products, or that other companies will not be issued patents that may prevent the sale of Company products or require licensing and the payment of significant fees or royalties by the Company. Furthermore, there can be no assurance any of the Company's products or methods will be patentable, will not infringe upon the patents of third parties, or that the Company's patents or future patents will give the Company an exclusive position in the subject matter claimed by those patents. The Company may be unable to avoid infringement of third party patents and may have to obtain licenses, defend infringement actions or challenge the validity of those patents in court. There can be no assurance a license will be available to the Company, if at all, on terms and conditions acceptable to the Company, or that the Company will prevail in any patent litigation. There can be no assurance the Company's pending patent applications will result in issued patents, patent protection will be secured for any particular technology, any patents that have been or may be issued to the Company or its licensors will be valid or enforceable or that the Company's patents will provide meaningful protection to the Company.

        The Company also relies on trade secrets and other unpatented proprietary information in its product development activities. The Company seeks to protect trade secrets and proprietary knowledge, in part, through confidentiality agreements with its employees, consultants, advisors and collaborators. To the extent the Company relies on confidential information to maintain its competitive position, there can be no assurance other parties may not independently develop the same or similar information. These agreements may not effectively prevent disclosure of the Company's confidential information and may not provide the Company with an adequate remedy in the event of unauthorized disclosure of such information. The Company's failure to obtain or maintain patent and trade secret protection, for any reason, could have a material adverse effect on the Company's business, financial position and results of operations. Also, the effect of potential legislative changes on the Company's intellectual property is uncertain.

        Need to Manage Expanding Operations.    If the Company is successful in achieving market acceptance of its products and products under development, it will be required to expand its operations, particularly in the areas of research and development, sales and marketing, and manufacturing. As the Company expands its operations in these areas, those expansions will likely result in new and increased responsibilities for management personnel and place significant strain on the Company's management, operating and financial systems and other resources. To accommodate any such growth and compete effectively, the Company will be required to implement improved information systems, procedures and controls, and to expand, train, motivate and manage its work force. The Company's future success will depend to a significant extent on the ability of its current and future management personnel to operate effectively both independently and as a group. There can be no assurance the Company's personnel, systems, procedures and controls will be adequate to support the Company's future operations.

        Future Capital Needs; Uncertainty of Additional Funding.    The further development and commercialization of the Company's products and technology will require a commitment of substantial funds to conduct research and development activities, including preclinical and clinical studies, to expand distribution and hire additional sales and marketing personnel and to expand and develop manufacturing capabilities. Although the Company believes that at its current operating levels, existing cash balances and cash generated from operations will be sufficient to fund its operating needs through fiscal 2004 and beyond, it may be required or elect to raise additional capital before that time. Actual capital requirements will depend on numerous factors, including but not limited to, the costs and timing of research and development activities, the number and type of clinical tests required in seeking approval of products from governmental agencies, the success of the development efforts, the costs and timing of sales and marketing expansion, the extent to which existing and new products gain market acceptance, the ability to maintain existing and enter into new collaborative relationships, competing technological and market developments, the progress of distributors' commercialization efforts, the costs involved in preparing, filing, prosecuting, maintaining, enforcing and defending patent claims and other intellectual property rights, developments related to regulatory and third party reimbursement issues, and other factors.

        To satisfy its capital requirements, the Company may seek to raise funds through public or private financings, collaborative relationships or other arrangements. Any additional equity financing may be dilutive to shareholders and debt financing may involve significant restrictive covenants. Collaborative arrangements to raise additional funds may require the Company to relinquish its rights to certain of its technologies, products or marketing territories. There can be no assurance that any such financing, if required, will be available on terms satisfactory to the Company, if at all. Failure to raise capital when needed could have a material adverse effect on the Company's business, financial condition and results of operations.

