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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996
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: 0-10521
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QUEST MEDICAL, INC.
(Exact name of registrant as specified in its charter)
TEXAS 75-1646002
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
201 ALLENTOWN PARKWAY,
ALLEN, TEXAS 75002
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (972) 390-9800
SECURITIES REGISTERED UNDER SECTION 12(B) OF THE EXCHANGE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
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NONE NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE EXCHANGE ACT:
TITLE OF CLASS
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Common Stock, $.05 Par Value
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Indicate by checkmark 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 the S-K is not contained herein, and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Aggregate market value of the registrant's Common Stock held by
non-affiliates of the registrant as of March 21, 1997:$51,514,600.
Number of shares outstanding of the registrant's Common Stock as of March
21, 1997: 8,353,938
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DOCUMENTS INCORPORATED BY REFERENCE
PORTIONS OF THE REGISTRANT'S DEFINITIVE PROXY STATEMENT FOR THE
REGISTRANT'S ANNUAL MEETING OF STOCKHOLDERS TO BE HELD ON JUNE 25, 1997, ARE
INCORPORATED BY REFERENCE INTO PART III.
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QUEST MEDICAL, INC.
ANNUAL REPORT
FORM 10-K
YEAR ENDED DECEMBER 31, 1996
PART I
ITEM 1. BUSINESS
GENERAL
Quest Medical, Inc., a Texas corporation ("Quest" or the "Company"),
designs, develops, manufactures and markets a variety of healthcare products
used primarily in cardiovascular surgery, neurostimulation and intravenous fluid
delivery applications. The Company operates several stable product lines,
including cardiovascular products (such as pressure control valves, filters and
surgical retracting tapes), specialized intravenous fluid delivery tubing sets
and accessories and pressure monitoring kits used primarily in labor and
delivery. The Company has levered these product lines, its existing corporate
infrastructure and its core competencies in manufacturing, engineering and
regulatory affairs to develop the Quest MPS(R) myocardial protection system, an
innovative and sophisticated system designed to manage the delivery of solutions
to the heart during open-heart surgery. In addition, the Company, during 1995,
entered the neurostimulation market by acquiring Neuromed, Inc. ("Neuromed"),
which designs, develops, manufactures and markets a line of electronic spinal
cord stimulation ("SCS") devices used to manage chronic severe pain. In November
1996, the Company merged Neuromed into a newly formed subsidiary, Advanced
Neuromodulation Systems, Inc., a Texas corporation ("ANS"). References to
"Quest" or the "Company" in this Form 10-K include ANS, unless otherwise
indicated.
In 1991, Quest acquired two companies that manufactured and marketed
various cardiovascular products, enhancing the Company's presence in the
cardiovascular products marketplace. In 1992, Quest identified a need in this
marketplace for an automated and integrated myocardial protection system that
would be versatile, easy to use, efficient to monitor and cost-effective.
Myocardial protection is the process of arresting and caring for the heart
during open-heart surgery. The Quest MPS system is designed to integrate key
functions relating to the delivery of solutions to the heart such as varying the
rate and ratio of oxygenated blood, crystalloid, potassium and other additives,
and controlling temperature, pressure and other variables to allow simpler, more
flexible and cost-effective management of this process. The MPS system employs
advanced pump, temperature control and microprocessor technologies and includes
a line of captive and noncaptive disposable products. The Company received
510(k) market clearance for its MPS system from the FDA in March 1996, and
shortly thereafter began clinical validation of the system, which was completed
during July 1996. The Company began commercial shipment of MPS in the U.S.
during September 1996.
In its continuing effort to expand into potentially high growth niche
markets in the medical device industry, the Company acquired Neuromed in March
1995. SCS is gaining acceptance as a viable, efficacious and cost-effective
treatment alternative to repeat back surgeries for relieving chronic severe back
pain. The Company believes that its CompuStim products, which are powered by
radio frequency transmitters external to the body, are the technological leaders
in the field. The Company in 1996 test marketed PainDoc, a pen-based computer
system that works in tandem with the Company's CompuStim devices to assist
physicians and their patients in optimizing the performance of the Company's SCS
devices both pre- and post-operatively. The Company anticipates full U.S. market
release of PainDoc in 1997.
Since its founding in 1979, the Company has developed, manufactured and
marketed specialized intravenous fluid delivery tubing sets and accessories sold
primarily to major hospitals in the United States. Over the last several years,
the revenues generated by this product line, a substantial component of the
Company's historical base business, have significantly aided the funding of the
Company's research and development efforts. The Company manufactures and markets
about 50 distinct models of specialized intravenous fluid delivery tubing sets.
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PRODUCTS
The following table summarizes certain information with respect to the
Company's principal products in commercial distribution.
PRODUCTS DESCRIPTION/USE
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Neuromodulation
SCS CompuStim Devices Neurostimulation devices used to relieve
chronic pain
PainDoc(R) Pen-based computer system used to
optimize the performance of the
Company's implanted SCS devices both
pre- and post-operatively
Cardiovascular
Pressure Control Valves Pressure control valves used during
open-heart surgery
Arterial Line Filters and Bubble Traps Filters and traps used to remove
potentially dangerous air and other
matter from the blood during open-heart
surgery
Retract-O-Tape(R) Surgical tubes used to retract and
occlude blood vessels during open-heart
surgery
MPS System and Related Disposables Cardioplegia delivery system and related
fluid delivery catheters and delivery
sets
Intravenous Fluid Delivery
Multiport(R) Sets Intravenous administration sets that
allow multiple drug infusions
Anesthesia Sets Intravenous administration sets that
allow needleless "port" administration
Other
Intrauterine Pressure Catheters and transducers used to assess
Catheters/Transducers the frequency, duration and intensity of
contractions during high risk labor
NEUROMODULATION
Background. SCS devices employ neurostimulation, the process of
electrically stimulating the spinal cord to reduce chronic severe neuropathic
(as opposed to acute) pain by "masking" the pain signals sent to the brain.
Neuropathic pain usually arises from nerve damage. SCS device implantation
manages the pain associated with failed back syndrome (resulting from certain
spinal disorders or unsuccessful spinal cord surgery), peripheral neuropathy,
phantom limb or stump pain, ischemic pain and reflex sympathetic dystrophy.
The market for SCS devices is currently divided between RF-coupled devices,
which use an external power source, and fully implantable systems known as
internal pulse generator ("IPG") devices. The Company believes that lPG devices
currently account for a substantial majority of the number of SCS procedures
performed, with RF-coupled devices accounting for the remainder. The Company
designs, develops, manufactures and markets RF-coupled SCS devices. The primary
advantages of the RF-coupled device include the simple replacement or recharge
of the external battery pack, and relatively lower overall cost. IPG devices
provide the convenience of a completely internalized system, but involve added
cost, complexity and risk because repeat surgeries are required to replace the
IPG power source. Moreover, the latest generation SCS devices generally include
more electrodes and dual channel receivers, both of which
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consume more electrical energy than an implanted power source can practically
deliver over an extended period of time.
SCS Devices. The Company's SCS systems consist of three primary components:
leads, a receiver and a transmitter. The leads are most commonly placed through
the skin into the spinal column's epidural space. This procedure is similar to
that employed by physicians to administer drugs for anesthesia and other common
medical applications. Typically, one or two leads are inserted, each of which
has multiple electrodes that can be used to stimulate the targeted nerve roots
of the spinal cord. Each lead is then connected to the receiver, which is
implanted under the skin on the side of the abdomen. The receiver contains
electronics that receive RF energy and data from a source (the transmitter)
outside the body, and delivers the prescribed electrical pulses to the leads.
The transmitter is approximately the size of a pager, and is typically worn on a
belt. Since it is external to the body, the transmitter can be easily programmed
and serviced as needed, and its battery can be simply recharged or replaced.
Neuromed introduced its first product, the Multiprogrammable Spinal Cord
Stimulator, or Multistim@, in 1979. Since that time, Neuromed has played a
significant role in the development of SCS products. Multistim incorporated a
quadrapolar electrode system within a single lead, and was considered a major
innovation in the field of neurostimulation because it significantly reduced
surgical time, cost and risk. Since the launch of Multistim, Neuromed has
developed and introduced a wide range of RF-coupled SCS systems with a variety
of options to accommodate different applications and degrees of pain.
The Company's recently introduced CompuStim systems include four, eight and
sixteen electrode leads; specialty leads for peripheral applications; single and
dual channel receivers; and rechargeable transmitters and antennae. The Company
believes that the CompuStim product line's multi-electrode leads and
multiprogrammable electronics technology have changed the manner in which
neurostimulation is performed worldwide. For example, Neuromed's "Dual Octrode"
device, a system of dual leads with eight electrodes each introduced in 1995,
creates a targeted current density that appears to be especially effective in
relieving chronic axial (or body trunk) pain. Previously, quadrapolar SCS
systems only relieved the leg pain associated with failed back syndrome.
Industry sources support the view that the Dual Octrode device provides improved
pain relief to both the legs and the back. Consequently, although the Dual
Octrode device has only been on the United States market since February 1995, it
now accounts for approximately 59 percent of Neuromed's current product revenue
and, in the Company's judgment, is the technological leader in the SCS field.
The Company believes that the long term results of SCS in the treatment of pain
have improved as a result of the flexibility of Neuromed's designs, epitomized
by the Dual Octrode product. Moreover, the ease of use of the system has
expanded the potential market for these products.
Use of the Company's current SCS products in certain operating modes
consumes relatively greater amounts of electrical current, reducing the
operating time of the rechargeable, externally worn battery packs. In addition,
certain of the Company's current SCS products have experienced switch failures
attributable in significant part to a specific brand of switches. These switches
were replaced by a new switch in April 1996 that have not exhibited the same
problems. Patient misuse has also contributed to the switch failures. Finally,
the Company's SCS products have exhibited some intermittent stimulation, which
the Company believes is attributable to several factors including improper
antenna placement, physicians or patients adjusting stimulation below
perceptible levels, improper receiver implant placement techniques and lead
movement. During 1996, the Company devoted significant engineering resources to
refining and enhancing its SCS products to address these matters. While most of
these enhancements were implemented during the second half of 1996, a few
enhancements are being implemented during the first quarter of 1997. The Company
believes these efforts have significantly improved the product quality,
reliability and performance of its current SCS products. In addition, during
1996, the Company began designing and implementing improved patient and
physician communications and training programs to address certain user problems.
The Company expects these efforts to continue throughout 1997.
The Company believes its RF-coupled SCS devices represent a strong base for
penetration of the broader neuromodulation market. The Company has begun
development of an IPG system and a constant rate implantable drug pump to better
serve the broad needs of the pain management market. By offering an IPG
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and implantable drug pump, the Company can serve the largest segment of the
neuromodulation market, leverage its sales and marketing capabilities and
address a number of new indications such as angina, various motor disorders, and
Alzheimer's and Parkinson's disease.
PainDoc. In addition to its current array of SCS devices, the Company is
developing and testing PainDoc, a pen-based computer system that is designed to
assist physicians and their patients in optimizing the performance of the
Company's SCS devices both pre- and post-operatively. PainDoc interfaces with
the Company's CompuStim transmitters to optimize SCS therapy and document
treatment outcomes. PainDoc allows the physician to input information regarding
the patient's description of the location and intensity of the patient's pain.
The resulting "pain map" is then analyzed by the computer to assess and select
the most effective stimulation sets, or combination of multi-electrode
stimulation arrays, to treat the pain. The selected arrays are uploaded into the
patient's CompuStim transmitter. After a trial period, the patient reports to
the physician the location and level of pain relief. These trial results are
uploaded back into PainDoc for the physician's objective review and analysis.
The physician can visually compare the patient's pain map against a stimulation
map and assess whether desired levels of pain relief have been obtained and
whether excess stimulation has been delivered. This process can be effective in
targeting the location of desired pain relief, reducing the patchiness of pain
relief delivered by many SCS devices and reducing or eliminating
overstimulation.
PainDoc enables the physician to program up to 24 different stimulation
sets delivering electrical stimulation every 50 milliseconds to expand pain area
coverage and relief. The Company believes that PainDoc should also allow
physicians to create a broad based database tool that, by using a standardized
methodology, will enable physicians to share and compare outcomes data, which
can then be used to deliver more efficacious pain relief to individual patients.
The Company believes that PainDoc and CompuStim devices used in tandem should
significantly enhance the effectiveness, flexibility and precision of managing
chronic neuropathic pain. The Company expects PainDoc to promote the selection
of the Company's CompuStim devices for SCS procedures, especially as SCS devices
become more complex and the pain management process becomes more refined. In
October 1995, the Company received 510(k) approval from the FDA to market
PainDoc as an interactive medical treatment device. See Item 1:
"Business -- Other Business Matters -- Government Regulation." The Company test
marketed the product during 1996 and expects full U.S. market release during
1997.
During the year ended December 31, 1996 and 1995, the Company's SCS
products accounted for $11.4 million and $10.4 million, respectively, of total
net revenue. The 1995 period includes revenue for nine months from the date of
acquisition of March 31, 1995.
CARDIOVASCULAR
Valves, Filters and Traps. The Company manufactures and markets a line of
proprietary specialized pressure control valves, pre-bypass and arterial line
filters and bubble traps, which are used by the perfusionist during
cardiopulmonary bypass surgery. Pressure control valves are placed in the
suction line to "vent," or decompress, the heart. These valves serve a number of
functions, including the maintenance of vacuum at a safe and consistent level to
minimize heart muscle tissue damage, as well as the prevention of inadvertent
and potentially catastrophic retrograde air flow into the heart. In 1993 and
1994, respectively, the Company introduced to the market two extensions of its
pressure control valve technology, the RetroGuard valve and the PlegiaGuard
valve. The RetroGuard valve is used with centrifugal pumps to prevent potential
retrograde blood flow and possible air embolism. The PlegiaGuard valve is used
to relieve overpressure in the cardioplegia line in the event that the line
becomes inadvertently clamped or occluded. The Company's arterial line filters
and bubble traps are used in the bypass circuit to remove air and other
potentially dangerous matter from the blood prior to the blood's return to the
patient. The Company's pre-bypass filters are used to flush the circuit external
to the patient's body prior to the initiation of the bypass procedure to
eliminate man-made debris within the lines. During the years ended December 31,
1996, 1995, and 1994, the Company's valves, filters and traps accounted for $5.4
million, $5.2 million, and $4.2 million, respectively, of total net revenue.
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Surgical Tapes and Other Products. The Company manufactures and markets
surgical retracting tapes under the trademark Retract-O-Tape, a product line of
silicone elastomer surgical tubing used to apply traction to and occlude blood
vessels during surgical procedures. The Company's surgical tapes are hollow
tubes, sealed at both ends to trap air, which resist collapsing when they come
into contact with a body structure. The Company's ACTester product line consists
of instrumentation and associated disposables used to measure the activated
clotting time of blood. During the years ended December 31, 1996, 1995, and
1994, the Company's surgical tapes and ACTester products accounted for $2.1
million, $1.8 million, and $1.6 million, respectively, of total net revenue.
MPS System. In 1992, based on discussions with perfusionists and
cardiovascular surgeons regarding the logistical limitations of existing
cardioplegia delivery systems, the Company identified a need for an automated
and integrated myocardial protection system that would be versatile, easy to
use, efficient and cost-effective. Over the past several years, cardiovascular
surgeons have developed advanced myocardial protection protocols for open-heart
surgery that significantly complicate the safe and efficient administration of
cardioplegia delivery using existing systems. Protocols now call for warm or
cold cardioplegia, various levels of potassium, retrograde or antegrade
cardioplegia flow, and a number of other variables. Existing cardioplegia
delivery systems are limited in their ability to accommodate these evolving
protocols, and are also difficult to control and monitor due to the number of
different components and protocol variables. Based on its reengineering of the
conceptual approach to cardioplegia delivery, the Company designed the MPS
system to address the limitations of existing cardioplegia delivery systems. The
Company then commissioned an independent research firm to survey over 150
surgeons and perfusionists to confirm the market demand for an automated and
integrated approach to managing cardioplegia delivery.
The Company subsequently developed, and in August 1995 filed a 510(k) with
the FDA for, the MPS system. In March 1996, the Company received clearance from
the FDA to market MPS and shortly thereafter began clinical testing of the
system. Clinical testing was completed during July 1996 and commercial shipment
of MPS began during September 1996.
The MPS system, which employs advanced pump, temperature control and
microprocessor technologies, is designed to enable the perfusionist to vary the
blood/crystalloid ratio and potassium concentration, maintain a constant blood
temperature, and maintain a constant delivery pressure through an automated and
integrated device. The MPS instrument is designed to provide this flexibility
through the simple setting of dials on its control panel. The Company believes
that the MPS system will simplify the cardioplegia delivery process and thus
improve the safety of this process by reducing the risk of human error.
