UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(x) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2002
Commission File Number 1-13165
CRYOLIFE, INC.
(Exact name of registrant as specified in its charter)
---------
Florida 59-2417093
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
1655 Roberts Boulevard, NW
Kennesaw, Georgia 30144
(Address of principal executive offices)
(zip code)
(770) 419-3355
(Registrant's telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
YES X NO _____
The number of shares of common stock, par value $0.01 per share, outstanding on
August 30, 2002 was 19,502,371.
Part I - FINANCIAL INFORMATION
INFORMATION WITH RESPECT TO FINANCIAL STATEMENTS
On April 11, 2002 CryoLife, Inc. filed a Form 8-K, indicating that the Board of
Directors, upon the recommendation of the audit committee, had dismissed the
accounting firm Arthur Andersen LLP as the Company's independent auditors
effective April 9, 2002. On May 10, 2002 CryoLife, Inc. filed a Form 8-K,
indicating that the Board of Directors, upon the recommendation of the audit
committee, had appointed Deloitte & Touche LLP as the Company's independent
auditors effective May 7, 2002.
CryoLife, Inc.'s Form 10-Q for the quarterly period ended March 31, 2002 was
previously filed without a review of the financial statements for the quarterly
period ended March 31, 2002, by an independent public accountant in accordance
with Rule 10-01(d) of Regulation S-X promulgated by the Securities and Exchange
Commission. CryoLife, Inc. elected not to obtain such a review from its prior
auditor, Arthur Andersen LLP.
Deloitte & Touche LLP has subsequently reviewed the financial statements for the
quarterly period ended March 31, 2002 in accordance with Rule 10-01(d).
2
Item 1. Financial statements
CRYOLIFE, INC. AND SUBSIDIARIES
SUMMARY CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------
(Unaudited) (Unaudited)
Revenues:
Human tissue preservation services, net $ 17,536 $ 18,765 $ 37,774 $ 37,331
Products 5,473 2,789 10,538 5,430
Distribution and grant 255 143 423 368
------------------------------- ------------------------------
23,264 21,697 48,735 43,129
Costs and expenses:
Human tissue preservation services
(including write-down of
$10,023 in 2002) 17,203 7,697 25,266 15,370
Products 1,843 1,423 4,078 2,855
General, administrative, and marketing 11,447 8,120 20,925 16,279
Research and development 1,196 1,286 2,349 2,372
Interest expense 196 16 388 16
Interest income (239) (576) (537) (1,138)
Other (income) expense, net (16) (5) (72) 742
-------------------------------- ------------------------------
31,630 17,961 52,397 36,496
------------------------------- ------------------------------
Income (loss) before income taxes (8,366) 3,736 (3,662) 6,633
Income tax (benefit) expense (2,844) 1,196 (1,244) 2,123
------------------------------- ------------------------------
Net (loss) income $ (5,522) $ 2,540 $ (2,418) $ 4,510
=============================== ==============================
Net (loss) earnings per share:
Basic $ (0.28) $ 0.14 $ (0.13) $ 0.24
=============================== ==============================
Diluted $ (0.28) $ 0.13 $ (0.13) $ 0.23
=============================== ==============================
Weighted average shares outstanding:
Basic 19,538 18,780 19,318 18,761
=============================== ==============================
Diluted 19,538 19,622 19,318 19,575
=============================== ==============================
See accompanying notes to summary consolidated financial statements.
3
Item 1. Financial Statements
CRYOLIFE, INC.
SUMMARY CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
June 30, December 31,
2002 2001
-----------------------------------
ASSETS (Unaudited)
---
Current Assets:
Cash and cash equivalents $ 12,290 $ 7,204
Marketable securities, at market 18,659 26,483
Trade receivables, net 13,800 13,305
Other receivables, net 3,727 2,820
Note receivable, net -- 1,169
Deferred preservation costs, net 21,039 24,199
Inventories 7,352 6,259
Prepaid expenses and other assets 2,976 2,341
Deferred income taxes 3,457 688
-----------------------------------
Total current assets 83,300 84,468
-----------------------------------
Property and equipment, net 39,574 39,246
Goodwill 1,399 1,399
Patents, net 4,998 2,919
Other, net 1,087 1,278
-----------------------------------
TOTAL ASSETS $ 130,358 $ 129,310
===================================
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities:
Accounts payable $ 1,826 $ 555
Accrued expenses and other current liabilities 2,784 1,491
Accrued compensation 1,233 2,560
Accrued procurement fees 8,224 6,592
Current maturities of capital lease obligations 628 609
Current maturities of long-term debt 6,400 1,600
Convertible debenture -- 4,393
-----------------------------------
Total current liabilities 21,095 17,800
-----------------------------------
Capital lease obligations, less current maturities 2,821 3,140
Bank loan, less current maturities -- 5,600
Deferred income taxes 199 449
Other long-term liabilities 961 882
-----------------------------------
Total liabilities 25,076 27,871
-----------------------------------
Shareholders' equity:
Preferred stock -- --
Common stock (issued 20,864 shares in 2002 and
20,172 shares in 2001) 208 202
Additional paid-in capital 73,336 66,828
Retained earnings 38,129 40,547
Deferred compensation (27) (33)
Accumulated other comprehensive income (loss) 137 (145)
Less: Treasury stock at cost (1,309 shares in 2002 and
1,286 shares in 2001) (6,501) (5,960)
-----------------------------------
Total shareholders' equity 105,282 101,439
-----------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 130,358 $ 129,310
===================================
See accompanying notes to summary consolidated financial statements.
4
Item 1. Financial Statements
CRYOLIFE, INC.
SUMMARY CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
Six Months Ended
June 30,
-----------------------------------
2002 2001
-----------------------------------
(Unaudited)
Net cash from operating activities:
Net (loss) income $ (2,418) $ 4,510
Adjustments to reconcile net (loss) income to net cash
provided by operating activities:
Loss on sale of marketable equity securities 228 --
Depreciation and amortization 2,526 2,169
Provision for doubtful accounts 48 47
Write-down of deferred preservation costs 10,023 --
Other non-cash adjustments to income -- 748
Deferred income taxes (3,048) (578)
Tax effect of nonqualified option exercises 481 114
Changes in operating assets and liabilities:
Receivables 90 (1,645)
Income taxes (1,540) 926
Deferred preservation costs and inventories (7,956) (2,053)
Prepaid expenses and other assets (635) (814)
Accounts payable, accrued expenses, and other liabilities 2,951 889
-----------------------------------
Net cash flows provided by operating activities 750 4,313
-----------------------------------
Net cash flows from investing activities:
Capital expenditures (2,735) (9,072)
Other assets (1,980) (257)
Purchases of marketable securities (11,725) (9,307)
Sales and maturities of marketable securities 19,391 10,664
Proceeds from note receivable 1,169 1,605
-----------------------------------
Net cash flows provided by (used in) investing activities 4,120 (6,367)
-----------------------------------
Net cash flows from financing activities:
Principal payments of debt (800) (133)
Proceeds from debt issuance -- 1,165
Payment of obligations under capital leases (300) (85)
Proceeds from exercise of stock options and
issuance of common stock 1,099 540
-----------------------------------
Net cash (used in) provided by financing activities (1) 1,487
-----------------------------------
Increase (decrease) in cash 4,869 (567)
Effect of exchange rate changes on cash 217 (124)
Cash and cash equivalents, beginning of period 7,204 17,480
-----------------------------------
Cash and cash equivalents, end of period $ 12,290 $ 16,789
===================================
See accompanying notes to summary consolidated financial statements.
5
CRYOLIFE, INC. AND SUBSIDIARIES
NOTES TO SUMMARY CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1 - BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with (i) accounting principles generally accepted in the
United States for interim financial information and (ii) the instructions to
Form 10-Q and Rule 10-01 of Regulation S-X of the Securities and Exchange
Commission ("SEC"). Accordingly, they do not include all of the information and
disclosures required by accounting principles generally accepted in the United
States for a complete presentation of financial statements. In the opinion of
management, all adjustments (consisting of normal recurring accruals and
estimated write-downs and accruals resulting from an order received from the
United States Food and Drug Administration ("FDA")) considered necessary for a
fair presentation have been included. Certain prior year balances have been
reclassified to conform to the 2002 presentation. CryoLife, Inc.'s ("CryoLife"
or the "Company") unaudited June 30, 2001 year to date results of operations
have been revised from the amounts previously reported in the Form 10-Q for the
quarter ended June 30, 2001, as indicated in Note 20 to the consolidated
financial statements included in the CryoLife, Inc Form 10-K for the year ended
December 31, 2001. Operating results for the three and six months ended June 30,
2002 are not necessarily indicative of the results that may be expected for the
year ending December 31, 2002. For further information, refer to the
consolidated financial statements and notes thereto included in the CryoLife,
Inc. Form 10-K for the year ended December 31, 2001.
The Company anticipates that the FDA Order, defined in Note 2, will have
significant adverse effects on its financial position, results of operations and
cash flows. The Company expects its liquidity to decrease significantly over the
remainder of the year due to the anticipated significant decrease in revenues as
a result of the FDA Order and an expected use of cash due to the increased legal
and professional costs relating to the defense of lawsuits and to addressing the
FDA Order. As a result, the Company plans to reduce the number of personnel it
employs in several areas, as needed, based in part on the Company's success in
its efforts to appeal or obtain a modification of the FDA Order. On September 3,
2002 the Company announced a reduction in employee force of approximately 105
employees. The Company anticipates that severance and related costs will be
approximately $625,000, which will be recorded in the third quarter of 2002. As
a result of the employee reduction, management anticipates personnel costs will
be reduced by approximately $360,000 per month. The Company anticipates that
after it has reduced the number of employees in response to the reduction in
revenues, the savings in resources will enable the Company to meet its liquidity
needs through June 30, 2003. Even if the Company is able to obtain a favorable
outcome of its appeal or requested modification of the FDA Order, there is no
assurance that the Company would experience a return to the current level of
demand for its tissue services as a result of the adverse publicity or as a
result of customers and tissue banks switching to competitors.
The Company's long term liquidity and capital requirements will depend upon
numerous factors, including the resolution of the Company's appeal of the FDA
Order as described in Note 2, the extent of the anticipated revenue decreases,
the costs associated with becoming compliant with the FDA requirements as
outlined in the FDA Order, the outcome of litigation against the Company as
described in Note 11, the level of demand for tissue based on adverse publicity
in the event the FDA Order is resolved in a manner favorable to the Company, the
default on the Term Loan as described in Note 6, and the Company's inability to
borrow on its line of credit as described in Note 12. The Company may require
additional financing or seek to raise additional funds through bank facilities,
debt or equity offerings, or other sources of capital to meet liquidity and
capital requirements beyond June 30, 2003. Additional funds may not be available
when needed or on terms acceptable to the Company, which could have a material
adverse effect on the Company's business, financial condition, results of
operations, and cash flows. These are factors that indicate that the Company may
be unable to continue operations.
6
NOTE 2 - FDA ORDER ON HUMAN TISSUE PRESERVATION
On August 13, 2002 the Company received an order from the Atlanta district
office of the FDA regarding the non-valved cardiac, vascular, and orthopaedic
tissue processed by the Company since October 3, 2001 (the "FDA Order"). Revenue
from human tissue preservation services accounted for 78% of the Company's
revenues for the six months ended June 30, 2002, and of those revenues 67% or
$26.9 million are derived from preservation of tissues subject to the FDA Order.
The Company announced the receipt of the FDA Order in a press release dated
August 14, 2002. The FDA Order follows an FDA warning letter dated June 17,
2002, which the Company announced in a press release dated June 24, 2002.
Subsequently, the Company responded to the warning letter and requested a
meeting with the FDA. The FDA Order contains the following principal provisions:
o The FDA alleges that, based on its inspection of the Company's
facility on March 25 through April 12, 2002, certain human tissue
received and distributed by the Company may be in violation of 21 Code
of Federal Regulations ("CFR") Part 1270. (Part 1270 requires persons
or entities engaged in the recovery, screening, testing, processing,
storage, or distribution of human tissue to perform certain medical
screening and testing on human tissue intended for transplantation.
The rule also imposes requirements regarding procedures for the
prevention of contamination or cross-contamination of tissues during
processing and the maintenance of certain records related to these
activities.)
o The FDA alleges that the Company has not validated procedures for the
prevention of infectious disease contamination or cross-contamination
of tissue during processing at least since October 3, 2001.
o Non-valved cardiac, vascular, and orthopaedic tissue processed by the
Company since October 3, 2001 must be retained until it is recalled,
destroyed, the safety is confirmed, or an agreement is reached with
the FDA for its proper disposition under the supervision of an
authorized official of the FDA.
o The FDA strongly recommends that CryoLife perform a retrospective
review of all tissue in inventory (i.e. currently in storage at
CryoLife) that is not referenced in the FDA Order to assure that it
was recovered, processed, stored, and distributed in conformance with
21 CFR 1270
o The Center for Devices and Radiological Health ("CDRH"), a division of
the FDA, is evaluating whether there are similar risks that may be
posed by CryoLife's allograft heart valves, and will take further
regulatory action if appropriate.
Pursuant to the FDA Order, the Company has placed all non-valved cardiac,
vascular, and orthopaedic tissue subject to the FDA Order on quality assurance
quarantine and is recalling all non-valved cardiac, vascular, and orthopaedic
tissues subject to the FDA Order (i.e. processed since October 3, 2001) that
have been distributed but not implanted. After the FDA issued its order
regarding the recall, Health Canada also issued a recall on the same types of
tissue and the United Kingdom Department of Health has begun investigating
tissue exported by the Company.
The Company appealed the FDA Order on August 14, 2002 and requested a hearing
with the FDA. No dates have been set for the hearing. In addition, the Company
has requested a modification of the FDA Order to allow distribution of certain
non-valved cardiac tissues and vascular tissues which are used in life saving or
limb salvaging surgical procedures. The Company has met with the FDA and is
holding on-going discussions regarding its request for modification of the FDA
Order to accommodate distribution of non-valved cardiac and vascular tissue in
life saving and limb salvaging situations. The Company is unable to predict if
it will obtain a favorable outcome to its appeal or request for modification of
the FDA Order or the timing of the resolution of these matters.
After receiving the FDA Order, the Company met with representatives of the FDA's
CDRH division regarding CDRH's review of the Company's processed allograft heart
valves, which are not required to be recalled pursuant to the FDA Order. On
August 21, 2002 the FDA publicly stated that allograft heart valves have not
7
been included in the FDA recall order as these devices are essential for the
correction of congenital cardiac lesions in neonate and pediatric patients and
no satisfactory alternative device exists. However, the FDA also publicly stated
that it still has serious concerns regarding the processing and handling of
allograft heart valves. The FDA also recommended that surgeons carefully
consider using processed allografts from alternative sources, that surgeons
inform prospective patients of the FDA's concerns with the Company's allograft
heart valves, and that patients be carefully monitored for both fungal and
bacterial infections.
Management has determined that, with respect to tissue subject to the FDA Order,
product liability claims and shareholder litigation, the FDA Order received on
August 13, 2002 is a type one subsequent event, as defined by generally accepted
auditing standards in the United States, which requires adjustment to the second
quarter financial statements. A type one subsequent event provides additional
evidence about conditions which existed at the balance sheet date, and results
in changes to the estimates used to prepare the financial statements. Management
has made this determination because the FDA Order clarified the accounting
estimates surrounding the June 17, 2002 FDA warning letter, which stated a
recall was a possible course of action for the FDA if the warning letter issues
were not resolved promptly. The Company was working with the FDA to correct the
issues and did not believe a recall would be instated. Therefore, the Company
previously estimated that there was no material accounting impact from the FDA
warning letter. This estimate was revised due to the receipt of the FDA Order.
Management has determined that the negative implications of the FDA Order to its
revenues generated from tissue not subject to the FDA Order and any resulting
impairments of other assets or incurrence of liabilities do not represent a type
one subsequent event and therefore any necessary adjustments will be recorded in
future periods.