        Uncertainty of Government Regulation.    The research, development, manufacture and marketing of the Company's products are extensively regulated by the FDA, which requires its approval of drugs and medical devices before they can be marketed in the United States. Similar approvals are also required from other regulatory bodies in foreign countries. The regulatory processes established by these government agencies are lengthy, expensive and uncertain. In addition, once approval is obtained, that approval may be withdrawn.

        The Company has received approval from the FDA on its NDA for Iontocaine, and the FDA has allowed the Company to market its iontophoretic dose controllers and electrode products for use with ions of soluble salts or other drugs under the FDA's 510(k) regulations governing medical devices. However, in 1994, the FDA publicly stated that it intends to require manufacturers of iontophoretic devices to obtain PMAs for marketed devices currently used with drugs not specifically labeled for iontophoretic delivery, which would include the Company's dose controller for use with ions of soluble salts or other drugs, such as dexamethasone. The agency to date has not published such a regulation.

        If the FDA calls for PMAs for preamendment class III iontophoretic devices, the Company would be required to have a PMA accepted for filing by the FDA within 90 days after the date of the final regulation calling for PMAs. There can be no assurance that the Company would be able to complete and file a PMA within the prescribed time period, or that the FDA would approve it. The Company's failure to submit a PMA within the required timeframe could result in the Company being required to cease commercial distribution of the Phoresor for use with any drug other than Iontocaine. Any interference with the Company's ability to distribute its Phoresor system for use with dexamethasone would have a material adverse effect on the Company's financial condition and results of operations.

        Even if the Company obtains regulatory approval, a marketed product, its manufacturer and its manufacturing facilities and pertinent operations are subject to extensive regulation and periodic inspections. Discovery of previously unknown problems with a product, manufacturer or facility could result in FDA sanctions, restrictions on a product or manufacturer, or an order to withdraw and/or recall a specific product from the market. There can also be no assurance that changes in the legal or regulatory framework or other subsequent developments will not result in the limitation, suspension or revocation of regulatory approvals granted to the Company. Such events, were they to occur, could have a material adverse effect on the Company's business, financial condition and results of operations.

        The Company and certain of its suppliers are also required to comply with US and foreign regulations governing manufacturing practices, which mandate procedures for extensive control and documentation of product design, control and validation of the manufacturing process and overall product quality. If the Company or its suppliers fail to comply with applicable regulations regarding these manufacturing practices, the Company could be subject to sanctions.

        Under the FDA's regulations, when a manufacturer changes or modifies a device for which it has received a 510(k) clearance, it is required to obtain an additional 510(k) clearance for the modified device if the modification significantly affects the safety or efficacy of the device, or if the modification results in a major change in intended use. In such cases, the manufacturer is expected to make the initial determination as to whether the modification is of a kind that would require a new 510(k) clearance. The FDA's regulations provide only limited guidance in making this determination. The FDA has cleared the Company's iontophoretic dose controller and electrode kits for marketing under a 510(k) clearance. Since obtaining its 510(k) clearances, the Company has made modifications to its products. Based on the checklist developed by the FDA to assist manufacturers in determining whether they are required to obtain a 510(k) clearance for a modified device, the Company has determined that a new 510(k) submission was not required in connection with the commercial introduction of such products. However, there can be no assurance that the FDA will not require the Company to obtain additional 510(k) clearances with respect to those products. If the FDA requires the Company to submit a new 510(k) notice for any device modification, the Company may be prohibited from marketing the modified device until the 510(k) notice is cleared by the FDA.

        The Company may be required to comply with other proposed and new US and foreign regulations governing its current and future products. There can be no assurance that proposed and new regulations will not have a materially adverse effect on the Company.