As a part of the MPS system, the Company has designed and developed a
"captive" disposable delivery set, which fits into the instrument and is
necessary to the operation of the instrument. The Company has also designed and
developed additional "non-captive" disposable tubing and other accessories for
use with the MPS system. These non-captive disposables are not integral to the
operation of the instrument and can be purchased from other manufacturers. The
Company has received FDA clearance to market certain of its non-captive
disposables through the submission and approval of 510(k)s, and began marketing
such products during the fourth quarter of 1996. During the year ended December
31, 1996, the Company's MPS system and related products accounted for $443,000
of total net revenue.
INTRAVENOUS FLUID DELIVERY
Since its founding in 1979, the Company has developed, manufactured and
marketed specialized intravenous fluid delivery tubing sets and accessories sold
primarily to major hospitals in the United States. Over the last several years
the revenues generated by this product line, a substantial component of the
Company's historical base business, have significantly aided the funding of the
Company's research and development efforts. The Company's core competencies in
medical device manufacturing, engineering and regulatory affairs have largely
been developed as a consequence of its experience with intravenous fluid
delivery products, including the electronic intravenous pump and associated
disposables business that was sold in 1987.
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The Company manufactures and markets about 50 distinct models of
specialized intravenous fluid delivery tubing sets, which can be broken down
into two major product categories -- Multiport(R) sets and anesthesia sets.
Hospitals frequently require specialized disposable intravenous tubing sets for
more complex therapy procedures employed in anesthesia administration,
intravenous feeding, intensive care and cancer therapy. The Company's
intravenous tubing sets generally consist of specialized tubing and connector
variations that distinguish them from standard intravenous sets. The Company
also manufactures and markets injection sites used in heparin and other
medication administrations.
The Company has one patented specialized tubing set, purchased primarily by
the University of Texas System Cancer Center (M.D. Anderson Hospital), which is
used to deliver multiple drugs for complex chemotherapy applications. See Item
1: "Business -- Other Business Matters -- Marketing and Major Customer." During
the years ended December 31, 1996, 1995, and 1994 the Company's intravenous
fluid delivery products accounted for $5.2 million, $6.0 million, and $6.3
million, respectively, of total net revenue.
OTHER PRODUCTS
The Company also designs, manufactures and markets other products for the
healthcare industry, including pressure monitoring kits used in labor and
delivery procedures and various critical care applications. The Company's
intrauterine pressure monitoring devices are used to determine pressure within
the mother's uterus primarily during high risk labor and delivery. Approximately
25 percent of the nearly four million births occurring annually in the United
States are categorized as "high risk" due to factors such as obesity, drug use,
disease, age or low fetus weight. During these procedures, a catheter is
inserted into the mother's uterus to measure uterine fluid pressure. This
information allows the clinician to monitor the progression of labor and to
determine whether intervention is necessary or advisable. The Company's
intrauterine pressure monitoring devices are marketed as kits containing all of
the components required to measure uterine fluid pressure. During the years
ended December 31, 1996, 1995, and 1994 the Company's other products (primarily
pressure monitoring kits) accounted for $1.6 million, $1.8 million, and $1.9
million, respectively, of total net revenue.
OTHER BUSINESS MATTERS
MARKETING AND MAJOR CUSTOMER
ANS has historically relied on specialty distributors to market its SCS
devices. During 1996, however, the Company made the strategic decision to
replace certain distributors in specified geographic markets with commissioned
sales agents. Currently, the Company has 11 specialty distributors who employ 34
personnel to market the SCS devices. In addition, the Company has eight
commissioned sales agents who sell the Company's SCS devices. The Company
employs three regional sales managers who oversee these specialty distributors
and commissioned sales agents. The primary medical specialists the Company
targets in its marketing efforts are anesthesiologists, neurosurgeons, and
orthopedic surgeons. Although neurosurgeons were the first practitioners to use
SCS applications, anesthesiologists now account for a greater percentage of
sales as the relative number of these practitioners has grown and as the
understanding and acceptance of SCS treatment has increased. The Company derives
85 percent of net revenues attributable to its SCS devices from domestic sales
and approximately 15 percent from European and Australian sales.
The Company markets its MPS system and related disposables domestically
through a direct sales force operating on a sales team approach. This team
consists of nine members who have been involved with the MPS through its final
development and clinical validation. The team consists of five regional sales
managers, two field clinical specialists, and two inside account
representatives. The Company does not plan to add additional sales personnel
during 1997. The inside account representatives qualify accounts and assist the
regional managers while the clinical specialists in-service and train surgeons,
perfusionists, and other personnel on the MPS system. The Company plans to
market the MPS system internationally through specialty distributors, although
it does not anticipate international market introduction until 1998.
Clinical evaluations since the commercial introduction of the MPS in
September 1996 have, in management's view, validated that the MPS provides
simpler, more flexible and cost-effective management of
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myocardial protection. As a consequence of the current hospital consolidation
trend, coupled with the intense pressure hospitals are under to minimize capital
expenditures, however, hospitals have been reluctant to make timely purchase
decisions on new capital equipment. Therefore, to accelerate the adoption of MPS
and shorten the selling process, the Company in early 1997 decided to offer MPS
on a one-year rental basis and on a lease/purchase basis. This strategy will
decrease short-term revenues because the rental agreement does not qualify as a
sale, but should, in management's opinion, accelerate placement of MPS systems
and related disposable revenues. The Company believes that once a surgeon
changes the cardioplegia protocol using features of MPS, it will be very
difficult to return to the old, make-shift system. There can be no assurance
that such rental strategy will accelerate placement of MPS systems.
The Company markets most of its other cardiovascular products, pressure
monitoring kits for labor, and delivery and intravenous fluid delivery tubing
sets through direct contact with hospitals, telemarketing, independent sales
representatives, marketing arrangements with certain distributors and, to a
lesser extent, through direct mail. The Company employs one direct sales manager
who oversees the distributors who sell the Company's pressure monitoring kits
and three inside sales representatives who primarily sell the Company's
intravenous fluid delivery tubing set products through telemarketing. The
Company derives approximately 87 percent of net revenues attributable to
cardiovascular products, pressure monitoring kits, and intravenous fluid
delivery tubing sets from domestic sales and approximately 13 percent from
European, Australian and Japanese sales.
During 1996, the Company had one major customer that accounted for 10
percent or more of its net revenues. Sun Medical, Inc., a specialty distributor
of ANS products, accounted for $2.6 million, or 10 percent, of the Company's net
revenues for the year ended December 31, 1996. In addition, the University of
Texas Cancer Center (M. D. Anderson Hospital) accounted for $2.3 million, $2.6
million and $2.7 million, or 9 percent, 10 percent and 19 percent of the
Company's net revenues for the years ended December 31, 1996, 1995 and 1994,
respectively. The Company supplies a patented specialized intravenous tubing set
used by M. D. Anderson Hospital for oncology applications. While the Company
believes its relations with Sun Medical and M. D. Anderson Hospital are good,
the loss of one or both of these customers could have a material adverse effect
on the Company's business, financial condition and results of operations.
RESEARCH AND DEVELOPMENT
Since 1992, the Company has focused a majority of its research and
development efforts on designing and developing the MPS system and related
products. The Company has spent $11.5 million on the research and development of
its MPS system and related products, representing about 80 percent of the
Company's research and development expense since 1992. Although the Company
plans to continue engaging in ongoing research and development to introduce new
products, enhance the effectiveness, ease of use, safety and reliability of
existing products and expand the applications for which its products are
appropriate, particularly in the cardiovascular and neuromodulation fields, the
Company expects research and development expense to decline from peak levels
during 1995, as a result of completing development of the MPS system and certain
related products. Research and development expense was $3.3 million, $4.6
million and $3.5 million for the years ended December 31, 1996, 1995 and 1994,
respectively. The Company has budgeted $2.8 million for research and development
during 1997. Management expects about half of such expenditures to be directed
to refining current ANS SCS products and designing and developing next
generation ANS SCS products, with the other half directed primarily to MPS. As
of March 21, 1997, the Company had an in-house research and development staff of
18 engineers, technicians and designers, down from 24 at March 1996.
MANUFACTURING
The Company manufactures and packages certain ANS SCS products,
cardiovascular products (such as pressure control valves, filters, traps, MPS
and surgical retracting tapes), pressure monitoring kits, and intravenous fluid
delivery products at its primary manufacturing facility in Allen, Texas. This
facility received ISO 9001 certification (for design and manufacturing
processes) in July 1995. See Item 1. "Business -- Other Business
Matters -- Government Regulations." Until the first quarter of 1996, when such
operations were moved to the Allen, Texas facility, the Company manufactured its
line of SCS devices and related products at
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an ISO 9002 certified (manufacturing only) facility in Fort Lauderdale, FL.
Finally, the Company manufactures certain cardiovascular products at a facility
in Orange County, California and will continue to do so for the foreseeable
future.
The Company's manufacturing processes consist of the assembly of standard
and custom component parts and the testing of completed products. The Company
subcontracts with various suppliers to provide it with the quantity of component
parts necessary to assemble its products. Almost all of these components are
available from a number of different suppliers, although certain components are
purchased from single sources, who manufacture these components from the
Company's toolings. For example, the Company relies on single suppliers for two
separate components of the specialized oncology intravenous tubing set that the
Company supplies to the University of Texas System Cancer Center (M.D. Anderson
Hospital), the Company's largest customer. The Company believes that there are
alternative and satisfactory sources for single-sourced components, although a
sudden disruption in supply from one of these suppliers could adversely affect
the Company's ability to deliver the finished product on time. The Company owns
its own molds for production of a majority of the components used in specialized
tubing sets and cardiovascular products. Consequently, in the event of supply
disruption, the Company would be able to fabricate its own components or
subcontract with another supplier, albeit after a delay in the production
process.
The Company devotes significant attention to quality control. Its quality
control measures begin at the manufacturing level where components are assembled
in a "clean room" environment designed and maintained to reduce product exposure
to particulate matter. Products are tested throughout the manufacturing process
for adherence to specifications. Finished components are shipped to outside
processors for sterilization through radiation or treatment with ethylene oxide
gas. After sterilization, the products are quarantined and tested before they
are shipped to customers.
Skills of assembly workers required for the manufacture of medical products
are similar to those required in typical assembly operations. The Company
believes that workers with these skills are readily available in the Dallas and
Orange County areas.
COMPETITION
In marketing its products, the Company competes with numerous companies
that have substantially greater financial resources and engage in substantially
greater research and development efforts than the Company. ANS competes in the
market for SCS devices with one other significant supplier, Medtronic, Inc.
Medtronic holds a substantial majority share of the market and sells both
RF-coupled systems and IPG devices.
Numerous competitors exist for the Company's cardiovascular products,
specialized tubing sets and pressure monitoring kits. These markets are
dominated by established manufacturers that have broader product lines, greater
distribution capabilities, substantially greater capital resources and larger
marketing, research and development staffs and facilities than the Company. Many
of these competitors offer broader product lines within the specific product
market and/or in the general field of medical devices and supplies. Broad
product lines give many of the Company's competitors the ability to negotiate
exclusive, long-term medical device supply contracts and, consequently, the
ability to offer comprehensive pricing of their competing products. By offering
a broader product line in the general field of medical devices and supplies,
competitors may also have a significant advantage in marketing competing
products to group purchasing organizations, HMOs and other managed care
organizations that are increasingly seeking to reduce costs through
centralization of purchasing functions. In addition, the Company's competitors
may use price reductions to preserve market share in their product markets.
The Company is aware of at least two cardioplegia delivery systems
currently being marketed that compete with the MPS system. While these products
represent improvements over cardioplegia delivery systems currently in use in
that they have partially integrated some of the cardioplegia equipment
components, the Company believes that the MPS system will offer a greater range
of functionality, flexibility and ease-of-use. In addition, innovations in
surgical techniques or medical practices could have the effect of reducing or
eliminating market demand for one or more of the Company's products. For
example, some cardiovascular
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surgeons and medical device companies are developing techniques, procedures and
devices for performing coronary artery bypass surgery without stopping the
heart, both through open-heart surgery and minimally invasive procedures,
thereby eliminating the need for myocardial protection in these cases and
potentially reducing the market for the MPS system. While these techniques,
procedures and devices have not to date attained widespread use, there can be no
assurance that they will not gain broader market acceptance. While these and
other surgical techniques, procedures and devices may reduce the number of
coronary artery bypass procedures that require myocardial protection, the
Company believes that most, if not all, surgical suites will need to be equipped
with a myocardial protection system.
The Company believes that the principal competitive factors in the
neurostimulation, cardiovascular and intravenous fluid delivery markets are
cost-effectiveness, impact on patient outcomes, product performance, quality and
ease of use, technical innovation and customer service. The Company intends to
continue to compete on the basis of its high performance products, innovative
technologies, manufacturing capability, close customer relations and support and
its strategy to increase its offerings of products within these markets.
PATENTS, TRADEMARKS AND PROPRIETARY INFORMATION
The Company owns twenty United States patents relating to products that the
Company currently markets. Although one of the Company's patents expired in
February 1996, the Company does not believe that such expiration will have a
material adverse effect on the Company or its ability to sell the applicable
product.
ANS currently owns four of the United States patents referred to above and
also owns one foreign patent. In management's view, these patents offer
reasonable coverage of its SCS devices' electrode, receiver and transmitter
technology. These patents cover both RF-coupled devices and IPG systems,
although the Company currently manufactures only RF-coupled devices. Pending
patent applications concern ANS' PainDoc computer system and its innovative
Multistim technology.
Twelve of the twenty patents cover the Company's cardiovascular products.
From 1993 through 1996, the Company filed five applications for patents relating
to the MPS system and related products. Three applications resulted in patents
and the remaining two are pending issuance. In the Company's opinion, the MPS
related patents broadly cover key elements of the MPS system, including the MPS
system's innovative methods of pumping, mixing and heating fluids. Management
believes that the issued patents should provide significant protection for its
MPS system. The Company also filed various applications regarding its unique
line of retrograde catheters which may be used with the MPS system or other
cardioplegia delivery systems.
The Company also owns three patents relating to its intravenous fluid
delivery tubing sets and accessories and other products.
The validity of any patents issued to the Company may be challenged by
others and the Company could encounter legal and financial difficulties in
enforcing its patent rights against infringers. In addition, there can be no
assurance that other technologies cannot or will not be developed or that
patents will not be obtained by others which would render the Company's patents
obsolete. With the possible exception of the patent relating to the specialized
tubing sets manufactured for the University of Texas System Cancer Center (M.D.
Anderson Hospital), the loss of any one patent would not have a material adverse
effect on the Company's current revenue base. Although the Company does not
believe that patents are the sole determinant in the commercial success of its
products, the loss of a significant percentage of its patents or its patents
relating to a specific product line, particularly the MPS system or ANS' SCS
product line, could have a material adverse effect on the Company's business,
financial condition and results of operations.
The Company has developed technical knowledge which, although
non-patentable, is considered by the Company to be significant in enabling it to
compete. However, the proprietary nature of such knowledge may be difficult to
protect. The Company has entered into an agreement with each key employee
prohibiting such employee from disclosing any confidential information or trade
secrets of the Company and prohibiting that employee from engaging in any
competitive business while the employee is working for the Company and for a
period of one year thereafter. In addition, these agreements also provide that
any inventions or discoveries
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relating to the business of the Company by these individuals will be assigned to
the Company and become the Company's sole property.
Claims by competitors and other third parties that the Company's products
allegedly infringe the patent rights of others could have a material adverse
effect on the Company. The medical device industry is characterized by frequent
and substantial intellectual property litigation. The cardiovascular device
market and the interventional pain management markets are maturing and, as such,
are characterized by extensive patent and other intellectual property claims,
which can create greater potential than in less developed markets for possible
allegations of infringement, particularly with respect to newly developed
technology. Intellectual property litigation is complex and expensive and the
outcome of this litigation is difficult to predict. Any future litigation,
regardless of outcome, could result in substantial expense to the Company and
significant diversion of the efforts of the Company's technical and management
personnel. An adverse determination in any such proceeding could subject the
Company to significant liabilities to third parties, or require the Company to
seek licenses from third parties or pay royalties that may be substantial.
Furthermore, there can be no assurance that necessary licenses would be
available to the Company on satisfactory terms or at all. Accordingly, an
adverse determination in a judicial or administrative proceeding or failure to
obtain necessary licenses could prevent the Company from manufacturing or
selling certain of its products, which could have a material adverse effect on
the Company's business, financial condition and results of operations.
QUEST, MULTIPORT, RETROGUARD, RETRACT-O-TAPE, ACTest, MPS, DUO-TUBE and
PainDoc are among the Company's registered trademarks and COMPUSTIM and ACTester
are among its nonregistered trademarks. Registration applications are pending
for various trademarks the Company believes have value in the marketplace.
GOVERNMENT REGULATION
The manufacture and sale of the Company's products are subject to
regulation by numerous governmental authorities, principally the FDA and
corresponding foreign agencies. The research and development, manufacturing,
promotion, marketing and distribution of the Company's products in the United
States are governed by the Federal Food, Drug and Cosmetic Act and the
regulations promulgated thereunder (the "FDC Act and Regulations"). The Company
is subject to inspection by the FDA for compliance with such regulations and
procedures.