As a result of the FDA Order, the Company has recorded a reduction to pretax
income of $12.6 million, in the quarter ended June 30, 2002. The reduction was
comprised of a net $8.9 million increase to cost of human tissue preservation
services, a $2.4 million reduction to revenues (and accounts receivable) for the
estimated return of the tissues subject to recall by the FDA Order, and a $1.3
million accrual recorded in general, administrative, and marketing expenses for
retention levels under the Company's product liability and directors' and
officers' insurance policies of $1.2 million (see Note 11) and for estimated
expenses of $75,000 for packaging and handling for the return of affected
tissues under the FDA Order.
The net increase of $8.9 million to cost of preservation services is comprised
of a $10.0 million write-down of deferred preservation costs for tissues subject
to the FDA Order, offset by a $1.1 million decrease in cost of preservation
services due to the estimated tissue returns resulting from the FDA Order (the
costs of such recalled tissue are included in the $10.0 million write-down). The
Company evaluated many factors in determining the magnitude of impairment to
deferred preservation costs, including the impact of the current FDA Order, the
possibility of continuing action by the FDA or other United States and foreign
government agencies, and the possibility of unfavorable actions by physicians,
customers, procurement organizations, and others. As a result of this
evaluation, management believes that since all non-valved cardiac, vascular, and
orthopaedic allograft tissues processed since October 3, 2001 are under recall
pursuant to the FDA Order, and the Company does not know if it will obtain a
favorable resolution of its appeal and request for modification of the FDA
Order, the deferred preservation costs for tissues subject to the FDA Order have
been significantly impaired. The Company has estimated that this impairment
approximates the full balance of the deferred preservation costs of the tissues
subject to the FDA Order, which includes the tissues stored by the Company and
the tissues to be returned to the Company, and has therefore recorded a
write-down of $10.0 million for these assets.
As of June 30, 2002 deferred preservation costs of tissues not subject to the
FDA Order (i.e. tissue processed prior to October 3, 2001) were $829,000 for
non-valved cardiac tissues, $7.3 million for vascular tissues, and $4.7 million
for orthopaedic tissues. Deferred preservation costs for allograft heart valves,
which are not subject to the FDA Order, were $8.5 million as of June 30, 2002.
The Company is continuing to ship these tissues.
The Company evaluated many factors in determining the potential impairment of
the deferred preservation costs for non-valved cardiac, vascular, and
orthopaedic tissues processed prior to October 3, 2001 and all of the Company's
8
allograft heart valves, as these tissue populations are not subject to the FDA
Order. The allograft heart valve, non-valved cardiac, and vascular tissues are
principally used in life saving and limb salvaging surgical procedures and are
often used after all other avenues of treatment have been exhausted. Therefore,
the Company believes that non-valved cardiac tissues and vascular tissues
processed prior to October 3, 2001 and allograft heart valves will continue to
be in demand. Although management believes that the demand for non-valved
cardiac and vascular tissues processed prior to October 3, 2001 and all
allograft heart valves stored by the Company will be affected by the adverse
publicity surrounding the FDA Order, the Company cannot estimate the degree to
which these tissues have been impaired. The Company may determine in the future
that a write-down of the deferred preservation costs for these tissues is
necessary. Management will continue to monitor the Company's progress in
satisfying the FDA's requirements and the effect of the FDA Order and the
related adverse publicity on the demand for these tissues to determine if
additional write-downs of deferred preservation costs are required.
Management has reviewed the current circumstances relating to orthopaedic
tissues not subject to the FDA order (i.e. processed prior to October 3, 2001),
including whether there were indications of impairment of deferred preservation
costs for such tissues as of June 30, 2002. Management has determined that the
demand for orthopaedic tissues had not been affected sufficiently as of June 30,
2002 to cause an impairment in the deferred preservation costs related to these
tissues (i.e., cost was not in excess of market). Accordingly, the Company has
not recorded a write-down in the deferred preservation costs related to the
orthopaedic tissue processed prior to October 3, 2001 in the June 30, 2002
financial statements. However, the adverse publicity following the FDA Order has
resulted in a significant decrease in orthopaedic tissue revenues since August
13, 2002. As a result, management believes that the deferred preservation costs
for orthopaedic tissues not subject to the FDA Order have been impaired in the
third quarter of 2002 and expects that it will record a substantial write-down
of such costs in the third quarter of 2002.
As noted above, the FDA Order strongly recommends that the Company perform a
retrospective review of all tissue in inventory not subject to the FDA Order.
The Company is having ongoing discussions with the FDA to establish the
procedures to be followed in the retrospective review and therefore is currently
unable to reasonably estimate the costs for such review. Once the Company and
the FDA agree on these procedures the Company will evaluate the costs associated
with performing the review and record an appropriate accrual for these costs.
The Company periodically evaluates the recoverability of noncurrent tangible and
intangible assets and measures the amount of impairment, if any. Management does
not believe an impairment of the Company's tangible and intangible assets
relating to the tissue preservation business had occurred as of June 30, 2002.
However, depending on the outcome of the FDA Order and the future effects of
adverse publicity surrounding the FDA Order and reported infections on
preservation revenues, these assets may become impaired. Management will
continue to evaluate the recoverability of these assets.
The Company anticipates that the FDA Order will also affect the financial
position, results of operations, and cash flows of the Company for the quarter
ended September 30, 2002. In addition to the anticipated write-down of deferred
preservation costs for orthopaedic tissue, the Company expects a $1.0 million
reversal of revenues recorded in July and August, due to the estimated returns
of tissues subject to the FDA Order, which were shipped in July and August. The
deferred preservation costs of tissues processed during the third quarter of
2002 that are subject to the FDA Order approximate $3.9 million as of August 14,
2002. The deferred preservation costs of these tissues processed during the
third quarter are anticipated to be fully impaired and the Company expects to
record a write-down approximating their full cost in the third quarter.
NOTE 3 - CASH EQUIVALENTS AND MARKETABLE SECURITIES
The Company maintains cash equivalents, which consist primarily of highly liquid
investments with maturity dates of 90 days or less at the time of acquisition,
and marketable securities in several large, well-capitalized financial
institutions, and the Company's policy disallows investment in any securities
rated less than "investment-grade" by national rating services.
9
Management determines the appropriate classification of debt securities at the
time of purchase and reevaluates such designations as of each balance sheet
date. Debt securities are classified as held-to-maturity when the Company has
the positive intent and ability to hold the securities to maturity.
Held-to-maturity securities are stated at amortized cost. Debt securities not
classified as held-to-maturity or trading and marketable equity securities not
classified as trading are classified as available-for-sale. At June 30, 2002 and
December 31, 2001, all marketable equity securities and debt securities were
designated as available-for-sale.
Available-for-sale securities are stated at their fair values, with the
unrealized gains and losses, net of tax, reported in a separate component of
shareholders' equity. Interest income, dividends, realized gains and losses, and
declines in value judged to be other than temporary are included in investment
income. The cost of securities sold is based on the specific identification
method.
The following is a summary of cash equivalents and marketable securities (in
thousands):
Unrealized Estimated
Adjustments Adjusted Holding Market
June 30, 2002 Cost Basis to Cost Basis Cost Basis Gains/(Losses) Value
-----------------------------------------------------------------------------------
Cash equivalents:
Money market funds $ 6,061 $ -- $ 6,061 $ -- $ 6,061
Municipal obligations 3,454 -- 3,454 -- 3,454
-----------------------------------------------------------------------------------
$ 9,515 $ -- $ 9,515 $ -- $ 9,515
===================================================================================
Marketable securities:
Municipal obligations $ 17,642 $ -- $ 17,642 $ 269 $ 17,911
Equity securities 1,075 (284) 791 (43) 748
-----------------------------------------------------------------------------------
$ 18,717 $ (284) $ 18,433 $ 226 $ 18,659
===================================================================================
Unrealized Estimated
Adjustments Adjusted Holding Market
December 31, 2001 Cost Basis to Cost Basis Cost Basis Gains/(Losses) Value
-----------------------------------------------------------------------------------
Cash equivalents:
Money market funds $ 1,301 $ -- $ 1,301 $ -- $ 1,301
Municipal obligations 500 -- 500 -- 500
-----------------------------------------------------------------------------------
$ 1,801 $ -- $ 1,801 $ -- $ 1,801
===================================================================================
Marketable securities:
Municipal obligations $ 17,696 $ -- $ 17,696 $ 147 $ 17,843
Debt securities 6,227 (1,217) 5,010 -- 5,010
Equity securities 3,900 (343) 3,557 10 3,567
Certificates of deposit 63 -- 63 -- 63
-----------------------------------------------------------------------------------
$ 27,886 $ (1,560) $ 26,326 $ 157 $ 26,483
===================================================================================
The Adjustments to Cost Basis column includes a $284,000 loss as of June 30,
2002 recorded for an other than temporary decline in the market value of equity
securities, and a $1.6 million loss as of December 31, 2001 recorded for an
other than temporary decline in the market value of debt and equity securities.
Differences between cost and market listed above, consisting of a net unrealized
holding gain less deferred taxes of $77,000 at June 30, 2002 and $50,000 as of
December 31, 2001, are included in the accumulated other comprehensive income
account of shareholders' equity.
At June 30, 2002 and December 31, 2001 approximately $2.0 million and $3.4
million, respectively, of marketable securities had a maturity date between 90
days and 1 year, approximately $4.6 million and $14.5 million, respectively of
marketable securities matured between 1 and 5 years, and approximately $12.1
million and $8.6 million of marketable securities matured in more than 5 years
or did not have a maturity date.
10
NOTE 4 - INVENTORIES
Inventories are comprised of the following (in thousands):
June 30, December 31,
2002 2001
---------------------------------
Raw materials $ 2,402 $ 1,987
Work-in-process 961 1,183
Finished goods 3,989 3,089
---------------------------------
$ 7,352 $ 6,259
=================================
NOTE 5 - EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per
share (in thousands, except per share data):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------
Numerator for basic and diluted earnings
per share:
Net (loss) income available to common
shareholders $ (5,522) $ 2,540 $ (2,418) $ 4,510
=============================== ==============================
Denominator for basic earnings per share:
Weighted-average basis 19,538 18,780 19,318 18,761
Effect of dilutive stock options -- 842 -- 814
------------------------------- ------------------------------
Denominator for diluted earnings per share:
Adjusted weighted-average shares 19,538 19,622 19,318 19,575
=============================== ==============================
Net (loss) earnings per share:
Basic $ (0.28) $ 0.14 $ (0.13) $ 0.24
=============================== ==============================
Diluted $ (0.28) $ 0.13 $ (0.13) $ 0.23
=============================== ==============================
The effects of stock options of 674,000 and 692,000 shares for the three and six
months ended June 30, 2002, respectively, were excluded from the calculation
because the amounts are antidilutive for the period presented.
NOTE 6 - DEBT
On April 25, 2000 the Company entered into a loan agreement permitting the
Company to borrow up to $8 million under a line of credit during the expansion
of the Company's corporate headquarters and manufacturing facilities. Borrowings
under the line of credit accrued interest equal to Adjusted LIBOR plus 2%
adjusted monthly. On June 1, 2001, the line of credit was converted to a term
loan (the "Term Loan") to be paid in 60 equal monthly installments of principal
plus interest computed at Adjusted LIBOR plus 1.5% (3.34% at June 30, 2002). At
June 30, 2002 the principal balance of the Term Loan was $6.4 million. The Term
Loan is secured by substantially all of the Company's assets. The Term Loan
contains certain restrictive covenants including, but not limited to,
maintenance of certain financial ratios, a minimum tangible net worth
requirement, and the requirement that no materially adverse event has occurred.
The lender has notified the Company that the FDA Order, as described in Note 2,
and the inquiries of the SEC, as described in Note 12, have had a material
adverse effect on the Company that constitute an event of default. As of August
11
30, 2002 the lender has elected not to declare an event of default, but reserves
the right to exercise any such right under the terms of the Term Loan.
Therefore, all amounts due under the Term Loan as of June 30, 2002 are reflected
as a current liability on the Summary Consolidated Balance Sheet.
In March 1997 the Company issued a $5.0 million convertible debenture in
connection with the Ideas for Medicine, Inc. acquisition. The debenture accrued
interest at 7% and was convertible into common stock of the Company at any time
prior to the due date of March 5, 2002 at $8.05 per common share. On March 30,
1998 $607,000 of the convertible debenture was converted into 75,000 shares of
the Company's common stock, and on March 4, 2002 the remaining $4.4 million was
converted into 546,000 shares of the Company's common stock.
NOTE 7 - DERIVATIVES
The Company's Term Loan, which accrues interest computed at Adjusted LIBOR plus
1.5%, exposes the Company to changes in interest rates going forward. On March
16, 2000, the Company entered into a $4 million notional amount forward-starting
interest swap agreement, which took effect on June 1, 2001 and expires in 2006.
This swap agreement was designated as a cash flow hedge to effectively convert a
portion of the Term Loan balance to a fixed rate basis, thus reducing the impact
of interest rate changes on future income. This agreement involves the receipt
of floating rate amounts in exchange for fixed rate interest payments over the
life of the agreement, without an exchange of the underlying principal amounts.
The differential to be paid or received is recognized in the period in which it
accrues as an adjustment to interest expense on the Term Loan.
On January 1, 2001 the Company adopted SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133") as amended. SFAS 133 requires
the Company to recognize all derivative instruments on the balance sheet at fair
value, and changes in the derivative's fair value must be recognized currently
in earnings or other comprehensive income, as applicable. The adoption of SFAS
133 impacts the accounting for the Company's forward-starting interest rate swap
agreement. Upon adoption of SFAS 133, the Company recorded an unrealized loss of
approximately $175,000 related to the interest rate swap, which was recorded as
part of long-term liabilities and accumulated other comprehensive income as the
cumulative effect of adopting SFAS 133 within the Statement of Shareholders'
Equity.
At June 30, 2002 the notional amount of this swap agreement was $3.2 million,
and the fair value of the interest rate swap agreement, as estimated by the bank
based on its internal valuation models, was a liability of $269,000. The fair
value of the swap agreement is recorded as part of long-term liabilities and is
recorded net of tax as part of accumulated other comprehensive income within
shareholders' equity.
NOTE 8 -COMPREHENSIVE INCOME
Components of comprehensive income consist of the following, net of tax (in
thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------
Net (loss) income $ (5,522) $ 2,540 $ (2,418) $ 4,510
Unrealized gain/(loss) on investments 128 115 42 817
Change in fair value of interest rate swap
(including cumulative effect of adopting
SFAS 133 in 2001) 15 5 23 (158)
Translation adjustment 250 (121) 217 (124)
-------------------------------- -------------------------------
Comprehensive income $ (5,129) $ 2,539 $ (2,136) $ 5,045
=============================== ==============================
12
The tax effect on the change in unrealized gain/loss on investments is $66,000
and $59,000 for the three months ended June 30, 2002 and 2001, respectively. The
tax effect for the six months ended June 30, 2002 and 2001 is $27,000 and
$398,000, respectively. The tax effect on the change in fair value of the
interest rate swap is $7,000 and $3,000 for the three months ended June 30, 2002
and 2001, respectively. The tax effect for the six months ended June 30, 2002
and 2001 is $2,000 and a tax benefit of $81,000, respectively. The translation
adjustment is not currently adjusted for income taxes as it relates to a
permanent investment in a foreign subsidiary.
NOTE 9 - ACCOUNTING PRONOUNCEMENTS
On January 1, 2002 the Company was required to adopt SFAS No. 142, "Goodwill and
Other Intangible Assets" ("SFAS 142"), and SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS 144"). SFAS 142 specifies
that goodwill and certain other intangible assets will no longer be amortized
but instead will be subject to periodic impairment testing. SFAS 144 clarifies
accounting and reporting for assets held for sale, scheduled for abandonment or
other disposal, and recognition of impairment loss related to the carrying value
of long-lived assets. The Company has completed its impairment testing as
required by FAS 142, and has determined that the recognition of an impairment
loss on intangible assets is not required. The adoption of these statements did
not have a material effect on the consolidated financial statements of the
Company. However, the adoption of SFAS 142 will increase the Company's pretax
income by approximately $100,000 in 2002 due to the cessation of goodwill
amortization.