        Dependence on Single Sources of Supply.    A key material used in many of the Company's current electrode products is available only from a single supplier. In addition, the Company obtains Iontocaine from Abbott Laboratories under a contract which may be terminated with six months notice. The Company also has the right to obtain dexamethasone from Luitpold Pharmaceuticals, Inc./American Regent Laboratories, Inc. under a contract expiring in January 2005. The Company believes that, if necessary, alternative sources can be developed or alternate materials can be substituted for each of these single-sourced materials. Although the Company has not experienced difficulty acquiring these materials on commercially reasonable terms and in sufficient quantities to maintain required production levels, no assurance can be given that price increases or interruptions in the supply of these materials will not occur in the future or that the Company will not have to seek alternate suppliers or obtain substitute materials, which may require additional product validations and regulatory submissions. Any significant price increase, interruption of supply, inability to secure an alternate source or qualify a substitute material could have a material adverse effect on the Company's ability to manufacture its products or to obtain or maintain regulatory approval of its products.

        The Company's current dose controllers are manufactured under a contract with a third party electronics manufacturer. There can be no assurance that its present supplier can manufacture sufficient quantities of dose controllers that meet quality and performance standards on a timely basis. If the supplier cannot meet the Company's requirements, or in the event of an interruption of its supply, the Company would be required to identify, qualify and validate an alternate supply source within a reasonable period of time.

        Limited Manufacturing Experience.    The Company manufactures its iontophoretic drug delivery electrodes in quantities sufficient to satisfy its current level of product sales. To meet increases in sales, the Company may need to increase its production significantly beyond its present manufacturing capacity. Accordingly, the Company may be required to increase its manufacturing capacity or to contract with another party to manufacture its products. There can be no assurance the Company can successfully increase its capacity on a profitable basis, or contract with another party on terms acceptable to the Company, if at all. Significant increases in production volume will likely require changes in the Company's product and manufacturing process in order to facilitate increased automation of the Company's production. There can be no assurance such changes in products or processes or efforts to automate the Company's manufacturing process will be successful.

        The Company believes its facilities operate in accordance with the Quality System Regulations currently prescribed by the FDA and in substantial compliance with ISO 9001 and CE Mark standards. The Company has GMP audits conducted by a qualified, independent organization on a regular basis and is ISO 9001 and CE Mark certified. There can be no assurance the Company will be able to maintain such compliance, particularly if the scale of the Company's manufacturing operations increases.

        Uncertainty of Health Care Reimbursement.    The Company's ability to commercialize its products successfully will depend, in part, on the extent to which reimbursement for the costs of those products and related treatments will be available from government health administration authorities, private health insurers and other organizations in the United States and in foreign markets where the Company's products will be sold and used. Third party payors can affect the pricing or relative attractiveness of the Company's products by regulating the reimbursement they provide on the Company's or competing products or therapies. There can be no assurance such reimbursement will continue at present levels, if at all. Some insurance carriers do not reimburse health care providers for use of the Company's products in certain applications. Furthermore, significant uncertainty exists as to the reimbursement status of new health care products.

        The Company is unable to predict what adverse impact on the Company, if any, additional government regulations, legislation or initiatives or changes by third party payors affecting reimbursement or other matters that may influence decisions to obtain medical devices may have.

        Retention and Attraction of Key Employees.    The Company is dependent on its ability to continue to attract and retain qualified scientific, managerial, manufacturing, engineering and sales and marketing personnel. There is intense competition for qualified personnel in the Company's area of activity, and there can be no assurance the Company will be able to continue to attract and retain the qualified personnel necessary for the development of its business. The Company does not carry key-man insurance with respect to any of its executives or employees.

        Risk of Product Liability, Product Recalls and Warranty Claims; Availability of Insurance.    The testing, marketing and sale of drug delivery and related pharmaceutical products for use in humans involves unavoidable risks. The use of the Company's products in clinical trials and the sale of its products upon approval may expose the Company to potential product liability resulting from the use of such products. In addition, the existence of a product liability claim, a product recall or excessive warranty claims (in any such case, whether arising from defects in design or manufacture or otherwise) could have an adverse effect on the Company's sales of that product or require a change in the indications for which it may be used.