The FDA has traditionally pursued a rigorous enforcement program to ensure
that regulated entities such as the Company comply with the FDC Act and
Regulations. A company not in compliance may face a variety of regulatory
actions, including warning letters, product detentions, device alerts, mandatory
recalls or field corrections, product seizures, injunctive actions or civil
penalties and criminal prosecutions of the company or responsible employees,
officers and directors. The Company was inspected in the summer of 1996 with no
major violations found.
Under the FDA's requirements, if a manufacturer can establish that a newly
developed device is "substantially equivalent" to a legally marketed device, the
manufacturer may seek marketing clearance from the FDA to market the device by
filing a 510(k) premarket notification with the FDA. The 510(k) premarket
notification must be supported by data establishing the claim of substantial
equivalence to the satisfaction of the FDA. The process of obtaining a 510(k)
clearance typically can take several months to a year or longer. If substantial
equivalence cannot be established, or if the FDA determines that the device
requires a more rigorous review, the FDA will require that the manufacturer
submit a PMA that must be carefully reviewed and approved by the FDA prior to
sale and marketing of the device in the United States. The process of obtaining
a PMA can be expensive, uncertain and lengthy, frequently requiring anywhere
from one to several or more years from the date of FDA submission. Both a 510(k)
and a PMA, if granted, may include significant limitations on the indicated uses
for which a product may be marketed. FDA enforcement policy strictly prohibits
the promotion of approved medical devices for unapproved uses. In addition,
product approvals can be withdrawn for failure to comply with regulatory
requirements or the occurrence of unforeseen problems following initial
marketing. Although all of the Company's currently marketed products have been
the subject of successful 510(k) submissions and the Company believes that most
of its products currently in
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development will also be eligible for the 510(k) submission process, there can
be no assurance that the FDA will agree with this view.
The Company is also subject to regulation in each of the foreign countries
in which it sells its products with regard to product standards, packaging
requirements, labeling requirements, import restrictions, tariff regulations,
duties and tax requirements. Many of the regulations applicable to the Company's
products in such countries are similar to those of the FDA. The national health
or social security organizations of certain countries require the Company's
products to be qualified before they can be marketed in those countries. To
date, the Company has not experienced significant difficulty in complying with
these regulations.
To position itself for access to European and other international markets,
Quest sought and obtained certification under the ISO 9000 Series of Standards.
ISO 9000 is a set of integrated requirements, which when implemented, form the
foundation and framework for an effective quality management system. These
standards were developed and published by the ISO, a worldwide federation of
national standard bodies, founded in Geneva, Switzerland in 1946. ISO has over
92 member countries. ISO certification is widely regarded as essential to enter
Western European markets.
The Company obtained certification and was registered as an ISO 9001
compliant company on July 1, 1995. The ISO 9001 registration is the most
stringent standard in the ISO series and lasts for three years. The German
notified body, Landesgewerbeanstalt Bayern ("LGA") issued the certificate. The
ISO 9001 standards cover design, production, installation and servicing of
products. The Company will be subject to an annual audit by the notified body to
maintain the registration. The Company was then certified to be in compliance
with the Medical Device Directive ("MDD") as well as ISO 9001 by the notified
body TUV Rheinland ("TUV") in July 1996. Subsequently, in December 1996, the
Company's ANS implantable products were certified to be in compliance with the
Active Implantable Medical Directive ("AIMD") by TUV product services, another
notified body. These certifications were sought and obtained for the purpose of
getting the CE mark which represents product approval throughout the European
Union. As a result, the CE mark was maintained on all ANS products. The Company
also received CE mark certification on its line of retrograde and antegrade
catheters.
The financial arrangements through which the Company markets, sells and
distributes its products may be subject to certain federal and state laws and
regulations in the United States with respect to the provision of services or
products to patients who are Medicare or Medicaid beneficiaries. The "fraud and
abuse" laws and regulations prohibit the knowing and willful offer, payment or
receipt of anything of value to induce the referral of Medicare or Medicaid
patients for services or goods. In addition, the physician anti-referral laws
prohibit the referral of Medicare or Medicaid patients for certain "Designated
Health Services" to entities in which the referring physician has an ownership
or compensation interest. Violations of these laws and regulations may result in
civil and criminal penalties, including substantial fines and imprisonment. In a
number of states, the scope of fraud and abuse or physician anti-referral laws
and regulations, or both, have been extended to include the provision of
services or products to all patients, regardless of the source of payment,
although there is variation from state to state as to the exact provisions of
such laws or regulations. In other states, and on a national level, several
health care reform initiatives have been proposed which would have a similar
impact. The Company believes that its operations and its marketing, sales and
distribution practices currently comply in all respects with all current fraud
and abuse and physician anti-referral laws and regulations, to the extent they
are applicable. Although the Company does not believe that it will need to
undertake any significant expense or modification to its operations or its
marketing, sales and distribution practices to comply with federal and state
fraud and abuse and physician anti-referral regulations currently in effect or
proposed, financial arrangements between manufacturers of medical devices and
other health care providers may be subject to increasing regulation in the
future. Compliance with such regulation could adversely affect the Company's
marketing, sales and distribution practices, and may affect the Company in other
respects not presently foreseeable, but which could have an adverse impact on
the Company's business, financial condition and results of operations.
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THIRD PARTY REIMBURSEMENT AND COST CONTAINMENT
The Company's products are purchased primarily by hospitals and other
users, which then bill various third party payors for the services provided to
the patients. These payors, which include Medicare, Medicaid, private insurance
companies and managed care organizations, reimburse part or all of the costs and
fees associated with the procedures performed with these devices.
Medicare and Medicaid reimbursement for hospitals is based on a fixed
amount for admitting a patient with a specific diagnosis. Because of this fixed
reimbursement method, hospitals have incentives to use less costly methods in
treating Medicare and Medicaid patients, and will frequently make capital
expenditures to take advantage of less costly treatment technologies.
Frequently, reimbursement is reduced to reflect the availability of a new
procedure or technique, and as a result hospitals are generally willing to
implement new cost saving technologies before these downward adjustments take
effect. Likewise, because the rate of reimbursement for certain physicians who
perform certain procedures has been and may in the future be reduced in the
event of further changes in the resource-based relative value scale method of
payment calculation, physicians may seek greater cost efficiency in treatment to
minimize any negative impact of reduced reimbursement. Any amendments to
existing reimbursement rules and regulations which restrict or terminate the
reimbursement eligibility (or the extent or amount of coverage) of medical
procedures using the Company's products or the eligibility (or the extent or
amount of coverage) of the Company's products could have an adverse impact on
the Company's business, financial condition and results of operations. Third
party payors are increasingly challenging the prices charged for medical
products and services and may deny reimbursement if they determine that a device
was not used in accordance with cost-effective treatment methods as determined
by the payor, was experimental or was used for an unapproved application.
The Company's SCS devices, for example, while cost-effective compared to
repeat back surgeries, have encountered some resistance to third party
reimbursement. Although Medicare, Medicaid and many private insurers reimburse
for the SCS device and procedure, especially after repeat back surgeries have
failed to relieve the chronic pain, certain payors refuse to reimburse for SCS
devices and others, including the Veterans Administration, restrict
reimbursement. There can be no assurance that in the future, third party payors
will continue to reimburse for the Company's products, or that their
reimbursement levels will not adversely affect the profitability of the
Company's products. In addition, the cost of health care has risen significantly
over the past decade, and there have been and may continue to be proposals by
legislators and regulators to curb these costs. Legislative action limiting
reimbursement for certain procedures could have a material adverse effect on the
Company's business, financial condition and results of operations.
In response to the focus of national attention on rising health care costs,
a number of changes to reduce costs have been proposed or have begun to emerge.
There have been, and may continue to be, proposals by legislators and regulators
and third party payors to curb these costs. There has also been a significant
increase in the number of Americans enrolling in some form of managed care plan.
It has become a typical practice for hospitals to affiliate themselves with as
many managed care plans as possible. Higher managed care penetration typically
drives down the prices of health care procedures, which in turn places pressure
on medical supply prices. This causes hospitals to implement tighter vendor
selection and certification processes, by reducing the number of vendors used,
purchasing more products from fewer vendors and trading discounts on price for
guaranteed higher volumes to vendors. Hospitals have also sought to control and
reduce costs over the last decade by joining group purchasing organizations or
purchasing alliances. The Company cannot predict what continuing or future
impact existing or proposed legislation, regulation or such third party payor
measures may have on its future business, financial condition or results of
operations.
Changes in reimbursement policies and practices of third party payors could
have a substantial and material impact on sales of certain of the Company's
products. The development or increased use of more cost-effective treatments
could cause such payors to decrease or deny reimbursement to favor these other
treatments.
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EMPLOYEES
As of March 21, 1997, the Company employed 247 full-time employees, 18 in
research and development, 43 in sales and marketing, 153 in manufacturing and
related operations, and the remainder in executive and administrative positions.
None of the Company's employees is represented by a labor union and the Company
considers its employee relations to be good.
ADVISORY BOARDS
The Company has established two Boards of Clinical Advisors (the "Advisory
Boards"). The Advanced Neuromodulation Systems Advisory Board (the "ANSAB") is
comprised of individuals with substantial expertise in neurostimulation and pain
management. Members of the Company's management and scientific and technical
staff consult closely with the ANSAB to identify specific areas where techniques
are changing and where existing products do not adequately fulfill the needs of
the pain physician. The ANSAB helps management evaluate new product ideas and
concepts and once a product is approved for development, its subsequent design
and development. The ANSAB may also participate in the clinical testing of
products developed.
The Quest Advisory Board (the "QAB") is comprised of individuals with
substantial expertise in the field of myocardial protection who have played
instrumental roles in the identification of the market need for MPS system and
its subsequent design and development. Members of the Company's management and
scientific and technical staff consult closely with the QAB to better understand
the technical and clinical requirements of the cardiovascular surgical team and
product functionality needed to meet those requirements. The Company anticipates
that the QAB will continue to play a similar role with respect to other
products, and may assist the Company in educating other physicians in the use of
the MPS and related products.
Certain members of the Advisory Boards are employed by academic
institutions and may have commitments to or consulting or advisory agreements
with other entities that may limit their availability to the Company. The
members of the Advisory Boards may also serve as consultants to other medical
device companies. No members of the ANSAB or QAB are expected to devote more
than a small portion of their time to the Company.
ITEM 2. PROPERTIES
In December 1993, the Company moved into its new manufacturing facility and
executive offices in Allen, Texas (located north of Dallas). The facility covers
approximately 107,000 square feet and was constructed during 1993 on a 19.2 acre
tract that the Company acquired in 1985. The Company borrowed $4.4 million from
MetLife Capital Corporation to construct and outfit this facility. This
financing is collateralized by the Allen land, the Allen facility and certain
equipment of the Company. See Note 5 of the Notes to Consolidated Financial
Statements. Management expects the current facility to serve its manufacturing,
storage and executive office needs in the Dallas area for the foreseeable
future.
The Company also currently leases approximately 4,600 square feet of office
and manufacturing space in Orange County, California on a month-to-month basis.
The Company plans to continue manufacturing certain cardiovascular surgery
products at this facility for the foreseeable future.
Until February 1996, ANS leased approximately 18,000 square feet of office
and manufacturing space in Fort Lauderdale, Florida, where it manufactured and
marketed its SCS devices. During late 1995 and early 1996, the Company relocated
the ANS operations to the Company's facility in Allen, Texas.
ITEM 3. LEGAL PROCEEDINGS
As a consequence of the Neuromed Acquisition in March 1995, the Company is
a party to product liability claims related to SCS devices sold by Neuromed
prior to the acquisition. Product liability insurers have assumed responsibility
for defending the Company against these claims, subject to reservation of rights
in certain cases. While historically product liability claims against Neuromed
have not resulted in significant
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monetary liability for Neuromed beyond its insurance coverage, there can be no
assurances that the Company will not incur significant monetary liability to the
claimants if such insurance is unavailable or inadequate for any reason, or that
the Company's SCS business and new SCS product lines will not be adversely
affected by these product liability claims. While the Company seeks to maintain
appropriate levels of product liability insurance with coverage that the Company
believes is comparable to that maintained by companies similar in size and
serving similar markets, there can be no assurance that the Company will avoid
significant future product liability claims relating to its SCS, cardiovascular,
intravenous fluid delivery or other products.
Except for such product liability claims and other ordinary routine
litigation incidental or immaterial to its business, the Company is not
currently a party to any other pending legal proceeding. The Company maintains
general liability insurance against risks arising out of the normal course of
business.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Inapplicable.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock is quoted on the Nasdaq National Market under
the symbol "QMED." On March 21, 1997, there were approximately 831 holders of
record of the Company's common stock. The following table sets forth the
quarterly high and low closing sales prices for the Company's common stock.
These prices do not include adjustments for retail mark-ups, mark-downs or
commissions.
HIGH LOW
1995: ------ ------
First Quarter............................................... $ 8.75 $ 4.88
Second Quarter.............................................. $12.50 $ 7.13
Third Quarter............................................... $14.50 $11.75
Fourth Quarter.............................................. $12.00 $ 9.75
HIGH LOW
1996: ------ ------
First Quarter............................................... $14.50 $10.25
Second Quarter.............................................. $14.38 $ 6.00
Third Quarter............................................... $ 9.13 $ 5.63
Fourth Quarter.............................................. $ 8.25 $ 5.75
HIGH LOW
1997: ------ ------
First Quarter............................................... $ 8.13 $ 6.00
(through March 21, 1997)
To date, the Company has not declared or paid any cash dividends on its
common stock, and the present policy of the Board of Directors is to retain any
earnings to provide for the Company's growth. Any future determination to pay
dividends will be at the discretion of the Board of Directors, and dependent
upon the Company's financial condition, results of operations, capital
requirements and such other factors as the Board of Directors deems relevant. In
addition, the Company's current credit arrangement with NationsBank of Texas,
N.A. ("NationsBank") prohibits the payment of cash dividends.
On August 26, 1996, the Board of Directors voted to redeem the Company's
then outstanding stock purchase rights at $0.01 per share. The redemption price
for the outstanding rights was paid on September 27,
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1996 to shareholders of record as of September 12, 1996. See Note 7 of the Notes
to Consolidated Financial Statements.
Subsequent to December 31, 1996, in connection with borrowing $2.0 million
from a stockholder, the Company issued the stockholder five-year warrants to
purchase 100,000 shares at an exercise price of $6.50 per share, the closing
sales price on the date the indebtedness was incurred. See Item 7. "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources" and Note 5 of the Notes to
Consolidated Financial Statements. The Company relied on the private placement
exemptions provided by Regulation D under the Securities Act of 1933, as
amended, in issuing the warrants.
ITEM 6. SELECTED FINANCIAL DATA
YEARS ENDED DECEMBER 31
----------------------------------------------------
1992 1993 1994 1995(1) 1996
------- ------- ------- -------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Statement of Operations Data:
Net revenue............................. $13,612 $13,643 $13,999 $ 25,321 $26,074
Gross profit............................ 6,553 6,591 6,381 14,697 15,069
Research and development expense........ 1,387 1,910 3,542 4,583 3,343
Nonrecurring charges(2)................. 1,247 -- -- 10,500 --
Marketing and general and administrative
expense.............................. 4,141 4,400 4,977 8,395 11,626
Earnings (loss) from operations,
excluding nonrecurring charges....... 1,025 281 (2,138) 1,719 100
Earnings (loss) from operations......... (222) 281 (2,138) (8,781) 100
Other income (expense), net............. 473 667 419 (1,168) (429)
Earnings (loss) from continuing
operations before income taxes,
extraordinary item and cumulative
effect of change in accounting
principle............................ 251 948 (1,719) (9,950) (329)
Net earnings (loss) 194 816(3) (1,719) (10,374)(4) (412)
Net earnings (loss) per share........... $ .03 $ .15 $ (.33) $ (1.56) $ (.05)
Weighted average common and common
equivalent shares outstanding........ 5,594 5,559 5,257 6,642 8,531(5)
YEARS ENDED DECEMBER 31
----------------------------------------------------
1992 1993 1994 1995 1996
------- ------- ------- -------- -------
(IN THOUSANDS)
Balance Sheet Data:
Cash, cash equivalents and marketable
securities........................... $ 6,693 $ 6,594 $ 5,262 $ 3,914 $ 2,062
Working capital......................... 10,847 9,566 7,411 12,183 11,088
Total assets............................ 20,448 26,739 24,235 44,496 48,992
Short-term notes payable and current
maturities of long-term notes
payable.............................. 799 2,297 2,759 1,616 2,084
Notes payable, excluding current
maturities........................... 242 4,101 4,124 8,558 11,912
Stockholders' equity.................... $17,639 $18,252 $15,931 $ 30,870 $30,993
- ---------------
(1) Includes results of Neuromed from April 1, 1995.
