UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
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: 0-21214
ORTHOLOGIC CORP.
(Exact name of registrant as specified in its charter)
Delaware 86-0585310
(State of other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
1275 W. Washington Street, Tempe, Arizona 85281
(Address of principal executive offices) (Zip Code)
(602) 286-5520
(Registrant's telephone number, including area code)
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. [X] Yes [ ] No
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
32,019,457 shares of common stock outstanding as of July 31, 2002
ORTHOLOGIC CORP.
INDEX
Page No.
--------
Part I Financial Information
Item 1. Unaudited Financial Statements
Condensed Consolidated Balance Sheets as of June 30, 2002 and
December 31, 2001 .................................................. 3
Condensed Consolidated Statements of Operations and of
Comprehensive Income for the Three months and Six months
ended June 30, 2002 and 2001 ....................................... 4
Condensed Consolidated Statements of Cash Flows for the
Six months ended June 30, 2002 and 2001 ............................ 5
Notes to Unaudited Condensed Consolidated Financial Statements ..... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ........................ 13
Item 3. Quantitative and Qualitative Disclosures about
Market Risk ................................................ 20
Part II Other Information
Item 1. Legal Proceedings .......................................... 25
Item 4. Submission of Matters to Vote of Security Holders .......... 25
Item 6. Exhibits and Reports on Form 8-K ........................... 26
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ORTHOLOGIC CORP.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
June 30, December 31,
2002 2001
--------- ---------
(Unaudited)
ASSETS
Cash and cash equivalents $ 10,495 $ 19,503
Short-term investments 18,669 11,008
Accounts receivable, net 10,314 11,361
Inventory, net 2,529 1,762
Prepaids and other current assets 822 688
Deferred income tax 2,631 2,631
--------- ---------
Total current assets 45,460 46,953
--------- ---------
Furniture and equipment 8,522 8,325
Accumulated depreciation (6,769) (6,423)
--------- ---------
Furniture and equipment, net 1,753 1,902
Long-term investments 3,396 --
Investment in Chrysalis BioTechnology 750 750
Deposits and other assets 96 92
--------- ---------
Total assets $ 51,455 $ 49,697
========= =========
LIABILITIES & STOCKHOLDERS' EQUITY
Liabilities
Accounts payable $ 1,307 $ 1,031
Accrued liabilities 4,110 4,861
Accrued liabilities on CPM divestiture and related charges 473 1,022
--------- ---------
Total current liabilities 5,890 6,914
Deferred rent 319 287
--------- ---------
Total liabilities 6,209 7,201
--------- ---------
Series B Convertible Preferred Stock -- 600
Stockholders' Equity
Common stock 16 16
Additional paid-in capital 135,974 135,326
Common stock to be used for legal settlement 2,969 2,969
Accumulated deficit (93,576) (96,278)
Treasury stock (137) (137)
--------- ---------
Total stockholders' equity 45,246 41,896
--------- ---------
Total liabilities and stockholders' equity $ 51,455 $ 49,697
========= =========
See Notes to Unaudited Condensed Consolidated Financial Statements.
3
ORTHOLOGIC CORP.
