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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended September 30, 1997
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ___________to _________
Commission file number 000-14242
CHEUNG LABORATORIES, INC.
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(Exact name of registrant as specified in its charter)
Maryland 52-1256615
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State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization
10220-I Old Columbia Road
Columbia, Maryland 21046-1705
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (410) 290-5390
Securities registered pursuant to Section 12(b) of the Act: None
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Securities registered pursuant to Section 12(g) of the Act: Common Stock, par
value $.01 per share
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(Title of Class)
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
---
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K (ss. 229.405 of this chapter) is not contained
herein, and will not be contained, to the best of Registrant's knowledge, in
definitive proxy or information statements incorporated by reference in Part III
of this Form 10-K or any amendment to this Form 10-K. [ ]
As of December 23, 1997, 30,756,542 shares of the Registrant's Common
Stock were issued and outstanding. As of December 23, 1997, the aggregate market
value of voting stock held by nonaffiliates of the Registrant was approximately
$16,738,256 based on the average of the closing bid and asked prices for the
Registrant's Common Stock as quoted on the over-the-counter market.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the following documents are incorporated by reference in
this Report on Form 10-K: None.
PART I
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ITEM 1. BUSINESS
The Company
Overview
Cheung Laboratories, Inc. ("CLI" or the "Company") was incorporated in
the State of Maryland in 1982 under the name A.Y. Cheung Associates, Inc. The
Company changed its name to Cheung Laboratories, Inc. on June 31, 1984.
The Company has been engaged in developing and marketing minimally
invasive thermotherapy devices utilized in the treatment of cancer as well as
genitourinary diseases associated with benign growth of the prostate in older
males, the most common being benign prostatic hyperplasia ("BPH"). Thermotherapy
(also known as hyperthermia), or heat therapy, is a historically recognized
successful method of treatment. In modern thermotherapy, a controlled heat dose
is targeted to treatment sites using microwave and/or other energy for
therapeutic benefits.
Thermotherapy is a clinically established, adjuvant modality for at
least doubling tumor response to radiation therapy or chemotherapy. The past
technical difficulty has been delivering a controlled amount of heat to internal
tumors without damaging surrounding healthy tissues. The Company has an
exclusive license from the Massachusetts Institute of Technology ("MIT") for
adaptive phase array ("APA") technology which the Company believes will overcome
this problem.
The Company will therefore be concentrating its business on the
development of two recently acquired technologies: (i) from MIT, APA targeting
of microwave energy, which the Company believes will have broad cancer and other
medical applications, and (ii) balloon catheter technology for enhanced
thermotherapy of BPH and other genitourinary tract conditions. While the balloon
catheter technology is related to the Company's previous BPH thermotherapy
devices, the Company believes the APA technology has the potential to serve as
the core technology for a broad array of medical devices, and accordingly the
Company will devote most of its resources to the exploitation of the APA
technology.
EXPLOITATION OF THE COMPANY'S DEEP FOCUSED HEAT TECHNOLOGIES
- ------------------------------------------------------------
The Company has acquired exclusive licenses from MIT for medical uses
of APA and nulling technology which allow microwave energy to be accurately
targeted deep within the body. Selectively heating tissue in conjunction with
either chemotherapy or radiation therapy has been proven for years to double the
complete response rates of tumors. Delivering the necessary heat within the body
without damaging surrounding tissue has been a major impediment to the use of
thermotherapy for deep seated disease. The APA technology concentrates the
microwave energy and resulting heating on a well defined target area and
nullifies energy in surrounding tissue.
In addition the Company has recently acquired a patented compression
technology from MMTC, which has been incorporated into a device to be utilized
with the catheter used in the Company's existing Microfocus BPH System. The
device consists of a microwave antenna combined with a balloon dilation
("angioplasty") mechanism which expands to compress the walls of the urethra as
the prostate is heated. The combined use of balloon angioplasty and microwave
heating provides a dual modality treatment approach which it is believed will
provide significantly improved treatment benefits over the "heat alone" systems
currently available commercially. First, the heat and compression create a
natural stent in the
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wall of the urethra thus permitting immediate relief. Second, the system's
relatively low temperature (43(degree)C to 44(degree)C) are sufficient to kill
prostatic cells outside the urethra but are not high enough to cause swelling in
the urethra as is often associated with competitive treatments using high
temperatures and no compression.
The Company will attempt to develop applications of the MIT (APA) and MMTC
technologies in the following areas:
A.) MIT "Adaptive Phased Array" Technology - The Enabling Platform
In mid 1996, CLI obtained an exclusive license to a patented portfolio
of MIT "adaptive phased array" technology that make it possible to accurately
target and focus heat directly on deep seated tumors without damaging the
surrounding healthy tissues.
On October 24, 1997, CLI entered into a revised exclusive license
agreement with MIT covering the above mentioned patents in the 1996 agreement as
well as an additional patent pending technology using the APA technology for
activating thermo-sensitive liposomes.
This technology, originally developed for the Strategic Defense
Initiative (Star Wars) plans of the Department of Defense, applies adaptive
phased arrays of microwave energy in conjunction with traditional radiation or
chemotherapy for the deep heating of breast, prostate and other deep seated
cancers.
The dual treatment modality of thermotherapy and radiation has already
been shown through many independent studies to double the efficacy rates on
surface cancers when used in conjunction with radiation or chemotherapy. More
recently, results from animal tests performed by Massachusetts General Hospital,
utilizing CLI's deep heating cancer treatment equipment, have verified the
ability to accurately and safely focus heat where targeted on internally located
tumors. This ability to selectively heat targeted internal areas of the human
body is will act as a technological platform from which the Company intends to
capitalize on, both in the near term and the long term. There are numerous
technologies that currently exist or are being developed can utilize the unique
properties of CLI's heat delivery technology, as well as numerous other
applications dependent on the heat delivery technology that may evolve over
time. Several of the leading applications that have been identified include:
i.) Radiation Plus Deep Focused Heat
The combination of thermotherapy (hyperthermia) and radiation is CLI's
initial market opportunity. Traditional radiation therapy is an expensive,
multi-treatment process that is physically debilitating to the person receiving
it, and has several inherent systemic limitations:
S-phase cancer cells are resistant to radiation. (S phase cells represent
about 40 percent of the cell cycle; tumeric cells go through a 24 hour
cycle of S and G phases.) They are highly susceptible to destruction by
heat.
Poorly oxygenated (hypoxic) cancer cells are resistant to radiation.
Thermotherapy is known to improve the chances of killing the cancer cells,
because
S-phase cancer cells missed by radiation can be killed by thermotherapy.
3
Thermotherapy increases the oxygenation of cancer cells making them more
susceptible to radiation.
Thermotherapy is a highly successful complement to radiation treatment. The
problem has been the ability to apply thermotherapy in a targeted and focused
way. CLI's technology has solved this problem.
On September 17, 1997, the FDA approved the CLI system of deep focused heat
as a treatment modality to be used in conjunction with radiation for the
treatment of recurrent surface and subsurface tumors. This approval was obtained
as a supplement to an existing approval for the Microfocus 1000, a thermotherapy
device that CLI has manufactured since 1989, albeit without the APA technology.
This approval, obtained without clinical trials, allows CLI to immediately begin
commercialization of the APA technology while concurrently pursuing expanded FDA
approvals.
ii.) Chemotherapy Plus Deep Focused Heat
Traditional chemotherapy is limited in its ability to kill cancer cells for
two major reasons:
Poor blood perfusion in the vicinity of tumor cells such that chemotherapy
delivered through the blood stream does not reach the tumor.
Tumor cell pressure prevents chemotherapy from penetrating tumor cell
membranes.
Thermotherapy improves the performance of chemotherapy in each of these areas
by:
Increasing the blood flow in the vicinity of tumors in the temperature
range of 41 to 43 deg C, thereby increasing the delivery of drugs to the
tumor site.
Decreasing the blood flow within the tumor itself to the point where the
tumor is easily heated and killed at temperatures above 43 deg C (tumor
vascularity is not robust and does not expand significantly when heated),
compared to normal tissue for which heat is easily removed and the tissue
is protected, and
Increasing the toxicity of the chemotherapy agent at 43 deg C, compared to
the toxicity of the same agent at 37 deg C.
Animal and clinical trials for the combined modalities of chemotherapy and deep
focused heat is planned to begin at leading hospitals in 1998.
iii.) Heat Sensitive Liposomes (Thermosomes(TM)) - Targeted and Highly Effective
Drug Delivery
One of the initial adjunct opportunities for this patented technology
relates to temperature sensitive liposomes (Thermosomes(TM)) that are being
developed at Duke University. Thermosomes are microscopic man-made lipid
particles (organic compounds including fats, fat-like compounds and steroids)
that can be engineered to encapsulate drugs, creating new pharmaceuticals with
enhanced efficacy, better safety or both. Toxicity of effective drugs can be
mitigated through Thermosome technology.
For application to the human body, the Thermosomes are injected into
the blood stream. As the Thermosomes circulate repeatedly within the small
arteries, arterioles, and capillaries, the drug contents of the Thermosomes are
released in significantly higher levels in areas that have been heated for 30 to
4
60 minutes, than in areas that do not receive heat. Hence, the Thermosome(TM)
technology is enabled by CLI's thermotherapy treatment modality. Together, these
two treatment modalities are expected to release toxins almost exclusively into
the targeted area, rather than across the entire circulatory system. This is a
fundamental distinction between traditional chemotherapy and Thermosome induced,
thermotherapy enhanced chemotherapy.
In addition to the increased efficacy, there is potential for great
improvement in the life process of chemotherapy patients. Chemotherapy is
essentially a poisoning of the body with toxins that attack cancerous cells more
readily than normal cells. The side effects include nausea, vomiting, and
exhaustion - all side effects of the body being poisoned. If the poisoning can
be limited to the tumeric area, and performed only once (due to the increased
efficacy) as is possible with the Thermosome related treatments, chemotherapy
should cease to be the horrid, debilitating process that it is today.
iv.) Gene Therapy - Making Tumors Susceptible to Eradication
Another application of the Cheung technology relates to Gene Therapy.
Researchers have developed heat sensitive, genetic biological modifiers which
suppress a tumor's resistance to heat, radiation and chemotherapy damage. In
clinical applications to management of cancer, the biological modifiers can be
attached to a heat shock promoter to form a gene therapy construct. The
construct can be delivered to deep seated tumors.
The action of focused heat will release and trigger the action of the
modifier, thus weakening the tumor's resistance to therapy and greatly enhancing
the effectiveness of the combination therapy approach using heat in conjunction
with radiation or chemotherapy.