(2) Nonrecurring charge in 1992 relates to the write-off of assets of a
discontinued business and in 1995 relates to purchased research and
development incurred in connection with the Neuromed acquisition.
(3) Includes an increase in net income of $169, or $.03 per share, relating to
the cumulative effect of a change in accounting principle.
(4) Includes a decrease in net income of $269 (net of income tax benefit of
$139), or $(.03) per share, from the write-off of capitalized debt issuance
costs due to early repayment of bank debt.
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(5) The Company completed a public offering of 1,676,667 shares for net proceeds
of $15.2 million in the fourth quarter of 1995.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion of the financial condition and results of
operations of the Company should be read in conjunction with the Consolidated
Financial Statements of the Company and the related Notes thereto.
RESULTS OF OPERATIONS
Comparison of the Years Ended December 31, 1996 and 1995
Revenues. Net revenue of $26.1 million for the year ended December 31,
1996, was $800,000 above the level for the comparable 1995 period of $25.3
million. This increase during 1996 compared to 1995 was primarily attributable
to including a full twelve months of revenue generated by ANS, formerly
Neuromed, Inc., which was acquired on March 31, 1995. Revenue of ANS products
for 1996 was $11.4 million compared to $10.4 million for the last nine months of
1995. In addition, the Company introduced the next generation of multi-electrode
leads in 1996, which prompted delays in purchase commitments. The Company made
the strategic decision in 1996 to market its ANS products through commissioned
sales agents rather than distributors in certain geographical areas of the
United States. This decision resulted in a decrease of approximately $300,000 in
ANS revenue during 1996 due to the return of inventories from those distributors
whom the Company decided to replace with sales agents. During early 1996,
management announced plans to re-build the infrastructure at ANS to transform
ANS into an industry leader and compete effectively in the SCS market.
Management believes it has taken major steps in improving the current products
of ANS and is continuing these efforts into the first quarter of 1997.
Management believes that these efforts should return ANS to sustained and
profitable revenue growth during 1997.
During the third quarter of 1996, the Company completed clinical validation
of the MPS system for cardioplegia delivery and began commercial shipments
during September 1996, a quarter later than management had expected. Revenue
from the MPS system and related disposable products during 1996 was $443,000,
significantly below management's expectations. Clinical evaluations since the
commercial introduction of the MPS have validated that the MPS provides simpler,
more flexible and cost-effective management of myocardial protection. As a
consequence of the current hospital consolidation trend, coupled with the
intense pressure hospitals are under to minimize capital expenditures, however,
hospitals have been reluctant to make timely purchase decisions on new capital
equipment. Therefore, to accelerate the adoption of MPS and shorten the selling
process, the Company, in early 1997, decided to offer MPS on a one-year rental
basis and on a lease/purchase basis. This strategy will decrease short-term
revenues because the rental agreement does not qualify as a sale, but should, in
management's opinion, accelerate placement of MPS systems and related disposable
revenues. The Company believes that once a surgeon changes the cardioplegia
protocol using features of MPS, it will be very difficult to return to the old,
make-shift system. There can be no assurance that such rental strategy will
accelerate placement of MPS systems.
Net revenue from sales of the Company's other cardiovascular products,
pressure monitoring kits used in labor and delivery and specialized intravenous
fluid delivery tubing sets decreased from $14.9 million in 1995 to $14.2 during
1996 due to lower unit sales volume from the Company's specialized intravenous
fluid delivery tubing sets.
Gross Profit. Gross profit during 1996 increased to $15.1 million compared
to $14.7 million in 1995. As a percentage of net revenue, gross profit decreased
slightly to 57.7 percent in 1996 compared to 58.0 percent during 1995. This
slight decrease in gross profit margin was principally the result of higher
manufacturing overhead expense related to the Company's ANS products.
Operating Expenses. Research and development expense decreased to $3.34
million in 1996 compared to $4.58 million in 1995, and as a percentage of net
revenue, decreased to 12.8 percent in 1996 from 18.1 percent
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during 1995. This decrease was the result of a reduction in salary and contract
labor expense from staffing reductions due to the completion of the development
of the MPS system. Separately, the Company devoted significant engineering
resources and took major steps to improve ANS products during 1996. This effort
is continuing into the first quarter of 1997. The Company has budgeted $2.8
million for research and development during 1997. Management expects about half
of such expenditures to be directed to refining current ANS products and
designing and developing next generation ANS products for market introduction
during 1998. The other half of 1997 budgeted expenditures will be directed to
continued developments in the MPS system. Management expects that most of its
research and development activities during 1997 will continue to be financed
through internally-generated funds.
Marketing, general and administrative expenses as a percentage of net
revenue increased to 44.6 percent during 1996 compared to 33.2 percent during
1995, and the dollar amount increased by $3.23 million. The largest increase
occurred in marketing expense with expenditures in 1996 increasing by $2.4
million over the comparable period a year ago and as a percentage of net
revenue, increased to 25.3 percent in 1996 compared to 16.6 percent in 1995. Of
such increase, $1.6 million was additional marketing expense of ANS related to
additional salary, benefit, commission, travel, samples and promotional expense.
The 1995 period included only nine months of expense. During 1996, the Company
reorganized part of its ANS distribution network for ANS products and replaced
several distributors in certain areas of the United States with eight
commissioned sales agents and three direct regional managers. Also during 1996,
the Company has designed ANS training, customer support and sales and marketing
materials and videos and will continue those efforts in early 1997. The Company
has also reestablished relationships with key implanters who had discontinued
using the ANS products prior to the Company's acquisition. The remainder of the
increase in marketing expense of $800,000 in 1996 compared to 1995 was primarily
the result of additional salary, benefit and travel expense from four additional
direct salespersons hired during the fourth quarter of 1995 in preparation of
the commercial introduction of the MPS system. As previously mentioned, the
Company began commercial shipments of MPS during September 1996, about a quarter
later than it had anticipated at the beginning of 1996. Currently, the Company
has five direct salespersons marketing the MPS system and does not anticipate
adding additional salespersons during 1997. In early 1997, the Company decided
to offer MPS on a one-year rental basis and on a lease/purchase basis to
accelerate the adoption of MPS and shorten the selling process. If this strategy
is successful, the Company would reevaluate adding salespersons during 1997, as
circumstances warrant. Management has decided to focus most of its efforts for
MPS during 1997 on the U.S. and Canadian markets, and does not anticipate
introduction of the MPS internationally until fiscal 1998.
General and administrative expense increased $800,000 during 1996 compared
to 1995, and as a percentage of net revenue, increased from 16.6 percent in 1995
to 19.3 percent in 1996. Of such increase, $335,000 was attributable to higher
amortization expense of ANS intangibles. In addition, the 1996 period includes
$256,000 of expense related to a writeoff of a receivable due from a former ANS
distributor who filed bankruptcy and an increase to the Company's reserves for
bad debt ($60,000). The remainder of the increase in expense during 1996
compared to 1995 was primarily the result of higher recruiting, relocation and
401(k) Company match expenses.
Earnings (Loss) From Operations. Earnings from operations for 1996 totaled
$100,000 compared to a net loss from operations in 1995 of $8.78 million. In
connection with the Neuromed acquisition, $10.5 million of the aggregate
purchase price was identified as purchased in-process research and development,
and in accordance with generally accepted accounting principles, was charged to
expense with no related tax benefit during 1995. Excluding the 1995 expense for
purchased research and development, earnings from operations decreased from
$1.72 million in 1995 to $100,000 in 1996, reflecting higher levels of
marketing, general and administrative expense discussed above.
Other Expense. Other expense decreased to $429,000 in 1996 compared to
$1.17 million in 1995 due to lower interest expense. The 1995 period reflects
interest expense on $15 million of bank debt incurred in March 1995 in
connection with the Neuromed acquisition, which was repaid in November of 1995
from the proceeds of a public offering. Interest income decreased $260,000 from
1995 levels due to reduced funds available for investment. This decrease in
interest income was partially offset, however, by a $108,000 increase in gains
on the sale of marketable securities.
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Income Taxes. Despite the Company's loss before income tax expense of
$329,000 in 1996, the Company recorded income tax expense of $83,000 as a
consequence of the nondeductibility of amortization costs in excess of net
assets acquired (goodwill). During 1995, the Company similarly recorded income
tax expense of $155,000 despite a loss before income tax expense of $9.95
million as a consequence of the nondeductibility of the $10.5 million expense
for purchased research and development and amortization costs in excess of net
assets acquired.
Net Loss. The net loss decreased from $10.4 million in 1995 to $412,000 in
1996 primarily due to the $10.5 million expense during 1995 for purchased
in-process research and development incurred in connection with the Neuromed
acquisition. Excluding this $10.5 million expense, the Company's net loss of
$412,000 in 1996 compared to net earnings of $126,000 in 1995 and resulted from
increased operating expenditures, particularly in general and administrative and
marketing.
Comparison of the Years Ended December 31, 1995 and 1994
Revenues. Net revenue of $25.3 million for the year ended December 31,
1995, was $11.3 million, or 80.7 percent above the level for the comparable 1994
period of $14.0 million. This increase during 1995 compared to 1994 was
primarily attributable to revenue generated by Neuromed, which was acquired on
March 31, 1995. Net revenue from sales of the Company's other products increased
6.3 percent during 1995 compared to 1994 primarily due to higher unit sales
volume from the Company's cardiovascular products.
Gross Profit. Gross profit during 1995 increased to $14.7 million compared
to $6.4 million in 1994, an increase of 130 percent. As a percentage of net
revenue, gross profit increased to 58.0 percent in 1995 compared to 45.6 percent
during 1994. This increase in gross profit and gross profit margin during 1995
compared to 1994 was primarily attributable to the revenue generated by
Neuromed, since Neuromed's products contribute higher gross profit margins than
the Company's other product lines.
Operating Expenses. Research and development expense increased to
approximately $4.6 million during 1995 compared to the 1994 level of $3.5
million, although such expense decreased as a percentage of net revenue from
25.3 percent during 1994 to 18.1 percent during 1995. These expenditures during
1995 were $2.1 million more than originally budgeted at the beginning of fiscal
1995. Of such overage, $650,000 were expenditures directed toward Neuromed while
the remainder represented additional expenditures directed at continued
development of the Company's MPS(TM) brand of myocardial protection system. As
previously noted, the Company filed for FDA market clearance under a 510(k)
during August 1995 and on March 8, 1996 received clearance to commercially
market the MPS system, which occurred during the third quarter of 1996.
Increased expenditures during 1995 compared to 1994 were primarily the result of
additional salary and contract labor expense from staff additions and increased
consulting expense.
Marketing, general and administrative expenses as a percent of net revenue
decreased to 33.2 percent during 1995 compared to 35.6 percent during 1994,
while the dollar amount increased $3.4 million. Marketing expense as a
percentage of net revenue increased to 16.6 percent in 1995 from 13.7 percent
during 1994, and the dollar amount increased by $2.3 million. Of such increase,
$1.7 million was Neuromed marketing expense. The remainder of the increase in
marketing expense was primarily the result of additional salary and benefit
expense from personnel additions, and increased travel, commission, convention
and recruiting expense. During the fourth quarter of 1995, the Company hired
four additional direct salespersons in anticipation of the 510(k) clearance of
its MPS system. General and administrative expense increased $1.1 million during
1995 compared to 1994, but as a percentage of net revenue, decreased from 21.9
percent during 1994 to 16.6 percent during 1995. This increase in expense during
1995 compared to 1994 was attributable to general and administrative expense of
Neuromed, including amortization expense of Neuromed intangibles.
Loss from Operations. On March 31, 1995, the Company acquired all of the
capital stock of Neuromed, Inc. Of the aggregate purchase price for Neuromed,
$10.5 million was identified as purchased in-process research and development
and in accordance with generally accepted accounting principles was charged to
expense, with no related tax benefit, during 1995. As a result, the loss from
operations increased from $2.1 million in 1994 to $8.8 million during 1995.
Excluding the charge for purchased research and
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development, the Company generated earnings from operations of $1.7 million
compared to the $2.1 million loss for the 1994 period, reflecting the positive
impact of the Neuromed acquisition.
Other Income (Expense). Other income (expense) decreased to an expense of
$1.2 million during 1995 compared to income of $419,000 during 1994. This
decrease was primarily the result of higher interest expense which increased
$1.1 million during 1995 from 1994. The Company incurred $15.0 million of
long-term bank debt on March 31, 1995, which was used to fund most of the cash
payment of the Neuromed acquisition. Higher overall interest rates on borrowed
money also contributed to the increase in interest expense during 1995 compared
to 1994. In addition, gains recognized on the sale of the Company's investments
was $29,000 for 1995 compared to $464,000 for 1994, also contributing to the
decrease in other income.
Income Taxes. The Company recorded income tax expense of $155,000 during
1995 as a consequence of the nondeductibility of the $10.5 million expense for
purchased research and development and amortization expense of costs in excess
of net assets acquired. No income tax benefit was recognized for the Company's
1994 net operating loss.
Net Loss. The net loss increased from $1.7 million in 1994 to $10.4 million
during 1995 primarily as a result of the aforementioned $10.5 million expense
for purchased in-process research and development incurred in connection with
the Neuromed acquisition. In addition, the net loss for 1995 reflects an
extraordinary charge of $269,000 for the writeoff of capitalized debt issuance
costs due to early repayment of the long-term bank debt.
LIQUIDITY AND CAPITAL RESOURCES
The Company's working capital decreased from $12.2 million at year-end 1995
to $11.1 million at year-end 1996 principally due to an increase of $1.1 million
in accounts payable. The ratio of current assets to current liabilities was
3.0:1 at December 31, 1996, compared to 3.7:1 at December 31, 1995. Cash, cash
equivalents and marketable securities totaled $2.1 million, a decrease of $1.8
million from year-end 1995.
The Company increased its investment in inventories during 1996 by $2.26
million, substantially all of which relates to the MPS system and its related
disposables. The Company anticipates a decrease in its investment in inventories
of approximately $1.0 million by year-end 1997.
During 1996, the Company invested $2.0 million in capital expenditures for
additional manufacturing tooling and equipment and an upgraded management
information system. The Company expects capital expenditures for fiscal 1997 to
decrease to $1.5 million. These capital expenditures, during 1997, are
principally for manufacturing tooling and equipment for the Company's current
ANS SCS products and next generation neuromodulation products.
In connection with the Neuromed acquisition in March 1995, the Company
agreed to pay contingent earn-out consideration in January 1996 and January
1997, depending on Neuromed's attainment of certain sales objectives. At yearend
1995, the Company had a note payable in connection with the 1995 earn-out
consideration in the amount of $1.5 million, payable in January 1996. The
Company withheld payment of the $1.5 million obligation pending arbitration of
certain disputes between the Company and Neuromed's former owner. In October
1996, the sales objectives for the 1996 earn-out were reached and the Company
recorded a note payable in the amount of $3.37 million which was due and payable
in January 1997. The Company similarly withheld payment of this note pending
arbitration. In addition, the Company had a short-term note payable to the
former owner of Neuromed at December 31, 1996, in the amount of $972,000 due in
January 1997, related to certain purchase price adjustments (principally tax
refunds and future tax credits) awarded through an arbitration. The Company paid
the $972,000 obligation during January 1997 utilizing a portion of its cash
reserves. On February 6, 1997, the Company and the former owner of Neuromed
reached a settlement (the "Settlement") of all issues between them. Under terms
of the Settlement, the Company agreed to pay $500,000 on March 3, 1997, and
deliver a promissory note in the amount of $1.0 million payable on February 6,
1998, for full settlement of the contingent earn-out considerations. The
promissory note bears interest at the rate of 10 percent per annum with interest
due and payable monthly. The Company also agreed to pay $3.0 million on March 3,
1997, to purchase certain patent rights from Neuromed's former owner. On
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March 3, 1997, the Company made payment of the $3.5 million pursuant to the
Settlement with borrowed funds discussed below. See Notes 3 and 5 of the Notes
to Consolidated Financial Statements.
On February 21, 1997, the Company borrowed $2.0 million from a shareholder
pursuant to a promissory note. The promissory note is due and payable on
February 21, 1998, and bears interest at the rate of 6 percent per annum. In
addition, the Company issued the shareholder five-year warrants to purchase
100,000 shares of common stock at an exercise price of $6.50 per share, the
closing sales price on the date the indebtedness was incurred. The Company
utilized proceeds from the loan to pay a portion of the Settlement discussed
above. See Note 5 of the Notes to Consolidated Financial Statements.
On March 3, 1997, the Company amended its $5.0 million working capital line
of credit with NationsBank of Texas, N.A. Under the third amended agreement, the
working capital line of credit was increased to $5.65 million and a $350,000
term loan facility was added. Both facilities expire on January 31, 1998.
Borrowings under the working capital line of credit bear interest at prime plus
100 basis points, or at the Company's option, LIBOR plus 275 basis points.