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS AND OF COMPREHENSIVE INCOME
(in thousands, except per share data)
Unaudited
Three months ended June 30, Six months ended June 30,
--------------------------- -------------------------
2002 2001 2002 2001
-------- -------- -------- --------
Revenues
Net sales $ 9,238 $ 12,777 $ 17,942 $ 25,226
Net rentals 8,739 17,256
Royalties and fee revenue from co-promotion agreement 467 578 1,371 1,294
-------- -------- -------- --------
Total net revenues 9,705 22,094 19,313 43,776
-------- -------- -------- --------
Cost of Revenues
Cost of goods sold 1,443 2,315 2,755 5,125
Cost of rentals 1,584 3,506
-------- -------- -------- --------
Total cost of revenues 1,443 3,899 2,755 8,631
-------- -------- -------- --------
Gross Profit 8,262 18,195 16,558 35,145
-------- -------- -------- --------
Operating expenses
Selling, general and administrative 6,652 17,087 13,356 33,190
Research and development 749 1,957 1,669 2,661
CPM divestiture and related charges (gains) (226) 14,327 (826) 14,327
-------- -------- -------- --------
Total operating expenses 7,175 33,371 14,199 50,178
-------- -------- -------- --------
Operating income (loss) 1,087 (15,176) 2,359 (15,033)
Other income 181 130 368 259
-------- -------- -------- --------
Income (loss) before income taxes 1,268 (15,046) 2,727 (14,774)
Provision for income taxes 12 (60) 25 8
-------- -------- -------- --------
Net Income (loss) $ 1,256 $(14,986) $ 2,702 $(14,782)
======== ======== ======== ========
BASIC EARNINGS PER SHARE
Net income (loss) per common
share $ 0.04 $ (0.48) $ 0.08 $ (0.47)
-------- -------- -------- --------
Weighted average number of
common shares outstanding 32,609 31,444 32,556 31,293
-------- -------- -------- --------
DILUTED EARNINGS PER SHARE
Net income (loss) per common
and equivalent share $ 0.04 $ (0.48) $ 0.08 $ (0.47)
-------- -------- -------- --------
Weighted shares outstanding 33,415 31,444 33,364 31,293
-------- -------- -------- --------
Consolidated Statement of Comprehensive Income
Net income (loss) $ 1,256 $(14,986) $ 2,702 $(14,782)
-------- -------- -------- --------
Foreign translation adjustment -- 236 -- 223
-------- -------- -------- --------
Comprehensive income (loss) $ 1,256 $(14,750) $ 2,702 $(14,559)
======== ======== ======== ========
See Notes to Unaudited Condensed Consolidated Financial Statements.
4
ORTHOLOGIC CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Unaudited
Six months ending
June 30,
--------------------
2002 2001
-------- --------
OPERATING ACTIVITIES
Net income (loss) $ 2,702 $(14,782)
Noncash items:
Depreciation and amortization 347 586
CPM divestiture and related charges 14,327
Net change on other operating items:
Accounts receivable 1,047 2,970
Inventory (767) 1,195
Prepaids and other current assets (134) (385)
Deposits and other assets (4) 147
Accounts payable 276 1,355
Accrued liabilities (719) 999
Accrued liabilities on CPM divestiture and related charges (549) (177)
-------- --------
Net cash provided by operating activities 2,199 6,235
-------- --------
INVESTING ACTIVITIES
Expenditures for rental fleet, equipment and furniture (198) (612)
Purchases of investments (16,125) (3,630)
Maturities of investments 5,068 2,492
-------- --------
Net cash used in investing activities (11,255) (1,750)
-------- --------
FINANCING ACTIVITIES
Payments on capital leases 53
Net proceeds from stock option exercises and other 48 319
-------- --------
Net cash provided by financing activities 48 372
-------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (9,008) 4,857
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 19,503 6,753
-------- --------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 10,495 $ 11,610
======== ========
Supplemental schedule of non-cash investing and financing activities:
Conversion of series B preferred stock to common stock $ 600 $ 2,640
Cash paid during the period for interest $ 3 $ 47
Cash paid during the period for income taxes $ 9 $ --
See Notes to Unaudited Condensed Consolidated Financial Statements.
5
ORTHOLOGIC CORP.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. FINANCIAL STATEMENT PRESENTATION
In the opinion of management, the unaudited interim financial statements
include all adjustments necessary for the fair presentation of the Company's
financial position, results of operations, and cash flows. The results of
operations for the interim periods are not indicative of the results to be
expected for the complete fiscal year. The Balance Sheet as of December 31, 2001
is derived from the Company's audited financial statements included in the 2001
Annual Report on Form 10-K. These financial statements should be read in
conjunction with the financial statements and notes thereto included in the
Company's 2001 Annual Report on Form 10-K.