B.) MMTC Benign Prostatic Hyperplasia Technology - Major Treatment Improvements
On August 23, 1996, the Company has acquired a patented compression
technology from MMTC, which has been incorporated into a device to be utilized
with the catheter used in the Company's existing Microfocus BPH System. The
device consists of a microwave antenna combined with a balloon dilation
("angioplasty") mechanism which expands to compress the walls of the urethra as
the prostate is heated. The combined use of balloon angioplasty and microwave
heating provides a dual modality treatment approach which it is believed will
provide significantly improved treatment benefits over the "heat alone" systems
currently available commercially. First, the heat and compression create a
natural stent in the wall of the urethra thus permitting immediate relief.
Second, the system's relatively low temperature (43(degree)C to 44(degree)C) are
sufficient to kill prostatic cells outside the urethra but are not high enough
to cause swelling in the urethra as is often associated with competitive
treatments using high temperatures and no compression.
On December 1, 1997, the Company entered into amended Licenses
agreement to give the Company rights to two additional patents of which one was
recently approved November 17, 1997. These additional patents related to a
innovative approach to monitor and control intra-prostatic temperatures using a
radiometer apparatus. The combination of these two patents and the one received
in 1996 enhances the safety and efficacy of our BPH system.
BPH is a highly prevalent prostate disease that afflicts a substantial
percentage of men over the age of 55. The BPH treatment market is substantial,
with an estimated 7.2 million men in America suffering from the disease. BPH
symptoms typically appear in men in their 50s and continue to worsen over time.
As a result of an aging population, the number of men with BPH is increasing.
5
In 1995 only 17% of the total men suffering with BPH symptoms were
treated for the disease. CLI believes that this number will be greatly increased
with the introduction of a BPH treatment device that improves on the major
drawbacks of the current treatment methods. These drawbacks include issues such
as extended procedure stays, required catheterization and a worsening of
conditions immediately after the procedure.
CLI's new proprietary BPH device confronts each one of these drawbacks
and delivers a treatment that is performed on an outpatient basis (1-2 hours),
does not require post-treatment catheterization and delivers immediate relief
that permits urination as soon as the procedure is completed.
Projected Deep Focused Heat Product Line
- -----------------------------------------
The Company has current plans to produce three specialized
thermotherapy products, each utilizing the APA technology for specific deep
seated tumors and one BPH product utilizing the MMTC technology.
Breast cancer treatment equipment. Breast cancer is the most prevalent
cancer in American women with over 183,000 new cases diagnosed each year. The
Company has produced a prototype machine for APA enhanced thermotherapy for
treatment of breast cancer. Preclinical evaluation of the prototype in animals
has been completed.
Prostate cancer treatment equipment. There are over 163,000 new cases
of prostate cancer diagnosed in the United States each year. Building on its
experience in BPH treatment, the Company is planning prostate cancer
thermotherapy equipment as the second of its APA product line. Although the
Company has developed several critical components of this equipment, development
is not expected to begin prior to December, 1997
Deep seated tumor treatment equipment. The third planned APA product
will be for thermotherapy of deep seated tumors, including liver, pancreas,
colon and lung cancers. It is expected that this equipment will also permit
treatment on other cancer sites including the head, neck and limbs.
This product is in the early design phase.
BPH treatment equipment. The Company has recently placed a newly
developed BPH System with the dual angioplasty-thermotherapy capabilities with
the Montifiore Medical Center, the teaching hospital of the Albert Einstein
College of Medicine in New York City, for preclinical and clinical evaluations.
Dr. Arnold Melman, Chairman and Professor of the Department of Urology of Albert
Einstein College of Medicine, will be the principal investigator of the study.
Balloon Catheter - BPH Treatment Background
- -------------------------------------------
BPH is a non-cancerous urological disease in which the prostate
enlarges and constricts the urethra. Symptoms associated with BPH affect the
quality of life of millions of sufferers worldwide, and BPH can lead to
irreversible bladder or kidney damage. The prostate is a walnut-size gland
surrounding the male urethra that produces seminal fluid and plays a key role in
sperm preservation and transportation. As the prostate expands, it compresses or
constricts the urethra, thereby restricting the normal passage of urine. This
restriction of the urethra may require a patient to exert excessive bladder
pressure to urinate. Since the urination process is one of the body's primary
means of cleansing impurities, the inability to urinate adequately increases the
possibility of infection and bladder and kidney damage.
6
Because BPH is an age-related disorder, its incidence increases as the
population ages. As many as 27 million men between the age of 50 and 80 in the
United States alone suffer from BPH. As the population continues to age, the
prevalence of BPH will continue to increase dramatically. As demonstrated by the
following chart, by age 55, fifty percent of all men, and by age 80, eighty
percent of all men will have BPH.
Like cancer, BPH historically has been treated by surgical intervention
or by drug therapy. The primary surgical treatment for BPH is transurethral
resection of the prostate ("TURP"), a procedure in which the prostatic urethra
and surrounding diseased tissue in the prostate are trimmed, thereby widening
the urethral channel for urine flow. While the TURP procedure typically has been
considered the most effective treatment available, the procedure has many
shortcomings which undermine its value. A large number of patients who undergo
TURP encounter significant complications, which can include painful urination,
infection, impotence, incontinence, and excessive bleeding. Furthermore, the
cost of the TURP procedure is also very high, ranging from $8,000 to $12,000,
including hospital stay. Medicare alone spent $1 billion to cover TURP
procedures in 1995. This high cost also fails to reflect the cost of lost work
time and reduction in quality of life. Finally, the TURP procedure is time
consuming, requiring hospitalization for up to three days.
Other less radical surgical procedures are available in addition to the
TURP procedure. Interstitial RF Therapy and Laser Therapies are surgical
procedures which employ concentrated radio frequency waves or laser radiation
instead of a surgical knife. There is minimal bleeding and damage to the urethra
associated with these procedures. However, the adverse side effects and costs
associated with surgery remain.
Drug therapy has emerged as an alternative to surgery in the last
several years. There are several drugs available for BPH treatment, the two most
widely prescribed drugs being Hytrin and Proscar. Hytrin works by relaxing
certain involuntary muscles surrounding the urethra, thereby easing urinary
flow, and Proscar is intended to actually shrink the enlarged gland. Drugs,
however, offer only modest relief (60% of drug patients stop within the first
year) and cost hundreds of dollars per year. In short, neither the surgical nor
the medicinal treatments available for BPH provide satisfactory, cost-effective
solutions to BPH.
Thermotherapy or high heat treatment using microwaves is another new
alternative treatment approach. In May 1996, the FDA approved a microwave-based
BPH treatment device manufactured by EDAP Technomed, Inc. ("Technomed"), called
Prostatron. FDA has recently approved another similar microwave treatment device
manufactured by Urologix, another thermotherapy company. However, due to the
high treatment temperatures used, there is no immediate objective and/or
subjective relief, and a large percentage of the treated patients will require a
post retention catheter due to the prostatic swelling caused by the intensity of
the heat used.
With the limited effectiveness of BPH drugs and the cost and potential
side effects associated with surgery, the Company believes thermotherapy
combined with "angioplasty"-like compression of the urethra provides a better
alternative for the treatment of BPH. The Company further believes the
percentage of men with moderate to severe symptoms of the disease who seek
treatment will increase significantly in the future as a result of increased
consumer knowledge of the disease and the development of treatments with less
severe complications and side effects than traditional treatments (estimated 50%
of all afflicted being treated vs. 30% today).
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Current Prostatic Disease Equipment
The Company's current BPH systems utilize a non-surgical catheter-based
therapy that incorporates proprietary microwave technology and is designed to
preferentially heat diseased areas of the prostate to a temperature sufficient
to cause cell death in those areas. The current systems do not utilize the
balloon catheter technology. The Company does not have an IDE or PMA on the
current BPH System and it is therefore not currently available for commercial
distribution in the United States. The Microfocus BPH System is manufactured in
Canada and is approved for export from Canada. The current systems will be
discontinued as the balloon catheter equipment becomes available.
MARKETING STRATEGY
- ------------------
The emphasis of the Company's marketing strategy for its new products
will be to maintain ongoing cash streams by selling disposable procedure kits
and sharing treatment revenue. Hospitals, clinics, HMOs, and pharmaceutical
companies will acquire equipment at a minimal cost and will pay for utilizing
such equipment, together with necessary disposable products -- on a per use
basis. The Company intends to increase the demand for its treatment by educating
patients about the benefits of its treatment via various means of media
publicity, consistent with FDA regulation. The Company will pursue for long-term
growth along two discrete development paths:
In the near term, from two to four years, the Company's treatment
revenues will come from an exploitation of its proprietary technology for BPH
and prostate disorders, and from its deep focused heat technology for breast
cancer and deep-seated tumors. The Company intends to generate initial sales
through a combination of direct marketing and development of marketing
alliances. The Company has begun discussions with a national HMO for the
development of a long-term joint research and marketing alliance. The company is
currently considering other offers to establish a series of value-added
marketing alliances with certain manufacturers that sell directly to the
nation's hospital community.
In the longer term from four to six years, the Company intends to
generate new revenue streams from its current development work with Duke
University and Memorial Sloan Kettering in targeted drug delivery systems and
gene therapy. The Company has first options to acquire Duke University patents
covering heat sensitive liposome targeted drug delivery technology. Treatment
revenues will come from pharmaceutical manufacturers, hospitals, and clinics
employing these technologies to deliver drug regimens or change genes throughout
the body. Duke has commenced development of this integrated, targeted drug
delivery system employing the Company's focused heat technology. To market its
liposome, heat sensitive drug delivery systems, the Company is currently seeking
alliances with pharmaceutical companies, major hospitals, and HMOs. The
Company's intended marketing strategy will be to sell its microwave equipment at
minimal cost, and to share revenues from drug delivery on a per transaction
basis. There will also be significant revenues from Cheung' both targeted drug
delivery and gene therapy delivery to major drug companies.
Assuming FDA approval, Cheung plans to launch its BPH treatment system
in late 1999. Pending FDA approvals, the Company's focused heat breast cancer
and deep tumor treatment systems could reach the market in the years 2000 and
2001. Microwave liposome drug delivery treatments could reach the market as
early as 2002.
Patents and Proprietary Rights
The Company owns no patents. Through the Company's license agreements
with MIT, MMTC and Haim Bither Cancer Institute ("H.B.C.I.") the Company has
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exclusive rights within defined fields of use to seven U.S. patents and one
patent pending. Four of the patents relate to the cancer equipment and three
relate to the BPH equipment. The patents expire at various times from May, 1999
to November, 2014. The Company, in conjunction with the patent holders, has
filed or intends to file international applications for certain of the U.S.
patents.
The Company also relies upon trade secrets and proprietary know-how,
which it seeks to protect, in part, through proprietary information agreements
with employees, consultants and others. There can be no assurance that
proprietary information agreements will not be breached, that the Company would
have adequate remedies for any such breach or that such agreements, even if
fully enforced, would be adequate to prevent third party use of the Company's
proprietary technology.