Borrowings under the term loan facility bear interest at prime plus 100 basis
points, or at the Company's option, LIBOR plus 225 basis points. The facilities
are collateralized by all of the Company's assets with the exception of the real
property, building, and equipment that collateralize the long-term financing on
the Company's facility in Allen, Texas. Under the working capital line, the
Company is required to make monthly principal payments of $90,000, with interest
payable quarterly. Under the term loan facility, no principal payments are due
until maturity and interest is payable quarterly. On March 3, 1997, the Company
increased its borrowings under the working capital line of credit by $1.1
million and borrowed $350,000 under the term loan facility. These additional
borrowings were utilized to pay a portion of the debt under the Settlement
described above. See Note 5 of the Notes to Consolidated Financial Statements.
Management believes that its current cash, cash equivalents and marketable
securities and funds generated from operations will be sufficient to satisfy
normal cash operating requirements, debt service and capital requirements during
the remainder of 1997. During the first quarter of 1998, however, $8.1 million
of debt will become due and payable. The Company is exploring various means to
either refinance or payoff the debt entirely, including without limitation, a
new loan facility, alternative debt or equity financing, asset or division sale,
technology transfer or other arrangements.
CASH FLOWS
Net cash used in operating activities in 1996 decreased to $446,000
compared to $1.53 million in 1995. The primary use of cash during 1996 was an
increase in the Company's investment in inventories, which increased by $2.26
million, primarily related to building MPS units and manufacturing supplies of
related disposables. The Company anticipates that its operating activities
during 1997 will provide cash and anticipates a decrease in its investment in
inventories of approximately $1.0 million by year-end 1997. During 1995, the net
cash used in operating activities of $1.5 million was primarily due to an
increase in net working capital, principally in the areas of accounts
receivable, inventory and prepaid expenses.
Investing activities in 1996 resulted in a net use of cash of $3.5 million
compared to a net use of cash during 1995 of $14.1 million. Primary uses of cash
in investing activities during 1996 were capital expenditures of $2.0 million
for additional manufacturing equipment and office equipment and $3.0 million for
the purchase of certain patent rights from the former owner of Neuromed, Inc.
See "-- Liquidity and Capital Resources" and Notes 3 and 5 of the Notes to
Consolidated Financial Statements. The primary source of cash from investing
activities in 1996 was from the sale of certain of the Company's investments in
marketable securities, which provided $1.5 million. Primary uses of cash in
investing activities during 1995 were $16.0 million utilized to consummate the
Neuromed acquisition and capital expenditures of $1.5 million. The primary
source of cash from investing activities in 1995 was from the sale of certain of
the Company's investments in marketable securities, which provided $3.3 million.
Financing activities in 1996 provided $3.3 million of net cash compared to
$16.9 million in 1995. Primary sources of cash from financing activities in 1996
consisted of a net increase in notes payable of $3.0 million to fund the
purchase of certain patent rights from the former owner of Neuromed and $559,000
from the exercise
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of stock options. The $3.0 million obligation was paid during March 1997. See
Note 5 of the Notes to Consolidated Financial Statements. Primary uses of cash
in financing activities during 1996 were $151,000 of principal payments for
long-term notes payable and $103,000 utilized in the redemption of the Company's
shareholder rights plan. Primary sources of cash from financing activities in
1995 consisted of $15.0 million provided from borrowings under a senior-term
bank facility which was utilized to fund most of the cash portion of the
Neuromed acquisition purchase price, $1.9 million of additional borrowings under
the Company's working capital line of credit, and $15.2 million of net proceeds
provided by a public offering. In addition, the exercise of stock options in
1995 provided $369,000. Primary uses of cash in financing activities during 1995
were repayment of the $15.0 million senior-term bank indebtedness and $108,000
of principal payments for long-term notes payable.
RECENT EVENTS
On March 10, 1997, the Company announced that the Company's Board of
Directors has engaged Smith Barney and Rauscher Pierce Refsnes to seek strategic
alternatives to enhance shareholder value. These strategic alternatives may
include a merger, sale of assets, other business combination, or a joint venture
or strategic alliance.
OUTLOOK AND UNCERTAINTIES
Quest does not provide forecasts of potential future financial performance.
While Quest management is optimistic about Quest's long-term prospects, the
following issues and uncertainties, among others, should be considered in
evaluating its growth outlook.
Liquidity. The Company's liquidity has been substantially reduced over the
course of the preceding year, and in the first quarter of 1998, $8.1 million in
debt will become due. The Company's management believes that it will be able to
refinance or repay the debt through a new loan facility, alternative debt or
equity financing, asset or division sale, technology transfer or other
arrangement, but there can be no assurance to this effect. The Company's
leverage and debt service requirements could affect its ability to grow and its
level of profitability.
Search for Strategic Alternatives. The Company has engaged Smith Barney and
Rauscher Pierce Refsnes to seek strategic alternatives to enhance shareholder
value. Although management is optimistic that it will identify an alternative to
pursue, there are many risks and uncertainties inherent in such a process and
there can be no assurance that a strategic alternative will be identified or, if
identified, will be implemented successfully.
Product Development and Market Acceptance. The Company's growth depends in
part on the development and market acceptance of new products, including the MPS
system and related products and next generation ANS products. There is no
assurance that the Company will continue to develop successful products, that
delays in product introduction will not be experienced, or that once such
products are introduced, the market will accept them. In addition, while
management believes that offering the MPS system on a one-year rental basis and
a lease/purchase basis should accelerate the placement of MPS units and related
disposables, there can be no assurance to this effect.
Government Regulation. The Company's business is subject to extensive
government regulation, principally by the FDA. The regulatory process,
especially as it relates to product approvals, can be lengthy, expensive and
uncertain.
Competition and Technological Change. The medical device market is highly
competitive. The Company competes with many larger companies that have access to
greater capital, research and development, marketing, distribution and other
resources than the Company. In addition, this market is characterized by
extensive research efforts and rapid product development and technological
change, which could render the Company's products obsolete or noncompetitive.
Intellectual Property Rights. The Company relies in part on patents, trade
secrets and proprietary technology to remain competitive. It may be necessary to
defend these rights or to defend against claims that
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the Company is infringing the rights of others. Intellectual property litigation
and controversies are disruptive and expensive.
Cost Pressures on Medical Technology. The overall escalating cost of
medical products and healthcare results in significant cost pressure. Third
party payors are under intense pressure to challenge the prices charged for
medical products and services.
Potential Product Liability. The testing, manufacturing, marketing and sale
of medical devices entail substantial risks of liability claims or product
recalls.
Other Uncertainties. Other operating, financial or legal risks or
uncertainties are discussed in this Form 10-K in specific contexts and in the
Company's other periodic SEC filings. The Company is, of course, also subject to
general economic risks, the risk of interruption in the source of supply, the
risk of loss of a major customer, dependence on key personnel and other risks
and uncertainties.
CURRENCY FLUCTUATIONS
Substantially all of the Company's international sales are denominated in
U.S. dollars. Fluctuations in currency exchange rates in other countries could
reduce the demand for the Company's products by increasing the price of the
Company's products in the currency of the countries in which the products are
sold, although management does not believe currency fluctuations have had a
material effect on the Company's results of operations to date.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item is set forth in Appendices A and C.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item is contained under the captions
"Election of Directors" and "Executive Officers" in the definitive proxy
material of the Company to be filed in connection with its 1997 annual meeting
of stockholders, which information is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is contained under the captions
"Compensation and Committees of the Board of Directors" and "Compensation of
Executive Officers" in the definitive proxy material of the Company to be filed
in connection with its 1997 annual meeting of stockholders, which information is
incorporated herein by reference. Information under the caption titled "Report
of the Board of Directors on Annual Compensation" and "Performance Graph" is not
incorporated by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT
The information required by this item is contained under the caption
"Security Ownership of Management and Principal Shareholders" in the definitive
proxy material of the Company to be filed in connection with its 1997 annual
meeting of stockholders, which information is incorporated herein by reference.
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ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is contained under the caption
"Certain Relationships and Related Transactions" in the definitive proxy
material of the Company to be filed in connection with its 1997 annual meeting
of stockholders, which information is incorporated herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. Financial Statements:
See Index to Financial Statements on the second page of Appendix A.
2. Financial Statement Schedules:*
Schedule II -- Valuation and Qualifying Accounts.
See Appendix B.
* Those schedules not listed above are omitted as not applicable or
not required.
3. Exhibits: See (c) below.
(b) Reports on Form 8-K:
None
(c) Exhibits:
2.1 -- Agreement for the Purchase and Sale of All of the Issued
Capital Stock of Neuromed, Inc. dated February 10, 1995,
between Quest Medical, Inc. and William N. Borkan(5)
2.2 -- Amendment Agreement dated March 17, 1995, between Quest
Medical, Inc. and William N. Borkan(5)
2.3 -- Letter Agreement dated as of September 23, 1995, by and
between Quest Medical, Inc. and William N. Borkan(6)
3.1 -- Articles of Incorporation, as amended(6)
3.2 -- Bylaws(1)
4.1 -- Rights Agreement dated as of August 30, 1996, between
Quest Medical, Inc. and KeyCorp Shareholder Services,
Inc. as Rights Agent(7)
10.1 -- Quest Medical, Inc. 1979 Amended and Restated Employees
Stock Option Plan(2)
10.2 -- Form of 1979 Employees Stock Option Agreement(3)
10.3 -- Quest Medical, Inc. Directors Stock Option Plan (as
amended)(2)
10.4 -- Form of Directors Stock Option Agreement(1)
10.5 -- Quest Medical, Inc. 1987 Stock Option Plan(6)
10.6 -- Form of 1987 Employee Stock Option Agreement(6)
10.7 -- Quest Medical, Inc. 1995 Stock Option Plan(6)
10.8 -- Form of 1995 Employee Stock Option Agreement(6)
10.9 -- Form of Employment Agreement and Covenant Not to Compete,
between the Company and key employees(1)
10.10 -- Promissory Note dated December 28, 1993, between Quest
Medical, Inc. and MetLife Capital Financial
Corporation(4)
10.11 -- Commercial Deed of Trust, Security Agreement and
Assignment of Leases and Rents and Fixture Filing dated
December 28, 1993, between Quest Medical, Inc. and
MetLife Capital Financial Corporation(4)
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10.12 -- Term Promissory Note dated December 28, 1993, between
Quest Medical, Inc. and MetLife Capital Corporation(4)
10.13 -- Loan and Security Agreement dated December 28, 1993,
between Quest Medical, Inc. and MetLife Capital
Corporation(4)
10.14 -- Supplemental Security Agreement Number One dated December
28, 1993, between Quest Medical, Inc. and MetLife Capital
Corporation(4)
10.15 -- Third Amended and Restated Credit Agreement dated as of
March 3, 1997, between Quest Medical, Inc. and
NationsBank of Texas, N.A.(8)
10.16 -- Promissory Note (Facility A. Note) in the original
principal amount of $5,650,000 dated March 3, 1997(8)
10.17 -- Promissory Note (Facility B. Note) in the original
principal amount of $350,000 dated March 3, 1997(8)
10.18 -- First Amended and Restated Security Agreement dated March
3, 1997, between Quest Medical, Inc. and NationsBank of
Texas, N.A.(8)
10.19 -- First Amended and Restated Security Agreement dated March
3, 1997, between Advanced Neuromodulation Systems, Inc.
and NationsBank of Texas, N.A.(8)
10.20 -- First Amended and Restated Intellectual Property Security
Agreement and Assignment dated as of March 3, 1997,
between Quest Medical, Inc. and NationsBank of Texas
N.A.(8)
10.21 -- First Amended and Restated Intellectual Property Security
Agreement and Assignment dated as of March 3, 1997,
between Advanced Neuromodulation Systems, Inc. and
NationsBank of Texas, N.A.(8)
10.22 -- First Amended and Restated License Agreement dated as of
March 3, 1997, between Quest Medical, Inc. and
NationsBank of Texas, N.A.(8)
10.23 -- First Amended and Restated License Agreement dated as of
March 3, 1997, between Advanced Neuromodulation Systems,
Inc. and NationsBank of Texas, N.A.(8)
10.24 -- Guaranty of Advanced Neuromodulation Systems, Inc. in
favor of NationsBank of Texas, N.A. under the Third
Amended and Restated Credit Agreement dated as of March
3, 1997(8)
11.1 -- Computation of Earnings Per Share(8)
21.1 -- Subsidiaries(8)
23.1 -- Consent of Independent Auditors(8)
- ---------------
(1) Filed as an Exhibit to the Company's Registration Statement on Form S-18,
Registration No. 2-71198-FW, and incorporated herein by reference.
(2) Filed as an Exhibit to the report of the Company on Form 10-K for the year
ended December 31, 1987, and incorporated herein by reference.
(3) Filed as an Exhibit to the Company's Registration Statement on Form S-1,
Registration No. 2-78186, and incorporated herein by reference.
(4) Filed as an Exhibit to the report of the Company on Form 10-KSB for the year
ended December 31, 1993, and incorporated herein by reference.
(5) Filed as an Exhibit to the report of the Company on Form 10-KSB for the year
ended December 31, 1994, and incorporated herein by reference.
(6) Filed as an Exhibit to the Company's Registration Statement on Form SB-2,
Registration No. 33-62991, and incorporated herein by reference.
(7) Filed as an Exhibit to the report of the Company on Form 8-K dated September
3, 1996, and incorporated herein by reference.
(8) Filed herewith.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
Date: March 28, 1997
QUEST MEDICAL, INC.
By: /s/ THOMAS C. THOMPSON
----------------------------------
Thomas C. Thompson,
President
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the Company and in
the capacities and on the dates indicated:
SIGNATURE TITLE DATE
--------- ----- ----
/s/ THOMAS C. THOMPSON President and Director of Quest March 28, 1997
- ----------------------------------------------------- Medical, Inc. (Principal
Thomas C. Thompson Executive Officer)
/s/ F. ROBERT MERRILL III Senior Vice March 28, 1997
- ----------------------------------------------------- President -- Finance,
F. Robert Merrill III Secretary and Treasurer of
Quest Medical, Inc.
(Principal Financial and
Accounting Officer)
Director of Quest Medical, Inc. March 28, 1997
- -----------------------------------------------------
Linton E. Barbee
Director of Quest Medical, Inc. March 28, 1997
- -----------------------------------------------------
Robert C. Eberhart
/s/ HUGH M. MORRISON Director of Quest Medical, Inc. March 28, 1997
- -----------------------------------------------------
Hugh M. Morrison
/s/ RICHARD D. NIKOLAEV Director of Quest Medical, Inc. March 28, 1997
- -----------------------------------------------------
Richard D. Nikolaev
/s/ MICHAEL J. TORMA Director of Quest Medical, Inc. March 28, 1997
- -----------------------------------------------------
Michael J. Torma
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APPENDIX A
CONSOLIDATED FINANCIAL STATEMENTS
INDEPENDENT AUDITORS' REPORT
THREE YEARS ENDED DECEMBER 31, 1996
FORMING A PART OF THE ANNUAL REPORT
FORM 10-K
ITEM 8
OF
QUEST MEDICAL, INC. AND SUBSIDIARIES
(NAME OF ISSUER)
FILED WITH THE
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
UNDER
THE SECURITIES AND EXCHANGE ACT OF 1934
28
QUEST MEDICAL, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
TO
CONSOLIDATED FINANCIAL STATEMENTS
FORM 10-K -- ITEM 8
INDEPENDENT AUDITORS' REPORT................................
CONSOLIDATED FINANCIAL STATEMENTS:
Consolidated Balance Sheets -- December 31, 1996 and 1995...
Consolidated Statements of Operations -- Three years ended
December 31, 1996.........................................
Consolidated Statements of Stockholders' Equity -- Three
years ended December 31, 1996.............................
Consolidated Statements of Cash Flows -- Three years ended
December 31, 1996.........................................
Notes to Consolidated Financial Statements..................
A-1
29
REPORT OF INDEPENDENT AUDITORS
The Board of Directors
Quest Medical, Inc.
We have audited the accompanying consolidated balance sheets of Quest
Medical, Inc. and subsidiaries (the Company) as of December 31, 1996 and 1995,
and the related consolidated statements of operations, stockholders' equity, and
cash flows for each of the three years in the period ended December 31, 1996.
Our audit also included the financial statement schedule listed in the Index at
Item 14A. These consolidated financial statements and schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and schedule 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 consolidated financial position of Quest Medical,
Inc. and subsidiaries at December 31, 1996 and 1995, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1996, in conformity with generally accepted
accounting principles. Also, in our opinion, the related financial statement
schedule, when considered in relation to the basic financial statements taken as
a whole, presents fairly in all material respects the information set forth
therein.