Use of estimates. The preparation of the financial statements in conformity
with accounting principles generally accepted in the United States of America
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
revenue and expenses during the reporting period. Actual results could differ
from these estimates. Significant estimates include the allowance for doubtful
accounts and sales discounts and adjustments of approximately $3.4 million and
$5.9 million at June 30, 2002 and December 31, 2001, respectively, which are
based primarily on trends in historical collection statistics, consideration of
current events, payor mix and other considerations. The Company derives a
significant amount of its revenues from third-party payors, including Medicare
and certain commercial insurance carriers, health maintenance organizations, and
preferred provider organizations. Amounts paid under these plans are generally
based on fixed or allowable reimbursement rates. Revenues are recorded at the
expected or pre-authorized reimbursement rates when earned and include unbilled
receivables of $2.3 million and $1.9 million on June 30, 2002 and December 31,
2001, respectively. Some billings are subject to review by such third party
payors and may be subject to adjustments. In the opinion of management, adequate
allowances have been provided for doubtful accounts and contractual adjustments.
However, these estimates are always subject to adjustment, which could be
material. Any differences between estimated reimbursement and final
determinations are reflected in the period finalized.
In July 2001, the Company divested its Continuous Passive Motion ("CPM")
business to refocus the Company on its core business of fracture healing and
spinal repair (See Note 3).
2. CO-PROMOTION AGREEMENT FOR HYALGAN
The Company began selling Hyalgan to orthopedic surgeons in July 1997,
pursuant to a Co-Promotion Agreement with Sanofi Synthelabo, Inc. (the
"Co-Promotion Agreement"). In October 2000, the Company and Sanofi mutually
agreed to terminate the agreement. The Company received an up-front cash payment
to complete the transition of the business and continuing royalties on each unit
of Hyalgan distributed by Sanofi from January 1, 2001 through December 31, 2002.
Hyalgan royalty revenue in the quarter ended June 30, 2002 was $467,000 as
compared to Hyalgan royalty revenue of $578,000 for the same period in 2001 and
was $1.4 million for the six month period ended June 30, 2002 compared to $1.3
6
million for the same period in 2001. The Company anticipates receiving royalties
of approximately $800,000 through the end of fiscal year 2002 at which time the
royalty agreement will terminate.
3. CPM DIVESTITURE AND RELATED CHARGES (GAINS)
In January 2001, the Company announced plans to divest its CPM business to
refocus the Company on its core business of fracture healing and spinal repair.
The sale of the CPM business was completed in July 2001 for $12.0 million in
cash, with the assumption of approximately $2.0 million in liabilities. The
Company may receive up to an additional $2.5 million in cash, if certain
objectives are achieved by the purchaser of the CPM business. Because there is
no reasonable basis for estimating the degree of certainty that the objectives
will be reached, the additional contingent consideration has not and will not be
recorded in the accompanying financial statements until the cash is actually
received by the Company.
In the second quarter of 2001, the Company recorded a $14.3 million charge
to write down the CPM assets to their fair value and related charges, plus the
direct cost of selling the assets, which is included in the "CPM divestiture and
related charges" total in the accompanying Statement of Operations for the
quarter ended June 30, 2001. The charge included $6.9 million directly related
to the value of the assets and the direct selling costs, $2.8 million related to
the collectibility of the retained accounts receivable, $3.3 million for
employee severance and stay on bonuses, and $1.4 million for additional exit
charges.
The Company recorded the $6.9 million charge to write down the CPM assets
to their fair value, and account for the direct costs of selling the assets.
Fair value was assessed to be the total consideration received for the CPM net
assets, which sale closed on July 11, 2001. The Company had previously received
non-binding letters-of-intent, which had indicated higher values in the past,
but negotiations that ensued during the second quarter of 2001 resulted in a
lower final sales price for the CPM net assets.