Third Party Reimbursement
The Company believes that third party reimbursement will be essential
to commercial acceptance of the Deep Focused Heat Systems and Microfocus BPH
System procedures, and that overall cost effectiveness and physician advocacy
will be keys to obtaining such reimbursement. The Company believes that its
procedures can be performed for substantially lower total cost than surgical
treatments for BPH or cancer or continuous drug therapy. Consequently, the
Company believes that third party payers seeking procedures that provide quality
clinical outcomes at lower cost will help drive acceptance of the Company's
products.
The Company's strategy for obtaining reimbursement in the United States
is to obtain appropriate reimbursement codes and perform studies in conjunction
with clinical studies to establish the efficacy and cost effectiveness of the
procedures as compared to surgical and drug treatments for BPH and cancer. The
Company plans to use this information when approaching health care payers to
obtain reimbursement authorizations.
With the increasing use of managed care and capitation as a means to
control health care costs in the United States, the Company believes that
physicians may view the Company's products as a tool to treat efficaciously BPH
and cancer patients at a lower total cost, thus providing them with a
competitive advantage when negotiating managed care contracts. This is
especially important in the United States, where a significant portion of the
aging Medicare population is moving into a managed care system.
Following regulatory approval, physicians using the Company's
Microfocus 1000 or, when completed, the Deep Focused Heat Systems to treat
cancer and the Microfocus BPH System to treat BPH, will submit insurance claims
for reimbursement for the procedure to third party payers, such as Medicare
carriers, Medicaid carriers, Health Maintenance Organizations ("HMOs"), and
private insurers. In the United States and in international markets, third party
reimbursement is generally available for existing therapies used to treat cancer
and BPH. The availability and level of reimbursement from such payors for the
use of the Company's new Deep Focus Heat Systems and the new Microfocus BPH
System will be a significant factor in the Company's ability to commercialize
these systems.
The Company believes that new regulations regarding third party
reimbursement for certain investigational devices in the United States will
allow it to pursue early reimbursement from Medicare with individual clinical
sites prior to receiving FDA approval. However, the Company believes that FDA
approval will be necessary to obtain a national coverage determination from
Medicare. The national coverage determination for third party reimbursement will
depend on the determination of the United States Health Care Financing
Administration ("HCFA"), which establishes national coverage policies for
Medicare carriers, including the amount to be reimbursed, for coverage of claims
9
submitted for reimbursement related to specific procedures. Private insurance
companies and HMOs make their own determinations regarding coverage and
reimbursement based upon "usual and customary" fees. Reimbursement experience
with a particular third party payor does not reflect a formal reimbursement
determination by the third party payor.
Internationally, reimbursement approvals for procedure utilizing the
Company's new products will be sought on an individual country basis. Some
countries currently have established reimbursement authorizations for
transurethral microwave therapy. Clinical studies and physician advocacy will be
used to support reimbursement requests in countries where there is currently no
reimbursement for such procedures.
Commercial Design and Manufacturing
The Company's existing BPH treatment devices were designed and
manufactured by the Company. The Company believes it is best suited to conduct
basic research and development, pursue a development idea through clinical
testing and regulatory approval and market the final product. The Company
intends to outsource the development of a commercial product from its
development stage product and the actual manufacture of the commercial product.
The Company has engaged Herbst Lazar Bell, Inc. to develop the commercial
versions of its future products. See "Certain Transactions". Manufacture of
future products will be contracted to manufacturers who have not yet been
identified.
Competition
Thermotherapy For Cancer
The Company believes that there are at least six other domestic firms,
as well as a number of foreign firms, producing, or designing and intending to
produce, thermotherapy systems to treat cancer. Of those firms, at least four
have obtained PMA for their machines and several have obtained IDE for their
machines. Some, and possibly all, of those firms have greater resources than
those which the Company now has or may reasonably be expected to have in the
near future. Other firms not presently in competition with the Company may
decide to produce thermotherapy systems which compete with those of the Company.
At least some of those firms may reasonably be expected to have resources
greater than those of the Company. As acceptance of thermotherapy as a cancer
treatment increases, the Company expects that the competition will also
increase.
The two major competitors of the Company are BSD Medical Corporation in
Salt Lake City, Utah ("BSD"), and Labthermics Technology, Inc. in Champaign,
Illinois ("Labthermics"), each of which manufactures thermotherapy machines
competitive with the Company's current Microfocus 1000. The major factors in
competition for sales of thermotherapy equipment are product performance,
product service, and product cost. The product performance of the Company's
Microfocus 1000 in PMA clinical trials has been superior to the performance of
competing machines. The system manufactured by BSD uses microwave technology.
Labthermics uses ultrasound technology to heat the cancer site.
BSD received its FDA approval in 1983 and was allowed to begin
marketing its system at that time. To date, BSD has sold approximately 200
thermotherapy systems worldwide and has a much larger presence in the
thermotherapy market than has the Company.
Service in the thermotherapy business includes maintenance of the
thermotherapy machines to minimize downtime as well as training for personnel
who will utilize the machines to render treatment to patients. The Company has
warranty and service policies which are competitive within the industry.
10
The Company's warranty for the Microfocus 1000 is for a period of 12 months and
the Company offers a service policy following expiration of the warranty. These
terms are substantially similar to the warranties and service policies offered
by competitors. The Company provides three to four days of training for the
personnel who will be operating each machine that the Company places at a
treatment center. The Company also provides training programs at its facility in
Maryland for doctors who desire to receive training on the Company's Microfocus
1000. Both training courses are helpful in marketing the Company's Microfocus
1000, because users who become familiar with one machine have a reluctance to
switch to another machine which would require additional training. For this
reason, the Company will seek to increase the frequency of its training sessions
given at its facility in Maryland.
Thermotherapy For Prostatic Diseases
The Company believes there are as many as 10 companies in the USA and
as many as 15 companies worldwide which are planning to enter or already active
in this marketplace.
On May 7, 1996, the FDA for the first time approved a microwave-based
BPH treatment device manufactured by EDAP Technomed, Inc. ("Technomed"), called
"Prostatron." In addition, Urologix recently received FDA approval on its BPH
system. These approvals should enhance market acceptance of microwave BPH
treatment systems both in the United States and abroad but gives Technomed a
competitive advantage of being first to the market in the United States. The
Company's current BPH systems are not approved by the FDA for sale in the United
States. However, the Company intends to apply for FDA approval in the near
future.
Large global companies such as Dornier, Olympus, and Technomed will
spend large amounts of resources to market and develop the BPH industry. In
addition to the above companies, the following are companies offering BPH
thermotherapy systems in the worldwide marketplace: BSD, Direx Medical,
Technomatix (Primus), Lund Science, Quantum, GENEMED, Bruker, and Meditherm.
There are several other companies which have not yet brought their products to
the international marketplace. Presently, Technomed is considered the market
leader with its Prostatron system. The Prostatron unit is a high cost system
which sells for approximately U.S. $300,000. Other companies are marketing their
systems in the range of US $100,000 to $300,000. To date, it is believed there
are over 600 installed BPH Systems worldwide of which Technomed and Direx have
the largest share of approximately 30% combined. There are approximately 75
Microfocus BPH Systems installed worldwide.
Government Regulation
United States Regulation
In the United States, the FDA regulates the sale and use of medical
devices, which include the Company's thermotherapy systems for both cancer and
BPH. A company introducing a medical device in the United States must go through
a two step process. The company must first obtain an Investigational Device
Exemption ("IDE") permit from the FDA. An IDE is granted upon the manufacturer
adequately demonstrating the safety of the device for patient use. Receipt of
the IDE allows the use of the device on patients for the purpose of obtaining
efficacy confirmation. A PMA is granted upon compilation of sufficient clinical
data to establish efficacy for the indicated use of the device. This process is
not only time consuming but is also expensive. Obtaining PMA is a significant
barrier to entry into the thermotherapy market. Firms which lack PMA face
significant impediments to the successful marketing of their thermotherapy
equipment, because under applicable regulations customers can obtain
reimbursement from Medicare, Medicaid and health insurers only for treatment
with products that have PMA.
11
The Company has a PMA for its Microfocus 1000 but does not have an IDE
or PMA on the Microfocus BPH System.
The Federal Communications Commission (the "FCC") regulates the
frequencies of microwave and radio-frequency emissions from medical and other
types of equipment to prevent interference with commercial and governmental
communications networks. The frequency of 915 MHZ has been approved by the FCC
for medical applications and machines utilizing that frequency do not require
shielding to prevent interference with communications. The Microfocus 1000 and
the Microfocus BPH System utilize the 915 MHZ frequency.
In December 1984, the Health Care Financing Administration ("HCFA")
approved reimbursement under Medicare and Medicaid for thermotherapy treatment
when used in conjunction with radiation therapy for the treatment of surface and
subsurface tumors. At this time, most of the large medical insurance carriers in
the United States have approved reimbursement for such thermotherapy treatment
under their health policies. Thermotherapy treatment administered using
equipment which has received PMA is eligible for such reimbursement.
The Company and its facilities are subject to inspection by the FDA at
any time to insure compliance with FDA regulations in the production and sale of
medical products. The Company believes that it is substantially in compliance
with FDA regulations governing the manufacturing and marketing of medical
devices.
Foreign Regulation
Sales of medical devices outside of the United States are subject to
United States export requirements and foreign regulatory requirements. Export
sales of investigational devices that are subject to PMA requirements and have
not received FDA marketing approval generally may be subject to FDA export
permit requirements under the Federal Food, Drug and Cosmetic Act ("FDC Act")
depending upon, among other things, the purpose of the export (investigational
or commercial) and on whether the device has valid marketing authorization in a
country listed in the FDA Export Reform and Enhancement Act of 1996. In order to
obtain such a permit, when required, the Company must provide the FDA with
documentation from the medical device regulatory authority of the country in
which the purchaser is located, stating that the device has the approval of the
country. In addition, the FDA must find that exportation of the device is not
contrary to the public health and safety of the country in order for the Company
to obtain the permit.
The Company has sold products in selected countries in Asia and Europe.
Meeting the registration requirements within these countries is the sole
responsibility of the distributors in each of these countries. Legal
restrictions on the sale of imported medical devices vary from country to
country. The time required to obtain approval by a foreign country may be longer
or shorter than that required for FDA approval, and the requirements may differ.
The Company expects to receive approvals for marketing in a number of countries
outside the United States prior to the time that it will be able to market its
products in the United States. The timing for such approvals is not known.
Product Liability and Insurance
The business of the Company entails the risk of product liability
claims. Although the Company has not experienced any product liability claims to
date, any such claims could have an adverse impact on the Company. In the past
and currently, the Company has not maintained product liability insurance. The
Company is currently in the process of securing product liability insurance in
12
the amount of $5,000,000 and has received quotes for such coverage. There can be
no assurance that once product liability insurance is obtained that product
liability claims will be covered by such insurance, will not exceed such
insurance coverage limits
Employees
As of September 30, 1997, the Company had eight full-time employees.