The Company will be required to adopt SFAS No. 143, "Accounting for Asset
Retirement Obligations" ("SFAS 143") on January 1, 2003. SFAS 143 addresses
accounting and reporting for asset retirement costs of long-lived assets
resulting from legal obligations associated with acquisition, construction, or
development transactions. The Company has determined that the adoption of SFAS
143 will not have a material effect on the results of operations or financial
position of the Company.
The Company will be required to adopt SFAS No. 145, "Rescission of FASB
Statements 4, 44 and 64, Amendment to FASB Statement 13, and Technical
Corrections" ("SFAS 145") on January 1, 2003. SFAS 145 changes the accounting
for the classification of gains and losses from the extinguishment of debt. The
Company is currently evaluating the impact of this Statement.
The Company will be required to adopt SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities" ("SFAS 146") on January 1, 2003.
SFAS 146 requires that costs associated with exit or disposal activities be
recorded at their fair values when a liability has been incurred. Under previous
guidance, certain exit costs were accrued upon management's commitment to an
exit plan, which is generally before an actual liability has been incurred. The
Company is currently evaluating the impact of this Statement.
NOTE 10 - SEGMENT INFORMATION
The Company has two reportable segments: Human Tissue Preservation Services and
Implantable Medical Devices. The Company's segments are organized according to
services and products.
The HUMAN TISSUE PRESERVATION SERVICES segment includes external revenue from
cryopreservation services of cardiac, vascular, and orthopaedic allograft
tissues. The IMPLANTABLE MEDICAL DEVICES segment includes external revenue from
product sales of BioGlue Surgical Adhesive and bioprosthetic devices, including
stentless porcine heart valves, SynerGraft treated porcine heart valves, and
SynerGraft treated bovine vascular grafts. There are no intersegment revenues.
The primary measure of segment performance, as viewed by the Company's
management, is segment gross margin, or net external revenues less cost of
preservation services and products. The Company does not segregate assets by
segment; therefore asset information is excluded from the segment disclosures
below.
13
The following table summarizes revenues, cost of preservation services and
products, and gross margins for the Company's operating segments (in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------
Revenue:
Human tissue preservation services, net a 17,536 18,765 37,774 37,331
Implantable medical devices 5,473 2,789 10,538 5,430
All other b 255 143 423 368
------------------------------- ------------------------------
$ 23,264 $ 21,697 $ 48,735 $ 43,129
------------------------------- ------------------------------
Cost of Preservation Services and Products:
Human tissue preservation services c 17,203 7,697 25,266 15,370
Implantable medical devices 1,843 1,423 4,078 2,855
All other b -- -- -- --
------------------------------- ------------------------------
19,046 9,120 29,344 18,225
------------------------------- ------------------------------
Gross Margin (Loss):
Human tissue preservation services 333 11,068 12,508 21,961
Implantable medical devices 3,630 1,366 6,460 2,575
All other b 255 143 423 368
------------------------------- ------------------------------
$ 4,218 $ 12,577 $ 19,391 $ 24,904
------------------------------- ------------------------------
a Revenue from human tissue preservation services includes the estimated
effect of the return of tissues subject to recall by the FDA Order of $2.4
million in the three and six months ended June 30, 2002.
b The "All other" designation includes 1) grant revenue and 2) distribution
revenue.
c Cost of human tissue preservation services includes the write-down of
deferred preservation costs for tissues subject to the FDA Order of $10.0
million in the three and six months ended June 30, 2002.
The following table summarizes net revenues by product (in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------
Revenue:
Human tissue preservation services, net a:
Cardiovascular tissue $ 7,336 $ 7,182 $ 14,644 $ 14,093
Vascular tissue 4,641 6,017 11,658 12,429
Orthopaedic tissue 5,559 5,566 11,472 10,809
------------------------------- ------------------------------
Total preservation services 17,536 18,765 37,774 37,331
------------------------------- ------------------------------
BioGlue surgical adhesive 5,251 2,631 10,124 5,074
Bioprosthetic devices 222 158 414 356
Distribution and grant 255 143 423 368
------------------------------- ------------------------------
$ 23,264 $ 21,697 $ 48,735 $ 43,129
=============================== ==============================
a Revenue from tissue preservation services includes the estimated effect of
the return of tissues subject to recall by the FDA Order of $340,000 in
cardiovascular tissue, $1.7 million in vascular tissue, and $380,000 in
orthopaedic tissue, totaling $2.4 million, for the three and six months
ended June 30, 2002.
14
NOTE 11 - COMMITMENTS AND CONTINGENCIES
In the normal course of business as a medical device and services company the
Company has product liability complaints filed against it. As of August 30, 2002
fifteen product liability cases had been filed against the Company between May
18, 2000 and August 15, 2002. The cases are currently in the pre-discovery or
discovery stages. Of these cases, nine allege product liability claims arising
out of the Company's orthopaedic tissue, four allege product liability claims
arising out of the Company's allograft heart valve tissue and one alleges
product liability claims arising out of the non-tissue products made by Ideas
for Medicine, when it was a subsidiary of the Company.
Included in these cases is the complaint filed against the Company in the
Superior Court of Cobb County, Georgia, on July 12, 2002 by Steve Lykins, as
Trustee for the benefit of next of kin of Brian Lykins. This complaint alleges
strict liability, negligence, professional negligence, and breach of warranties
related to tissue implanted in November of 2001. The plaintiff seeks unspecified
compensatory and punitive damages.
The Company maintains product liability insurance policies, which the Company
believes to be adequate to defend against these suits. The Company's insurance
company has been notified of these actions. The Company intends to vigorously
defend against these claims. Nonetheless, an adverse judgment in excess of the
Company's insurance coverage could have a material adverse effect on the
Company's financial position, results of operations, and cash flows.
Several putative class action lawsuits were filed in July 2002, one of which was
amended in August of 2002, against the Company and certain officers of the
Company alleging that the defendants violated Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, by
issuing a series of materially false and misleading statements to the market
throughout the Class Period of August of 2000 through August of 2002, which
statements had the effect of artificially inflating the market price of the
Company's securities. The principal allegations of the complaints are that the
Company failed to disclose its alleged lack of compliance with certain FDA
regulations regarding the handling and processing of certain tissues and other
product safety matters. The plaintiffs seek unspecified compensatory damages in
an amount to be proven at trial. The Company believes these cases will be
consolidated into one putative class action lawsuit. The Company believes the
claims made in the lawsuits are without merit and intends to vigorously defend
against these claims. Management has retained the services of the Atlanta based
law firm of King & Spalding to defend the Company. The Company carries
director's and officer's liability insurance which the Company believes to be
adequate to defend against these suits. Nonetheless, an adverse judgment in
excess of the Company's insurance coverage could have a material adverse effect
on the Company's financial position, results of operations, and cash flows.
The Company has concluded that it is probable that it will incur losses relating
to claims and litigation of at least $1.2 million; which represents the
aggregate amount of the Company's deductibles under its product liability and
directors and officer's insurance policies. Therefore the Company has recorded
an accrual of $1.2 million as of June 30, 2002.
NOTE 12 - SUBSEQUENT EVENTS
On July 23, 2002 the Company's Board of Directors authorized the purchase of up
to $10 million of its Common Stock. As of August 13, 2002 the Company had
repurchased 68,000 shares of its Company stock for $666,000. No further
purchases are anticipated in the near term.
On July 30, 2002 the Company entered into a line of credit agreement with the
lender that made the Term Loan, as discussed in Note 6, permitting the Company
to borrow up to $10 million. Borrowings under the line of credit agreement
accrue interest equal to Adjusted LIBOR plus 1.25% adjusted monthly. This loan
is secured by substantially all of the Company's assets. As of August 30, 2002
$6,900 has been drawn on the line of credit. As a result of the FDA Order, as
discussed in Note 2, the Company is not in compliance with the lender's
requirements for advances of funds under the line of credit. On August 21, 2002
the lender notified the Company that it was not entitled to any further advances
under the line of credit.
15
On August 7, 2002 the Company announced the settlement of its ongoing litigation
with Colorado State University Foundation ("CSURF") over the ownership of the
Company's SynerGraft technology. The settlement resolves all disputes between
the parties and extinguishes all CSURF ownership claims to any aspect of
CryoLife's SynerGraft technology. The settlement includes an unconditional
assignment to CryoLife of CSURF tissue engineering patents, trade secrets and
know-how relating to tissue decellularization and recellularization. The
technology assignment supercedes the 1996 technology license, which was
terminated by the terms of the settlement. Payment terms include a nonrefundable
advance of $400,000 paid by the Company to CSURF that will be applied to earned
royalties as they accrue through March 2011. The Company will record these
amounts as prepaid royalties and will expense the amounts as the royalties
accrue. The earned royalty rate is a maximum of 0.75% of net revenues from
products or tissue services utilizing the SynerGraft technology. Royalties
earned under the agreement for revenues through June 30, 2002 were approximately
$27,000.
On August 14, 2002 the compensation committee determined to pay bonuses to
Steven G. Anderson, Chairman, President and CEO, of $225,000 and Sidney B.
Ashmore, Vice President Marketing, of $15,000. On August 16, 2002 the
compensation committee determined to pay a bonus to James Vander Wyk, Vice
President Regulatory Affairs and Quality Assurance, of $60,000. In each case the
compensation committee determined to grant the mid-year bonus in recognition of
the officer's efforts on behalf of the Company in addressing important Company
issues in difficult times, the officer's long term service to the Company, and
to accommodate the economic needs of the officers arising from their desire to
retain Company shares rather than permit them to be sold pursuant to margin
calls. These officers now have no margin loans against their shares.
On Saturday, August 17, 2002 the Company received a letter from the United
States Securities and Exchange Commission (the "SEC Letter") that stated that
the Company was subject to an investigation related to the Company's August 14,
2002 announcement of the FDA Order and requesting information from the Company
from the period between September 1, 2001 through the date of the Company's
response to the SEC Letter. The SEC Letter stated, in part, that "We are trying
to determine whether there have been any violations of the federal securities
laws. The investigation and the subpoena do not mean that we have concluded that
anyone has broken the law. Also, the investigation does not mean that we have a
negative opinion of any person, entity or security." The staff of the SEC
subsequently confirmed that its investigation is informal in nature, and that it
does not have subpoena power at this time. At the present time, the Company is
unable to predict the outcome of this matter.
16
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
RECENT EVENTS
On August 13, 2002 the Company received an order from the Atlanta district
office of the FDA regarding the non-valved cardiac, vascular, and orthopaedic
tissue processed by the Company since October 3, 2001 (the "FDA Order"). Revenue
from human tissue preservation services accounted for 78% of the Company's
revenues for the six months ended June 30, 2002, and of those revenues 67% or
$26.9 million are derived from preservation of tissues subject to the FDA Order.
The Company announced the receipt of the FDA Order in a press release dated
August 14, 2002. The FDA Order follows an FDA warning letter dated June 17,
2002, which the Company announced in a press release dated June 24, 2002.
Subsequently, the Company responded to the warning letter and requested a
meeting with the FDA. The FDA Order contains the following principal provisions:
o The FDA alleges that, based on its inspection of the Company's
facility on March 25 through April 12, 2002, certain human tissue
received and distributed by the Company may be in violation of 21 Code
of Federal Regulations ("CFR") 1270. Code 21, 1270 (PROVIDE A BRIEF
DESCRIPTION OF WHAT THIS IS)
o The FDA alleges that the Company has not validated procedures for the
prevention of infectious disease contamination or cross-contamination
of tissue during processing at least since October 3, 2001.
o Non-valved cardiac, vascular, and orthopaedic tissue processed by the
Company since October 3, 2001 must be retained until it is recalled,
destroyed, the safety is confirmed, or an agreement is reached with
the FDA for its proper disposition under the supervision of an
authorized official of the FDA.
o The FDA strongly recommends that CryoLife perform a retrospective
review of all tissue in inventory that is not referenced in the FDA
Order to assure that it was recovered, processed, stored, and
distributed in conformance with 21 CFR 1270
o The Center for Devices and Radiological Health ("CDRH") is evaluating
whether there are similar risks that may be posed by CryoLife's
allograft heart valves, and will take further regulatory action if
appropriate.
Pursuant to the FDA Order, the Company has placed all non-valved cardiac,
vascular, and orthopaedic tissue subject to the FDA Order on quality assurance
quarantine and is recalling all non-valved cardiac, vascular, and orthopaedic
tissues subject to the FDA Order that have been distributed but not implanted.
After the FDA issued its order regarding the recall, Health Canada also issued a
recall on the same types of tissue and the United Kingdom Department of Health
has begun investigating tissue exported by the Company.
The Company appealed the FDA Order on August 14, 2002 and requested a hearing
with the FDA. No dates have been set for the hearing. In addition, the Company
has requested a modification of the FDA Order to allow distribution of certain
non-valved cardiac tissues and vascular tissues which are used in life saving or
limb salvaging surgical procedures. The Company has met with the FDA and is
holding on-going discussions regarding its request for modification of the FDA
Order to accommodate distribution of non-valved cardiac and vascular tissue in
life saving and limb salvaging situations. The Company is unable to predict if
it will obtain a favorable outcome to its appeal or request for modification of
the FDA Order or the timing of the resolution of these matters.
After receiving the FDA Order, the Company met with representatives of the FDA's
CDRH division regarding CDRH's review of the Company's processed allograft heart
valves, which are not required to be recalled pursuant to the FDA Order. On
August 21, 2002 the FDA publicly stated that allograft heart valves have not
17
been included in the FDA recall order as these devices are essential for the
correction of congenital cardiac lesions in neonate and pediatric patients and
no satisfactory alternative device exists. However, the FDA also publicly stated
that it still has serious concerns regarding the processing and handling of
allograft heart valves. The FDA also recommended that surgeons carefully
consider using processed allografts from alternative sources, that surgeons
inform prospective patients of the FDA's concerns with the Company's allograft
heart valves, and that patients be carefully monitored for both fungal and
bacterial infections.
Management has determined that, with respect to tissue subject to the FDA Order,
product liability claims and shareholder litigation, the FDA Order received on
August 13, 2002 is a type one subsequent event, as defined by generally accepted
auditing standards in the United States, which requires adjustment to the second
quarter financial statements. A type one subsequent event provides additional
evidence about conditions which existed at the balance sheet date, and results
in changes to the estimates used to prepare the financial statements. Management
has made this determination because the FDA Order clarified the accounting
estimates surrounding the June 17, 2002 FDA warning letter, which stated a
recall was a possible course of action for the FDA if the warning letter issues
were not resolved promptly. The Company was working with the FDA to correct the
issues and did not believe a recall would be instated. Therefore, the Company
previously estimated that there was no material accounting impact from the FDA
warning letter. This estimate was revised due to the receipt of the FDA Order.
Management has determined that the negative implications of the FDA Order to the
tissue revenues not subject to the FDA Order and any resulting impairments of
other assets or incurrence of liabilities do not represent a type one subsequent
event and therefore any necessary adjustments will be recorded in future
periods.
As a result of the FDA Order, the Company has recorded a reduction to pretax
income of $12.6 million, in the quarter ended June 30, 2002. The reduction was
comprised of a net $8.9 million increase to cost of human tissue preservation
services, a $2.4 million reduction to revenues (and accounts receivable) for the
estimated return of the tissues subject to recall by the FDA Order, and a $1.3
million accrual recorded in general, administrative, and marketing expenses for
retention levels under the Company's product liability and directors' and
officers' insurance policies of $1.2 million (see Note 11) and for estimated
expenses of $75,000 for packaging and handling for the return of affected
tissues under the FDA Order.