The Company retained all the billed accounts receivable related to the CPM
business, with a net carrying value of approximately $10.8 million (net of a
$5.2 million allowance for doubtful accounts). The net carrying amount reflects
a $2.8 million charge in the second quarter to increase the allowance for
doubtful accounts. The collection staff and supervisors previously responsible
for the collection of these receivables were part of the employee team hired by
the purchaser of the CPM business. The purchaser requested an accelerated
transition plan to hire the majority of the Company's collection team following
the divestiture. The loss of experienced personnel, without a sufficient period
to hire and train new staff, changed the Company's estimate of what would be
collectable of the retained CPM accounts receivable. The Company hired
contractors to replace the previous collection personnel. The Company focused
the contract collection staff on working accounts that had been billed during
the most recent months. The majority of the additional reserve of $2.8 million
was applied to the balance of older CPM related receivables. Actual collection
results could differ materially from these estimates. Any difference between
estimated reimbursement and final determinations will be reflected in the period
finalized.
At December 31, 2001, the Company had collected $10.2 million of the $10.8
million of net receivables estimated during the second quarter of 2001 for the
CPM business. During the first quarter of 2002, collection results were more
favorable than anticipated, resulting in collections of approximately $900,000
7
for the quarter. Based on the improved collection trends during the first
quarter of 2002, the Company increased the originally estimated total
collections by $600,000, which was recognized as a gain in the Statement of
Operations for the quarter ended March 31, 2002. Collection rates during the
second quarter were again slightly better than anticipated, with collections of
approximately $400,000. Therefore, based on the ongoing favorable collection
trends, during the second quarter of 2002, the Company estimated that an
additional $226,000 would be collected in the future, which was recognized as a
gain in the Statement of Operations for the quarter ended June 30, 2002. At June
30, 2002, the approximate carrying value of the remaining CPM accounts
receivable was approximately $180,000.
In connection with the sale of the CPM business, in the second quarter of
2001, the Company notified approximately 331 of the Company's 505 employees that
their positions were being eliminated. A charge of approximately $3.3 million is
included in the "CPM divestiture and related charges" for terminated employees.
The severance and stay on bonus was based on years of service and position grade
level within the Company, respectively. The Company also recorded additional
exit charges of approximately $1.4 million for CPM commissions and rent related
liabilities not divested as part of the sale, concessions for prepaid rents, and
space build out costs relating to the divestiture.
A summary of the severance and other reserve balances at June 30, 2002 and
2001 are as follows (in thousands):
Reserves Amount Charged Cash Reserves
December 31, 2001 Against Assets Paid June 30, 2002
----------------- -------------- ------ -------------
Severance $ 946 $ -- $ (538) $ 408
Other exit costs 76 (11) $ 65
------ ------ ------ ------
Total non-recurring charges $1,022 $ -- $ (549) $ 473
Total Amount Charged Cash Reserves
Charges Against Assets Paid June 30, 2001
------- -------------- ---- -------------
Severance $3,300 -- $ (177) $3,123
Other exit costs 1,387 (245) -- 1,142
------ ------ ------ ------
Total non-recurring charges $4,687 $ (245) $ (177) $4,265
Subsequent to the sale, the Company is no longer in the CPM business.
Substantially all costs, expenses and impairment charges related to CPM exit
activities were recorded prior to the end of the second quarter of 2001. The
revenue and cost of revenue attributable to the CPM business for the six months
ended June 30, 2001 were approximately (in thousands):
Revenue $ 28,015
Cost of revenue 5,943
--------
Gross profit $ 22,072
Operating expenses were not directly allocated between the Company's
various lines of business.
8
The Company leases its headquarters facility in Tempe, Arizona under an
operating lease arrangement. This lease has an expiration date of November 2007.