        Product liability insurance in the Company's industry is expensive and difficult to obtain. Although the Company currently has product liability insurance, there can be no assurance the existing coverage is adequate. The Company will seek to maintain and appropriately increase its insurance coverage as its product sales increase and the clinical development of its new product applications progress. There can be no assurance, however, that the Company will be able to maintain its current levels of insurance on acceptable terms, will be able to secure increased coverage as the commercialization of its products proceeds or that any particular level of insurance will provide adequate protection against potential liabilities.

        Potential Volatility of Share Price.    The market price of the Company's common shares, like that of the common shares of many other drug delivery, pharmaceutical, biotechnology, medical device and other high technology companies, is likely to be highly volatile. Factors such as fluctuations or volatility in the Company's operating results, announcements of technological innovations, results of clinical trials or new commercial products by the Company or competitors, regulatory developments in the United Sates or foreign countries, changes in the current structure of health care financing and payment systems, developments in or disputes regarding patent or other proprietary rights, general market conditions, economic and other external factors may have a significant effect on the market price of the common shares. In addition, sales of substantial amounts of common shares (including shares issuable upon exercise of outstanding options and warrants) in the public market could adversely affect the market price of the common shares. Such sales could also make it more difficult for the Company to sell equity securities or equity-related securities in the future at a time and price that the Company deems appropriate.

        Anti-Takeover Provisions of Certain of the Company's Agreements.    Certain provisions of a cross-license agreement between the Company and Alza may have the effect of deferring, delaying or preventing a change in control of the Company, a merger involving the Company or the assignment or transfer of certain technologies of the Company. Under the agreement, the Company and Alza, among other things, exchanged non-exclusive, royalty free rights to certain patented technologies which each party believed to be of significant strategic importance to the potential technological success of many iontophoretic drug delivery applications. Both parties are prohibited from assigning their rights under the agreement to certain named companies or any other entity that derives more than 50 percent of its income from the development, licensing and/or sale of drug delivery systems to other pharmaceutical companies without first receiving the consent of the other party. Restrictions imposed on the Company's ability to assign its rights under this agreement may have the effect of prohibiting a sale of the Company to such named companies or entities, or may otherwise limit the Company's ability to capitalize on the commercial and other economic potential of these technologies through a technology license, asset sale, merger, combination or similar transaction.

        Environmental Matters.    The Company's research and development activities involve the controlled use of hazardous materials, chemicals and various radioactive compounds. These materials, and their use, disposal and handling, are extensively regulated by federal, state and local government authorities. Although the Company believes its safety procedures for handling and disposing of such materials comply in all material respects with the standards prescribed by state and federal regulations, the risk of accidental environmental contamination or personal injury from these materials cannot be completely eliminated. In the event of such an accident, the Company could be held liable for any damages and any such liability could exceed the resources of the Company. There can be no assurance the Company will not be required to incur significant costs to comply with such environmental and health and safety laws and regulations in the future, particularly if the Company develops additional manufacturing or research facilities and capacity.

Item 7a. QUANTITATIVE AND QUALITATIVE INFORMATION ABOUT MARKET RISK

        Not applicable.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

        The Company's consolidated financial statements are included elsewhere in this Report.

Item 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

        None.

Consolidated Financial Statements

IOMED, Inc.

June 30, 2002

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS


IOMED, Inc.

REPORT OF INDEPENDENT AUDITORS

The Board of Directors and Shareholders
IOMED, Inc.

        We have audited the accompanying consolidated balance sheets of IOMED, Inc. as of June 30, 2002 and 2001, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended June 30, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

        We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

        In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of IOMED, Inc. at June 30, 2002 and 2001, and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 30, 2002, in conformity with accounting principles generally accepted in the United States.

ERNST & YOUNG LLP

Salt Lake City, Utah
August 8, 2002

IOMED, Inc.


Consolidated Balance Sheets

See accompanying notes.

IOMED, Inc.


Consolidated Statements of Operations

See accompanying notes.

IOMED, Inc.


Consolidated Statements of Shareholders' Equity

See accompanying notes.

IOMED, Inc.


Consolidated Statements of Cash Flows

See accompanying notes.