/s/ ERNST & YOUNG LLP
------------------------------------
ERNST & YOUNG LLP
Dallas, Texas
March 14, 1997
A-2
30
QUEST MEDICAL INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1996 AND 1995
ASSETS
1996 1995
----------- -----------
Current assets:
Cash and cash equivalents................................. $ 696,196 $ 1,325,630
Marketable securities..................................... 1,366,089 2,588,547
Receivables:
Trade accounts, less allowance for doubtful accounts of
$174,337 in 1996 and $114,337 in 1995................. 4,829,827 4,955,235
Net investment in sales-type leases.................... 176,875 --
Interest and other..................................... 134,162 128,492
----------- -----------
Total receivables...................................... 5,140,864 5,083,727
----------- -----------
Inventories:
Raw materials.......................................... 3,931,282 2,743,702
Work-in-process........................................ 1,400,712 1,077,529
Finished goods......................................... 3,032,600 2,285,961
----------- -----------
Total inventories...................................... 8,364,594 6,107,192
----------- -----------
Deferred income taxes..................................... 317,276 356,703
Prepaid expenses and other current assets................. 668,808 1,226,268
----------- -----------
Total current assets................................... 16,553,827 16,688,067
----------- -----------
Property, plant and equipment:
Land...................................................... 1,930,289 1,930,289
Building and improvements................................. 5,296,125 5,271,718
Furniture and fixtures.................................... 3,827,738 2,964,471
Machinery and equipment................................... 4,962,846 3,879,802
----------- -----------
16,016,998 14,046,280
Less accumulated depreciation and amortization............ 4,832,468 3,784,510
----------- -----------
Net property, plant and equipment...................... 11,184,530 10,261,770
----------- -----------
Cost in excess of net assets acquired, net of accumulated
amortization of $817,784 in 1996 and $340,300 in 1995..... 10,931,849 9,546,298
Patents, net of accumulated amortization of $1,311,556 in
1996 and $1,086,433 in 1995............................... 4,063,843 1,288,966
Purchased technology from acquisitions, net of accumulated
amortization of $730,775 in 1996 and $413,558 in 1995..... 3,967,225 4,284,442
Tradenames, net of accumulated amortization of $218,750 in
1996 and $93,750 in 1995.................................. 2,281,250 2,406,250
Other assets, net of accumulated amortization of $190,000 in
1996 and $178,667 in 1995................................. 9,931 19,964
----------- -----------
$48,992,455 $44,495,757
=========== ===========
See accompanying notes to consolidated financial statements.
A-3
31
QUEST MEDICAL INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1996 AND 1995
LIABILITIES AND STOCKHOLDERS' EQUITY
1996 1995
----------- -----------
Current liabilities:
Accounts payable.......................................... $ 2,269,269 $ 1,210,265
Short-term notes payable and current maturities of
long-term notes payable................................ 2,084,122 1,616,311
Accrued salary and employee benefit costs................. 924,309 630,908
Accrued relocation costs.................................. -- 291,370
Other accrued expenses.................................... 188,605 755,976
----------- -----------
Total current liabilities......................... 5,466,305 4,504,830
----------- -----------
Notes payable............................................... 11,912,036 8,558,297
Deferred income taxes....................................... 620,631 562,580
Commitments and contingencies
Stockholders' equity:
Common stock, $.05 par value.
Authorized 25,000,000 shares in 1996 and 10,000,000
shares in 1995; issued 8,338,510 shares in 1996 and
8,147,349 shares in 1995.............................. 416,926 407,367
Additional capital........................................ 38,699,517 38,253,670
Retained earnings (deficit)............................... (7,992,082) (7,579,925)
Unrealized loss on marketable securities net of tax
benefit of $67,423 in 1996 and $108,729 in 1995........ (130,878) (211,062)
----------- -----------
Total stockholders' equity........................ 30,993,483 30,870,050
----------- -----------
$48,992,455 $44,495,757
=========== ===========
See accompanying notes to consolidated financial statements.
A-4
32
QUEST MEDICAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31
1996 1995 1994
----------- ------------ -----------
Net revenue......................................... $26,073,808 $ 25,320,990 $13,999,165
Cost of revenue..................................... 11,005,260 10,624,215 7,617,932
----------- ------------ -----------
Gross profit.............................. 15,068,548 14,696,775 6,381,233
----------- ------------ -----------
Operating expenses:
General and administrative........................ 5,027,749 4,199,398 3,063,296
Research and development.......................... 3,342,626 4,582,868 3,542,193
Purchased research and development................ -- 10,500,000 --
Marketing......................................... 6,597,983 4,195,972 1,913,793
----------- ------------ -----------
14,968,358 23,478,238 8,519,282
----------- ------------ -----------
Earnings (loss) from operations........... 100,190 (8,781,463) (2,138,049)
Other income (expense):
Gain on sale of marketable securities............. 136,975 29,115 464,113
Interest expense.................................. (766,769) (1,657,818) (569,428)
Investment and other income, net.................. 200,322 460,282 524,171
----------- ------------ -----------
(429,472) (1,168,421) 418,856
----------- ------------ -----------
Loss before income taxes and extraordinary
item.................................... (329,282) (9,949,884) (1,719,193)
Income taxes........................................ 82,875 155,114 --
----------- ------------ -----------
Loss before extraordinary item............ (412,157) (10,104,998) (1,719,193)
Extraordinary item -- loss on early extinguishment
of debt, net of income tax benefit of $138,599.... -- (269,045) --
----------- ------------ -----------
Net loss.................................. $ (412,157) $(10,374,043) $(1,719,193)
=========== ============ ===========
Per common and common equivalent share:
Loss before extraordinary item.................... $ (.05) $ (1.52) $ (.33)
=========== ============ ===========
Extraordinary item................................ $ -- $ (.04) $ --
=========== ============ ===========
Net loss.......................................... $ (.05) $ (1.56) $ (.33)
=========== ============ ===========
See accompanying notes to consolidated financial statements.
A-5
33
QUEST MEDICAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31
1996 1995 1994
----------- ------------ -----------
Cash flows from operating activities:
Net loss......................................... $ (412,157) $(10,374,043) $(1,719,193)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation.................................. 1,047,958 952,935 761,174
Amortization.................................. 1,156,157 922,454 362,771
Extraordinary item: write off of debt issuance
costs....................................... -- 407,644 --
Deferred income taxes......................... 97,478 200,002 --
Non-operating gains included in net loss...... (139,030) (137,898) (464,113)
Purchased research and development............ -- 10,500,000 --
Changes in assets and liabilities, net of
effects of acquisition:
Receivables................................. (57,137) (2,020,213) 387,347
Inventories................................. (2,257,402) (557,095) 22,471
Prepaid expenses............................ 415,289 (750,284) (128,770)
Accounts payable............................ 700,679 (346,134) (325,167)
Accrued expenses............................ (998,289) (340,966) (304,894)
Other....................................... -- 9,720 (39,701)
----------- ------------ -----------
Net cash used in operating activities.... (446,454) (1,533,878) (1,448,075)
----------- ------------ -----------
Cash flows from investing activities:
Net proceeds from marketable securities
transactions.................................. 1,480,924 3,317,881 1,346,903
Additions to property, plant and equipment....... (1,972,300) (1,468,732) (1,076,871)
Additions to patents............................. (3,000,000) -- --
Acquisition, net of cash acquired................ -- (15,996,910) --
Other............................................ 3,637 6,550 19,510
----------- ------------ -----------
Net cash provided by (used in) investing
activities............................. (3,487,739) (14,141,211) 319,542
----------- ------------ -----------
Cash flows from financing activities:
Net increase (decrease) in short-term notes
payable....................................... (1,450,000) -- 500,000
Proceeds of long-term notes payable, net of debt
issuance costs................................ 4,450,000 16,431,233 106,978
Payment of long-term notes payable............... (150,647) (15,108,486) (121,977)
Exercise of stock options........................ 558,552 369,449 137,047
Net proceeds from public offering of common
stock......................................... -- 15,218,815 --
Redemption of rights plan........................ (103,146) -- --
Issuance (purchase) of treasury stock, net....... -- 1,745 --
----------- ------------ -----------
Net cash provided by financing
activities............................. 3,304,759 16,912,756 622,048
----------- ------------ -----------
Net increase (decrease) in cash and cash
equivalents...................................... (629,434) 1,237,667 (506,485)
Cash and cash equivalents at beginning of year..... 1,325,630 87,963 594,448
----------- ------------ -----------
Cash and cash equivalents at end of year........... $ 696,196 $ 1,325,630 $ 87,963
=========== ============ ===========
Supplemental cash flow information is presented
below:
Income taxes paid.................................. $ -- $ -- $ --
=========== ============ ===========
Interest paid (net of amounts capitalized)......... $ 668,049 $ 1,571,553 $ 558,337
=========== ============ ===========
See accompanying notes to consolidated financial statements.
A-6
34
QUEST MEDICAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
THREE YEARS ENDED DECEMBER 31, 1996
UNREALIZED
COMMON STOCK RETAINED LOSS ON TOTAL
-------------------- ADDITIONAL EARNINGS MARKETABLE TREASURY STOCKHOLDERS'
SHARES AMOUNT CAPITAL (DEFICIT) SECURITIES STOCK EQUITY
--------- -------- ----------- ------------ ---------- ----------- -------------
Balance at December 31, 1993....... 7,939,441 $396,972 $18,787,628 $ 5,430,286 $(169,308) $(6,193,796) $ 18,251,782
Shares issued upon exercise of
stock options.................. 43,057 2,153 134,894 -- -- -- 137,047
Issuance of 1,882 common shares
from treasury.................. -- -- 5,595 -- -- 4,075 9,670
Stock dividend................... -- -- 586,054 (916,975) -- 330,921 --
Adjustment to unrealized losses
on marketable securities....... -- -- -- -- (748,326) -- (748,326)
Net loss......................... -- -- -- (1,719,193) -- -- (1,719,193)
--------- -------- ----------- ------------ --------- ----------- ------------
Balance at December 31, 1994....... 7,982,498 399,125 19,514,171 2,794,118 (917,634) (5,858,800) 15,930,980
Shares issued upon exercise of
stock options.................. 160,422 8,021 361,429 -- -- -- 369,450
Issuance of 245 common shares
from treasury.................. -- -- 1,216 -- -- 529 1,745
Adjustment to unrealized losses
on marketable securities....... -- -- -- -- 706,572 -- 706,572
Issuance of 1,033,333 common
shares from treasury for
acquisition.................... -- -- 6,779,285 -- -- 2,237,246 9,016,531
Sale of treasury and new common
shares in public offering, net
of offering costs.............. 4,429 221 11,597,569 -- -- 3,621,025 15,218,815
Net loss......................... -- -- -- (10,374,043) -- -- (10,374,043)
--------- -------- ----------- ------------ --------- ----------- ------------
Balance at December 31, 1995....... 8,147,349 407,367 38,253,670 (7,579,925) (211,062) -- 30,870,050
Shares issued upon exercise of
stock options.................. 159,178 7.959 479,207 -- -- -- 487,166
Adjustment to unrealized losses
on marketable securities....... -- -- -- -- 80,184 -- 80,184
Issuance of 31,983 new common
shares for employee bonuses and
cancellation of a stock
option......................... 31,983 1,600 69,786 -- -- -- 71,386
Redemption of rights plan
dividend....................... -- -- (103,146) -- -- -- (103,146)
Net loss......................... -- -- -- (412,157) -- -- (412,157)
--------- -------- ----------- ------------ --------- ----------- ------------
Balance at December 31, 1996....... 8,338,510 $416,926 $38,699,517 $ (7,992,082) $(130,878) -- $ 30,993,483
========= ======== =========== ============ ========= =========== ============
See accompanying notes to consolidated financial statements.
A-7
35
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1996
(1) BUSINESS
Quest Medical, Inc. and its subsidiaries (the "Company") design, develop,
manufacture and market a variety of healthcare products used primarily in
cardiovascular surgery, interventional pain management and intravenous fluid
delivery applications. The Company's revenues are derived primarily from sales
throughout the United States, Europe and Australia.
The research and development, manufacture, sale and distribution of medical
devices is subject to extensive regulation by various public agencies,
principally the Food and Drug Administration and corresponding state, local and
foreign agencies. Product approvals and clearances can be delayed or withdrawn
for failure to comply with regulatory requirements or the occurrence of
unforeseen problems following initial marketing.
In addition, the Company's products are purchased primarily by hospitals
and other users which then bill various third party payors including Medicare,
Medicaid, private insurance companies and managed care organizations. These
third party payors reimburse fixed amounts for services based on a specific
diagnosis. The impact of changes in third party payor reimbursement policies and
any amendments to existing reimbursement rules and regulations which restrict or
terminate the eligibility of the Company's products could have an adverse impact
on the Company's financial condition and results of operations.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The consolidated financial statements include the accounts of Quest
Medical, Inc. and subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation. 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 these
estimates.
Revenue from product sales is recognized at the time the product is
shipped.
The Company leases the Quest MPS myocardial protection system to customers
under noncancellable leases with terms of five years. The present value of the
minimum rentals to be received under such leases is recorded as net sales. The
difference between the gross rentals to be received and the present value of the
rentals is recorded as unearned finance income and is amortized into income on
the interest method over the lease term. The cost of the leased equipment is
charged to cost of sales at the time the sale is recorded. The present value of
the rentals to be received under such leases is recorded as net investment in
sales-type leases. At December 31, 1996, the balance in the net investment in
sales-type leases was $176,875.
Cash equivalents include certificates of deposit and short-term, highly
liquid debt instruments with original maturities of three months or less.
The Company's marketable equity and debt securities are classified as
available-for-sale and are carried at fair value, with the unrealized gains and
losses reported in a separate component of stockholders' equity. The amortized
cost of debt securities in this category is adjusted for amortization of
premiums and accretion of discounts to maturity. Such amortization is included
in investment income. Realized gains and losses and declines in value judged to
be other-than-temporary are included in other income. The cost of securities
sold is based on the specific identification method. Interest and dividends are
included in investment income.
Inventories are recorded at the lower of standard cost or market. Standard
cost approximates actual cost determined on the first-in, first-out (FIFO)
basis.
A-8
36
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Property, plant and equipment are stated at cost. Major renewals and
betterments are capitalized; maintenance and repairs are charged to operations
as incurred. Provisions for depreciation and amortization of property, plant and
equipment are computed using the straight-line method using estimated useful
lives of 3 to 30 years.
The excess of costs over the net assets of businesses acquired is amortized
on a straight line basis over the estimated useful lives of 20 to 25 years. The
Company assesses the recoverability of this intangible asset, as well as other
intangible assets, primarily based on its current and anticipated future
undiscounted cash flows. At December 31, 1996, the Company does not believe
there has been any impairment of its intangible assets.
Cost of purchased patents is amortized on a straight-line basis over the
estimated useful lives (4 to 17 years) of such patents. Costs of patents which
are the result of internal development are charged to current operations.
The cost of purchased technology related to acquisitions is based on
appraised values at the date of acquisition and is amortized on a straight-line
basis over the estimated useful lives (10 to 15 years) of such technology.
The cost of purchased tradenames is based on appraised values at the date
of acquisition and is amortized on a straight-line basis over the estimated
useful life (20 years) of such tradenames.
Product development costs including start-up, research and development,
advertising and promotional costs are charged to operations in the year in which
such costs are incurred. Total advertising expense included in marketing was
$25,914, $84,978 and $61,388 at December 1996, 1995 and 1994, respectively.
Loss per share for 1996, 1995, and 1994 is based upon 8,531,499, 6,642,082
and 5,256,683 common and common equivalent shares outstanding, respectively.
Common stock equivalents are outstanding stock options and are included in
average common and common equivalent shares outstanding using the treasury stock
method except during periods where their effect would be antidilutive. During
1994, the Board of Directors approved a 3 percent stock dividend. The weighted
average number of common and common equivalent shares outstanding used in
computing loss per share were increased to retroactively reflect the stock
dividend.
Deferred income taxes are recorded based on the liability method and
represent the tax effect of the differences between the financial and tax basis
of assets and liabilities other than costs in excess of the net assets of
businesses acquired.
The Company has elected to follow APB No. 25, "Accounting for Stock Issued
to Employees" and related Interpretations in the primary financial statements
and to provide supplementary disclosures required by FASB Statement No. 123,
"Accounting for Stock-Based Compensation." (See Note 7.)
Certain prior period amounts have been reclassified to conform to current
year presentation.
(3) ACQUISITION
On March 31, 1995, the Company acquired for $15,403,263 cash (excluding
$1,062,414 of related acquisition and financing costs) and 833,333 shares of
Quest common stock valued at $6,458,331, all of the capital stock of Neuromed,
Inc. ("Neuromed"). The transaction also provided for contingent consideration
over the following two years, payable in a combination of cash and additional
shares of Quest common stock in January 1996 and January 1997, depending on
sales of Neuromed's products reaching certain objectives. Financing for the cash
portion of the purchase price was provided by a bank. (See Note 5.)