As a result of the Company's sale of its CPM business during 2001, the purchaser
of the CPM business subleases from the Company approximately 50% of the
facility, which sublease expires in December 2002. It is unlikely that the
existing sublease will be renewed. While the Company believes the facility is
well maintained and adequate for use in the foreseeable future, there can be no
guarantee that a different lessee will assume the remaining lease obligation. If
the Company determines in the future that it cannot sublease this space for a
lease rate at least equal to what the Company pays, then a charge would be
recorded to establish a liability equal to the total of the remaining lease
obligation, reduced by any actual or probable sublease income.
4. LICENSING AGREEMENT FOR CHRYSALIN
The Company announced in January 1998, that it had acquired a minority
equity investment (less than 10%) in a biotech firm, Chrysalis BioTechnology,
Inc. ("Chrysalis") for $750,000. As part of the transaction, the Company was
awarded a worldwide exclusive option to license the orthopedic applications of
Chrysalin, a patented 23-amino acid peptide that had shown promise in
accelerating the healing process and had completed a pre-clinical safety and
efficacy profile of the product. The Company's agreement with Chrysalis contains
provisions for the Company to continue and expand its option to license
Chrysalin contingent upon regulatory approvals, successful pre-clinical trials,
and certain trials and milestone payments to Chrysalis by the Company. As part
of the equity investment, OrthoLogic acquired options to license Chrysalin for
orthopedic applications. A fee of $750,000 for the initial license was expensed
in the third quarter of 1998.
In January 1999, the Company exercised its option to license the U. S.
development, marketing and distribution rights for Chrysalin, for fresh fracture
indications. As part of the license agreement, and in conjunction to FDA
clearance of an Investigational New Drug ("IND") application to begin human
clinical trials for fracture repair, OrthoLogic made a $500,000 milestone
payment to Chrysalis in the fourth quarter of 1999. In January 2000, the Company
began enrolling patients in the combined Phase I/II clinical trial for
Chrysalin. In July 2000, the Company made a $2.0 million payment to Chrysalis
and announced it was expanding its license agreement to include all Chrysalin
orthopedic indications worldwide.
In July 2001 the Company paid $1.0 million to Chrysalis to extend its
worldwide license for Chrysalin to include the rights for orthopedic "soft
tissue" indications including cartilage, tendon and ligament repair. The license
agreement calls for the Company to pay certain additional milestone payments and
royalty fees, based upon products developed and achievement of commercial
services.
In March 2002, the Company received clearance from by the FDA to commence a
Phase I/II clinical trial under an IND application for a spinal fusion
indication and made a $500,000 milestone payment to Chrysalis for receiving this
FDA clearance. The Company anticipates initiating this trial in 2002. Except for
the $750,000 minority equity interest, all payments made to Chrysalis have been
expensed as research and development.
During 2001 the Company completed a Phase I/II clinical trial utilizing
Chrysalin for fresh fracture repair and subsequent to June 30, 2002, the Company
announced that the FDA had authorized a Phase III trial for that indication. The
Company is currently moving forward with an IND application for Phase I/II human
9
clinical trial for Chrysalin for articular cartilage repair in 2002. There can
be no assurance, however, that these clinical trials will result in favorable
data or that FDA approvals, if sought, will be obtained. Significant additional
costs for the Company will be necessary to complete development of these
products.