The net increase of $8.9 million to cost of preservation services is comprised
of a $10.0 million write-down of deferred preservation costs for tissues subject
to the FDA Order, offset by a $1.1 million decrease in cost of preservation
services due to the estimated tissue returns resulting from the FDA Order. The
Company evaluated many factors in determining the magnitude of impairment to
deferred preservation costs, including the impact of the current FDA Order, the
possibility of continuing action by the FDA or other United States and foreign
government agencies, and the possibility of unfavorable actions by physicians,
customers, procurement organizations, and others. As a result of this
evaluation, management believes that since all non-valved cardiac, vascular, and
orthopaedic allograft tissues processed since October 3, 2001 are under recall
pursuant to the FDA Order, and the Company does not know if it will obtain a
favorable resolution of its appeal and request for modification of the FDA
Order, the deferred preservation costs for tissues subject to the FDA Order have
been significantly impaired. The Company has estimated that this impairment
approximates the full balance of the deferred preservation costs of the tissues
subject to the FDA Order, which includes the tissues stored by the Company and
the tissues to be returned to the Company, and has therefore recorded a
write-down of $10.0 million for these assets.
As of June 30, 2002 deferred preservation costs of tissues not subject to the
FDA Order (i.e. tissue processed prior to October 3, 2001) were $829,000 for
non-valved cardiac tissues, $7.3 million for vascular tissues, and $4.7 million
for orthopaedic tissues. Deferred preservation costs for allograft heart valves,
which are not subject to the FDA Order, were $8.5 million as of June 30, 2002.
The Company is continuing to ship these tissues.
The Company evaluated many factors in determining the potential impairment of
the deferred preservation costs for non-valved cardiac, vascular, and
orthopaedic tissues processed prior to October 3, 2001 and all of the Company's
allograft heart valves, as these tissue populations are not subject to the FDA
18
Order. The allograft heart valve, non-valved cardiac, and vascular tissues are
principally used in life saving and limb salvaging surgical procedures and are
often used after all other avenues of treatment have been exhausted. Therefore,
the Company believes that non-valved cardiac tissues and vascular tissues
processed prior to October 3, 2001 and allograft heart valves will continue to
be in demand. Although management believes that the demand for non-valved
cardiac and vascular tissues processed prior to October 3, 2001 and all
allograft heart valves stored by the Company will be affected by the adverse
publicity surrounding the FDA Order, the Company cannot estimate the degree to
which these tissues have been impaired. The Company may determine in the future
that a write-down of the deferred preservation costs for these tissues is
necessary. Management will continue to monitor the Company's progress in
satisfying the FDA's requirements and the effect of the FDA Order and the
related adverse publicity on the demand for these tissues to determine if
additional write-downs of deferred preservation costs are required.
Management has reviewed the current circumstances relating to orthopaedic
tissues not subject to the FDA order (i.e. processed prior to October 3, 2001),
including whether there were indications of impairment of deferred preservation
costs for such tissues as of June 30, 2002. Management has determined that the
demand for orthopaedic tissues had not been affected sufficiently as of June 30,
2002 to cause an impairment in the deferred preservation costs related to these
tissues (i.e., cost was not in excess of market). Accordingly, the Company has
not recorded a write-down in the deferred preservation costs related to the
orthopaedic tissue processed prior to October 3, 2001 in the June 30, 2002
financial statements. However, the adverse publicity following the FDA Order has
resulted in a significant decrease in orthopaedic tissue revenues since August
13, 2002. As a result, management believes that the deferred preservation costs
for orthopaedic tissues not subject to the FDA Order have been impaired in the
third quarter of 2002 and expects that it will record a substantial write-down
of such costs in the third quarter of 2002.
As noted above, the FDA Order strongly recommends that the Company perform a
retrospective review of all tissue in inventory not subject to the FDA Order.
The Company is having ongoing discussions with the FDA to establish the
procedures to be followed in the retrospective review and therefore is currently
unable to reasonably estimate the costs for such review. Once the Company and
the FDA agree on these procedures the Company will evaluate the costs associated
with performing the review and record an appropriate accrual for these costs.
The Company periodically evaluates the recoverability of noncurrent tangible and
intangible assets and measures the amount of impairment, if any. Management does
not believe an impairment of the Company's tangible and intangible assets
relating to the tissue preservation business has occurred as of June 30, 2002.
However, depending on the outcome of the FDA Order and the future effects of
adverse publicity surrounding the FDA Order and reported infections on
preservation revenues, these assets may become impaired. Management will
continue to evaluate the recoverability of these assets.
The Company anticipates that the FDA Order will also affect the financial
position, results of operations, and cash flows of the Company for the quarter
ended September 30, 2002. In addition to the anticipated write-down of deferred
preservation costs for orthopaedic tissue, the Company expects a $1.0 million
reversal of revenues recorded in July and August, due to the estimated returns
of tissues subject to the FDA Order, which were shipped in July and August. The
deferred preservation costs of tissues processed during the third quarter of
2002 that are subject to the FDA Order approximate $3.9 million as of August 14,
2002. The deferred preservation costs of these tissues processed during the
third quarter are anticipated to be fully impaired and the Company expects to
record a write-down approximating their full cost in the third quarter.
On July 23, 2002 the Company's Board of Directors authorized the purchase of up
to $10 million of its Common Stock. As of August 13, 2002 the Company had
repurchased 68,000 shares of its Company stock for $666,000. No further
purchases are anticipated in the near term.
On August 7, 2002 the Company announced the settlement of its ongoing litigation
with Colorado State University Foundation ("CSURF") over the ownership of the
Company's SynerGraft technology. The settlement resolves all disputes between
the parties and extinguishes all CSURF ownership claims to any aspect of
CryoLife's SynerGraft technology. The settlement includes an unconditional
assignment to CryoLife of CSURF tissue engineering patents, trade secrets and
19
know-how relating to tissue decellularization and recellularization. The
technology assignment supercedes the 1996 technology license, which was
terminated by the terms of the settlement. Payment terms include a nonrefundable
advance of $400,000 paid by the Company to CSURF that will be applied to earned
royalties as they accrue through March 2011. The Company will record these
amounts as prepaid royalties and will expense the amounts as the royalties
accrue. The earned royalty rate is a maximum of 0.75% of net revenues from
products or tissue services utilizing the SynerGraft technology. Royalties
earned under the agreement for revenues through June 30, 2002 were approximately
$27,000.
On August 14, 2002 the compensation committee determined to pay bonuses to
Steven G. Anderson, Chairman, President and CEO, of $225,000 and Sidney B.
Ashmore, Vice President Marketing, of$15,000. On August 16, 2002 the
compensation committee determined to pay a bonus to James Vander Wyk, Vice
President Regulatory Affairs and Quality Assurance, of $60,000. In each case the
compensation committee determined to grant the mid-year bonus in recognition of
the officer's efforts on behalf of the Company in addressing important Company
issues in difficult times, the officer's long term service to the Company, and
to accommodate the economic needs of the officers arising from their desire to
retain Company shares rather than permit them to be sold pursuant to margin
calls. The officers now have no margin loans against their shares.
On Saturday, August 17, 2002 the Company received a letter from the United
States Securities and Exchange Commission (the "SEC Letter") that stated that
the Company was subject to an investigation related to the Company's August 14,
2002 announcement of the FDA Order and requesting information from the Company
from the period between September 1, 2001 through the date of the Company's
response to the SEC Letter. The SEC Letter stated, in part, that "We are trying
to determine whether there have been any violations of the federal securities
laws. The investigation and the subpoena do not mean that we have concluded that
anyone has broken the law. Also, the investigation does not mean that we have a
negative opinion of any person, entity or security." The staff of the SEC
subsequently confirmed that the investigation is informal in nature, and that it
does not have subpoena poser at this time. At the present time, the Company is
unable to predict the outcome of this matter.
On September 3, 2002 the Company announced a reduction in employee force of
approximately 105 employees. The Company anticipates that severance and related
costs will be approximately $625,000, which will be recorded in the third
quarter of 2002. As a result of the employee reduction, management anticipates
personnel costs will be reduced by approximately $360,000 per month.
CRITICAL ACCOUNTING POLICIES
A summary of the Company's significant accounting policies is included in Note 1
to the consolidated financial statements, as filed in the Form 10-K for the
fiscal year ended December 31, 2001. Management believes that the consistent
application of these policies enables the Company to provide users of the
financial statements with useful and reliable information about the Company's
operating results and financial condition. The consolidated financial statements
are prepared in accordance with accounting principles generally accepted in the
United States, which require the Company to make estimates and assumptions. The
following are accounting policies that management believes are most important to
the portrayal of the Company's financial condition and results and may involve a
higher degree of judgment and complexity.
REVENUE RECOGNITION: The Company recognizes revenue in accordance with SEC Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB
101"), which provides guidance on applying generally accepted accounting
principles to revenue recognition issues. Revenues for human tissue preservation
services are recognized when services are completed and tissue is delivered to
the customer. The Company accepts returned human tissue within 72 hours of
20
original shipment. The Company has recorded the estimated revenues of tissues to
be recalled pursuant to the FDA Order as a service revenue return. Revenues for
products are recognized at the time the product is shipped, at which time title
passes to the customer. There are no further performance obligations and
delivery occurs upon shipment. Revenues from research grants are recognized in
the period the associated costs are incurred. The Company assesses the
likelihood of collection based on a number of factors, including past
transaction history with the customer and the credit-worthiness of the customer.
DEFERRED PRESERVATION COSTS: Tissue is procured from deceased human donors by
organ procurement agencies and tissue banks, which consign the tissue to the
Company for processing and preservation. Preservation costs related to tissue
held by the Company are deferred until revenue is recognized upon shipment of
the tissue to the implanting hospital. Deferred preservation costs consist
primarily of laboratory expenses, tissue procurement fees, fringe and facility
allocations, and freight-in charges, and are stated, net of reserve, on a
first-in, first-out basis. As of June 30, 2002 the deferred preservation costs
were $8.5 million for allograft heart valve tissues, $829,000 for non-valved
cardiac tissues, $7.3 million for vascular tissues, and $4.7 million for
orthopaedic tissues, excluding valuation allowances of $300,000. At June 30,
2002 the Company recorded a write-down of deferred preservation costs of $1.6
million for non-valved cardiac tissues, $5.0 million for vascular tissues, and
$3.4 million for orthopaedic tissue totaling $10.0 million. These write-downs
were recorded as a result of the FDA Order as discussed in the Recent Events
section. The amount of these write-downs reflects management's estimate based on
information currently available to it. These estimates may prove inaccurate, as
the scope and impact of the FDA Order are determined. Management will continue
to evaluate the recoverability of these deferred preservation costs based on the
factors discussed in the Recent Events section and record additional write-downs
if it becomes clear that additional impairments have occurred.
INTANGIBLE ASSETS: Goodwill resulting from business acquisitions is not
amortized, but is instead subject to periodic impairment testing in accordance
with FAS 142. Patent costs are amortized over the expected useful lives of the
patents (primarily 17 years) using the straight-line method. Other intangibles,
which consist primarily of manufacturing rights and agreements, are amortized
over the expected useful lives of the related assets (primarily five years). The
Company periodically evaluates the recoverability of noncurrent tangible and
intangible assets and measures the amount of impairment, if any. Management does
not believe an impairment exists to the intangible assets relating to the tissue
preservation business. However, depending on outcome of the FDA Order and the
future effects adverse publicity surrounding the FDA Order and reported
infections on preservation revenues, these assets may become impaired.
Management will continue to evaluate the recoverability of these intangible
assets.
NEW ACCOUNTING PRONOUNCEMENTS
On January 1, 2002 the Company was required to adopt SFAS No. 142, "Goodwill and
Other Intangible Assets" ("SFAS 142"), and SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS 144"). SFAS 142 specifies
that goodwill and certain other intangible assets will no longer be amortized
but instead will be subject to periodic impairment testing. SFAS 144 clarifies
accounting and reporting for assets held for sale, scheduled for abandonment or
other disposal, and recognition of impairment loss related to the carrying value
of long-lived assets. The Company has completed its impairment testing as
required by FAS 142, and has determined that the recognition of an impairment
loss on intangible assets is not required. The adoption of these statements did
not have a material effect on the consolidated financial statements of the
Company. However, the adoption of SFAS 142 will increase the Company's pretax
income by approximately $100,000 in 2002 due to the cessation of goodwill
amortization.
The Company will be required to adopt SFAS No. 143, "Accounting for Asset
Retirement Obligations" ("SFAS 143") on January 1, 2003. SFAS 143 addresses
accounting and reporting for asset retirement costs of long-lived assets
resulting from legal obligations associated with acquisition, construction, or
development transactions. The Company has determined that the adoption of SFAS
143 will not have a material effect on the financial position, results of
operations, and cash flows of the Company.
The Company will be required to adopt SFAS No. 145, "Rescission of FASB
Statements 4, 44 and 64, Amendment to FASB Statement 13, and Technical
Corrections" ("SFAS 145") on January 1, 2003. SFAS 145 changes the accounting
for the classification of gains and losses from the extinguishment of debt. The
Company is currently evaluating the impact of this Statement.
21
The Company will be required to adopt SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities" ("SFAS 146") on January 1, 2003.
SFAS 146 requires that costs associated with exit or disposal activities be
recorded at their fair values when a liability has been incurred. Under previous
guidance, certain exit costs were accrued upon management's commitment to an
exit plan, which is generally before an actual liability has been incurred. The
Company is currently evaluating the impact of this Statement.
RESULTS OF OPERATIONS
REVENUES
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------------------ ------------------------------------------
2002 2001 2002 2001
------------------------------------------ ------------------------------------------
Revenues $ 23,264 $ 21,697 $ 48,735 $ 43,129
Revenues excluding recall $ 25,697 $ 21,697 $ 51,168 $ 43,129
Revenues increased 7% and 13%, respectively, for the three and six months ended
June 30, 2002. Revenues were adversely impacted by the estimated effect of the
return of tissues subject to recall by the FDA Order, which resulted in an
estimated decrease of $2.4 million in preservation service revenues during the
three and six months ended June 30, 2002.
Excluding the effect of the FDA Order, revenues increased 18% and 19%,
respectively, for the three and six months ended June 30, 2002. This increase in
revenues for the three month and six month periods ended June 30, 2002 was
primarily due to increased sales of BioGlue Surgical Adhesive and growth in the
Company's preservation businesses. The increases are primarily attributable to
the receipt of FDA approval for BioGlue in December 2001, a greater acceptance
of these products by the surgical community and the Company's ability to procure
greater amounts of tissue. Management currently believes the FDA Order will have
an adverse impact on these trends.
The Company has not yet determined the full impact of the FDA Order on future
revenues. In the event the Company is not successful in its appeal of the FDA
Order or is unable to reach a satisfactory agreement with the FDA, future
revenues can be expected to decrease significantly. Revenues from human tissue
preservation services accounted for 78% of the Company's revenues for the six
months ended June 30, 2002, and of those revenues 67% were derived from
preservation of tissues subject to the FDA Order. In 2001 revenues for human
tissue preservation services were 87% of the Company's revenues, or $75.6
million, and of those revenues 68%, or $51.6 million, were derived from
preservation of tissues subject to the FDA Order.
BIOGLUE SURGICAL ADHESIVE
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------------------ ------------------------------------
2002 2001 2002 2001
------------------------------------------ ------------------------------------
Revenues $ 5,251 $ 2,631 $ 10,124 $ 5,074
Percentage of total revenue 23% 12% 21% 12%
Percentage of total revenue excluding recall 20% 12% 20% 12%
Revenues from the sale of BioGlue Surgical Adhesive increased 100% for the three
and six month periods ended June 30, 2002. The increase in revenues for the
three month and six month periods ended June 30, 2002 was due to an increase in
22
the milliliters of BioGlue shipped of 81% and 79%, respectively, and an increase
in the average selling price of the BioGlue shipped. The increase in shipments
was primarily due to the receipt of FDA approval in December 2001 for the use of
BioGlue in the United States as an adjunct in open surgical repair of large
vessels for adult patients. Domestic revenues accounted for 77% and 64% of total
BioGlue revenues for the three months ended June 30, 2002 and 2001,
respectively. Domestic revenues accounted for 78% and 65% of total BioGlue
revenues for the six months ended June 30, 2002 and 2001, respectively.