IOMED, Inc.


Notes to Consolidated Financial Statements

1. Description of Business and Summary of Significant Accounting Policies

Description of Business

        IOMED, Inc., a Utah corporation (the "Company"), is a leader in the development, manufacture and sale of active drug transport systems primarily used to treat acute local inflammation in the sports and occupational medicine and physical therapy markets. The Company is seeking opportunities to market or develop new products designed to improve the quality and efficiency of medical care in its served markets. In addition, the Company is seeking collaborative opportunities to develop its non-invasive drug transport technology to satisfy substantial unmet medical needs. The Company has proprietary technology in various stages of research and product development for the treatment of acute local inflammation and for the treatment of ophthalmic disease.

Principles of Consolidation

        The consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Dermion, Inc., which was unincorporated in fiscal 2002. All significant intercompany transactions and accounts have been eliminated.

Estimates

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

Cash Equivalents

        The Company considers all highly liquid investments with maturities of three months or less, when purchased, to be cash equivalents, including $375,000 restricted to secure the current portion of long-term obligations (see note 4).

Concentrations of Credit Risk

        The Company's financial instruments that are exposed to concentrations of credit risk consist primarily of cash, cash equivalents and trade accounts receivable. Cash and cash equivalents are held in federally insured financial institutions or invested in high-grade short-term commercial paper issued by major United States corporations. The Company sells its products primarily to, and has trade accounts receivable with, independent durable medical equipment dealers in the United States and abroad. Less than 10% of product sales are to foreign customers. As a general policy, collateral is not required for accounts receivable; however, the Company maintains an allowance for losses based upon expected collections of accounts receivable. Additionally, customers' financial condition and credit worthiness are regularly evaluated and historical losses have not been material. Sales to one customer accounted for approximately 20%, 18% and 16% of the Company's product sales for the years ended June 30, 2002, 2001 and 2000. At June 30, 2002, 2001 and 2000, amounts due from such customer accounted for approximately 29%, 14% and 14% of trade receivables, all of which was current. The Company considers credit risk from concentrations of trade accounts receivable to be low.

Reclassifications

        Certain reclassifications have been made to prior year balances to conform to the financial statement presentation included herein.

Revenue Recognition

        Revenues on product sales are recognized when there is persuasive evidence that an arms length transfer has occurred, generally upon shipment, when title has passed, and the price is fixed or determinable. The Company recognizes revenue from contract research based upon performance of its obligations, making qualifying expenditures and delivery of specified research reports and data. Revenues from royalty and license agreements are based on third-party sales and are recognized in the quarter in which payment is either received or may be reasonably estimated.

Patent Development Costs

        In connection with its research and development efforts, costs of which are expensed as incurred, the Company incurs certain costs in the preparation, application, filing, maintenance and defense of patents and trademarks. Where such costs primarily relate to patents and trademarks covering technologies or products which are under development or in the early stages of commercialization, the Company expenses such costs as incurred.

Inventories

        Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. The Company evaluates the carrying value of its inventories at least quarterly, taking into account such factors as historical and anticipated future sales compared with quantities on hand, the price the Company expects to obtain for its products in their respective markets compared with historical cost, and the remaining shelf life of goods on hand. Inventories consist of the following:

Equipment and Furniture

        Equipment and furniture are stated at cost. Depreciation and amortization is computed using the straight-line method over estimated useful lives of three to five years. Leasehold improvements are amortized over the term of the lease or the useful life of the improvements, whichever is shorter. Equipment and furniture consist of the following:

Intangible Assets

        In June 2002, the Company recorded a non-recurring, non-cash charge of $1,190,000 for the impairment of long-lived intangible assets (see Note 6), which represented the unamortized acquisition costs of these intangible assets. At June 30, 2001, intangible assets totaling $1,362,000, net of amortization, are included in other assets and consist of rights to certain patents, trademarks, non-compete agreements, and other intellectual property.