In July 1995, the sales objectives for 1995 were reached which triggered a
liability for the 1995 contingent consideration payments with regard to the
Neuromed acquisition. The Company recorded the additional "earn-out"
consideration of 200,000 shares of Quest common stock valued at $2,558,200 and a
$1,500,000 liability (payable in cash in January 1996). In addition, in
September 1995, the Company amended certain
A-9
37
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
terms of the acquisition agreement whereby the Company agreed to accelerate
issuance of the 200,000 shares for the 1995 earn-out and the seller relinquished
certain rights from the previous agreement. The amended agreement set the 1996
contingent consideration, payable in January 1997, at a cash payment equal to
$3,370,000, if earned.
In January 1996, the Company withheld payment of the $1,500,000 pursuant to
the 1995 contingent consideration obligation pending arbitration of certain
disputes between the Company and Neuromed's former owner. In October 1996, the
sales objectives for the 1996 earn-out were reached and the Company recorded a
note payable in the amount of $3,370,000 which was due in January 1997. The
Company similarly withheld payment of this note pending arbitration. In
addition, the Company had a short-term note payable to the former owner of
Neuromed at December 31, 1996, in the amount of $972,000 due in January 1997,
related to certain purchase price adjustments (principally tax refunds and
future tax credits) awarded through an arbitration. The Company paid the
$972,000 obligation during January 1997. On February 6, 1997, the Company and
the former owner of Neuromed reached a settlement (the "Settlement") of all
issues between them. Under the terms of the Settlement, the Company agreed to
pay $500,000 in cash on March 3, 1997, and deliver a promissory note in the
amount of $1,000,000 payable on February 6, 1998, for full settlement of the
contingent considerations. The Company also agreed to pay $3,000,000 in cash on
March 3, 1997, to purchase certain patent rights from Neuromed's former owner.
(See Note 5.)
The acquisition was accounted for by the purchase method of accounting. The
allocation of the purchase price among identifiable tangible and intangible
assets was based upon a risk adjusted income approach. The cost in excess of net
assets acquired is being amortized on a straight line basis over twenty years.
Purchased in-process research and development was identified and valued
through extensive interviews and analysis of data concerning Neuromed's products
under development. Expected future cash flows for products under development
were discounted taking into account economic risks associated with the inherent
difficulties and uncertainty in completing the products, and thereby achieving
technological feasibility, and risks related to the viability of and potential
changes in future target markets. This resulted in $10,500,000 of purchased
research and development which had not yet achieved technological feasibility
and does not have alternative uses. Therefore, in accordance with generally
accepted accounting principles, the $10,500,000, with no related tax benefit,
was charged to expense during the year ended December 31, 1995.
The purchase price allocation for the acquisition of Neuromed, as of
December 31, 1996, is summarized below:
Tradenames.................................................. $ 2,500,000
Purchased technology........................................ 4,000,000
Cost in excess of net assets acquired....................... 10,736,427
Purchased research and development.......................... 10,500,000
Excess of liabilities over tangible assets acquired......... (1,222,986)
Deferred financing costs.................................... 468,767
-----------
$26,982,208
===========
In connection with the purchase, the Company determined that the operations
of Neuromed would be relocated to the Company's facility in Allen, Texas by the
end of the first quarter of 1996. The relocation was completed during the first
quarter of 1996 and the Company incurred $1,234,335 of relocation costs which
were recorded as an adjustment to cost in excess of net assets acquired.
A-10
38
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following unaudited pro forma summary presents the results of
operations as if the acquisition had occurred on January 1, 1994. This summary
does not purport to be indicative of what would have occurred had the
acquisition been made as of this date or of results which may occur in the
future. This method of combining the companies is for the presentation of
unaudited pro forma summary results of operations. Actual statements of
operations of Quest Medical and of Neuromed have been combined from the
effective date of the acquisition forward.
YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31,
1995 1994
------------ ------------
Pro forma revenue......................................... $27,728,289 $22,043,518
Pro forma earnings (loss) from operations................. 2,634,499 (86,467)
----------- -----------
Pro forma net earnings (loss) before extraordinary item in
1995.................................................... 584,986 (1,220,055)
----------- -----------
Pro forma net earnings (loss) per common and equivalent
share before extraordinary item in 1995................. $ .08 $ (0.20)
=========== ===========
The pro forma operations information excludes the charge of $10,500,000
($1.72 per share) related to purchased in-process research and development which
was expensed at the date of acquisition.
(4) MARKETABLE SECURITIES
The following is a summary of available-for-sale securities at December 31,
1996:
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUE
---------- ---------- ---------- ----------
Investment grade preferred securities... $ 622,596 $4,503 $ 45,817 $ 581,282
Publicly traded limited partnerships.... 263,004 -- 44,019 218,985
Real estate investment trusts........... 297,695 3,498 41,688 259,505
Other................................... 381,095 10 74,788 306,317
---------- ------ -------- ----------
$1,564,390 $8,011 $206,312 $1,366,089
========== ====== ======== ==========
At December 31, 1996, no individual security represented more than 20
percent of the total portfolio or 1 percent of total assets. The Company did not
have any investments in derivative financial instruments at December 31, 1996.
The following is a summary of available-for-sale securities at December 31,
1995:
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUE
---------- ---------- ---------- ----------
Investment grade preferred securities... $ 993,241 $ 252 $135,928 $ 857,565
Publicly traded limited partnerships.... 506,447 -- 39,697 466,750
Real estate investment trusts........... 1,031,417 11,899 96,816 946,500
Other................................... 377,233 3,884 63,385 317,732
---------- ------- -------- ----------
$2,908,338 $16,035 $335,826 $2,588,547
========== ======= ======== ==========
At December 31, 1995, no individual security represented more than 15
percent of the total portfolio or 2 percent of total assets. The Company did not
have any investments in derivative financial instruments at December 31, 1995.
A-11
39
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(5) CURRENT AND LONG-TERM DEBT
On March 31, 1995, the Company entered into a loan agreement (the "Loan
Agreement") with a bank providing for $15 million in senior term financing,
which was utilized to pay substantially all of the cash portion of the Neuromed
purchase price and a working capital line of up to $5 million. Borrowings under
both facilities bore interest at prime plus 125 basis points, or at the
Company's option, LIBOR plus 300 basis points. During December 1995, the Company
repaid in its entirety the senior term loan utilizing net proceeds it received
from a public offering. (See Note 7.)
At December 31, 1996 and 1995, the Company had advances in the amount of
$4,550,000 outstanding under its working capital line with a weighted average
interest rate of 7.19 percent and 7.69 percent for 1996 and 1995, respectively.
At December 31, 1996, the Company was not in compliance with certain financial
covenants in its loan agreement, but has cured the noncompliance through an
amended loan agreement described below.
On March 3, 1997, the Company amended the $5 million working capital line
of credit. Under the amended agreement, the working capital line of credit was
increased to $5,650,000 and a $350,000 term loan facility was added. Borrowings
under the working capital line of credit bear interest at prime plus 100 basis
points, or at the Company's option, LIBOR plus 275 basis points. Borrowings
under the term loan bear interest at prime plus 100 basis points, or at the
Company's option, LIBOR plus 225 basis points. The facilities are collateralized
by all of the Company's assets with the exception of the real property,
building, and equipment that collateralize the long-term financing on the Allen
facility described below. The Company is subject to certain covenants related to
the loan agreement including the maintenance of a minimum fixed charge ratio, a
maximum total liabilities to tangible net worth ratio, and a maximum margin
ratio (as defined). Under the amended agreement, the Company is prohibited from
paying cash dividends. Under the working capital line of credit, the Company is
required to make monthly payments of $90,000 with interest payable quarterly.
Under the term loan, no principal payments are due until maturity and interest
is payable quarterly. These facilities will expire on January 31, 1998. On March
3, 1997, the Company increased its borrowings under the working capital line of
credit by $1,100,000 and borrowed $350,000 under the term loan facility. These
additional borrowings were utilized to pay a portion of the debt under the
February 6, 1997 Settlement discussed below.
On February 21, 1997, the Company borrowed $2,000,000 from a shareholder
pursuant to a promissory note. The promissory note bears interest at the rate of
6 percent per annum. Under the terms of the promissory note, the Company is
required to make quarterly interest payments with a principal payment of
$2,000,000 due and payable at the maturity of the note on February 21, 1998. In
conjunction with the promissory note, the Company issued the shareholder
five-year warrants to purchase 100,000 shares of common stock at an exercise
price of $6.50 per share, the closing sales price on the date the indebtedness
was incurred. Under the warrant agreement, the shareholder has the right to one
demand registration in addition to piggyback registration rights. The loan is
subordinated to the bank debt described above and the shareholder has a second
lien on all of the assets collateralizing the bank debt. Proceeds of the loan
were utilized to pay a portion of the debt under the Settlement described below.
At December 31, 1996, the Company had a short-term, noninterest-bearing
note payable in the amount of $972,197 due in connection with certain purchase
price adjustments (primarily tax refunds and tax credits) awarded through an
arbitration to the former owner of Neuromed, Inc. The note was paid during
January 1997 from cash reserves. In addition, on February 6, 1997, the Company
reached a Settlement (the "Settlement") on all outstanding issues with the
former owner of Neuromed relating to the Neuromed acquisition. Under the
Settlement, the Company agreed to pay $4.5 million in settlement of the earn-out
provisions of the purchase agreement and the purchase of certain patent rights.
Of the Settlement, $3.5 million is an interest bearing note at 10.25 percent per
annum from February 6, 1997, and is due and payable on March 3, 1997. The
Company paid such note on March 3, 1997, utilizing proceeds from the bank debt
and shareholder debt described above. In addition, the Company issued the former
owner a promissory note in the
A-12
40
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
amount of $1,000,000. The promissory note bears interest at the rate of 10
percent per annum with interest due and payable monthly and a principal payment
of $1,000,000 due and payable on February 6, 1998. The loan is subordinated to
the bank debt described above and is collateralized with a second lien that is
pari passu with the shareholder's lien.
The Company classified short-term notes payable of $8,100,000 at December
31, 1996, as long-term notes payable due to refinancings that took place during
February and March of 1997. Of such amount, $3,650,000 (excluding current
maturities of $900,000) relates to borrowings under the Company's working
capital line of credit which was amended in March 1997, and the remaining
$4,450,000 relates to the February 1997 Settlement with the former owner of
Neuromed which was financed through the amended bank agreement which provided
funds of $1,450,000, the shareholder promissory note of $2,000,000, and the
promissory note due to Neuromed's former owner of $1,000,000, all of which are
discussed above.
On December 28, 1993, the Company entered into two agreements for long-term
financing of its principal office and manufacturing facility in the amount of
$4,355,071. The first agreement, in the amount of $3,000,000, is related to the
building. This loan bore interest through 1995 at an adjustable rate based on
the 30-day commercial paper rate plus 300 basis points. Effective January 1996,
the Company fixed the rate of interest for the remainder of the term of the loan
at 8.59 percent. This note has a 25-year amortization. The Company has the
option of prepaying this note during years 6-10, subject to certain provisions.
The loan is collateralized by the Allen facility building and land and has an
unpaid balance of $2,923,260 at December 31, 1996. The second agreement, in the
amount of $1,355,071, is related to certain equipment and furnishings. This loan
bore interest through 1995 at an adjustable rate based on the 30-day commercial
paper rate plus 250 basis points. Effective January 1996, the Company fixed the
rate of interest for the remainder of the term of the loan at 7.94 percent. This
note has a 10-year amortization. This loan is collateralized by the equipment
and furnishings purchased with the proceeds and has an unpaid balance of
$1,050,702 at December 31, 1996.
Scheduled payments of current and long-term debt are as follows:
1997..................................................... $2,084,122
1998..................................................... $8,278,566
1999..................................................... $ 192,082
2000..................................................... $ 208,336
2001..................................................... $ 225,824
Thereafter............................................... $3,007,228
==========
The carrying value of the Company's debt approximates its fair value.
A-13
41
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(6) FEDERAL INCOME TAXES
The significant components of the net deferred tax liability at December
31, were as follows:
1996 1995
----------- -----------
Deferred tax assets:
Tax credit and net operating loss carry forwards........ $ 2,631,362 $ 2,119,781
Accrued expenses and reserves........................... 344,915 377,302
Unrealized loss on marketable securities................ 67,422 108,729
Valuation allowance..................................... (858,835) (271,767)
----------- -----------
Total deferred tax asset........................ 2,184,864 2,334,045
Deferred tax liabilities:
Purchased intangible assets............................. (1,976,958) (2,110,125)
Excess of tax over book depreciation.................... (335,368) (259,361)
Other................................................... (175,893) (170,436)
----------- -----------
Total deferred tax liability.................... (2,488,219) (2,539,922)
----------- -----------
Net deferred tax liability...................... $ (303,355) $ (205,877)
=========== ===========
At December 31, 1996 and 1995, $688,895 and $271,767, respectively, of the
total valuation allowance is attributable to stock option deductions which, when
realized, will be credited to additional capital. The additional valuation
allowance at December 31, 1996, is for certain tax credit carryforwards related
to the Neuromed acquisition. During 1996, the valuation allowance increased by
$587,068. During 1995, the valuation allowance decreased by $1,473,323 which was
recorded as a reduction of costs in excess of net assets acquired because the
decrease resulted from deferred tax liabilities recorded in connection with the
acquisition of Neuromed.
The provision for income taxes for the years ended December 31 consists of
the following amounts:
1996 1995 1994
-------- -------- --------
Current.............................................. $(14,603) $(44,888) $ --
Deferred............................................. 97,478 200,002 --
-------- -------- --------
$ 82,875 $155,114 $ --
======== ======== ========
A reconciliation of the provision for taxes on the loss before
extraordinary item, to the benefit calculated at the U.S. statutory rate
follows:
1996 1995 1994
--------- ----------- ---------
Federal income tax benefit at statutory rate... $(111,956) $(3,382,961) $(584,526)
Tax effect of:
Tax exempt interest.......................... (11,734) (19,949) (52,862)
Nondeductible amortization of goodwill....... 163,258 81,855 13,856
Recognition of research and development tax
credit benefit............................ -- (109,135) --
Nondeductible writeoff of purchased
in-process research and development....... -- 3,570,000 --
Benefit of net operating loss not
recognized................................ -- -- 637,308
Other........................................ 43,307 15,304 (13,776)
--------- ----------- ---------
Income tax expense................... $ 82,875 $ 155,114 $ --
========= =========== =========
A-14
42
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
At December 31, 1996, general business credits of $1,008,523 and
alternative minimum tax credits of $152,620 are available to offset future tax
liabilities. If unused, the general business credits expire in various amounts
beginning in 1997 through 2010.
(7) STOCKHOLDERS' EQUITY
On August 26, 1996, the Board of Directors voted to redeem the Company's
then outstanding stock purchase rights at $0.01 per share. The redemption price
for the outstanding rights was paid on September 27, 1996 to shareholders of
record as of September 12, 1996.
Also on August 26, 1996, the Board of Directors adopted a new Shareholder's
Rights Plan in which rights to purchase shares of the Company's common stock
were distributed as a dividend, one right per share, to shareholders of record
as of September 12, 1996. The rights are not exercisable or transferable apart
from the common stock until ten business days following the date that a person
or group acquires more than 15 percent of the Company's common stock or
announces a tender or exchange offer for more than 20 percent of the Company's
common stock. Upon becoming exercisable, each right entitles the holders to
purchase one share of common stock for $30.00. If the rights become exercisable
because a person or group acquires more than 15 percent of the common stock (an
"Acquiring Person"), however, the purchase price and number of shares
purchasable will be adjusted so that the holder will have the right to receive,
upon the exercise of the right at the applicable exercise price, that number of
shares of the Company's common stock having a market value equal to two times
the applicable exercise price of the right. If the Company is acquired in a
merger or other business combination transaction, or 50 percent or more of its
consolidated assets or earning power are sold, provision will be made so that
each holder of a right will have the right to receive, upon the exercise of the
right at the applicable exercise price, that number of shares of the acquiring
company's common stock having a market value of two times the applicable
exercise price of the right. Until a right is exercised, the holder of a right,
as such, will have no rights as a stockholder of the Company, including, without
limitation, the right to vote as a stockholder or receive dividends. Under the
Rights Plan, the number of shares issuable upon exercise of the rights is
subject to adjustment by the Company to prevent dilution. After a person becomes
an Acquiring Person, the Company's board of directors may exchange the rights,
other than those owned by the Acquiring Person, in whole or in part, at an
exchange ratio of one share of common stock per right, subject to adjustment.
The rights may be redeemed in whole by the Company at a price of $0.01 per right
at any time prior to their expiration on September 12, 2006, or prior to the
point at which they become exercisable.
The Company has various stock option plans pursuant to which stock options
may be granted to key employees and officers (the "Employees' Plans") and one
plan under which directors and advisory directors of the Company may be granted
options (the "Directors' Plan"). The most recent of the Employees' Plans was
adopted and approved by shareholders of the Company during 1995 (the "1995
Plan") which reserved for issuance 250,000 shares of Common Stock; provided,
however, that on January 1 of each year (commencing in 1996), the aggregate
number of shares of Common Stock reserved for issuance under the 1995 Plan shall
be increased by the same percentage that the total number of issued and
outstanding shares of Common Stock increased from the preceding January 1 to the
following December 31 (if such percentage is positive). On January 1, 1996,
pursuant to this provision, the Company added 136,000 shares to the 1995 Plan.