Although BioGlue was not included in the FDA Order, future sales of BioGlue
could be adversely affected due to the adverse publicity surrounding the FDA's
review of and correspondence with the Company. Additionally, there is a
possibility the Company's BioGlue operations could come under increased scrutiny
from the FDA as a result of their review of the Company's tissue processing
laboratories.
PRESERVATION SERVICE REVENUES
Quarter over quarter statistics presented for tissues procured and processed for
human tissue preservation services are from the period February through April,
as such procurement and processing of tissues received during this time period
is the primary generator of second quarter revenues. Year-to-date over
year-to-date statistics presented for tissues procured and processed for human
tissue preservation services are from the period beginning in November of the
prior year through April of the year presented, as such procurement and
processing of tissues received during this time period is the primary generator
of year-to-date revenues. During the time period for which procurement
statistics are discussed, the Company benefited from significant increases in
procurement due to new relationships with tissue banks and competitive wins of
tissue bank contracts. Additionally, the Company changed certain tissue
acceptance guidelines, which resulted in an increase in tissues procured and
processed. Tissue acceptance and processing guidelines include donor age,
gender, manner of death, time of procurement, and other factors. These
guidelines are under constant review to allow the most recipients to benefit
from donated tissues, while preserving the quality of tissue procured and
processed. Tissue acceptance guidelines are changed periodically through the
general course of business based on the demand for certain types or sizes of
tissue and based on the scientific analysis of the viability of tissues procured
under the guidelines. More stringent guidelines have recently been implemented
for certain tissues.
The increases in procurement surpassed the Company's expectations during this
period. However, the Company expects that future procurement levels of all
tissues will decrease as a result of the uncertainties surrounding the Company's
inability to continue to ship non-valved cardiac, vascular and orthopaedic
grafts as a result of the FDA Order and due to the uncertainties as to whether
tissue banks will continue to send tissues to the Company to process as a result
of the adverse publicity surrounding the FDA's review and the FDA Order. As of
August 14, 2002 the Company reduced its acceptance of orthopaedic and vascular
tissues for processing to minimal levels until it receives resolution of its
request for modification or appeal of the FDA Order. The Company is continuing
to accept cardiac tissues for processing from tissue banks. As of August 30,
2002 the Company estimates approximately 50% of its cardiovascular procurement
has been suspended due to the FDA Order and the surrounding publicity.
Due to a variety of factors, primarily the FDA Order, but including the time
required to process the greater amounts of tissue, the increase in processing
time and complexity for tissues processed using the SynerGraft technology, the
focus of the Company on the marketing and rollout of BioGlue, and adverse
publicity resulting from certain tissue infections and lawsuits during this
period, the increases in tissues procured and processed did not translate into
equivalent increases in revenues from preservation services. As a result of this
increased procurement, the level of deferred preservation costs prior to
write-downs increased in all of the Company's main tissue service categories:
cardiac, vascular, and orthopaedic. These higher levels of deferred preservation
costs are expected to result in some revenue growth for allograft heart valve
tissues in the short term as the Company provides services related to the more
critical implant needs. The Company expects that the majority of this increase
in procurement will generate more modest increases in service revenues over a
longer period of time for cardiac tissues, as less critical need tissues and
tissues of various sizes are properly matched with recipients.
23
CARDIOVASCULAR PRESERVATION SERVICES
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------------------ ------------------------------------------
2002 2001 2002 2001
------------------------------------------ ------------------------------------------
Revenues $ 7,336 $ 7,182 $ 14,644 $ 14,093
Percentage of total revenue 32% 33% 30% 33%
Revenues excluding recall $ 7,676 $ 7,182 $ 14,984 $ 14,093
Percentage of total revenue 30% 33% 29% 33%
Revenues from cardiovascular preservation services increased 2% and 4%,
respectively, for the three and six months ended June 30, 2002. The revenues
from cardiovascular preservation services were adversely impacted by the
estimated effect of the tissues returned subject to the FDA Order on service
revenues for non-valved cardiac tissues, which resulted in an estimated decrease
of $340,000 in service revenues during the three and six months ended June 30,
2002. At June 30, 2002 $9.3 million of cardiac deferred preservation costs
related to tissue not subject to the FDA Order was available for shipment.
Excluding the effect of the FDA Order, revenues from cardiovascular preservation
services increased 7% and 6%, respectively, for the three and six months ended
June 30, 2002. This increase in revenues for the three month and six month
periods ended June 30, 2002 was in part due to an increase in the number of
cardiovascular allograft shipments of 3% in each such period as a result of a
20% and 23% increase in cardiovascular tissues procured and processed quarter
over quarter and year-to-date over year-to-date, respectively. Additionally,
average service fees were higher by 4% and 3%, during the three and six months
ended June 30, 2002, respectively, due to an increase in shipments during 2002
as compared to 2001 of SynerGraft processed cardiovascular grafts, which have
higher service fees than non-SynerGraft cardiovascular grafts.
The Company anticipates a future decrease in cardiovascular preservation
revenues as a result of the uncertainties regarding the Company's inability to
ship non-valved cardiac tissue processed since October 3, 2001 pursuant to the
FDA Order and the adverse publicity surrounding the FDA's review of and
correspondence with the Company.
VASCULAR PRESERVATION SERVICES
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------------------ ------------------------------------------
2002 2001 2002 2001
------------------------------------------ ------------------------------------------
Revenues $ 4,641 $ 6,017 $ 11,658 $ 12,429
Percentage of total revenue 20% 28% 24% 29%
Revenues excluding recall $ 6,354 $ 6,017 $ 13,371 $ 12,429
Percentage of total revenue 25% 28% 26% 29%
Revenues from human vascular tissue preservation services decreased 23% and 6%,
respectively, for the three and six months ended June 30, 2002. The revenues
from vascular tissue preservation services were adversely impacted by the
estimated effect of the return of tissues subject to recall by the FDA Order,
which resulted in an estimated decrease of $1.7 million in service revenues
during the three and six months ended June 30, 2002. At June 30, 2002 $7.3
million of vascular deferred preservation costs related to tissue not subject to
the FDA Order was available for shipment.
24
Excluding the effect of the FDA Order, revenues from human vascular tissue
preservation services increased 6% and 8%, respectively, for the three and six
months ended June 30, 2002. This increase in revenues for the three month and
six month periods ended June 30, 2002 was due to an increase in the number of
vascular allograft shipments of 8% and 3%, respectively, which resulted from a
17% increase in vascular tissues procured and processed year-to-date over
year-to-date.
The Company anticipates a future decrease in vascular preservation revenues due
to the Company's inability to ship vascular grafts processed subsequent to
October 2, 2001 pursuant to the FDA Order and the adverse publicity surrounding
the FDA's review of and correspondence with the Company. If the Company is
unable to obtain a favorable decision from its appeal or request for
modification of the FDA Order and/or to clear the issues as outlined in the
FDA's warning letter and the FDA Order, future vascular preservation revenues,
if any, may be immaterial.
ORTHOPAEDIC PRESERVATION SERVICES
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------------------ ------------------------------------------
2002 2001 2002 2001
------------------------------------------ ------------------------------------------
Revenues $ 5,559 $ 5,566 $ 11,472 $ 10,809
Percentage of total revenue 24% 26% 24% 25%
Revenues excluding recall $ 5,939 $ 5,566 $ 11,852 $ 10,809
Percentage of total revenue 23% 26% 23% 25%
Revenues from human orthopaedic tissue preservation services increased 0% and 6%
for the three and six months ended June 30, 2002. The revenues from orthopaedic
tissue preservation services were adversely impacted by the estimated effect of
the return of tissues subject to recall by the FDA Order, which resulted in an
estimated decrease of $380,000 in service revenues during the three and six
months ended June 30, 2002. At June 30, 2002 $4.7 million of orthopaedic
deferred preservation costs related to tissue not subject to the FDA Order was
available for shipment; see discussion of impairment of this asset in the Recent
Events section.
Excluding the effect of the FDA Order, revenues from human orthopaedic tissue
preservation services increased 7% and 10% for the three and six months ended
June 30, 2002. This increase in revenues for the three month and six month
periods ended June 30, 2002 was primarily due to an increase in the number of
allograft shipments of 6% and 8%, respectively. The increase in orthopaedic
shipments, primarily boned tendons, resulted from a 76% and 62% increase in
orthopaedic allograft tissues procured and processed quarter over quarter and
year-to-date over year-to-date, respectively, and an increasing acceptance of
these tissues in the orthopaedic surgeon community. Shipments of boned tendons
increased 42% and 52% in the three and six months ended June 30, 2002,
respectively, due to increased availability of these higher demand tissues,
which resulted in an increase of $400,000 and $1 million in revenues with
respect to these tissues for the three and six months ended June 2002 as
compared to the same periods in 2001, partially offset by a decrease in
shipments of non-boned tendons. Additional increases in revenues in the
six-month period were due to a more favorable product mix, with increased
shipments of hemi-osteochondral grafts, which carry higher average service fees
than other orthopaedic tissues. The increases in orthopaedic revenues were
smaller than anticipated, due to the effects of adverse publicity surrounding
the reports of infections in some orthopaedic allograft recipients.
The Company anticipates a substantial decrease in the orthopaedic preservation
revenues in the future due to the Company's inability to ship orthopaedic grafts
processed since October 3, 2001 pursuant to the FDA Order, the adverse publicity
surrounding the FDA's review of and correspondence with the Company, and the
reported infections in some orthopaedic allograft recipients. If the Company is
unable to clear the issues as outlined in the FDA's warning letter and FDA Order
or obtain a favorable appeal of the FDA Order, future orthopaedic preservation
revenue, if any, may be immaterial. These factors would be likely to result in a
substantial decrease of revenues from tissues preserved both prior to and since
October 3, 2001.
25
BIOPROSTHETIC DEVICES
Revenues from bioprosthetic cardiovascular devices increased 41% to $222,000 for
the three months ended June 30, 2002 from $158,000 for the three months ended
June 30, 2001, representing 1% of total revenues during each such period.
Revenues from bioprosthetic cardiovascular devices increased 16% to $414,000 for
the six months ended June 30, 2002 from $356,000 for the six months ended June
30, 2001, representing 1% of total revenues during each such period.
DISTRIBUTION AND GRANT REVENUES
Distribution and grant revenues increased to $255,000 for the three months ended
June 30, 2002 from $143,000 for the three months ended June 30, 2001.
Distribution and grant revenues increased to $423,000 for the six months ended
June 30, 2002 from $368,000 for the six months ended June 30, 2001. Grant
revenues of $104,000 and $143,000, for the three and six months ended June 30,
2002 and 2001, respectively, and $131,000 and $368,000, for the six months ended
June 30, 2002 and 2001, respectively, are primarily attributable to the
SynerGraft research and development programs.
COSTS AND EXPENSES
Cost of human tissue preservation services aggregated $17.2 million for the
three months ended June 30, 2002 as compared to $7.7 million for the three
months ended June 30, 2001, representing 98% and 41%, respectively, of total
human tissue preservation service revenues for each such period. Cost of human
tissue preservation services aggregated $25.3 million for the six months ended
June 30, 2002 as compared to $15.4 million for the six months ended June 30,
2001, representing 67% and 41%, respectively of total human tissue preservation
service revenues for each period. The cost of human tissue preservation services
for the three and six months ended June 30, 2002 includes a $10.0 million
write-down of deferred preservation costs related to the FDA Order, as discussed
in Recent Events. The Company anticipates a reduction in the cost of human
tissue preservation services due to a reduction in shipments of tissues as a
result of the FDA Order; however the cost of human tissue preservation services
as a percent of revenue may increase due to potential write-downs of deferred
preservation costs if the Company is unable to meet the requirements of the FDA
as outlined in the FDA Order and if there is a significant decline in the demand
for the tissues.
Cost of products aggregated $1.8 million for the three months ended June 30,
2002 as compared to $1.4 million for the three months ended June 30, 2001,
representing 34% and 51%, respectively, of product revenues for each such
period. Cost of products aggregated $4.1 million for the six months ended June
30, 2002 as compared to $2.9 million for the six months ended June 30, 2001,
representing 39% and 53%, respectively, of total product revenues for each
period. The decrease in the 2002 cost of products as a percentage of total
product revenues is due to a more favorable product mix during 2002. The product
mix was impacted by an increase in revenues from BioGlue Surgical Adhesive,
which carries higher gross margins than bioprosthetic devices.
General, administrative, and marketing expenses increased 41% to $11.4 million
for the three months ended June 30, 2002, compared to $8.1 million for the three
months ended June 30, 2001, representing 49% and 37%, respectively of total
revenues during each such period. General, administrative, and marketing
expenses increased 29% to $20.9 million for the six months ended June 30, 2002,
compared to $16.3 million for the six months ended June 30, 2001, representing
43% and 38%, respectively, of total revenues during each such period. The
increase in expenditures for the three and six months ended June 30, 2002 was
primarily due to an increase in marketing and general expenses to support
planned revenue growth, increased overhead costs in connection with the
expansion of the corporate headquarters and manufacturing facility, which was
substantially completed in the first quarter of 2002, an increase in insurance
premiums, an increase in legal costs and a $1.3 million accrual for retention
levels under the Company's product liability and directors' and officers'
insurance policies of $1.2 million (see Legal Proceedings under Item 1) and for
estimated expenses of $75,000 for packaging and handling fees for the return of
affected tissues subject to the FDA Order. The Company expects to incur
significant increases in legal costs and professional fees over the remainder of
the year as a result of defending the lawsuits filed against the Company and the
26
Company's appeal of the FDA Order. Additional marketing expenses may be incurred
to address the effects of the adverse publicity surrounding the FDA Order.
Research and development expenses decreased 7% to $1.2 million for the three
months ended June 30, 2002, compared to $1.3 million for the three months ended
June 30, 2001, representing 5% and 6%, respectively, of total revenues for each
such period. Research and development expenses decreased 1% to $2.3 million for
the six months ended June 30, 2002, compared to $2.4 million for the six months
ended June 30, 2001, representing 5% of total revenues for each such periods.
Research and development spending for the three and six months ended June 30,
2002 was primarily focused on the Company's SynerGraft and Protein Hydrogel
Technologies.
Interest income, net of interest expense, was $43,000 and $560,000 for the three
months ended June 30, 2002 and 2001, respectively. Interest income, net of
interest expense, was $149,000 and $1.1 million for the six months ended June
30, 2002 and 2001, respectively. The 2002 decrease in net interest income is due
to reduced interest rates in 2002 as compared to 2001 and the lack of interest
expense capitalized in 2002 in connection with the expansion of the corporate
headquarters and manufacturing facility, which was substantially completed in
the first quarter of 2002.
The effective income tax rate was 34% and 32% for the three and six months ended
June 30, 2002 and 2001, respectively.
SEASONALITY
The demand for the Company's cardiovascular tissue preservation services is
seasonal, with peak demand generally occurring in the second and third quarters.
Management believes this trend for cardiovascular tissue preservation services
is primarily due to the high number of surgeries scheduled during the summer
months. However, the demand for the Company's human vascular and orthopaedic
tissue preservation services, BioGlue Surgical Adhesive, and bioprosthetic
cardiovascular and vascular devices does not appear to experience seasonal
trends.
LIQUIDITY AND CAPITAL RESOURCES
At June 30, 2002 net working capital was $62.2 million, with a current ratio of
4 to 1, compared to $66.7 million at December 31, 2001. The Company's primary
capital requirements historically arose out of general working capital needs,
capital expenditures for facilities and equipment, and funding of research and
development projects. The Company funded these requirements through bank credit
facilities, cash generated by operations and equity offerings. Based on the
anticipated decrease in revenues resulting from the FDA Order and associated
adverse publicity, the Company expects that its cash generated by operations
will decrease significantly over the near term, and that net working capital
will decrease. The Company anticipates that after it has reduced the number of
employees to reflect the reduction in revenues, the savings in resources will
enable the Company to meet its liquidity needs through 2002. It is possible that
the Company will not have sufficient funds to meet its primary capital
requirements over the long term.