Long Lived Assets

        The carrying amounts of long-lived assets, and the related amortization periods, are reviewed for impairment whenever events occur or changes in circumstances indicate that the carrying amount of an asset may not be recoverable within the estimated useful life. When the Company determines the existence of impairment indicators, the impairment loss is measured based on the excess of carrying value over the estimated fair value of the impaired assets (see Note 6). The carrying value of the underlying asset is reduced, with the reduction charged to expense, so that the carrying amount is equal to fair value.

Stock Options

        The Company has elected to follow Accounting Principles Board Opinion No. 25-Accounting for Stock Issued to Employees (APB 25) and related interpretations in accounting for its employee stock options rather than adopting the alternative fair value accounting provided for under Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation. Because the exercise price of the Company's employee stock options equals the market price of the underlying shares on the date of grant, under APB 25, the Company does not recognize any compensation expense.

        Stock compensation expense for options granted to non-employees has been determined in accordance with SFAS 123 and the Emerging Issues Task Force consensus in Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods or Services (EITF 96-18). The fair value of options granted to non-employees and the associated expense is periodically re-measured as the underlying options vest.

Loss Per Share

        The Company's net loss per share has been calculated in accordance with SFAS No. 128-Earnings Per Share and, accordingly, includes a computation of both basic and diluted loss per share. Net loss as presented in the statements of operations represents the numerator used in computing loss per share and the following table sets forth the computation of the weighted average shares used in determining basic and diluted loss per share:

        At June 30, 2002, the following securities were outstanding but were not included in the computation of diluted loss per share due to their anti-dilutive effect: options to purchase 1,477,383 common shares at a weighted average exercise price of $3.11 per share; warrants to purchase 233,542 common shares at a weighted average price of $10.26 per share; and 893,801 Series D Convertible Preferred Shares convertible on a share-for-share basis into common stock.

Research and Development Costs

        Research and development expenses, including those incurred in relation to the Company's collaborative agreements, are expensed in the period incurred and are comprised of costs incurred in performing research and development activities, including salaries and benefits, facilities costs, overhead costs, clinical trial and related clinical manufacturing costs, consulting, contract services, and costs related to development of commercial scale manufacturing capabilities.

Income Taxes

        The Company accounts for income taxes using the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

New Accounting Pronouncements

        In October 2001, FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-lived Assets," which addresses financial accounting and reporting for the disposal of long-lived assets. SFAS 144 is required to be adopted for all fiscal years beginning after December 15, 2001. The Company does not expect the adoption of SFAS 144 to have a significant impact on its financial position or results of operation.

        In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," which requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The Company does not expect the adoption of SFAS 146 to have a significant impact on its financial position or results of operation.

2. Restricted Cash

        The Company maintains an interest bearing money market account with a lending bank, $2,279,000 of which is being held as a compensating balance under a long-term obligation (see note 4) and is restricted as to withdrawal. The restricted cash balance requirement decreases over the life of the obligation as payments are made.

3. Accrued Liabilities

        Accrued liabilities consist of the following:

        Product development obligations are expenses incurred prior to June 30, 2001, relating to clinical research, product development, and pre-marketing activities associated with the Company's product development program for the treatment of acute local inflammation that was suspended in June 2001. Included in this amount at June 30, 2002 and 2001, is approximately $8,000 and $285,000, respectively, for certain involuntary employee termination benefits (see Note 6).

4. Commitments

Royalty Agreements

        The Company is the licensee under royalty agreements, which provide for the payment of royalties to the licensor based upon net sales of the products under royalty. Royalty expense in each of the three years in the period ended June 30, 2002 was not material.

Operating Leases

        The Company leases space and certain equipment under non-cancelable operating lease agreements that expire at various dates through April 2006. Rental expense for such leases was $426,000, $405,000 and $227,000 for the years ended June 30, 2002, 2001 and 2000, respectively. It is generally expected that, in the normal course of business, operating leases that expire will be renewed or replaced by other leases with similar terms. Future minimum lease payments under non-cancelable operating leases at June 30, 2002, were $1,353,000. These obligations mature as follows: fiscal 2003—$383,000; fiscal 2004—$338,000; fiscal 2005—$339,000; fiscal 2006—$287,000; and fiscal 2007—$6,000.