None of the Company's employees is represented by a collective bargaining
organization. The Company considers its relations with its employees to be good.
None of the Company's employees is represented by a collective
bargaining organization. The Company considers its relations with its employees
to be good.
ITEM 2. PROPERTIES
The Company's corporate headquarters consist of approximately 5,918
square feet of office, laboratory and production space at 10220-I Old Columbia
Road, Columbia, Maryland 21046-1705. The Company leases the premises from an
unaffiliated party on a three year lease which will terminate on May 31, 2000.
Monthly rent is $5,489.00.
The Company leases from Augustine Cheung, Chairman of the Board, and
John Mon, an officer and director, on a month to month basis a townhouse near
its corporate offices in Columbia, Maryland for $900 per month, plus utilities.
The housing is used for visiting executives.
The Company also leases office space consisting of approximately 500
square feet located at 11/F Flat B, Hanley House 68 Canton Road, T.S.T. Kowloon,
Hong Kong. The property is leased on a month-to-month basis from an unaffiliated
party at a monthly lease rate of $1,200 (U.S.). The Company plans to terminate
the leasing of the Hong Kong office on December 31, 1997.
ITEM 3. LEGAL PROCEEDINGS
The Company presently is not a party to any litigation, and the Company
is not aware of any threat of litigation, except as follows:
The Company has been named as a defendant in a lawsuit filed by
Eastwell Management Services, Ltd. ("Eastwell") in the United States District
Court for the District of Maryland. In the lawsuit, Eastwell is seeking damages
in the amount of $125,000, plus interest. The Company denies that any funds are
due to Eastwell and intends to defend the lawsuit.
In the normal course of business, the Company may be subject to
warranty and product liability claims on its thermotherapy equipment. The
Company does not have a product liability insurance policy in effect. The
assertion of any product liability claim against the Company, therefore, may
have an adverse affect on its financial condition. As of September 30, 1997, no
liability claims against the Company have been asserted.
13
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the security holders during the
calendar year ending 1996.
PART II
-------
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
The Company's Common Stock is traded on the over-the-counter market.
The quotations set forth below reflect inter-dealer prices, do not include
retail markups, markdowns or commissions, and may not necessarily represent
actual transactions. There were approximately 1,207 holders of record of the
Common Stock as of December 8, 1997. The Company has never paid cash dividends
on its stock and does not expect to pay any cash dividends in the foreseeable
future.
September 30
------------
Period 1996 1997
- ------ ---- ----
High Low High Low
---- --- ---- ---
1st Quarter (Oct. 1 to Dec. 31) 17/32 1/2 1-1/8 11/16
2nd Quarter (Jan. 1 to March 31) 5/8 25/64 13/16 9/16
3rd Quarter (April 1 to June 30) 1-1/16 17/64 15/16 15/32
4th Quarter (July 1 to Sept. 30) 1-9/32 21/32 1-1/8 5/8
Issuance of Shares Without Registration
During the fourth quarter of the fiscal year ended September 30, 1997,
the Company issued the following securities without registration under the
Securities Act of 1933:
1. During the quarter, the Company issued 517,342 shares to seven
persons upon conversion of previously outstanding convertible notes totalling
$212,110.22. The issuance was made to a limited number of accredited investors
upon conversion of previously outstanding convertible securities. Stearns
Management Company was one of the investors. No commissions were paid with
respect to the conversions. The Company believes the issuance was exempt from
registration under the Securities Act pursuant to Sections 3(a)(9), 4(2) or 4(6)
of the Securities Act and Regulation D promulgated thereunder.
2. During the quarter, the Company issued 248,294 shares to nine
persons in satisfaction of previously outstanding debt totalling $124,147. The
issuance was made to a limited number of accredited investors. Mr. Soule and
Herbst, Lazar, Bell were two of investors. No commissions were paid with respect
to the conversions. The Company believes the issuance was exempt from
registration under the Securities Act pursuant to Sections 4(2) or 4(6) of the
Securities Act and Regulation D promulgated thereunder.
3. During the quarter, the Company issued 1,166,000 shares to thirty
accredited investors for cash consideration totalling $583,000. The issuance was
made to a limited number of accredited investors. No commissions were paid with
respect to the issuance, but finders fees of $3,600 were paid to persons who
introduced the Company to certain investors. The Company believes the issuance
14
was exempt from registration under the Securities Act pursuant to Section 4(2)
or 4(6) of the Securities Act and Regulation D promulgated thereunder.
4. During the quarter, the Company issued 10,534 shares to its current
and certain past directors as directors fees. Such shares were valued at a total
of $11,192. Such fees include payment for attendance at meetings prior to the
current quarter. The issuance was made to a limited number of accredited
investors. No commissions were paid with respect to the conversions. The Company
believes the issuance was exempt from registration under the Securities Act
pursuant to Sections 4(2) or 4(6) of the Securities Act.
(Remainder of page intentionally left blank)
15
ITEM 6. SELECTED FINANCIAL DATA
The following table summarizes certain financial data for the Company for the
years ended September 30, 1997, 1996, 1995, 1994 and 1993 and is qualified in
its entirety by, and should be read in conjunction with the Financial
Statements, the related Notes thereto and "Management's Discussion and Analysis
of Financial Condition and Results of Operations" included elsewhere in this
report.
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
Statement of Operations Data:
Revenues:
Product Sales (Net) $1,811,774 $1,025,651 $157,618 $74,006 $121,257
Research and development contracts 40,377 60,742 0 0 0
------- ------- ------- ------- -------
Total revenues $1,852,151 $1,086,393 $157,618 $74,006 $121,257
Cost of product sales 694,150 494,946 67,350 64,406 46,734
--------- --------- ------- ------ -------
Gross profit on product sales 1,158,001 591,447 90,268 9,600 74,523
Other costs and expenses:
Research and development 186,916 202,569 18,546 94,012 185,974
Selling, general and administrative 739,595 704,295 1,386,854 1,321,361 2,283,245
Total operating expenses 926,511 906,864 1,405,400 1,415,373 2,469,219
Profit(Loss) from operations 231,490 (315,417) (1,315,132) (1,405,773) (2,394,696)
Other income (expense) (7,244) 170,997 8,620 (442,192) (1) (471,631) (2)
Interest income (expense) (236,847) (184,700) (90,805) (85,506) (185,562)
Extraordinary Item - Gain on forgiveness
of debt 591,728
Net income (loss) (12,601) 390,880 (1,397,317) (1,933,471) (3,051,889)
Net loss per share ($.00) $.02 ($.06) ($0.05) ($0.11)
Weighted average shares outstanding 15,608,490 16,712,978 23,466,070 39,499,650 28,386,145
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
Balance Sheet Data:
Working Capital (2,434,832) (748,193) (1,101,136) (646,754) (2,645,908)
Total Assets 998,403 955,456 9,710,742 9,321,600 (3) 823,209
Long-term debt, less current maturities 26,000 2,000 1,213,000 ---
Redeemable Convertible Preferred Stock
Accumulated deficit (9,271,725) (8,880,845) (10,278,162) (12,211,633) (15,263,522)
Total stockholders' equity (deficit) (2,346,021) (666,542) 8,128,768 6,755,874 (3) (2,460,646)
(1) Includes $17,009 gain on disposition of investment in Ardex Equipment,
L.L.C.
(2) Includes $438,803 loss on write off of Ardex Notes Receivable.
(3) On October 23, 1996, the Company, based on the provisions of an agreement
reached on June 6, 1996, as amended, redeemed 16,000,000 shares of its Common
Stock. The redemption provided for the Company to return its investment in
Aestar Fine Chemical Company (valued at $8,000,000 on the Company's September
30, 1996 balance sheet) and to relinquish its rights to the funds held under an
investment contract ($40,000 at September 30, 1996) in order to affect the
transaction. This transaction has a significant impact on the financial
position, current ratios and stockholder's equity of the Company. If the
foregoing transaction had occurred on or before September 30, 1996, total assets
would have been reduced by $8,040,000 and stockholder's equity would have
reduced by $8,040,000, resulting in a negative stockholder's equity of
($1,284,126).
16
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Forward-Looking Statements
Statements regarding the Company's expectations as to the effectiveness
of its technology, demand for its products and certain other information
presented in this Form 10-K constitute forward looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995. Although the
Company believes that its expectations are based on reasonable assumptions
within the bounds of its knowledge of its business and operations, there can be
no assurance that actual results will not differ materially from its
expectations. Factors which could cause actual results to differ from
expectations include, but are not limited to the following:
1. Decreasing Sales, Increasing Losses and Undercapitalization. The Company's
product sales have been substantially decreasing over the past three years.
There is no assurance sales will increase with the application of new
technologies being developed by the Company. The Company has had increasing
losses which have resulted in an accumulated deficit of $15,263,522 for the
period ending September 30, 1997. Losses will continue until current and future
sales increase substantially. The Company lacks adequate capital to finance its
research and development and marketing. Lack of adequate capital and
governmental regulatory approvals will effect future sales.
2. Acceptance of Products. Hyperthermia has not been widely accepted by the
medical community as an effective cancer treatment. Although the Company
believes that this is primarily due to the inability to adequately focus heat
prior to introduction of the Company's APA technology. The medical community may
not embrace the advantages of APA-focused hyperthermia without more extensive
testing and clinical experience than the Company could afford to conduct. It is
also possible that the technology will not be as effective in practice as theory
and testing have indicated. Similarly, the medical community has no experience
with balloon catheter treatment for BPH.
2. Limited Products. The Company currently has a limited number of products.
Failure to develop new products utilizing current products and newly acquired
technology will effect the profitability of the Company. The development of new
products and application of new technology to existing products is subject to
uncertainty and delay.
3. Lack of a Proven Marketing Plan. The Company intends to market its new
products by concentrating on per-use revenue. Such plan is dependant on market
acceptance and adequate capitalization.
General
Since inception, the Company has incurred substantial operating losses,
principally from expenses associated with the Company's research and development
programs, the clinical trials conducted in connection with the Company's
thermotherapy system and PMA application for submission to the FDA. The Company
has experienced significant operating losses and as of September 30, 1997 had an
accumulated deficit of $15,263,522. The Company expects such operating losses to
continue and possibly increase in the near term and for the foreseeable future
as it continues its product development efforts, expands its marketing and sales
activities and scales up its manufacturing operations. The Company's ability to
achieve profitability is dependent upon its ability to successfully obtain
governmental approvals, manufacture, market and sell its new technology and
integrate such technology into its thermotherapy systems. The Company has not
17
been able to successfully market its current thermotherapy system. There can be
no assurance that the Company will be able to successfully commercialize its
newly acquired technology and apply it to its current thermotherapy systems or
that profitability will ever be achieved. The operating results of the Company
have fluctuated significantly in the past on an annual and a quarterly basis.