All options outstanding under the Employees' Plans and Directors' Plan are
nonqualified stock options, however, the 1995 Plan allows for the grant of
incentive stock options intended to qualify for preferential tax treatment under
Section 422 of the Internal Revenue Code of 1986. Under all of the Company's
plans, the exercise price of all options granted must equal or exceed the fair
market value of the Common Stock at the time of the grant. Options granted under
the Employees' Plans expire ten years from the date of grant and for the most
part are exercisable one-fourth each year over a four-year period of continuous
service. Options under the Directors' Plan expire six years from the date of
grant and for the most part are exercisable one-fourth each year over a
four-year period of continuous service. Certain options under both the
Employees' Plans and Directors' Plan,
A-15
43
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
however, have a special two-year vesting schedule. These options are exercisable
one-half each year over a two-year period.
At December 31, 1996, under all of the Company's stock option plans,
1,175,188 shares have been granted and are outstanding, 1,091,715 shares of
Common Stock have been issued upon exercise, and 55,409 shares were reserved for
future grants.
Data with respect to stock option plans of the Company are as follows:
EXERCISABLE
OPTIONS OUTSTANDING OPTIONS
- ----------------------------------------------------------------------- -------------------
WEIGHTED WEIGHTED
AVERAGE AVERAGE
EXERCISE EXERCISE
SHARES PRICE SHARES PRICE
--------- -------- ------- --------
January 1, 1994................................. 894,455 $2.90
Granted......................................... 252,444 $4.68
3% stock dividend............................... 31,709 --
Exercised....................................... (43,057) $3.18
Rescinded....................................... (47,548) $3.23
--------- -----
December 31, 1994............................... 1,088,003 $3.25 488,590 $2.50
------- -----
Granted......................................... 239,520 $8.11
Exercised....................................... (160,422) $2.30
Rescinded....................................... (40,540) $4.11
--------- -----
December 31, 1995............................... 1,126,561 $4.33 622,226 $2.84
------- -----
Granted......................................... 323,000 $8.12
Exercised....................................... (159,178) $3.06
Rescinded....................................... (115,195) $8.36
--------- -----
December 31, 1996 1,175,188 $5.16 663,459 $3.51
--------- ----- ------- -----
OPTIONS OUTSTANDING AT EXERCISABLE OPTIONS AT
DECEMBER 31, 1996 DECEMBER 31, 1996
- ------------------------------------------------------------------------- ---------------------------
WEIGHTED
AVERAGE WEIGHTED AVERAGE WEIGHTED AVERAGE
RANGE OF REMAINING LIFE EXERCISE EXERCISE
EXERCISE PRICE SHARES (YEARS) PRICE SHARES PRICE
-------------- --------- -------------- ---------------- ------- ----------------
$1.45 -- 2.25........ 223,831 2.41 $1.78 223,831 $ 1.78
$2.25 -- 3.50........ 78,893 4.46 $3.17 78,893 $ 3.17
$3.50 -- 5.25........ 411,064 5.27 $4.11 297,910 $ 3.97
$5.25 -- 8.00........ 303,400 7.28 $6.63 47,200 $ 6.71
$8.00 -- 12.25........ 158,000 8.44 $10.74 15,625 $11.27
--------- ---- ------ ------- -------
1,175,188 5.62 $5.15 663,459 $ 3.51
========= ==== ====== ======= =======
A-16
44
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In accordance with APB No. 25, the Company records no compensation expense
for its stock option awards. As required by SFAS No. 123, the Company provides
the following disclosure of hypothetical values for these awards. The
weighted-average fair value of an option granted in 1996 and 1995, was $3.09 and
$3.01, respectively. For purposes of fair market value disclosures, the fair
market value of an option grant was estimated using the Black-Scholes option
pricing model with the following assumptions:
1996 1995
---- ----
Risk-free interest rate..................................... 6.0% 6.2%
Average life of options (years)............................. 3.0 3.0
Volatility.................................................. 48.4% 48.4%
Dividend Yield.............................................. -- --
Had the compensation expense been recorded based on these hypothetical
values, pro forma net loss for 1996 and 1995 would have been $(541,855) and
$(10,466,956), respectively, and pro forma net loss per common share for 1996
and 1995 would have been $(.06) and $(1.58), respectively.
In the fourth quarter of 1995, the Company sold 1,676,667 shares in a
public offering. Net proceeds to the Company were $15.2 million, of which $13.9
million was used to repay the senior-term bank debt incurred in connection with
the Neuromed acquisition. Net loss per share would have been ($1.28) if this
transaction had occurred on March 31, 1995, the date at which the debt incurred
in connection with the Neuromed acquisition was first outstanding.
(8) COMMITMENTS AND CONTINGENCIES
The Company has no material commitments under noncancellable operating
leases. Total rent expense under operating leases for the years ended December
31, 1996, 1995, and 1994 was $47,476, $127,113 and $24,930, respectively.
As a consequence of the Neuromed Acquisition in March 1995, the Company is
a party to product liability claims related to SCS devices sold by Neuromed
prior to the acquisition. Product liability insurers have assumed responsibility
for defending the Company against these claims, subject to reservation of rights
in certain cases. While historically product liability claims against Neuromed
have not resulted in significant monetary liability for Neuromed beyond its
insurance coverage, there can be no assurances that the Company will not incur
significant monetary liability to the claimants if such insurance is unavailable
or inadequate for any reason, or that the Company's SCS business and new SCS
product lines will not be adversely affected by these product liability claims.
Except for such product liability claims and other ordinary routine
litigation incidental or immaterial to its business, the Company is not
currently a party to any other pending legal proceeding. The Company maintains
general liability insurance against risks arising out of the normal course of
business.
(9) FINANCIAL INSTRUMENTS, RISK CONCENTRATION, AND MAJOR CUSTOMERS
In the United States, the Company's accounts receivable are due primarily
from hospitals and distributors located throughout the country. Internationally,
the Company's accounts receivable are due primarily from distributors located in
Europe and Australia. The Company generally does not require collateral for
trade receivables. The Company maintains an allowance for doubtful accounts
based upon expected collectibility. Any losses from bad debts have historically
been within management's expectations.
Net sales to a major customer for each of the years ended December 31, as a
percentage of total net revenues were as follows: 1996 -- 10 percent, 1995 -- 10
percent, and 1994 -- 19 percent. Foreign sales, primarily in Europe and
Australia, for the years ended December 31, 1996 and 1995 were approximately 14
percent and 12 percent of total net revenue, respectively.
A-17
45
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(10) EMPLOYEE BENEFIT PLANS
The Company has a defined contribution retirement savings plan (the "Plan")
available to substantially all employees. The Plan permits employees to elect
salary deferral contributions of up to 15 percent of their compensation and
requires the Company to make matching contributions equal to 50 percent of the
participants' contributions, to a maximum of 6 percent of the participants'
compensation. The expense of the Company's contribution was $176,858 in 1996,
$142,485 in 1995, and $102,961 in 1994.
(11) SUBSEQUENT EVENT
On March 10, 1997, the Company announced that the Company's Board of
Directors has engaged Smith Barney and Rauscher Pierce Refsnes to seek strategic
alternatives to enhance shareholder value. These strategic alternatives may
include a merger, sale of assets, other business combination, or a joint venture
or strategic alliance.
A-18
46
APPENDIX B
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
FORMING A PART OF THE ANNUAL REPORT
FORM 10-K
ITEM 14
OF
QUEST MEDICAL, INC. AND SUBSIDIARIES
(NAME OF ISSUER)
FILED WITH THE
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
UNDER
THE SECURITIES AND EXCHANGE ACT OF 1934
47
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
QUEST MEDICAL, INC. AND SUBSIDIARIES
DECEMBER 31, 1996
BALANCE AT CHARGED BALANCE
BEGINNING CHARGED TO TO OTHER AT END OF
DESCRIPTION OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS PERIOD
----------- ---------- ---------- -------- ---------- ---------
Year ended December 31, 1996:
Allowance for doubtful accounts.... $114,337 $ 60,000 $ -- $ -- $174,337
Reserve for obsolete inventory..... 238,679 12,100 -- 20,307(1) 230,472
-------- -------- -------- ------- --------
Total...................... $353,016 $ 72,100 $ -- $20,307 $404,809
======== ======== ======== ======= ========
Year ended December 31, 1995:
Allowance for doubtful accounts.... $ 14,337 $ -- $100,000(2) $ -- $114,337
Reserve for obsolete inventory..... -- 238,679 -- -- 238,679
-------- -------- -------- ------- --------
Total...................... $ 14,337 $238,679 $100,000 $ -- $353,016
======== ======== ======== ======= ========
Year ended December 31, 1994:
Allowance for doubtful accounts.... $ 14,337 $ -- $ -- $ -- $ 14,337
Reserve for obsolete inventory..... 53,927 29,197 -- 83,124(1) --
-------- -------- -------- ------- --------
Total...................... $ 68,264 $ 29,197 $ -- $83,124 $ 14,337
======== ======== ======== ======= ========
- ---------------
(1) Obsolete inventory written off, net of recoveries.
(2) Addition to reserve is result of purchase of Neuromed, Inc.
B-1
48
APPENDIX C
QUARTERLY FINANCIAL DATA
(UNAUDITED)
FORMING A PART OF THE ANNUAL REPORT
FORM 10-K
ITEM 8
OF
QUEST MEDICAL, INC. AND SUBSIDIARIES
(NAME OF ISSUER)
FILED WITH THE
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
UNDER
THE SECURITIES AND EXCHANGE ACT OF 1934
49
1ST 2ND 3RD 4TH
---------- ------------ ---------- ----------
1996
Net revenue............................. $6,149,126 $ 6,669,619 $6,486,521 $6,768,542
Gross profit............................ 3,496,976 3,931,915 3,786,638 3,853,019
Earnings (loss) from operations......... 24,796 217,978 124,249 (266,833)
Earnings (loss) before income taxes..... (76,225) 122,675 35,564 (411,296)
Net earnings (loss)..................... $ (94,572) $ 114,323 $ 6,748 $ (438,656)
---------- ------------ ---------- ----------
Net earnings (loss) per common and
common equivalent share............... $ (.01) $ .01 $ -- $ (.05)
1ST 2ND(1)(2) 3RD 4TH(3)
---------- ------------ ---------- ----------
1995
Net revenue............................. $4,071,640 $ 7,231,494 $6,818,923 $7,198,933
Gross profit............................ 2,044,288 4,348,356 3,968,885 4,335,246
Earnings (loss) from operations......... (336,944) (9,775,378) 543,507 787,352
Earnings (loss) before income taxes..... (364,598) (10,248,708) 90,541 572,881
Earnings (loss) before extraordinary
item.................................. (364,598) (10,248,708) 90,541 417,767
Extraordinary item -- loss on early
extinguishment of debt................ -- -- -- (269,045)
Net earnings (loss)..................... $ (364,598) $(10,248,708) $ 90,541 $ 148,722
---------- ------------ ---------- ----------
Per common and common equivalent share:
Net earnings (loss) before extraordinary
item.................................. $ (.07) $ (1.66) $ .01 $ .05
Extraordinary item...................... -- -- -- (.03)
---------- ------------ ---------- ----------
Net earnings (loss)..................... $ (.07) $ (1.66) $ .01 $ .02
========== ============ ========== ==========
- ---------------
(1) Includes results of Neuromed, Inc. from April 1, 1995 (See Note 3)
(2) Includes a charge of $10,500,000 for purchased in-process research and
development incurred in connection with the acquisition of Neuromed, Inc.
(See Note 3)
(3) Extraordinary item of $269,045 (net of income tax benefit of $138,599) from
write-off of capitalized debt issuance costs due to repayment of bank debt.
C-1
50
INDEX TO EXHIBITS
EXHIBIT NO. DESCRIPTION
----------- -----------
2.1 -- Agreement for the Purchase and Sale of All of the Issued
Capital Stock of Neuromed, Inc. dated February 10, 1995,
between Quest Medical, Inc. and William N. Borkan(5)
2.2 -- Amendment Agreement dated March 17, 1995, between Quest
Medical, Inc. and William N. Borkan(5)
2.3 -- Letter Agreement dated as of September 23, 1995, by and
between Quest Medical, Inc. and William N. Borkan(6)
3.1 -- Articles of Incorporation, as amended(6)
3.2 -- Bylaws(1)
4.1 -- Rights Agreement dated as of August 30, 1996, between
Quest Medical, Inc. and KeyCorp Shareholder Services,
Inc. as Rights Agent(7)
10.1 -- Quest Medical, Inc. 1979 Amended and Restated Employees
Stock Option Plan(2)
10.2 -- Form of 1979 Employees Stock Option Agreement(3)
10.3 -- Quest Medical, Inc. Directors Stock Option Plan (as
amended)(2)
10.4 -- Form of Directors Stock Option Agreement(1)
10.5 -- Quest Medical, Inc. 1987 Stock Option Plan(6)
10.6 -- Form of 1987 Employee Stock Option Agreement(6)
10.7 -- Quest Medical, Inc. 1995 Stock Option Plan(6)
10.8 -- Form of 1995 Employee Stock Option Agreement(6)
10.9 -- Form of Employment Agreement and Covenant Not to Compete,
between the Company and key employees(1)
10.10 -- Promissory Note dated December 28,1993, between Quest
Medical, Inc. and MetLife Capital Financial
Corporation(4)
10.11 -- Commercial Deed of Trust, Security Agreement and
Assignment of Leases and Rents and Fixture Filing dated
December 28,1993, between Quest Medical, Inc. and MetLife
Capital Financial Corporation(4)
10.12 -- Term Promissory Note dated December 28,1993, between
Quest Medical, Inc. and MetLife Capital Corporation(4)
10.13 -- Loan and Security Agreement dated December 28,1993,
between Quest Medical, Inc. and MetLife Capital
Corporation(4)
10.14 -- Supplemental Security Agreement Number One dated December
28,1993, between Quest Medical, Inc. and MetLife Capital
Corporation(4)
10.15 -- Third Amended and Restated Credit Agreement dated as of
March 3, 1997, between Quest Medical, Inc. and
NationsBank of Texas, N.A.(8)
10.16 -- Promissory Note (Facility A. Note) in the original
principal amount of $5,650,000 dated March 3, 1997(8)
10.17 -- Promissory Note (Facility B. Note) in the original
principal amount of $350,000 dated March 3, 1997(8)
10.18 -- First Amended and Restated Security Agreement dated March
3, 1997, between Quest Medical, Inc. and NationsBank of
Texas, N.A.(8)
10.19 -- First Amended and Restated Security Agreement dated March
3, 1997, between Advanced Neuromodulation Systems, Inc.
and NationsBank of Texas, N.A.(8)
51
EXHIBIT NO. DESCRIPTION
----------- -----------
10.20 -- First Amended and Restated Intellectual Property Security
Agreement and Assignment dated as of March 3, 1997,
between Quest Medical, Inc. and NationsBank of Texas
N.A.(8)
10.21 -- First Amended and Restated Intellectual Property Security
Agreement and Assignment dated as of March 3, 1997,
between Advanced Neuromodulation Systems, Inc. and
NationsBank of Texas, N.A.(8)
10.22 -- First Amended and Restated License Agreement dated as of
March 3, 1997, between Quest Medical, Inc. and
NationsBank of Texas, N.A.(8)
10.23 -- First Amended and Restated License Agreement dated as of
March 3, 1997, between Advanced Neuromodulation Systems,
Inc. and NationsBank of Texas, N.A.(8)
10.24 -- Guaranty of Advanced Neuromodulation Systems, Inc. in
favor of NationsBank of Texas, N.A. under the Third
Amended and Restated Credit Agreement dated as of March
3, 1997(8)
11.1 -- Computation of Earnings Per Share(8)
21.1 -- Subsidiaries(8)
23.1 -- Consent of Independent Auditors(8)
- ---------------
(1) Filed as an Exhibit to the Company's Registration Statement on Form S-18,
Registration No. 2-71198-FW, and incorporated herein by reference.
(2) Filed as an Exhibit to the report of the Company on Form 10-K for the year
ended December 31, 1987, and incorporated herein by reference.
(3) Filed as an Exhibit to the Company's Registration Statement on Form S-1,
Registration No. 2-78186, and incorporated herein by reference.
(4) Filed as an Exhibit to the report of the Company on Form 10-KSB for the year
ended December 31, 1993, and incorporated herein by reference.
(5) Filed as an Exhibit to the report of the Company on Form 10-KSB for the year
ended December 31, 1994, and incorporated herein by reference.
(6) Filed as an Exhibit to the Company's Registration Statement on Form SB-2,
Registration No. 33-62991, and incorporated herein by reference.
(7) Filed as an Exhibit to the report of the Company on Form 8-K dated September
3, 1996, and incorporated herein by reference.
(8) Filed herewith.