Long-Term Obligations

        The Company has acquired various equipment and furniture under capital lease agreements. The capitalized cost of such equipment was $1,379,000 at June 30, 2002 and 2001 and accumulated amortization was $577,000 and $298,000, respectively. Under these capital lease agreements, the Company is required to meet certain financial covenants, all of which have been met.

        The Company refinanced $2,700,000 of capital lease obligations into a term loan, collateralized by the underlying assets, restricted cash and cash, with a fixed rate of 6.82%, payable in 84 monthly installments of $40,519 maturing April 2008. At June 30, 2002, the outstanding balance was $2,334,000. Payments of approximately $486,000 are due within one year, of which $337,000 is principal reduction.

        The carrying values of the long-term obligations approximate fair values as the interest rates on these long-term obligations approximate market rates of interest. Future minimum payments under long-term obligations consisted of the following at June 30, 2002:

5. Shareholders' Equity

Stock Options

        The Company has adopted and approved two incentive compensation plans. The Company's 1988 Stock Option Plan was approved by the shareholders in November 1988 and the Company's 1997 Share Incentive Plan was approved by the shareholders in November 1997. The 1988 Stock Option Plan expired in August 1998 and no further grants were made under the Plan following the adoption of the 1997 Share Incentive Plan. In general, options granted vest over zero to five years. A summary of the activity under the Plans during each of the three years ended June 30, 2002, is as follows:

The weighted average fair value of options granted in the years ended June 30, 2002, 2001 and 2000, was $1.49, $3.44 and $2.26, respectively. Additional information regarding the options outstanding at June 30, 2002 follows:

        Pro forma information regarding net income and earnings per share is required by SFAS 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. Had compensation cost for the Company's employee stock options been determined consistent with the methodology prescribed under SFAS 123, the Company's net loss and loss per share would have been increased by approximately $241,000, $680,000, and $378,000, or $0.04, $0.10, and $0.06 per common share in fiscal 2002, 2001, and 2000, respectively. The fair value of these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions for 2002, 2001 and 2000, respectively: risk-free interest rates of 3.8%, 5.5% and 6.5%; dividend yield of 0%; volatility factors of the expected market price of the Company's common stock of 0.73, 0.74 and 0.63; and a weighted-average expected life of the option of 6 years.

        The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. In management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options because the Company's employee stock options have characteristics different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate.

        For purposes of pro forma disclosures, the estimated fair value of the options is amortized over the options' vesting period. Because the effect of SFAS 123 is prospective, the initial impact on pro forma net loss may not be representative of compensation expense in future years.

        In accordance with EITF 96-18, the Company accounts for stock options issued to non-employees at fair value. The value of the stock options is amortized to expense over the vesting period. The Company has issued stock options to certain non-employees and recognized related compensation expense of $10,000 and $101,000 during the fiscal years ended June 30, 2002 and 2001.

Series D Convertible Preferred Shares

        The Series D preferred shares are convertible at the option of the holder, Elan Corporation, plc, into common shares, on a share-for-share basis, subject to adjustment for certain corporate transactions. Further, the Series D preferred shares are non-redeemable, non-voting and have no dividend, liquidation or similar preferences over common shares but are entitled to a pro rata share of any such distribution as if the Series D preferred shares had been converted into common shares.

Warrants

        The Company has three outstanding warrants, which entitle the holders thereof to acquire common shares of the Company. In April 1998, the Company issued a warrant to Everen Securities to acquire up to 170,000 shares for an initial exercise price of $9.38 per share. In November 1997, a warrant was issued to Novartis Pharmaceuticals Corporation to acquire up to 18,750 shares for an exercise price of $21.60 per share. In December 1996, a warrant was issued to the Alliance of Children's Hospitals, Inc. to acquire up to 44,792 shares for an exercise price of $8.88 per share. The warrants expire in April 2003, November 2002, and December 2003, respectively. At June 30, 2002, the Company had 233,542 shares of its authorized, unissued common shares reserved for issuance pursuant to these warrant obligations.