5. LITIGATION
UNITED STATES OF AMERICA EX REL. DAVID BARMAK V. SUTTER CORP., UNITED
STATES ORTHOPEDIC CORP., ORTHOLOGIC CORP., ET AL., United States District Court,
Southern District of New York, Civ Action No 95 Civ 7637. The complaint in this
matter was filed in September 1997 under the Qui Tam provisions of the Federal
False Claims Act and primarily relates to events occurring prior to the
Company's acquisition of Sutter Corporation. The allegations relate to the
submission of claims for reimbursement for continuous passive motion exercisers
to various federal health care programs. In their complaint, the plaintiff
sought unspecified monetary damages and civil penalties related to each alleged
violation. In June 2001, the U.S. Department of Justice and the Company entered
into a settlement agreement and the government's amended complaint was dismissed
with prejudice. In October 2001, Plaintiff Barmak filed a second amended
complaint, pursuing the claim independent of the U.S. Department of Justice. The
court dismissed the plaintiff's second amended complaint, but allowed the
plaintiff to re-file on May 31, 2002. On June 13, 2002, the Company filed a
motion to dismiss the third amended complaint on various grounds including that
the allegations are barred because of the earlier settlement. At the present
stage, it is not possible to evaluate the likelihood of an unfavorable outcome
or the amount or a range of potential loss, if any, which may be experienced by
the Company.
ORTHOREHAB, INC. AND ORTHOMOTION, INC. V. ORTHOLOGIC CORPORATION AND
ORTHOLOGIC CANADA, LTD., Superior Court of the State of Delaware, County of New
Castle, Case No. C.A. No. 01C-11-224 WCC. In November 2001, OrthoRehab, Inc.,
the company which purchased the assets related to the CPM business of OrthoLogic
Corp., filed a complaint in connection with the acquisition of the Company's
continuous passive motion business in July 2001 alleging, among other things,
that some of the assets purchased were over valued and that the Company had
breached its contract. The case is being heard in the Superior Court of the
State of Delaware. The Company has denied the Plaintiffs' allegations and
intends to defend the matter vigorously. The case is currently in discovery. At
the present stage, it is not possible to evaluate the likelihood of an
unfavorable outcome or the amount or a range of potential loss, if any, which
may be experienced by the Company.
10
SETTLEMENT OF CLASS ACTION SUIT NORMAN COOPER, ET AL. V. ORTHOLOGIC CORP.
ET AL., Maricopa County Superior Court, Arizona, Case No. CV 96-10799, and
related federal cases. In early October 2000, OrthoLogic settled certain federal
and state court class action and the federal class action suits alleging
violations of Sections 10(b) of the Securities Exchange Act if 1934 ("Exchange
Act") and SEC Rule 10b-5 promulgated thereunder, and, as to other defendants,
Section 20(a) of the Exchange Act. The settlement called for $1 million payment
in cash and one million shares of newly issued OrthoLogic Common Stock valued at
$2,969,000 based on the stock price on the date of the judge's ruling approving
the settlement of $2.969 per share. A significant portion (approximately
$800,000) of the cash payment was funded from the Company's directors and
officers' liability insurance policy. Legal expenses related to this settlement
totaled an additional $383,000. As a result, the Company recorded a $3.6 million
charge in 2000 including legal expenses for settlement of the litigation in the
"Legal Settlement" total in the 2000 Statement of Operations.
Pursuant to the terms of the settlement, the Company has issued and
delivered 300,000 shares of common stock to plaintiffs' settlement counsel as
part of the plaintiffs' counsel's fee award. The remaining 700,000 shares remain
to be delivered to the settlement fund pending administration of the claims
process under the settlement. Notices have been sent to stockholders of record
for the relevant time period to calculate the settlement pool each stockholder
is to receive.
Management believes the settlement is in the best interests of the Company
and its shareholders as it frees the Company from the cost and significant
distraction of the ongoing litigation. The settlement does not constitute, and
should not be construed as, an admission that the defendants have any liability
or acted wrongfully in any way with respect to the plaintiffs or any other
person.
The health care industry is subject to numerous laws and regulations of
federal, state, and local governments. Compliance with these laws and
regulations, specifically those relating to the Medicare and Medicaid programs,
can be subject to government review and interpretations, as well as regulatory
actions unknown and unasserted at this time. Recently, federal government
activity has increased with respect to investigations and allegations concerning
possible violations by health care providers of regulations, which could result
in the imposition of significant fines and penalties, as well as significant
repayments of previously billed and collected revenues from patient services.