The Company expects that its operating results will fluctuate significantly from
quarter to quarter in the future and will depend on a number of factors, many of
which are outside the Company's control.
The major obstacles facing the Company over the last several years have
been inadequate funding, a negative net worth, and the slow development of the
thermotherapy market as a sizeable market due to technical shortcomings of the
thermotherapy equipment available commercially.
The Company has refocused the Company's efforts on the enhancement of
current products through the development of new technology and sale of the
thermotherapy products as the Company's core business. The Company is currently
focused on the enhancement of its thermotherapy equipment and obtaining
governmental approvals. Towards this end the Company has licensed the APA
technology and the MMTC technology.
The Company anticipates that its results of operations will be affected
for the foreseeable future by a number of factors, including its ability to
develop the new technology to enhance its current systems, regulatory matters,
health care cost reimbursements, clinical studies and market acceptance.
Results of Operations
Comparison of Fiscal Year Ended September 30, 1997 to Fiscal Year Ended
September 30, 1996
Product sales for the fiscal year ended September 30, 1997 ("fiscal
1997") were $121,257. During the prior fiscal year, gross product sales were
$134,006, but net product sales after returns and allowances were $74,006.
Increased sales of products are not expected until products incorporating the
new technologies are developed and approved for sale by governmental regulatory
agencies. Furthermore, with respect to the APA-focused hyperthermia machines,
the Company believes it must complete clinical studies to satisfy potential
users.
Cost of sales decreased to $46,734 in fiscal 1997 from $64,406 in
fiscal 1996. This reflects the decrease in gross sales. The Company does not
believe that fluctuations in gross margin are meaningful at the current low
level of sales.
Research and development expense increased to $185,974 in fiscal 1997
from $94,012 in fiscal 1996. The Company expects to significantly increase its
expenditures for research and development to fund the development or enhancement
of products by incorporating the APA technology and the MMTC technology.
Selling, general and administrative expenses increased to $2,283,245 in
fiscal 1997 from $1,321,361 in fiscal 1996. Increased administrative expenses
reflect strengthening of the Company's management team and the resulting
increased salary levels. These expenses also reflect the increased use of
outside consultants and advisers to assist the Company in formulating its plans
to utilize its new technologies. The Company expects selling and marketing
expense to increase substantially as it expands its advertising and promotional
activities and increases its marketing and sales force, principally for the
commercialization of its thermotherapy systems.
18
During fiscal 1997, the Company wrote off as uncollectible the notes
receivable related to Ardex Equipment, LLC. As part of the Gao settlement, the
Company also lost the funds held under an investment contract. Together these
two items resulted in $478,803 of non-operating expense in fiscal 1997.
Interest expense increased to $185,562 in fiscal 1997 from $85,506 in
fiscal 1996. This primarily reflects an increase in short term debt incurred to
finance the Company's operations. See "Liquidity and Capital Resources" below.
Comparison of Fiscal Year Ended September 30, 1996 to Fiscal Year Ended
September 30, 1995
Net product sales decreased to $74,006 in fiscal 1996 from $157,618 in
fiscal 1995. The decrease was due, primarily, to decreased emphasis on sales of
Microfocus products as the Company sought other business opportunities. With the
renewed focus on the development and sale of the Microfocus products, the
Company anticipates that sales of its thermotherapy systems will account for all
sales in the foreseeable future. The Company will focus on developing its new
products. Increased sales of products are not expected until the new
technologies are developed and approved for sale by governmental regulatory
agencies.
Cost of product sales decreased to $64,406 in fiscal 1996 from $67,350
in fiscal 1995 due to decreased sales volume.
Research and development expense increased to $94,012 in fiscal 1996
from $18,546 in fiscal 1995.
Selling, general and administrative expenses decreased in amount to
$1,321,361 in fiscal 1996 from $1,386,854 in fiscal 1995. The Company expects
selling and marketing expense to increase substantially as it expands its
advertising and promotional activities and increases its marketing and sales
force, principally for the commercialization of its thermotherapy systems.
Interest expense decreased to $85,506 in fiscal 1996 from $90,805 in
fiscal 1995.
Liquidity and Capital Resources
Since inception, the Company's expenses have significantly exceeded its
revenues, resulting in an accumulated deficit of $15,263,522 at September 30,
1997. The Company has funded its operations primarily through the sale of equity
securities. At September 30, 1997, the Company had cash, cash equivalents and
short-term investments aggregating approximately $267,353. Current liabilities
on such date were $3,283,855. Net cash used in the Company's operating
activities was $1,154,751 for fiscal 1997.
The Company does not have any bank financing arrangements. The
Company's indebtedness consists of two notes payable to Dr. Augustine Cheung
with a total face amount of $121,419; a note payable to Yu Shai Lai in the
amount of $36,041; a note payable to Ada Lam in the amount of $28,502; a note
payable to Lake Shu Loon in the amount of $10,000; an oral agreement to pay
Charles Shelton an amount currently estimated between $35,000 and $50,000; and
trade debt totaling $197,190. In addition, commencing on July 10, 1996, the
Company sold $1,505,000 in senior secured convertible notes accruing interest at
8 percent per annum (the "Senior Notes"). At September 30, 1997, $1,169,800 of
the Senior Notes were outstanding. The Senior Notes have priority over payment
of any other indebtedness of the Company. The holders of the Senior Notes can
19
elect to either convert the notes into Common Stock at an option price of $0.41
per share or be paid principal and interest upon the earlier to occur of (i) the
next private offering; or (ii) December 31, 1997. In May, 1997 the Company
issued a $220,000 Secured Promissory Note to a trust. The note is secured by
certain equipment and is due by its terms on December 15, 1997. At September 30,
1997, $200,000 of the principal of the note was outstanding. The holder of the
note has verbally agreed to convert $100,000 of the principal into the Company's
common stock and an additional $50,000 of principal has been repaid in cash. The
remaining principal balance of $50,000 was not paid on December 15, 1997. The
holder's remedies for non-payment include foreclosing on the collateral,
increasing the interest rate to 17% per annum or converting the balance into
common stock having a market value of 200% of the note balance.
The Company has incurred negative cash flows from operations since its
inception, and has expended, and expects to continue to expend in the future,
substantial funds to complete its planned product development efforts, including
seeking FDA approval for the domestic sale of the Company's products, expand its
sales and marketing activities and scale up its manufacturing. The Company
expects that its existing capital resources will not be adequate to fund the
Company's operations through the next twelve months. The Company is dependent on
raising additional capital to fund its development of technology and to
implement a marketing plan. Such dependence will continue at least until the
Company begins marketing its new technologies. The Company's future capital
requirements and the adequacy of its financing depend upon numerous factors,
including the successful commercialization of the thermotherapy systems progress
in its product development efforts, the magnitude and scope of such efforts,
progress with preclinical studies and clinical trials, the cost and timing of
manufacturing scale-up, the development of effective sales and marketing
activities, the cost of filing, prosecuting, defending and enforcing patent
claims and other intellectual property rights, competing technological and
market developments, and the development of strategic alliances for the
marketing of its products. To the extent that funds generated from the Company's
operations are insufficient to meet current or planned operating requirements,
the Company will be required to obtain additional funds through equity or debt
financing, strategic alliances with corporate partners and others, or through
other sources. The Company does not have any committed sources of additional
financing, and there can be no assurance that additional funding, if necessary,
will be available on acceptable terms, if at all. If adequate funds are not
available, the Company may be required to delay, scale-back or eliminate certain
aspects of its operations or attempt to obtain funds through arrangements with
collaborative partners or others that may require the Company to relinquish
rights to certain of its technologies, product candidates, products or potential
markets. If adequate funds are not available, the Company's business, financial
condition and results of operations will be materially and adversely effected.
The Company intends to spend over $1,000,000, subject to availability
of funding, with various educational and research institutions for research and
development in fiscal 1998. The Company is also required to pay HLB certain
engineering fees, the amount of which are presently unknown. The Company is also
required to do clinical trials to prepare for submission of products to the FDA.
The amount required to perform such trials and to prosecute the applications in
not currently known, but is expected to run in the millions of dollars. The
Company does not currently have funds available to do such trials and clinical
work. The Company has committed to pay advisors and officers pursuant to
contractual arrangements set forth in "Directors and Executive Officers of the
Registrant" and "Certain Relationships and Related Transactions." The Company
will be dependent on additional capital to be raised to fulfill all of the above
agreements and obligations.
During fiscal year 1997, the Company issued a large number of shares in
connection with its funding activities. Options or warrants to officers,
directors, related parties and five percent (5%) shareholders are addressed in
Part III of this Form 10-K. In addition to those options and warrants, the
Company has issued options and warrants in connection with funding activities to
20
purchase a total of 4,670,715 shares of Common Stock, with exercise prices
ranging from $.25 per share to $.41 per share. Some of the warrants issued have
anti-dilution provisions which may affect the total number of shares available
for purchase under the warrants.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements, supplementary data and report of independent
public accountants are filed as part of this report on pages F-1 through F-15.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
No change of accountants and/or disagreements on any matter of
accounting principles or financial statement disclosures have occurred within
the last two years.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Incorporated by reference to Registrant's definitive proxy statement.
ITEM 11. EXECUTIVE COMPENSATION
Incorporated by reference to Registrant's definitive proxy statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Incorporated by reference to Registrant's definitive proxy statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Incorporated by reference to Registrant's definitive proxy statement.
(Remainder of page intentionally left blank)
21
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND
REPORTS ON FORM 8-K
(a)(1) Index to Financial Statements and Supplemental Schedules
Title of Documents Page No.
- ------------------ --------
Independent Auditors' Report F-1
Balance Sheet F-2
Statements of Operations F-4
Statements of Changes in Stockholders' Equity F-5
Statements of Cash Flows F-6
Notes to Financial Statements F-8
(a)(2) No schedules are provided because of the absence of conditions under
which they are required.
(b) Reports on Form 8-K.
The following reports on Form 8-K were filed by the Company during the last
quarter of the period covered by this report.
The Company filed a report on Form 8-K dated September 26, 1997
announcing the grant of PMA Supplement approval to allow use of the APA
technology in connection with its Microfocus 1000 product and to announce the
appointment of Dr. Max Link to the board of directors.
The Company filed no other reports on Form 8-K during the fourth
quarter of its fiscal year ended September 30, 1997.
(c) Exhibits.