6. Non-recurring Charges

        Non-recurring charges consist of the following:

Non-cash Charge For the Impairment of Long-Lived Assets

        In accordance with accounting principles generally accepted in the United States, certain patents and other intellectual property rights acquired from third parties were capitalized and were being amortized over the estimated useful lives. Consistent with the requirements of SFAS 144 and its predecessor, SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," the Company reviews long-lived assets for impairment whenever events occur or changes in circumstances indicate that the carrying value of an asset may not be recoverable within its estimated useful life. Following the suspension or curtailment of certain research and development activities, a change in strategic focus, and the implementation of a new patent management strategy, the Company performed a review for impairment of its intangible assets. Based on the review, the Company recorded a non-recurring, non-cash charge of $1,190,000 for the estimated impairment in the carrying value of certain long-lived assets in the period ended June 30, 2002. The impairment charge represents the write-off of unamortized acquisition costs of certain patents and other intellectual property rights related to product development programs that have either been suspended or curtailed.

Restructuring Charge

        The Company accrued for and recorded restructuring charges of $505,000 and $353,000 in fiscal 2002 and 2001 for certain involuntary employee termination benefits related to the suspension of certain product development programs. During fiscal 2002 and 2001, 13 and 5 employees, respectively, were terminated and received involuntary termination benefits. Of the 18 total employees terminated, 11 were engaged in research and product development activities, and 7 in sales and general administration. As of June 30, 2002, substantially all of the termination benefits have been paid.

Lease Abandonment Charge

        In fiscal 2000, the Company entered into a lease agreement for a new facility and recorded a net non-recurring lease abandonment charge of $360,000 and accrued for costs associated with the non-cancelable abandoned lease and other obligations. All lease and other obligations associated with the abandonment are current and are classified as accrued liabilities at June 30, 2002.

7. Employee Benefit Plan

        The Company has established a 401(k) savings plan for its full-time employees and makes a matching contribution based on a percentage of the contributions of participating employees. The Company contributed approximately $77,000, $91,000 and $63,000 for the years ended June 30, 2002, 2001 and 2000.

8. Income Taxes

        Deferred taxes result from differences in the carrying value of various assets and liabilities between income tax reporting and financial reporting purposes. These differences arise from differing depreciation methods, and other reserves that are deductible in different periods for tax and financial reporting purposes. The approximate tax effect of temporary differences, net operating loss carryforwards and tax credit carryforwards as of June 30, 2002 and 2001, is as follows:

        There were no significant deferred tax liabilities in 2002 or 2001. The valuation allowance increased by $1,294,000 during the fiscal year.

        There were no net deferred income tax provisions in any of the years presented. The Company recorded no current federal or state income tax provision for fiscal 2002, 2001 and 2000.

        The reconciliation of income taxes at the statutory United States federal income tax rate and the Company's effective income expense attributable to continuing operations is as follows:

        As of June 30, 2002, the Company had approximately $29,916,000 and $25,300,000 in federal and state net operating loss carryforwards, respectively, and $918,000 in federal tax credit carryforwards, that expire from 2003 through 2022. Utilization of the Company's net operating loss and credit carryforwards is limited to the future taxable income of the Company. Under the "change of ownership" provisions of the Internal Revenue Code, utilization of these net operating loss and credit carryforwards may be subject to an annual limitation.

9. Contingencies

        The Company is subject to various claims and legal proceedings covering matters that arise in the ordinary course of its business activities. Management believes any liability that may ultimately result from the resolution of these matters will not have a material adverse effect on the Company's consolidated financial position, operating results, or cash flows.

10. Quarterly Financial Information (Unaudited)