Management believes that the Company is in substantial compliance with current
laws and regulations.
As of June 30, 2002, in addition to the matters disclosed above, the
Company is involved in various other legal proceedings that arose in the
ordinary course of business. The costs associated with defending the above
allegations and the potential outcome cannot be determined at this time and
accordingly, no estimate for such costs have been included in the accompanying
financial statements. In management's opinion, the ultimate resolution of the
above legal proceedings will not have a material effect on the Company's
financial position, results of operations or cash flows.
6. LINE OF CREDIT
The Company has a $4 million revolving line of credit with a lending
institution. The Company may borrow up to 75% of eligible account receivable, as
defined in the agreement. The interest rate is at prime rate. Interest accruing
on any outstanding balance and a monthly administration fee is due in arrears on
the first day of each month. The line of credit expires February 28, 2003. There
are certain financial covenants and reporting requirements associated with the
loan. Included in the financial covenants are (1) tangible net worth of not less
than $30 million, (2) a quick ratio of not less than 2.0 to 1.0, (3) a debt to
tangible net worth ratio of not less than 0.50 to 1.0, and (4) capital
expenditures will not exceed more than $7.0 million during any fiscal year. As
of June 30, 2002, the Company has not utilized this line of credit.
11
7. SERIES B CONVERTIBLE PREFERRED STOCK
As of June 30, 2002, 15,000 shares of Series B Convertible Preferred Stock
had been converted into 5,964,080 shares of common stock. Currently, there is no
remaining outstanding Convertible Preferred Stock.
8. SEGMENT INFORMATION
The Company operates as one segment. Revenues and cost of goods sold, by
product line, are separately identified in the Statement of Operations. Most
operating expenses were not directly allocated between the Company's various
lines of business.
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The following is management's discussion of significant factors that
affected the Company's interim financial condition and results of operations.
This should be read in conjunction with Management's Discussion and Analysis of
Financial Condition and Results of Operations included in the Company's Annual
Report on Form 10-K for the year ending December 31, 2001.
OVERVIEW
OrthoLogic Corp. ("OrthoLogic" or the "Company") develops, manufactures and
markets proprietary, technologically-advanced orthopedic products designed to
promote the healing of musculoskeletal tissue, with particular emphasis on
fracture healing and spinal repair. OrthoLogic's products are designed to
enhance the healing of diseased, damaged, degenerated or recently repaired
musculoskeletal tissue. The Company's products focus on improving the clinical
outcomes and cost-effectiveness of orthopedic procedures that are characterized
by compromised healing, high-cost, potential for complication and long
recuperation time.
In January 2001, the Company announced plans to divest its CPM business to
refocus the Company on its core business of fracture healing and spinal repair.
The Company's decision to divest the CPM business was based on its desire to
refocus all of its activities in the fracture healing and spinal repair segments
of the orthopedic market. The CPM business, which is focused in the
rehabilitation segment of the orthopedic market, no longer fit in the Company's
long-term strategic plans.
The CPM business was sold in July 2001 for $12.0 million in cash, the
assumption of approximately $2.0 million in liabilities and a potential
additional payment to OrthoLogic of up to $2.5 million in cash, conditioned on
the purchaser's ability to collect on certain accounts receivable in the year
following the sale. OrthoLogic is currently in litigation with the purchaser
regarding this $2.5 million contingent payment and other matters. The litigation
is described in greater detail in Note 5 to the Unaudited Condensed Financial
Statements contained herein.