Net cash provided by operating activities was $750,000 for the six months ended
June 30, 2002, as compared to $4.3 million for the six months ended June 30,
2001. The $750,000 in current year cash provided was primarily due to $7.8
million in net income before depreciation, taxes, and excluding non-cash items,
partially offset by a decrease in cash of $7.1 million due to an increase in
working capital requirements from current and planned future revenue growth,
expansion of product lines, and an increase in tissue procurement. Adjustments
to net income for the six months ended June 30, 2002 include a $10.0 million
write-down for the impairment of deferred preservation costs resulting from the
FDA Order.
Net cash provided by investing activities was $4.1 million for the six months
ended June 30, 2002, as compared to cash used of $6.4 million for the six months
ended June 30, 2001. The $4.1 million in current year cash provided was
primarily due to a net $7.7 million increase in cash from marketable securities,
27
primarily due to the maturity of debt securities, and $1.2 million in proceeds
from notes receivable, partially offset by a $2.7 million decrease due to
capital expenditures in 2002, as the expansion and renovation of the Company's
corporate headquarters and manufacturing facilities approached completion, and a
decrease due to spending on patents of $2.3 million, primarily relating to costs
incurred to defend the SynerGraft technology patents. For further information
please refer to the Recent Events section.
Net cash used by financing activities was $1,000 for the six months ended June
30, 2002, as compared to cash provided of $1.5 million for the six months ended
June 30, 2001. The $1,000 in current year cash used was primarily due to
$800,000 in principal payments on the Term Loan and $300,000 in principal
payments on capital leases, offset by a $1.1 million increase due to proceeds
from stock option exercises.
The Company's Term Loan, of which the principal balance was $6.1 million as of
August 30, 2002, contains certain restrictive covenants including, but not
limited to, maintenance of certain financial ratios and a minimum tangible net
worth requirement, and the requirement that no materially adverse event has
occurred. The lender has determined that the FDA Order, as described in Note 2
to the Summary Consolidated Financial Statements, and the inquiries of the
Securities and Exchange Commission, as described in Note 12 to the Summary
Consolidated Financial Statements, have a material adverse effect on the Company
that constitutes an event of default. As of August 30, 2002 the lender has
elected not to declare an event of default, but reserves the right to exercise
any such right under the terms of the Term Loan. Therefore, all amounts due
under the Term Loan as of June 30, 2002 are reflected as a current liability on
the Consolidated Balance Sheet. In the event the lender calls the Term Loan, the
Company at present has adequate funds to pay the principal amount outstanding.
The Term Loan is secured by substantially all of the Company's assets.
The Company's Term Loan, which accrues interest computed at Adjusted LIBOR plus
1.5%, exposes the Company to changes in interest rates going forward. On March
16, 2000, the Company entered into a $4 million notional amount forward-starting
interest swap agreement, which took effect on June 1, 2001 and expires in 2006.
This swap agreement was designated as a cash flow hedge to effectively convert a
portion of the Term Loan balance to a fixed rate basis, thus reducing the impact
of interest rate changes on future income. This agreement involves the receipt
of floating rate amounts in exchange for fixed rate interest payments over the
life of the agreement, without an exchange of the underlying principal amounts.
The differential to be paid or received is recognized in the period in which it
accrues as an adjustment to interest expense on the Term Loan.
On January 1, 2001 the Company adopted SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133") as amended. SFAS 133 requires
the Company to recognize all derivative instruments on the balance sheet at fair
value, and changes in the derivative's fair value must be recognized currently
in earnings or other comprehensive income, as applicable. The adoption of SFAS
133 impacts the accounting for the Company's forward-starting interest rate swap
agreement. Upon adoption of SFAS 133, the Company recorded an unrealized loss of
approximately $175,000 related to the interest rate swap, which was recorded as
part of long-term liabilities and accumulated other comprehensive income within
the Statement of Shareholders' Equity.
At June 30, 2002 the notional amount of this swap agreement was $3.2 million,
and the fair value of the interest rate swap agreement, as estimated by the bank
based on its internal valuation models, was a liability of $269,000. The fair
value of the swap agreement is recorded as part of long-term liabilities and is
recorded net of tax as part of accumulated other comprehensive income within the
Statement of Shareholders' Equity.
On July 30, 2002 the Company entered into a line of credit agreement with the
lender that made the Term Loan, permitting the Company to borrow up to $10
million. Borrowings under the line of credit agreement accrue interest equal to
Adjusted LIBOR plus 1.25% adjusted monthly. This loan is secured by
substantially all of the Company's assets. As of August 30, 2002 $6,900 has been
drawn on the line of credit. As a result of the FDA Order, as discussed in Note
2 to the Summary Consolidated Financial Statements, the Company is not in
compliance with the lender's requirements for advances of funds under the line
of credit. On August 21, 2002 the lender notified the Company that it was not
entitled to any further advances under the line of credit.
28
Since October 1998 management has been seeking to enter into a corporate
collaboration or to complete a potential private placement of equity or
equity-oriented securities to fund the commercial development of its Activation
Control Technology ("ACT"). This technology is now held by the Company's
wholly-owned subsidiary AuraZyme Pharmaceutical, Inc., which was formed on
February 26, 2001. This strategy, if successful, will allow an affiliated entity
to fund the ACT and should expedite the commercial development of its oncology,
fibrin olysis (blood clot dissolving), and surgical sealant product applications
without additional research and development expenditures by the Company (other
than through the affiliated company). This strategy, if successful, will
favorably impact the Company's liquidity going forward. However, if the Company
is unable to obtain funds for the commercial development of the ACT and/or if
the Company decides to fund the technology itself, the expenses required to fund
the ACT could adversely impact the Company's liquidity going forward. The
Company expects that it will reduce its efforts to fund the commercial
development of ACT in the near term until it has evaluated the financial impact
of the recent FDA Order.
The Company expects its liquidity to decrease significantly over the remainder
of the year due to the anticipated significant decrease in revenues as a result
of the FDA Order and an expected decrease in cash due to the increased legal and
professional costs relating to the defense of lawsuits and the FDA Order. As a
result, the Company plans to reduce the number of personnel it employs in
several areas, with the exact number to be based in part on the Company's
success in its efforts to appeal or obtain a modification of the FDA Order. On
September 3, 2002 the Company announced a reduction in employee force of
approximately 105 employees. The Company anticipates that severance and related
costs will be approximately $625,000, which will be recorded in the third
quarter of 2002. As a result of the employee reduction, management anticipates
personnel costs will be reduced by approximately $360,000 per month. The Company
anticipates that after it has reduced the number of employees to reflect the
reduction in revenues, the savings in resources will enable the Company to meet
its liquidity needs through the June 30, 2003. Even if the Company is able to
obtain a favorable outcome of its appeal of the FDA Order or requested
modification, there is no assurance that the Company would be able to return to
the current level of demand for its tissue services as a result of the adverse
publicity or as a result of customers and tissue banks switching to competitors.
The Company's long term liquidity and capital requirements will depend upon
numerous factors, including the resolution of the Company's appeal of the FDA
Order, the extent of the anticipated revenue decreases, the costs associated
with becoming compliant with the FDA requirements as outlined in the FDA Order,
the outcome of litigation against the Company as described in Part II Item 1 of
this Form 10-Q, the level of demand for tissue based on adverse publicity in the
event the FDA Order is resolved in a manner favorable to the Company, the timing
of the Company's receipt of FDA approvals to begin clinical trials for its
products currently in development, the availability of resources required to
further develop its marketing and sales capabilities if and when those products
gain approval, the extent to which the Company's products generate market
acceptance and demand and the resolution of the "Risk Factors" discussed below.
The ultimate impact of many of these factors will be affected by the outcome of
others. There can be no assurance the Company will not require additional
financing or will not seek to raise additional funds through bank facilities,
debt or equity offerings, or other sources of capital to meet future
requirements. Additional funds may not be available when needed or on terms
acceptable to the Company, which could have a material adverse effect on the
Company's business, financial condition, results of operations, and cash flows.
29
RISK FACTORS
FDA ORDER ON HUMAN TISSUE-DEPENDENCE ON PRESERVATION OF HUMAN TISSUE
On Tuesday, August 13, 2002 the Company received an order from the FDA calling
for the retention, recall, and/or destruction of all non-valved cardiac,
vascular and orthopaedic tissue processed by the Company at its headquarters
since at least October 3, 2001 based upon allegations of FDA violations by the
Company of its handling of such tissue and alleged contamination through the
Company's processing of such tissue that resulted in 14 post-transplant
infections including one death. A significant portion of the Company's current
revenues is derived from the preservation of human tissues. Revenues of human
tissue preservation services for the six months ended June 30, 2002 were 79% of
the Company's revenues. Of those revenues, 67% were derived from preservation of
tissues subject to the FDA Order representing $26.9 million. Revenues for human
tissue preservation services for the year ended 2001 were 86% of the Company's
revenues. Of those revenues, 68% were derived from preservation of tissues
subject to the FDA Order.
The Company expects the FDA Order to have a material adverse effect on the
Company's business, financial condition, results of operations and cash flows.
As a result of the FDA Order, the Company expects to experience decreases in
revenues and profits and there is a possibility that the Company may not
generate sufficient cash from operations to fund its operations.
Even if the FDA Order is lifted or modified at some future date such that the
Company may resume the processing of the types of human tissue covered by the
FDA Order, demand for such tissue may be reduced by the adverse publicity
generated from the recall or from implanting physicians' decisions to use human
tissue from the Company's competitors. Therefore, even if the FDA Order is
lifted or modified, the Company could still experience significant decreases in
revenues and profits and there is a possibility that the Company would not
generate sufficient cash from operations to fund its operations.
In the event that the Company resumes successful processing of human tissue in
accordance with FDA standards, the success of the Company depends upon, among
other factors, the availability of sufficient quantities of tissue from human
donors. Any material reduction in the supply of donated human tissue could
restrict the Company's growth. The Company relies primarily upon the efforts of
third party procurement agencies and tissue banks (most of which are
not-for-profit) and others to educate the public and foster a willingness to
donate tissue. If the Company's relationships with procurement agencies continue
to be adversely affected, the Company may be unable to obtain adequate supplies
of donated tissues to operate profitably.
EFFECTS OF FDA ORDER ON LIQUIDITY AND CAPITAL RESOURCES
Based upon the FDA Order, the Company anticipates a decrease in liquidity. Based
upon the anticipated decrease in revenues and profits from the FDA Order and
associated adverse publicity, the Company expects that cash generated by
operations could decrease over the near term and working capital could decrease.
Although the Company anticipates reducing its level of operation and the number
of personnel employed in response to the FDA Order, there is a possibility that
the Company may not have sufficient funds to fund its primary capital
requirements or to meet its operating and development needs.
IMPLANTATION OF ORTHOPAEDIC AND OTHER TISSUE MAY BECOME ILLEGAL OR SUBJECT TO
SIGNIFICANT ADDITIONAL RESTRICTIONS
As a result of the FDA's and the CDC's ongoing investigation regarding the
safety of cryopreserved orthopaedic tissue, and because orthopaedic tissue is
generally not involved in life-saving or limb salvaging procedures, this tissue
may no longer be legally available for implantation or may become subject to
significant additional restrictions before it is considered safe for use. As a
30
result, this portion of the Company's business may have to be discontinued or
may only continue at an extremely reduced level due to a restricted supply of
tissue for transplant or increased costs that render the business unprofitable.
Either occurrence would result in a significant decrease in the Company's
revenues and profitability. In addition, although the vascular and
cardiovascular tissues preserved by the Company are frequently used in
lifesaving or limb salvaging operations and the Company has requested a
modification of the FDA Order, there is also the possibility that their
implantation will be restricted or prohibited. Either of these occurrences would
also result in a significant decrease in the Company's revenues and
profitability.
PHYSICIANS MAY BE RELUCTANT TO IMPLANT CRYOLIFE PRESERVED TISSUES
Even if the FDA Order is lifted or modified, and the Company is allowed to
resume shipping the tissues subject to the FDA Order, there is a risk that
physicians will be reluctant to choose the Company's preserved tissues for use
in implantation, due to a perception that they may not be safe or to a belief
that the implanting physician or hospital may be subject to a heightened
liability risk if the Company tissues are used. In addition, for similar
reasons, hospital risk managers may forbid implanting surgeons to utilize the
Company tissues where alternatives are available. If a significant number of
implanting hospitals or physicians refused to use tissues preserved by the
Company, the Company's revenues and profits would be materially adversely
affected.
HEART VALVES PROCESSED BY THE COMPANY MAY ALSO BE RECALLED
On August 21, 2002 the FDA publicly stated that allograft heart valves have not
been included in the FDA recall order as these devices are essential for the
correction of congenital cardiac lesions in neonate and pediatric patients and
no satisfactory alternative device exists. However, the FDA also publicly stated
that it still has serious concerns regarding the processing and handling of
allograft heart valves. The FDA also recommended that surgeons carefully
consider using processed allografts from alternative sources, that surgeons
should inform prospective patients of the FDA's concerns with the Company's
allograft heart valves, and that patients should be carefully monitored for both
fungal and bacterial infections. The FDA could institute a recall or other
corrective measures if it felt that the Company was not making progress in
complying with the FDA Order. Any adverse finding by the FDA regarding allograft
heart valves, including a recall, would cause further decreases in the Company's
revenue base and profits and significantly reduce the Company's potential for
growth. If such a recall occurs, the Company may also be required to write-down
all or a portion of the deferred preservation costs for allograft heart valves,
which could have a material adverse effect on the results of operations and
financial condition of the Company.
ESTIMATED COSTS OF RECALL AND RELATED WRITE-DOWNS
The Company's financial statements reflect the estimated cost of recalling
tissue pursuant to the FDA Order. The Company has recorded a write-down of $10.0
million of deferred preservation costs for tissues subject to the FDA Order and
anticipates a further write-down of deferred preservation costs in the third
quarter of 2002 for additional tissues processed in the third quarter that are
subject to the FDA Order and orthopaedic tissue not subject to the FDA Order.
Such write-downs could have a material adverse effect on the results of
operations and financial condition of the Company. While these estimates are
based on the Company's best estimate of the costs associated with the recall and
the impairment of deferred preservation costs subject to the FDA Order, there
can be no assurance that these costs and write-downs will in fact be limited to
the amount estimated.
REGULATORY ACTION OUTSIDE OF THE UNITED STATES
After the FDA issued its order regarding the recall, Health Canada also issued a
recall on the same types of tissue and the United Kingdom Department of Health
has begun investigating tissue exported by the Company. We expect that such
actions will further decrease revenues. Although management is not aware of any
reports of contamination in Canada or the United Kingdom of tissues processed by
the Company, in the event that any tissue processed by the Company that was
exported by the Company to other countries is found to be contaminated, it would
have a further material adverse impact on the Company's business and operations.
31
THE COMPANY MAY BE FORCED TO CEASE TISSUE PRESERVATION
If the FDA Order is not reversed or modified in the near future, or if the
allograft heart valves processed by the Company are also recalled, the Company
may not be able to profitably continue its tissue processing business. In such
an event, the Company would attempt to continue as a smaller adhesives and valve
manufacturing company; however, in order to do so the Company would be required
to divest itself of a number of assets related to its tissue processing business
and would have to institute large-scale workforce reductions. There is no
guarantee that the resulting entity would be able to generate sufficient
revenues to operate profitably, and in any event, the Company would be much
smaller and would likely be valued at a reduced level by the marketplace.