The following documents are included as exhibits to this report:
Exhibit
Number Description
------ -----------
3.1 Articles of Incorporation of the Company as filed May 19,
1982 with the State of Maryland Department of Assignments
and Taxation.(1)
3.1.1 Articles of Amendment and Restatement to the Articles of
Incorporation of the Company as filed June 21, 1984 with
the State of Maryland Department of Assignments and
Taxation.*
3.1.2 Articles of Amendment to the Articles of Incorporation of
the Company as filed December 14, 1994 with the State of
Maryland Department of Assignments and Taxation.*
22
3.2 By-laws*
3.2.1 Amendment to the By-laws of the Company adopted December
9, 1994.*
9.1 Irrevocable Proxy between Augustine Y. Cheung, as
representative of the Company, and Gao Yu Wen regarding
20,000,000 shares of Common Stock dated June 6, 1996
(pursuant to the Redemption Agreement, the number of
shares governed by the proxy has been reduced to
4,000,000)*
10.1 Patent License Agreement between the Company and
Massachusetts Institute of Technology dated June 1, 1996
(Confidential Treatment Requested)*
10.2 License Agreement between the Company and MMTC, Inc. dated
August 23, 1996 (Confidential Treatment Requested)*
10.3 Letter Agreement between the Company and H.B.C.I., Inc.,
dated September 17, 1996*
10.4 Letter Agreement between the Company and Herbst, Lazar,
Bell, Inc. dated October 4, 1996*
10.5 Agreement between the Company and Stearns Management
Company dated May 28, 1996*
10.6 Consulting Agreement between the Company and NACE
Resources, Inc. dated August 1, 1996*
10.7 Settlement Agreement between the Company and William O.
Cave, dated October 28, 1996*
10.8 Redemption Agreement between the Company and Mr. Sun Shou
Y. representative of Mr. Gao Yu Wen dated June 6, 1996 and
Letter of Intent between the parties dated May 27, 1996*
10.9 Amendment among the Company, Sun Shau Yi, Ou Yang An, Gao
Yu Wen, dated October 23, 1996*
10.10 Binding Letter of Intent Concerning Rescission of Cheung
Laboratories, Inc. Investment in Ardex Equipment, LLC
between the Company and Ardex dated August 2, 1996*
10.11 Letter Agreement between the Company and New
Opportunities, Ltd., an affiliate of Verle D. Blaha,
dated August 15, 1996*
10.12 Unsecured Promissory Note, dated June 30, 1994, in the
amount of $42,669 and bearing interest at ten percent per
annum, payable to Augustine Cheung*
10.13 Unsecured Promissory Note, dated January 26, 1987, in the
amount of $78,750 and bearing interest at the rate of
twelve percent, payable to Augustine Cheung*
10.14 Demand Promissory Note, dated October 2, 1990, in the
amount of $28,502 and bearing interest at the rate of
twelve percent, payable to Ada Lam*
10.15 8% Senior Secured Convertible Note*
10.16 Registration Rights Agreement*
10.17 Warrant to Purchase Shares of Common Stock of Cheung
Laboratories, Inc.*
10.18 Certificate of Warrant to Purchase Common Stock of Cheung
Laboratories, Inc. dated June 1, 1996*
10.19 Certificate of Warrant to Purchase Common Stock of Cheung
Laboratories, Inc. dated May 28, 1996*
21.1 Subsidiaries of the Registrant*
23
23.1 Consent of Stegman & Company, independent public
accountants of the Company**
27.1 Financial Data Schedule**
- ------------------
* Pursuant to Rule 12b-32, this exhibit is incorporated herein by reference to
the exhibits filed with respect to the Company's Annual Report on Form 10-K
for the year ended September 30, 1996.
** Filed herewith
(1) Pursuant to Rule 12b-32, this exhibit is incorporated herein by reference
to the exhibits filed with respect to the Company's Registration Statement
on Form S-1, as amended, originally filed on October 17, 1984,
Registration No. 2-93826-W.
(Remainder of page intentionally left blank)
24
CHEUNG LABORATORIES, INC.
REPORT ON AUDITS OF FINANCIAL STATEMENTS
FOR THE YEARS ENDED
SEPTEMBER 30, 1997, 1996 AND 1995
No extract from this report may be published without our written consent
Stegman & Company
TABLE OF CONTENTS
INDEPENDENT AUDITORS' REPORT
FINANCIAL STATEMENTS Page
----
Balance Sheets 1 - 2
Statements of Operations 3
Statements of Changes in Stockholders' Equity 4
Statements of Cash Flows 5 - 6
NOTES TO FINANCIAL STATEMENTS 7 - 15
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders
Cheung Laboratories, Inc.
Columbia, Maryland
We have audited the accompanying balance sheets of Cheung
Laboratories, Inc., as of September 30, 1997 and 1996, and the related
statements of operations, changes in stockholders' equity, and cash flows for
each of the three years in the period ended September 30, 1997. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted
auditing standards. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above
present fairly, in all material respects, the financial position of Cheung
Laboratories, Inc., as of September 30, 1997 and 1996, and the results of its
operations and its cash flows for each of the three years in the period ended
September 30, 1997 in conformity with generally accepted accounting principles.
The accompanying financial statements have been prepared
assuming that the Company will continue as a going concern. As discussed in Note
2 of the financial statements, the Company has suffered recurring losses from
operations, which raise substantial doubt about its ability to continue as a
going concern. Management's plans regarding those matters are also described in
Note 2. The financial statements do not include any adjustments that might
result from the outcome of this uncertainty.
Towson, Maryland
December 10, 1997
CHEUNG LABORATORIES, INC.
BALANCE SHEETS
SEPTEMBER 30, 1997 AND 1996
ASSETS
1997 1996
---------- ----------
CURRENT ASSETS:
Cash $ 267,353 $ 246,931
Accounts receivable (net of an allowance for
doubtful accounts of $-0- and $20,770 in
1997 and 1996, respectively) 5,891 154,335
Accrued interest receivable - related parties -- 5,333
Inventories 329,741 270,952
Prepaid expenses 8,207 1,669
Other current assets 26,755 26,755
Total current assets 637,947 705,975
---------- ----------
PROPERTY AND EQUIPMENT - at cost:
Furniture and office equipment 180,348 176,541
Laboratory and shop equipment 92,228 62,228
---------- ----------
272,576 238,769
Less accumulated depreciation 213,885 205,766
---------- ----------
Net value of property and equipment 58,691 33,003
---------- ----------
OTHER ASSETS:
Investment in Aestar Fine Chemical Company - at cost -- 8,000,000
Funds held under investment contract -- 40,000
Notes receivable - Ardex Equipment, L.L.C. and
related individuals -- 400,000
Patent licenses (net of accumulated amortization
of $53,379 and $37,328 in 1997 and 1996,
respectively) 126,571 142,622
---------- ----------
Total other assets 126,571 8,582,622
---------- ----------
TOTAL ASSETS $ 823,209 $9,321,600
========== ==========
See accompanying notes.
1
LIABILITIES AND STOCKHOLDERS' EQUITY
1997 1996
------------- -------------
CURRENT LIABILITIES:
Accounts payable - trade $ 614,173 $ 197,190
Notes payable - other 1,369,800 --
Notes payable - related parties 221,943 331,712
Accrued interest payable - related parties 245,784 339,660
Accrued interest payable - other 116,604 8,417
Accrued compensation 331,715 186,459
Accrued professional fees 256,301 76,352
Other accrued liabilities 15,504 100,905
Deferred revenues 112,031 112,031
------------ ------------
Total current liabilities 3,283,855 1,352,726
------------ ------------
LONG-TERM LIABILITIES:
Note payable - related party, due after one year -- 8,000
Notes payable - other -- 1,205,000
------------ ------------
Total long-term liabilities -- 1,213,000
------------ ------------
Total liabilities 3,283,855 2,565,726
------------ ------------
STOCKHOLDERS' EQUITY:
Capital stock - $.01 par value; 51,000,000 shares
authorized, 29,095,333 and 41,206,360 issued and
outstanding for 1997 and 1996, respectively 290,953 412,063
Additional paid-in capital1 2,511,923 18,555,444
Accumulated deficit (15,263,522) (12,211,633)
------------ ------------
Total stockholders' (deficit) equity (2,460,646) 6,755,874
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS'
EQUITY $ 823,209 $ 9,321,60
============ ============
2
CHEUNG LABORATORIES, INC.
STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED SEPTEMBER 30, 1997, 1996 AND 1995
1997 1996 1995
----------- ----------- -----------
REVENUES:
Hyperthermia sales and parts $ 121,257 $ 134,006 $ 157,618
Returns and allowances -- (60,000) --
------------ ------------ ------------
Total revenues 121,257 74,006 157,618
COST OF SALES 46,734 64,406 67,350
------------ ------------ ------------
GROSS PROFIT 74,523 9,600 90,268
------------ ------------ ------------
OPERATING EXPENSES:
Selling, general and administrative 2,283,245 1,321,361 1,386,854
Research and development 185,974 94,012 18,546
------------ ------------ ------------
Total operating expenses 2,469,219 1,415,373 1,405,400
------------ ------------ ------------
LOSS FROM OPERATIONS (2,394,696) (1,405,773) (1,315,132)
COSTS INCURRED IN DEVELOPMENT OF
COSMETICS DIVISION -- (471,000) --
LOSS ON FUNDS HELD IN INVESTMENT
CONTRACT (40,000) -- --
LOSS ON WRITE-OFF OF ARDEX EQUIPMENT,
L.L.C. NOTES RECEIVABLE AND RELATED
ACCRUED INTEREST RECEIVABLE (438,803) -- --
OTHER INCOME 7,172 28,808 8,620
INTEREST EXPENSE (185,562) (85,506) (90,805)
------------ ------------ ------------
LOSS BEFORE INCOME TAXES (3,051,889) (1,933,471) (1,397,317)
INCOME TAXES -- -- --
------------ ------------ ------------
NET LOSS $ (3,051,889) $ (1,933,471) $ (1,397,317)
============ ============ ============
LOSS PER COMMON SHARE $ (.11) $ (.05) $ (.06)
============ ============ ============
WEIGHTED AVERAGE SHARES
OUTSTANDING 28,386,145 39,499,650 23,466,070
============ ============ ============
See accompanying notes.
3
CHEUNG LABORATORIES, INC.
STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED SEPTEMBER 30, 1997, 1996 AND 1995
Common Stock Additional
------------ Paid-In
Shares Amount Capital Deficit Total
------ ------ ------- ------- -----
Balances at October 1, 1994 18,623,651 $ 186,236 $ 8,028,067 $ (8,880,845) $ (666,542)
Sale of common stock 20,003,000 200,030 9,801,470 -- 10,001,500
Issuance of 581,013 shares of
common stock as payment of
indebtedness and expenses 581,013 5,810 185,317 -- 191,127
Net loss -- -- -- (1,397,317) (1,397,317)
----------- ------------ ------------ ------------ ------------
Balances at September 30, 1995 39,207,664 392,076 18,014,854 (10,278,162) 8,128,768
Sale of common stock 1,299,711 12,997 406,513 -- 419,510
Issuance of 698,985 shares of
common stock as payment of
indebtedness and expenses 698,985 6,990 134,077 -- 141,067
Net loss -- -- -- (1,933,471) (1,933,471)
----------- ------------ ------------ ------------ ------------
Balances at September 30, 1996 41,206,360 412,063 18,555,444 (12,211,633) 6,755,874
Sale of common stock 1,409,902 14,099 668,901 -- 683,000
Issuance of 2,479,071 shares
of common stock as payment
of indebtedness and expenses 2,479,071 24,791 1,127,578 -- 1,152,369
Retirement of shares (16,000,000) (160,000) (7,840,000) -- (8,000,000)
Net loss -- -- -- (3,051,889) (3,051,889)
----------- ------------ ------------ ------------ ------------
Balances at September 30, 1997 29,095,333 $ 290,953 $ 12,511,923 $(15,263,522) $ (2,460,646)
=========== ============ ============ ============ ============
See accompanying notes.
4
CHEUNG LABORATORIES, INC.
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED SEPTEMBER 30, 1997, 1996 AND 1995
1997 1996 1995
------------ ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(3,051,889) $(1,933,471) $(1,397,317)
Noncash items included in net loss:
Funds held under investment contract used
for cosmetic division expenses 40,000 471,000 --
Depreciation and amortization 24,169 18,545 13,922
Bad debt expense 120,865 51,397 180,539
Gain on disposition of investment in Ardex
Equipment, L.L.C -- (17,009) --
Equity in loss of Ardex Equipment, L.L.C -- -- 17,009
Write-off of Ardex Equipment - note receivable
and accrued interest 438,803 -- --
Common stock issued for operating expenses 297,542 9,000 108,926
Net changes in:
Accounts receivable (2,421) (68,631) 208,680
Inventories (58,789) 45,327 (80,478)
Accrued interest receivable - related parties (33,470) (5,333) --
Prepaid expenses (6,538) 6,000 (5,875)
Other current assets- (1,204) (25,551)
Accounts payable and accrued interest payable 837,172 25,445 59,025
Accrued compensation1 45,256 (166,039) 51,423
Accrued professional fees1 79,950 74,852 (174,606)
Other accrued liabilities (85,401) 31,033 24,803
Deferred revenues -- (3,500) 105,531
----------- ----------- -----------
Net cash used in operating activities (1,154,751) (1,462,588) (913,969)
----------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Rescission of investment in Ardex Equipment, L.L.C -- 100,000 --
Purchases of patent licenses -- (100,000) --
Investment in Ardex Equipment, L.L.C -- -- (500,000)
Purchase of property and equipment (3,807) (10,256) (5,183)
Funds invested - investment contract -- -- (700,000)
Funds returned - investment contract -- 139,000 50,000
----------- ----------- -----------
Net cash (used) provided by investing activities (3,807) 128,744 (1,155,183)
----------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from notes payable 615,000 1,205,000 --
Payment on notes payable - related parties (24,020) (48,973) --
Payment on notes payable - other (95,000) (2,000) (24,000)
Proceeds of stock issuances 683,000 419,510 2,001,500
----------- ----------- -----------
Net cash provided by financing activities 1,178,980 1,573,537 1,977,500
----------- ----------- -----------
NET INCREASE (DECREASE) IN CASH 20,422 239,693 (91,652)
CASH AT BEGINNING OF YEAR 246,931 7,238 98,890
----------- ----------- -----------
CASH AT END OF YEAR$ 267,353 $ 246,931 $ 7,238
=========== =========== ===========
5
Cheung Laboratories, Inc.
Statements of Cash Flows (Continued)
For the Years Ended September 30, 1997, 1996 and 1995
1997 1996 1995
---------- --------- --------
Acquisition and rescission of a 9.5% interest
in the Aestar Fine Chemical Company in
exchange for 16,000,000 shares of
common stock $ (8,000,000) $ -- $ 8,000,000
============ =========== ===========
Schedule of noncash investing and financing transactions:
Conversion of accounts payable, debt and accrued
interest payable through issuance of common stock $ 854,826 $ 132,067 $ 82,200
============ =========== ===========
Equipment repossessed for internal use $ 30,000 $ -- $ --
============ =========== ===========
Schedule of noncash investing and financing activities:
Proceeds of notes payable:
Increase in notes payable $ -- $ -- $ 25,223
Offset of accounts payable -- -- (25,223)
------------ ----------- -----------
Net cash received $ -- $ -- $ --
============ =========== ===========
Payment on notes payable:
Decrease in notes payable $ -- $ 25,223 $ 24,000
Offset of accounts receivable -- (25,223) --
------------ ----------- -----------
Net cash paid $ -- $ -- $ 24,000
============ =========== ===========
Rescission of investment in Ardex Equipment,
L.L.C. in exchange for notes receivable $ -- $ 400,000 $ --
============ =========== ===========
Cash paid during the year for:
Interest $ -- $ 45,000 $ 47,079
============ =========== ===========
Income taxes $ -- $ -- $ --
============ =========== ===========
See accompanying notes.
6
CHEUNG LABORATORIES, INC.
NOTES TO FINANCIAL STATEMENTS
FOR THE YEARS ENDED SEPTEMBER 30, 1997, 1996 AND 1995
1. DESCRIPTION OF BUSINESS
Cheung Laboratories, Inc. (the "Company") is in the business of
providing hyperthermia products for medical applications. The Company markets
its products internationally and was classified as a development stage company
until October 1, 1989.
2. GOING CONCERN UNCERTAINTY
The accompanying financial statements have been prepared in
conformity with generally accepted accounting principles, which contemplates
continuation of the Company as a going concern. However, the Company has
sustained substantial operating losses in recent years. In addition, the Company
has used substantial amounts of working capital in its operations. Further, at
September 30, 1997, current liabilities exceed current assets by $2,645,908. In
view of these matters, realization of a major portion of the assets in the
accompanying balance sheet is dependent upon continued operations of the
Company, which in turn is dependent upon the Company's ability to meet its
financing requirements and the success of its future operations.
During 1997 and 1996, in an attempt to focus its resources on its
core business, the Company rescinded its investments in two unrelated ventures,
respectively. Despite these efforts, working capital deficits continue as the
majority of cash funds raised during 1997 was in the form of issuance of capital
stock and debt financing through private placement.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates
----------------
The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Net Loss Per Common Share
-------------------------
Net loss per common share was computed by dividing net loss by
the weighted average number of shares of common stock outstanding during each
period. The impact of common stock equivalents has been excluded from the
computation of weighted average common shares outstanding because the effect
would be antidilutive.
7
Inventories
-----------
Inventories are stated at the lower of cost or market. Cost is
determined using the average cost method.
Property and Equipment
----------------------
Property and equipment is stated at cost. Depreciation is
provided over the estimated useful lives of the related assets of five years.
Major renewals and betterments are capitalized at cost and ordinary repairs and
maintenance are charged against operations as incurred.
Financial Instruments
---------------------
For most financial instruments, including cash, accounts payable
and accruals, management believes that the carrying amount approximates fair
value, as the majority of these instruments are short-term in nature.
Investments - at Equity
-----------------------
Investments in which the Company has a 20% to 50% interest or
otherwise exercises significant influence are carried at cost, adjusted for the
Company's proportionate share of their undistributed earnings or losses.
Otherwise, investments are carried at cost and dividend income is recognized as
earned in other income.
Patent Licenses
---------------
The Company has purchased several licenses to use the rights to
patented technologies. Patent licenses are amortized straight-line over the
remaining patent life.
Revenue Recognition
-------------------
Revenue is recognized when systems, products or components are
shipped and when consulting services are rendered. Deferred revenue includes
customer deposits received on contingent sale agreements.
Research and Development
------------------------
Research and development costs are expensed as incurred.
Equipment and facilities acquired for research and development activities which
have alternative future uses are capitalized and charged to expense over their
estimated useful lives.
8
Accounting for Stock Based Compensation
---------------------------------------
In October 1995, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 123, Accounting for Stock Based
Compensation (SFAS No. 123), which is effective for the Company's year ended
September 30, 1997. SFAS No. 123 allows companies either to continue to account
for stock-based employee compensation plans under existing accounting standards
or to adopt a fair value based method of accounting as defined in the new
standard. The Company will follow the existing accounting standards for these
plans, and has provided pro forma disclosure of net income and earnings per
share as if the expense provisions of SFAS No. 123 had been adopted.
Implementation of SFAS No. 123 did not have a material impact on results of
operations or financial condition.
New Accounting Pronouncements
-----------------------------
The Company will adopt in the fiscal year ending September 30,
1998, Statement of Financial Accounting Standards No. 128 Earnings Per Share
(SFAS) No. 128), which was issued in February 1997. SFAS No. 128 requires
disclosure of basic earnings per share (EPS) and diluted EPS, which replaces the
existing primary EPS and fully diluted EPS, as defined by APB No. 15. Basic EPS
is computed by dividing net income by the weighted average number of shares of
common stock outstanding during the year. Diluted EPS is computed similar to
primary EPS as previously reported, provided that, when applying the treasury
stock method to common equivalent shares, the Company must use its average share
price for the period rather than the more dilutive greater of the average share
price or end of period share price required by APB No. 15. The Company believes
this will not have a material effect on EPS.
4. ACCOUNTS RECEIVABLE
Accounts receivable consist of the following:
1997 1996
-------- ----------
Trade receivables $4,431 $138,465
Related party receivables:
Microfocus 1,460 1,910
Ardex Equipment, L.L.C. - 34,730
Allowance for doubtful accounts - (20,770)
--------- ---------
$5,891 $154,335
====== ========
5. INVENTORIES
Inventories are comprised of the following at September 30:
1997 1996
--------- ---------
Materials $235,748 $169,752
Work-in-process 16,990 46,062
Finished products 77,003 55,138
--------- ---------
$329,741 $270,952
======== ========
9
6. RELATED PARTY TRANSACTIONS
Notes Receivable - Related Parties
Notes receivable due from related parties consist of the
following:
1997 1996
--------- --------
Term note due August 31, 2001 from Ardex
Equipment, L.L.C., accruing interest at
8% per annum. $ -- $350,000
Term note due August 31, 2001 from the
principals of Ardex Equipment, L.L.C.,
accruing interest at 8% per annum. -- 50,000
----------- ----------
$ -- $400,000
=========== ==========
The above notes receivable and related accrued interest were
written-off as uncollectible during the year ended September 30, 1997.