THE COMPANY'S COMMON STOCK IS POTENTIALLY AT RISK OF BEING DELISTED FROM THE NEW
YORK STOCK EXCHANGE
Because of the FDA Order and the current trading price of the Company's common
stock, there is a possibility that the Company's common stock could be delisted
from the New York Stock Exchange. If the stock is delisted, there is no guaranty
that there will be a liquid market for the stock and the trading price of the
stock would likely be adversely affected.
THE COMPANY IS THE SUBJECT OF AN ONGOING SEC INVESTIGATION
The Company received notice from the Securities and Exchange Commission on
Saturday, August 17, 2002 that it is the subject of an investigation with
respect to accounting issues and trades in the Company's stock related to the
FDA Order. The Company does not know any details of the investigation, but
believes that an adverse finding by the SEC could have a material adverse effect
on its business financial position, results of operations, and cash flows. The
staff of the SEC subsequently confirmed that its investigation is informal in
nature, and that it does not have subpoena power at this time. At the present
time, the Company is unable to predict the outcome of this matter.
EFFECTS OF THE FDA RECALL ON CREDIT FACILITY
The Term Loan contains certain restrictive covenants including, but not limited
to, maintenance of certain financial ratios, a minimum tangible net worth
requirement, and the requirement that no materially adverse event has occurred.
The lender has determined that the FDA Order, as described in Note 2 to the
Summary Consolidated Financial Statements, and the inquiries of the Securities
and Exchange Commission, as described in Note 12 to the Summary Consolidated
Financial Statements, have a material adverse effect on the Company that
constitutes an event of default. As of August 30, 2002 the lender has elected
not to declare an event of default, but reserves the right to exercise any such
right under the terms of the Term Loan. There is no assurance the lender will
not exercise its rights, which could have a material adverse effect on the
Company's liquidity.
THE COMPANY'S PRODUCT LIABILITY AND INSURANCE COVERAGE MAY BE INSUFFICIENT TO
COVER CURRENT AND FUTURE CLAIMS AND ADDITIONAL COVERAGE MAY BE DIFFICULT OR
IMPOSSIBLE TO OBTAIN IN THE FUTURE
The Company's products are used by health care providers in connection with the
treatment of patients, who will, on occasion, sustain injury or die as a result
of their condition or medical treatment. As a result, the use of the Company's
products and human tissue processed by the Company involves the possibility of
adverse effects that could expose the Company to product liability claims,
including the lawsuits filed against the Company relating to infection of
implanted tissue described below in Item 3 "Legal Proceedings." The recent FDA
Order could adversely influence the outcome of current product liability claims
relating to infection of tissue processed by the Company.
32
In addition, a recent United States Supreme Court decision held that product
liability may exist despite FDA approval, and future court decisions may also
increase the Company's risk of product liability.
Whether or not the Company is ultimately determined to be liable for product
liability claims, the Company will incur significant legal expenses. In
addition, such litigation could damage the Company's reputation and therefore
impair its ability to market its products or obtain product liability insurance
and could cause the premiums for such insurance to increase. Although the
Company has incurred minimal losses due to product liability claims to date, the
Company may incur significant losses in the future. The Company currently
maintains product liability insurance in the aggregate amount of $25 million per
year. Management believes that the coverage is adequate to cover any losses due
to product claims if actually incurred however, there can be no assurance that
such coverage will be adequate. In addition, there can be no assurance that such
coverage will continue to be available on terms acceptable to the Company,
especially in light of the recent FDA Order. Furthermore, if any product
liability claims are successful, it could have a material adverse effect on the
Company's business, financial condition, results of operations, and cash flows.
Because of the current litigation and the adverse publicity from the FDA Order,
the Company may be unable to obtain additional insurance coverage in the future,
causing the Company to be subject to additional future exposure from product
liability claims.
INTENSE COMPETITION
The Company faces competition from other companies that cryopreserve human
tissue, as well as companies that market mechanical valves and synthetic and
animal tissue for implantation and companies that market wound closure products.
During the time that the Company is restricted from processing and marketing
human tissue, tissue preservation service customers may be forced to obtain
tissue from the Company's competitors, which could lead to permanent
substitution when, and if, the Company resumes processing tissues subject to the
FDA Order.
Management believes that at least four tissue banks offer preservation services
for allograft heart valves and many companies offer processed porcine heart
valves and mechanical heart valves. A few companies dominate portions of the
mechanical and porcine heart valve markets, including St. Jude Medical, Inc.,
Medtronic, Inc. and Edwards Life Sciences. The Company is aware that several
companies have surgical adhesive products under development. Competitive
products may also be under development by other large medical device,
pharmaceutical and biopharmaceutical companies. Many of the Company's
competitors have greater financial, technical, manufacturing and marketing
resources than the Company and are well established in their markets.
There can be no assurance that the Company's products and services will be able
to compete successfully with the products of these or other companies. Any
products developed by the Company that gain regulatory clearance or approval
would have to compete for market acceptance and market share. Failure of the
Company to compete effectively could have a material adverse effect on the
Company's business, financial condition, results of operations and cash flows.
The FDA Order and related adverse publicity will have an adverse effect on the
Company's competitive position, which may have material adverse effect on the
Company's results of operations. As a result of the FDA Order, the Company's
competitors may gain competitive advantages that may be difficult to overcome.
RAPID TECHNOLOGICAL CHANGE
The technologies underlying the Company's products and services are subject to
rapid and profound technological change. The Company expects competition to
intensify as technical advances in each field are made and become more widely
known. There can be no assurance that others will not develop products or
processes with significant advantages over the products and processes that the
Company offers or is seeking to develop. Any such occurrence could have a
material adverse effect on the Company's business, financial condition, results
of operations, and cash flows.
33
UNCERTAINTIES REGARDING PRODUCTS IN DEVELOPMENT
The Company's growth and profitability will depend, in part, upon its ability to
complete development of and successfully introduce new products, including
additional applications of its BioGlue and SynerGraft technologies and its ACT.
The Company may be required to undertake time consuming and costly development
activities and seek regulatory clearance or approval for new products. The
Company expects that it will have to reduce its development efforts in the near
term because of the impact of the FDA Order on the Company's financial
condition.
Although the Company has conducted pre-clinical studies on many of its products
under development which indicate that such products may be effective in a
particular application, there can be no assurance that the results obtained from
expanded clinical studies will be consistent with earlier trial results or be
sufficient for the Company to obtain any required regulatory approvals or
clearances. There can be no assurance that the Company will not experience
difficulties that could delay or prevent the successful development,
introduction and marketing of new products, that regulatory clearance or
approval of these or any new products will be granted on a timely basis, if
ever, or that the new products will adequately meet the requirements of the
applicable market or achieve market acceptance.
The completion of the development of any of the Company's products remains
subject to all of the risks associated with the commercialization of new
products based on innovative technologies, including unanticipated technical or
other problems, manufacturing difficulties and the possible insufficiency of the
funds allocated for the completion of such development. Consequently, the
Company's products under development may not be successfully developed or
manufactured or, if developed and manufactured, such products may not meet price
or performance objectives, be developed on a timely basis or prove to be as
effective as competing products.
The inability to complete successfully the development of a product or
application, or a determination by the Company, for financial, technical or
other reasons, not to complete development of any product or application,
particularly in instances in which the Company has made significant capital
expenditures, could have a material adverse effect on the Company's business,
financial condition, results of operations, and cash flows. The Company's
porcine heart valve products, including its SynerGraft treated porcine valves,
are currently only offered for sale outside of the United States. The Company's
porcine heart valves are subject to the risk that the Company may be unable to
obtain regulatory approval necessary to permit commercial distribution of these
products in the United States. The Company's research and development efforts
are time consuming and expensive and there can be no assurance that these
efforts will lead to commercially successful products or services. Even the
successful commercialization of a new service or product in the medical industry
can be characterized by slow growth and high costs associated with marketing,
under-utilized production capacity and continuing research, and development and
education costs. Generally, the introduction of new human tissue products
requires significant physician training and years of clinical evidence derived
from follow-up studies on human implant recipients in order to gain acceptance
in the medical community.
UNCERTAINTIES REGARDING THE FUNDING OF THE ACT TECHNOLOGY
The ACT is a reversible linker technology that has potential uses in the areas
of cancer therapy, fibrin olysis (blood clot dissolving) and other drug delivery
applications. The Company has formed AuraZyme, a wholly owned subsidiary, in
order to seek a corporate collaboration or to complete a potential private
placement of equity or equity-oriented securities to fund the commercial
development of the ACT.
This strategy is designed to allow the Company to continue development of this
technology without incurring additional research and development expenditures,
other than through AuraZyme. There can be no guarantee that such funding can be
obtained on acceptable terms, if at all, especially in light of the recent FDA
Order. If such funding is not obtained, the Company may be unable to effectively
test and develop the ACT, and may therefore be unable to determine its
effectiveness. Even if such financing is obtained, there is no guarantee that
the ACT will in fact prove to be effective in the above applications. Failure to
obtain the desired financing, or failure of the ACT to perform as anticipated in
future tests, could have a material adverse effect on the Company's future
expansion plans and could limit future growth.
34
UNCERTAINTIES REGARDING THE SYNERGRAFT TECHNOLOGY
The Company processes porcine, bovine and human tissues with the SynerGraft
process. In animal studies, explanted porcine heart valves have been shown to
repopulate with the hosts' cells. However, should SynerGraft-treated tissues
implanted in humans not repopulate with the human host cells, the
SynerGraft-treated tissues may not have the longevity that the Company currently
expects. This could have a material adverse effect on future expansion plans and
could limit future growth.
EXTENSIVE GOVERNMENT REGULATION
Government regulation in the United States, the EC and other jurisdictions
represents a potentially determinative factor in the success of the Company's
efforts to market and develop its products. The allograft heart valves to which
the Company applies its preservation services are currently regulated as Class
II medical devices by the FDA and are subject to significant regulatory
requirements, including Quality System Regulations and record keeping
requirements. Changes in regulatory treatment or the adoption of new statutory
or regulatory requirements are likely to occur, which could adversely impact the
marketing or development of these products or could adversely affect market
demand for these products. Other allograft tissues processed and distributed by
the Company are currently regulated as "human tissue" under rules promulgated by
the FDA pursuant to the Public Health Services Act. These rules establish
requirements for donor testing and screening of human tissue and record keeping
relating to these activities and impose certain registration and product listing
requirements on establishments that process or distribute human tissue or
cellular-based products. The FDA has proposed and is refining a regulation that
will improve good tissue practices, akin to good manufacturing practices, on
tissue banks and processors of human tissue. It is anticipated that these good
tissue practices regulations when promulgated will enhance regulatory oversight
of the Company and other processors of human tissue.
BioGlue Surgical Adhesive is regulated as a Class III medical device and the
Company believes that its ACT may be regulated as a biologic or drug by the FDA.
The ACT has not been approved for commercial distribution in the United States.
or elsewhere. Fixed porcine heart valve products are classified as Class III
medical devices. There can be no assurance that the Company will be able to
obtain the FDA approval required to distribute its porcine heart valve products
in the United States. Distribution of these products within the EC is dependent
upon the Company maintaining its CE Mark and ISO 9001 certifications, of which
there can be no assurance.
Most of the Company's products in development, if successfully developed, will
require regulatory approvals from the FDA and perhaps other regulatory
authorities before they may be commercially distributed. The process of
obtaining required regulatory approvals from the FDA normally involves clinical
trials and the preparation of an extensive PMA application and often takes many
years. The process is expensive and can vary significantly based on the type,
complexity and novelty of the product. There can be no assurance that any
products developed by the Company, independently or in collaboration with
others, will receive the required approvals for manufacturing and marketing.
Delays in obtaining United States or foreign approvals could result in
substantial additional cost to the Company and adversely affect the Company's
competitive position. The FDA may also place conditions on product approvals
that could restrict commercial applications of such products. Product marketing
approvals or clearances may be withdrawn if compliance with regulatory standards
is not maintained or if problems occur following initial marketing. Delays
imposed by the governmental clearance process may materially reduce the period
during which the Company has the exclusive right to commercialize patented
products.
35
Also, delays or rejections may be encountered during any stage of the regulatory
approval process based upon the failure of the clinical or other data to
demonstrate compliance with, or upon the failure of the product to meet, the
regulatory agency's requirements for safety, efficacy and quality, and those
requirements may become more stringent due to changes in applicable law,
regulatory agency policy or the adoption of new regulations. Clinical trials may
also be delayed due to unanticipated side effects, inability to locate, recruit
and qualify sufficient numbers of patients, lack of funding, the inability to
locate or recruit clinical investigators, the redesign of clinical trial
programs, the inability to manufacture or acquire sufficient quantities of the
particular product candidate or any other components required for clinical
trials, changes in the Company's or its collaborative partners' development
focus and disclosure of trial results by competitors.
Even if regulatory approval is obtained for any of the Company's products or
services, the scope of the approval may significantly limit the indicated usage
for which such products or services may be marketed. Products marketed by the
Company pursuant to FDA or foreign oversight or approvals are subject to
continuing regulation. In the United States, devices and biologics must be
manufactured in registered establishments (and, in the case of biologics,
licensed establishments) and must be produced in accordance with Quality System
Regulations. Manufacturing facilities and processes are subject to periodic FDA
inspection. Labeling and promotional activities are also subject to scrutiny by
the FDA and, in certain instances, by the Federal Trade Commission. The export
of devices and biologics is also subject to regulation and may require FDA
approval. From time to time, the FDA may modify such regulations, imposing
additional or different requirements. Failure to comply with any applicable FDA
requirements, which may be ambiguous, could result in civil and criminal
enforcement actions, warnings, citations, product recalls or detentions and
other penalties and could have a material adverse effect on the Company's
business, financial condition, results of operations, and cash flows. As noted
above, the FDA Order may have such an effect.
In addition, NOTA prohibits the acquisition or transfer of human organs for
"valuable consideration" for use in human transplantation. NOTA permits the
payment of reasonable expenses associated with the removal, transportation,
processing, preservation, quality control and storage of human organs. There can
be no assurance that restrictive interpretations of NOTA will not be adopted in
the future that will challenge one or more aspects of the Company's methods of
charging for its preservation services. The Company's laboratory operations are
subject to the United States Department of Labor, Occupational Safety and Health
Administration and Environmental Protection Agency requirements for prevention
of occupational exposure to infectious agents and hazardous chemicals and
protection of the environment. Some states have enacted statutes and regulations
governing the processing, transportation and storage of human organs and tissue.
More restrictive state laws or regulations may be adopted in the future and they
could have a material adverse effect on the Company's business, financial
condition, results of operations and cash flows.
UNCERTAINTIES RELATED TO PATENTS AND PROTECTION OF PROPRIETARY TECHNOLOGY
The Company owns several patents, patent applications and licenses relating to
its technologies, which it believes provide important competitive advantages.
There can be no assurance that the Company's pending patent applications will
issue as patents or that challenges will not be instituted concerning the
validity or enforceability of any patent owned by the Company, or, if
instituted, that such challenges will not be successful. The cost of litigation
to uphold the validity and prevent infringement of a patent could be
substantial. Furthermore, there can be no assurance that competitors will not
independently develop similar technologies or duplicate the Company's
technologies or design around the patented aspects of the Company's
technologies. There can be no assurance that the Company's proposed technologies
will not infringe patents or other rights owned by others.
In addition, under certain of the Company's license agreements, if the Company
fails to meet certain contractual obligations, including the payment of minimum
royalty amounts, such licenses may become nonexclusive or terminable by the
licensor, which could have a material adverse effect on the Company's business,
financial condition, results of operations, and cash flows. Additionally, the
Company protects its proprietary technologies and processes in part by
confidentiality agreements with its collaborative partners, employees and
consultants. There can be no assurance that these agreements will not be
breached, that the Company will have adequate remedies for any breach or that
the Company's trade secrets will not otherwise become known or independently
discovered by competitors, any of which could have a material adverse effect on
the Company's business, financial condition, results of operations, and cash
flows.