Notes Payable - Related Parties
Notes payable to related parties as of September 30 are comprised
of the following:
1997 1996
---------- ----------
Term note payable to an officer and stockholder of
the Company, accruing interest at 10% per annum. $ 28,650 $ 42,669
Term notes payable to an officer and stockholder of
the Company, accruing interest at 12% per annum. 68,750 78,750
Demand note payable to relative of an officer and
stockholder of the Company, accruing interest at
12% per annum. 36,041 36,041
Demand note payable to related party of remainder
of funds borrowed for discontinued project, note
bears interest at 12% per annum. 28,50228,502
Term notes payable to interested parties of the
Company accruing interest at 12% per annum. 10,000 103,750
Term note payable to stockholder of the Company
accruing interest at 10% per annum payable in
monthly payments of $2,000 for 25 months. The
note is secured by all accounts receivable and
general intangibles of the Company. 50,000 50,000
------ ------
221,943 339,712
Less current portion 221,943 331,712
------- -------
Long-term portion - due in 1998 $ -- $ 8,000
========= =========
10
Accrued interest payable on these notes amounted to $245,784 and
$339,660 at September 30, 1997 and 1996, respectively.
Stock Based Compensation Plan
-----------------------------
As part of the Company's employment agreement with the current
chief executive officer (CEO), the Company has granted to the CEO 1,900,000
shares of the Company's capital stock which vests in certain milestones
throughout the one-year term of employment. Ultimately all shares become fully
vested, provided that the CEO remains with the Company through the term of the
contract. The total amount charged to compensation expense for 1997 under this
plan was $280,000.
7. NOTES PAYABLE - OTHER
Notes payable - other consist of the following as of September 30:
1997 1996
----------- -----------
Senior secured convertible notes, resulting from private
placement offerings in July 1996 and June 1997,
accruing interest at 8% per annum. The notes are
secured by the Company's common stock held by
Augustine Cheung. The notes mature December 31,
1997. $1,169,800 $1,205,000
Term note with accrued interest payable each month
at 12% per annum. The note is secured by inventory
and property. The note matures December 18, 1997. 200,000 --
----------- ---------
$1,369,800 $1,205,000
========== ==========
Accrued interest payable on these notes amounted to $116,604 and
$1,262 at September 30, 1997 and 1996, respectively.
8. RETIREMENT PLAN
The Company provides a SAR-SEP savings plan to which eligible
employees may make pretax payroll contributions up to 15% of compensation. The
Company does not make contributions to the plan.
9. INVESTMENT IN AESTAR FINE CHEMICAL COMPANY - AT COST
During 1995, the Company acquired a 9.5% equity interest in Aestar
Fine Chemical Company (Aestar) in exchange for 16,000,000 shares of its common
stock. The investment was carried at cost, as measured by the $.50 per share
fair market value of the 16,000,000 shares of the Company's common stock. The
Company has subsequently rescinded this investment during the year ended
September 30, 1997.
11
10. INVESTMENT IN ARDEX EQUIPMENT, L.L.C. - AT EQUITY
The Company purchased a 19.25% equity interest in Ardex Equipment,
L.L.C. (Ardex) in 1995. The investment was carried at cost, adjusted for the
Company's proportionate share of Ardex's loss from the purchase date through
September 30, 1995. During 1996, the Company rescinded its investment in Ardex,
the effects of which are reflected in these financial statements.
11. FUNDS HELD UNDER INVESTMENT CONTRACT
During 1995, the issuance of 20,000,000 shares of common stock to
Mr. Gao Yu Wen enabled Mr. Gao to obtain a majority interest in the Company. Mr.
Gao had essentially recapitalized the Company through this investment of
$2,000,000 in cash and an $8,000,000 interest in Aestar. Pursuant to the terms
of an investment agreement between the Company and Mr. Gao, the Company had
invested surplus working capital funds in Hong Kong and China. At September 30,
1995, the Company had drawn $50,000 from the account, reducing the balance to
$650,000. The balance as of September 30, 1996 had been further reduced to
$40,000 to reflect $471,000 in costs incurred by Mr. Gao while developing a
cosmetic division in Hong Kong on behalf of the Company, per an agreement to
rescind the investment in Aestar Fine Chemical Company. During 1997, the Company
has written off the balance of this account.
12. INCOME TAXES
Income tax expense on loss before extraordinary item differs from
that computed at the federal income tax rate as follows:
1997 1996 1995
------------- ----------- -----------
Income tax (benefit) at statutory rate
(34%) $(1,037,642) $(657,380) $(475,088)
Tax benefits not recognized 1,037,642 657,380 475,088
--------- ------- -------
Income tax (benefit) expense $ -- $ -- $ --
========= ========= ==========
The tax benefit of net operating losses has been completely offset
by a valuation allowance until the Company demonstrates earnings that would
utilize the net operating loss carryforwards. At September 30, 1997, the Company
has net operating loss carryforwards approximating $14,000,000. These carryovers
expire in various amounts through the period 1998 to 2012.
13. COMMON STOCK
During the year ended September 30, 1997, the Company issued
1,409,902 shares of common stock for $683,000, 1,317,143 shares were issued to
extinguish debt, and 1,161,828 shares were issued as payment for various
operating expenses. Additionally, the Company retired 16,000,000 shares of
common stock in connection with the rescission in its investment in Aestar.
During the year ended September 30, 1996, the Company issued
1,299,711 shares of common stock for $419,510, 689,985 shares were issued to
extinguish debt, and 9,000 shares were issued as payments for various operating
expenses.
12
During the year ended September 30, 1995, the Company issued
20,000,000 shares of common stock in exchange for $2,000,000 in cash and
$8,000,000 as a 9.5% interest in the Aestar from an investor. This transaction
enabled the investor to obtain a majority interest in the Company's common
stock. Additionally, the Company issued 3,000 shares of common stock for $1,500,
360,000 shares were issued to extinguish debt, and 221,000 shares were issued as
payments for various operating expenses.
14. STOCK OPTIONS AND WARRANTS
The Company has granted stock options to certain employees on a
periodic basis at the discretion of the Board of Directors. Options are granted
at market value at the date of the grant and are immediately exercisable.
A summary of the Company's stock option activity and related
information for the years ended September 30, 1997 and 1996 is as follows:
1997 1996
------------------------- -------------------------
Weighted Weighted
Common Average Common Average
Stock Exercise Stock Exercise
Options Price Options Price
Outstanding at beginning of year 3,050,000 $ .34 630,000 $ .25
Granted 515,000 .61 2,420,000 .36
Exercised -- .00 -- .34
--------- ------------- ----------- ------------
Outstanding at end of year 3,565,000 $ .38 3,050,000 $ .34
========= ============= =========== ============
Additionally, the Company has issued warrants to purchase the
Company's stock as follows:
1997 1996
------------------------- --------------------------
Weighted Weighted
Common Average Common Average
Stock Exercise Stock Exercise
Warrants Price Warrants Price
Outstanding at beginning of year 2,218,035 $ .29 -- $ .00
Granted 1,058,783 .48 2,218,035 .2935
--------- ------------- ----------- -------------
Outstanding at end of year 3,276,818 $ .35 2,218,035 $ .2935
========= ============= =========== =============
Additionally, the Company has sold warrants to certain individuals
to purchase shares of common stock at a price based on future stock sales by the
Company.
SFAS No. 123 requires pro forma information regarding net loss and
earnings per share as if the Company has accounted for its employee stock
options and warrants granted subsequent to December 31, 1994 under the fair
value method of SFAS No. 123. The fair value of these equity awards was
13
estimated at the date of grant using a Black-Scholes option pricing model with
the following weighted average assumptions for 1997 and 1996: risk-free interest
rate of 6.5%; expected volatility of 50%; expected option life of 5 years from
vesting and an expected dividend yield of 0.0%.
The Company's pro forma information is as follows:
1997 1996
------------- -------------
Pro forma net loss $(3,476,159) $(2,708,362)
Pro forma net loss per common share (.12) (.07)
15. COMMITMENTS AND CONTINGENCIES
Potential Liability and Insurance
---------------------------------
In the normal course of business, the Company may be subject to
warranty and product liability claims on its hyperthermia equipment. Currently,
the Company does not have a product liability insurance policy in effect
although management does anticipate obtaining such coverage when adequate
financial resources are available. The assertion of any product liability claim
against the Company, therefore, may have an adverse effect on its financial
condition. As of September 30, 1996, no product, warranty claims or other
liabilities against the Company have been asserted.
Warranty Reserve
----------------
The Company warrants its hyperthermia units to be free from
defects in material and workmanship under normal use and service for the period
of one year from the date of shipment. Claims have been confined to basic
repairs. Given the one year limitation of the warranty, management has elected
to not set up a warranty reserve but, instead, to expense repairs as costs are
incurred.
16. OTHER BUSINESS VENTURES - PURCHASE OF PORTABLE X-RAY TECHNOLOGY
On August 28, 1996, the Company entered into a termination agreement
with Carlton Poon, a representative of Rainbow Ball Development Limited
("Rainbow Ball"). This agreement terminated a previous agreement with Rainbow
Ball under which the Company was to share its portable x-ray business line. The
termination agreement returns all rights to the portable x-ray business line to
the Company in exchange for 355,757 shares of the Company's common stock issued
in September 1996.
17. OTHER BUSINESS VENTURES - TERMINATION OF PURCHASE OPTION
On April 26, 1995, the Company entered into an agreement to purchase
a 50% interest in the United Aerosol and Home Products Company, LTD ("Unisol"),
located in Zhongshan, China. Unisol is a specialty chemical and fine chemical
aerosol packaging and bottle/can filling business. The purchase price was to be
20% of the appraised value of Unisol equipment, payable in the Company's common
stock at the close of business on April 26, 1996. The Unisol acquisition was
executed as part of the Gao transaction. This agreement was terminated during
the year ended September 30, 1997.
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18. LEASE OBLIGATIONS
The Company has entered into a 3-year lease for their facilities in
Columbia, Maryland. Annual lease obligations payments are as follows:
1998 $ 67,465
1999 69,131
2000 55,877
---------
$192,473
=========
Total amounts charged to rent expense for 1997 and 1996 were $64,594
and $55,982, respectively.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
CHEUNG LABORATORIES, INC.
December 26, 1997 By /s/ Spencer Volk
Spencer Volk
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated:
Signature Title Date
/s/ Spencer Volk Chief Executive Officer, December 26, 1997
Spencer Volk President and Director
/s/ Warren C. Sterns Acting Chief Financial Officer, December 29, 1997
Warren C. Stearns Director
/s/ John Mon General Manager, Treasurer December 26, 1997
John Mon Director
/s/ Augustine Y. Cheung Chairman, Director December 26, 1997
Dr. Augustine Y. Cheung
/s/ Mel Soule Director December 26, 1997
Mel Soule
Director December __, 1997
Walter Herbst
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Director December __, 1997
Max Link
26