36
UNCERTAINTIES REGARDING FUTURE HEALTH CARE REIMBURSEMENT
Even though the Company does not receive payments directly from third-party
health care payors, their reimbursement methods and policies impact demand for
the Company's cryopreserved tissue and other services and products. The
Company's preservation services may be particularly susceptible to third-party
cost containment measures. In particular, the initial cost of a cryopreserved
allograft heart valve generally exceeds the cost of a mechanical, synthetic or
animal-derived valve. The Company is unable to predict what changes will be made
in the reimbursement methods and policies utilized by third-party health care
payors or their effect on the Company.
Changes in the reimbursement methods and policies utilized by third-party health
care payors, including Medicare, with respect to cryopreserved tissues provided
for implant by the Company and other Company services and products, could have a
material adverse effect on the Company. Significant uncertainty exists as to the
reimbursement status of newly approved health care products and services and
there can be no assurance that adequate third-party coverage will be available
for the Company to maintain price levels sufficient for realization of an
appropriate return on its investment in developing new products.
Government, hospitals, and other third-party payors are increasingly attempting
to contain health care costs by limiting both coverage and the level of
reimbursement for new products approved for marketing by the FDA and by refusing
in some cases to provide any coverage for uses of approved products for
indications for which the FDA has not granted marketing approval. If adequate
coverage and reimbursement levels are not provided by government and other
third-party payors for uses of the Company's new products and services, market
acceptance of these products would be adversely affected, which could have a
material adverse effect on the Company's business, financial condition, results
of operations and cash flows.
DEPENDENCE ON KEY PERSONNEL
The Company's business and future operating results depend in significant part
upon the continued contributions of its key technical personnel and senior
management, many of who would be difficult to replace. The Company's business
and future operating results also depend in significant part upon its ability to
attract and retain qualified management, processing, technical, marketing, sales
and support personnel for its operation. Competition for such personnel is
intense and there can be no assurance that the Company will be successful in
attracting and retaining such personnel. The loss of key employees, the failure
of any key employee to perform adequately or the Company's inability to attract
and retain skilled employees as needed could have a material adverse effect on
the Company's business, financial condition, results of operations and cash
flows.
VOLATILITY OF SECURITIES PRICES
The trading price of the Company's Common Stock has been subject to wide
fluctuations recently and may continue to be subject to such volatility in the
future. Trading price fluctuations can be caused by a variety of factors,
including regulatory actions such as the recent FDA Order, recent product
liability claims, quarter to quarter variations in operating results,
announcement of technological innovations or new products by the Company or its
competitors, governmental regulatory acts, developments with respect to patents
or proprietary rights, general conditions in the medical device or service
industries, actions taken by government regulators, changes in earnings
estimates by securities analysts or other events or factors, many of which are
beyond the Company's control. If the Company's revenues or operating results in
37
future quarters fall below the expectations of securities analysts and
investors, the price of the Company's Common Stock would likely decline further,
perhaps substantially. Changes in the trading price of the Company's Common
Stock may bear no relation to the Company's actual operational or financial
results. If the Company's share prices do not meet the requirements of the New
York Stock Exchange, the Company's shares may be delisted. The Company's closing
stock price since January 1, 2002 has ranged from a high of $31.31 to a low of
$2.03.
ANTI-TAKEOVER PROVISIONS
The Company's Articles of Incorporation and Bylaws contain provisions that may
discourage or make more difficult any attempt by a person or group to obtain
control of the Company, including provisions authorizing the issuance of
preferred stock without shareholder approval, restricting the persons who may
call a special meeting of the shareholders and prohibiting shareholders from
taking action by written consent. In addition, the Company is subject to certain
provisions of Florida law that may discourage or make more difficult takeover
attempts or acquisitions of substantial amounts of the Company's Common Stock.
Further, pursuant to the terms of a shareholder rights plan adopted in 1995,
each outstanding share of Common Stock has one attached right. The rights will
cause substantial dilution of the ownership of a person or group that attempts
to acquire the Company on terms not approved by the Board and may have the
effect of deterring hostile takeover attempts.
ABSENCE OF DIVIDENDS
The Company has not paid, and does not presently intend to pay, cash dividends.
The Company's major credit agreement contains, and future credit agreements may
contain, financial covenants, including covenants to maintain certain levels of
net worth and certain leverage ratios, which could have the effect of
restricting the amount of dividends that the Company may pay. It is not likely
that any cash dividends will be paid in the foreseeable future.
38
FORWARD-LOOKING STATEMENTS
This Form 10-Q includes "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended (the "Securities Act"),
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange
Act") and the Private Securities Litigation Reform Act of 1995.
All statements, other than statements of historical facts, included herein which
address activities, events or developments which the Company expects or
anticipates will or may occur in the future, including statements regarding the
impact of recent accounting pronouncements, adequacy of product liability
insurance to defend against lawsuits, the outcome of lawsuits filed against the
Company, the impact of the FDA Order on future revenues, profits and business
operations, the effect of the FDA Order on sales of BioGlue, future tissue
procurement levels resulting from the FDA Order, the outcome of the Company's
appeal of the FDA Order, the estimates underlying the charges recorded in the
second quarter due to the FDA Order, the estimates underlying the accrual to
second quarter earnings established to account for the cost to the Company of
the FDA Order and the legal and professional fees necessary because of the FDA
Order, the estimates of the amounts accrued for the retention levels under its
product liability and directors' and officers' insurance policies, future costs
of human tissue preservation services, changes in liquidity and capital
resources as a result of the FDA Order, the outcome of any evaluation of
allograft heart valves by the FDA, the possible adverse outcome of the SEC
investigation referenced in the SEC Letter, future product development plans as
a result of the FDA Order, the Company's competitive position, the successful
development of its SynerGraft porcine valves, funding available to continue
development of the ACT, estimated dates relating to the Company's proposed
regulatory submissions, the Company's expectations regarding the adequacy of
current financing arrangements, product demand and market growth, the potential
of the ACT for use in cancer therapies, fibrin olysis (blood clot dissolving),
and other drug delivery applications, the outcome of litigation, the impact on
the Company of adverse results of surgery utilizing tissue processed by it, and
other statements regarding future plans and strategies, anticipated events or
trends and similar expressions concerning matters that are not historical facts
are forward-looking statements.
These statements are based on certain assumptions and analyses made by the
Company in light of its experience and its perception of historical trends,
current conditions and expected future developments as well as other factors it
believes are appropriate in the circumstances. However, whether actual results
and developments will conform to the Company's expectations and predictions is
subject to a number of risks and uncertainties, as is the Company's business.
These risks and uncertainties, which could cause actual results to differ
materially from the Company's expectations, include the risk factors discussed
in this Form 10-Q and other factors, many of which are beyond the control of the
Company. Consequently, all of the forward-looking statements made in this Form
10-Q are qualified by these cautionary statements and there can be no assurance
that the actual results or developments anticipated by the Company will be
realized or, even if substantially realized, that they will have the expected
consequences to or effects on the Company or its business or operations. The
Company assumes no obligation to update publicly any such forward-looking
statements, whether as a result of new information, future events or otherwise.
39
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
The Company's interest income and expense are most sensitive to changes in the
general level of United States interest rates. In this regard, changes in United
States interest rates affect the interest earned on the Company's cash and cash
equivalents of $12.3 million and short-term investments in municipal obligations
of $18.7 million as of June 30, 2002, as well as interest paid on its debt. A
10% adverse change in interest rates affecting the Company's cash equivalents
and short-term investments would not have a material impact on the Company's
interest income for 2002.
The Company manages interest rate risk through the use of fixed debt and an
interest rate swap agreement. At June 30, 2002 approximately $3.2 million of the
Company's $6.4 million in debt charged interest at a fixed rate. This fixed rate
debt includes a portion of the Company's outstanding term loan balance that has
been effectively converted to fixed rate debt through an interest rate swap
agreement. A 10% increase in interest rates affecting the Company's variable
rate debt, net of the effect of the interest rate swap agreement, would not have
a material increase in the Company's interest expense for 2002.
Item 4. Controls and Procedures.
Not applicable.
40
Part II - OTHER INFORMATION
Item 1. Legal Proceedings.
In the normal course of business as a medical device and services company
the Company has product liability complaints filed against it. As of August
30, 2002 fifteen product liability cases had been filed against the Company
between May 18, 2000 and August 15, 2002. The cases are currently in the
pre-discovery or discovery stages. Of these cases, nine allege product
liability claims arising out of the Company's orthopaedic tissue, four
allege product liability claims arising out of the Company's allograft
heart valve tissue and one alleges product liability claims arising out of
the non-tissue products made by Ideas for Medicine, when it was a
subsidiary of the Company.
Included in these cases is the complaint filed against the Company in the
Superior Court of Cobb County, Georgia, on July 12, 2002 by Steve Lykins,
as Trustee for the benefit of next of kin of Brian Lykins. This complaint
alleges strict liability, negligence, professional negligence, and breach
of warranties related to tissue implanted in November 2001. The plaintiff
seeks unspecified compensatory and punitive damages.
The Company maintains general liability insurance policies, which the
Company believes to be adequate to defend against these suits. The
Company's insurance company has been notified of these actions. The Company
intends to vigorously defend against these claims. Nonetheless, an adverse
judgment in excess of the Company's insurance coverage could have a
material adverse effect on the Company's results of operations.
Several putative class action lawsuits were filed in July 2002, one of
which was amended in August of 2002, against the Company and certain
officers of the Company alleging that the defendants violated Sections
10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5
promulgated thereunder, by issuing a series of materially false and
misleading statements to the market throughout the Class Period of August
of 2000 through August of 2002, which statements had the effect of
artificially inflating the market price of the Company's securities. The
principal allegations of the complaints are that the Company failed to
disclose its alleged lack of compliance with certain FDA regulations
regarding the handling and processing of certain tissues and other product
safety matters. The plaintiffs seek unspecified compensatory damages in an
amount to be proven at trial. The Company believes these cases will be
consolidated into one putative class action lawsuit. The Company believes
the claims made in the lawsuits are without merit and intends to vigorously
defend against these claims. Management has retained the services of the
Atlanta based law firm of King & Spalding to defend the Company. The
Company carries director's and officer's liability insurance which the
Company believes to be adequate to defend against this suit. Nonetheless,
an adverse judgment in excess of the Company's insurance coverage could
have a material adverse effect on the Company's results of operations.
On August 7, 2002 the Company announced the settlement of its ongoing
litigation with Colorado State University Foundation ("CSURF") over the
ownership of the Company's SynerGraft technology. The settlement resolves
all disputes between the parties and extinguishes all CSURF ownership
claims to any aspect of CryoLife's SynerGraft technology. The settlement
includes an unconditional assignment to CryoLife of CSURF tissue
engineering patents, trade secrets and know-how relating to tissue
decellularization and recellularization. The technology assignment
supercedes the 1996 technology license, which was terminated by the terms
of the settlement. Payment terms include a nonrefundable advance of
$400,000 paid by the Company to CSURF that will be applied to earned
royalties as they accrue through March 2011. The Company will record these
amounts as prepaid royalties and will expense the amounts as the royalties
accrue. The earned royalty rate is a maximum of 0.75% of net revenues from
products or tissue services utilizing the SynerGraft technology. Royalties
earned under the agreement for revenues through June 30, 2002 were
approximately $27,000.
41
On Saturday, August 17, 2002 the Company received a letter from the United
States Securities and Exchange Commission (the "SEC Letter") that stated
that the Company was subject to an investigation related to the Company's
August 14, 2002 announcement of the FDA Order and requesting information
from the Company from the period between September 1, 2001 through the date
of the Company's response to the SEC Letter. The SEC Letter stated, in
part, that "We are trying to determine whether there have been any
violations of the federal securities laws. The investigation and the
subpoena do not mean that we have concluded that anyone has broken the law.
Also, the investigation does not mean that we have a negative opinion of
any person, entity or security." The staff of the SEC subsequently
confirmed that its investigation is informal in nature, and that it does
not have subpoena power at this time.
Item 2. Changes in Securities.
None
Item 3. Defaults Upon Senior Securities.
See Note 6 to the Summary Consolidated Financial Statements for information
regarding a notification by the Company's lender that the FDA Order and the
inquiries of the SEC have had a material adverse effect on the Company,
which constitutes an event of default. The lender has elected not to
declare an event of default at this time.
Item 4. Submission of Matters to a Vote of Security Holders.
(a) The Annual Meeting of Shareholders was held on May 29, 2002.
(b) Management's nominees for director were elected at the meeting by
the holders of common stock. The election was uncontested.
The following table shows the results of voting in the election
of Directors:
Shares Voted For Authority Withheld
Steven G. Anderson 16,611,274 875,356
John M. Cook 17,366,243 120,387
Ronald C. Elkins, M.D. 17,351,146 135,484
Virginia C. Lacy 17,366,243 120,387
Ronald D. McCall, Esq. 16,561,274 925,356
Alexander C. Schwartz, Jr. 17,366,243 120,387
Bruce J. Van Dyne, M.D. 17,351,146 135,484
(c) A proposal was passed which approved the CryoLife, Inc. 2002
Stock Incentive Plan.
The following table shows the results of voting:
Common Shares
Voting for 16,261,220
Voting against 1,078,559
Abstain from voting 146,851
------------------
Total 17,486,630
==================
Item 5. Other information.
None.
42
Item 6. Exhibits and Reports on Form 8-K
(a) The exhibit index can be found below.
Exhibit
Number Description
3.1 Restated Certificate of Incorporation of the Company, as amended.
(Incorporated by reference to Exhibit 3.1 to the Registrant's Annual
Report on Form 10-K for the fiscal year ended December 31, 2000.)
3.2 ByLaws of the Company, as amended. (Incorporated by reference to
Exhibit 3.2 to the Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1995.)
3.3 Articles of Amendment to the Articles of Incorporation of the Company.
(Incorporated by reference to Exhibit 3.3 to the Registrant's Annual
Report on Form 10-K for the fiscal year ended December 31, 2000.)
4.1 Form of Certificate for the Company's Common Stock. (Incorporated by
reference to Exhibit 4.1 to the Registrant's Registration Statement on
Form S-1 (No. 33-56388).)
10.1* 2002 Stock Incentive Plan
99.1* Certification Pursuant To 18 U.S.C. Section 1350, As Adopted Pursuant
To Section 906 Of The Sarbanes-Oxley Act Of 2002.
(b) Current Reports on Form 8-K.
The Registrant filed a Current Report on Form 8-K with the
Commission on April 11, 2002 with respect to a Change in the
Registrant's Certifying Accountant.
The Registrant filed a Current Report on Form 8-K with the
Commission on May 10, 2002 with respect to a Change in the
Registrant's Certifying Accountant.
_____________
* Filed herewith.
43
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CRYOLIFE, INC.
(Registrant)
/s/ STEVEN G. ANDERSON /s/ DAVID ASHLEY LEE
- --------------------------------- ----------------------------------
STEVEN G. ANDERSON DAVID ASHLEY LEE
Chairman, President, and Vice President and Chief Financial
Chief Executive Officer Officer
(Principal Financial and
Accounting Officer)
September 3, 2002
- ------------------------
DATE
44
CERTIFICATIONS
I, Steven G. Anderson, certify that:
1. I have reviewed this quarterly report on Form 10-Q of CryoLife, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report; and
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report.
Date: September 3, 2002
/s/STEVEN G. ANDERSON
Chief Executive Officer
I, Ashley D. Lee, certify that:
1. I have reviewed this quarterly report on Form 10-Q of CryoLife, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report; and
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report.
Date: September 3, 2002
/s/DAVID ASHLEY LEE
Chief Financial Officer
EXPLANATORY NOTE REGARDING CERTIFICATIONS: Representations 4, 5 and 6 of the
Certifications as set forth in Form 10-Q have been omitted, consistent with the
Transition Provisions of SEC Exchange Act Release No. 34-46427, because this
Quarterly Report on Form 10-Q covers a period ending before the Effective Date
of Rules 13a-14 and 15d-14.
45