The Company periodically discusses with third parties the possible
acquisition and sale of technology, product lines and businesses in the
orthopedic health care market and, from time to time, enters into letters of
intent that provide OrthoLogic with an exclusivity period during which it
considers possible transactions.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The Company's discussion and analysis of the financial conditions and
results of operations are based upon the Unaudited Condensed Consolidated
Financial Statements prepared in conformity with accounting principles generally
accepted in the United States of America. The preparation of these statements
necessarily 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 reported period. These estimates and
assumptions form the basis for the carrying values of assets and liabilities. On
an on-going basis, the Company evaluates these estimates, including those
related to allowance for doubtful accounts, sales adjustments and discounts,
investments, inventories, restructuring, income taxes, contingencies, and
13
litigation. Management bases its estimates on historical experience and various
other assumptions and believes its estimates are reasonable under the
circumstances, the results of which form the basis for making judgments. Actual
results may differ from these estimates.
Significant estimates include the allowance for doubtful accounts and sales
discounts and adjustments of approximately $3.4 million and $5.9 million at June
30, 2002 and December 31, 2001, respectively, which are based primarily on
trends in historical collection statistics, consideration of current events,
payor mix and other considerations. The Company derives a significant amount of
its revenues from third-party payors, including Medicare and certain commercial
insurance carriers, health maintenance organizations, and preferred provider
organizations. Amounts paid under these plans are generally based on fixed or
allowable reimbursement rates. Revenues are recorded at the expected or
pre-authorized reimbursement rates when earned and include unbilled receivables
of $2.3 million and $1.9 million on June 30, 2002 and December 31, 2001,
respectively. Some billings are subject to review by such third party payors and
may be subject to adjustments. In the opinion of management, adequate allowances
have been provided for doubtful accounts and contractual adjustments. However,
these estimates are always subject to adjustment, which could be material. Any
differences between estimated reimbursement and final determinations are
reflected in the period finalized.
The Company recognizes revenue when the product is placed on the patient,
or if the sale is to a commercial buyer, at the time of shipment. Reductions to
revenues are estimated based on historical experience and are in the form of
sales discounts and adjustments from certain commercial carriers, health
maintenance organizations and preferred provider organizations. Changes to
estimated revenues are recognized in the period in which the facts that give
rise to the changes become known. Allowances for doubtful accounts are
maintained for estimated losses resulting from the inability of its customers
and third-party payors inability to make the required payments. If the financial
condition of the third-party payors were to deteriorate, resulting in an
inability to make payments, additional allowances might be necessary.
The Company recognized fee revenue for the distribution and promotion of
Hyalgan at a fee equal to wholesale cost, less any Sanofi discounts, rebates,
returns, amounts deducted for distribution costs, an overhead and a royalty
factor. These reductions are determined prior to royalties being sent to the
Company. After the termination of the fee revenue agreement, the Company
recognizes royalty revenue based on a flat royalty fee for each unit of the
product distributed between January 1, 2001 and December 31, 2002.
The Company writes-down its inventory for inventory shrinkage and
obsolescence equal to the difference between the cost of the inventory and the
estimated market value based upon assumptions about future demand and market
conditions. If conditions used in determining these valuations changes, future
additional inventory write-downs would be necessary.
The Company considers future taxable income and tax planning strategies in
determining the need for valuation allowances. In the event the Company
determines it is unable to realize deferred tax assets in the future, an
adjustment to the deferred tax asset and charge to income would be necessary in
the period such a determination is made.
The Company holds a minority interest in Chrysalis BioTechnology, Inc., a
company in the technological field in which the Company has a strategic focus.
Chrysalis BioTechnology, Inc. is not publicly traded so it is difficult to
determine the value of the investment. Should the investment be determined to be
14
permanently impaired, a charge to income would be recorded in the period such a
determination is made.
The Company leases its headquarters facility in Tempe, Arizona under an
operating lease arrangement. This lease has an expiration date of November 2007.
As a result of the Company's sale of its CPM business during 2001, the purchaser
of the CPM business subleases from the Company approximately 50% of the
facility, which sublease expires in December 2002. It is unlikely that the
existing sublease will be renewed. While the Company believes the facility is
well maintained and adequate for use in the foreseeable future, there can be no
guarantee that a different lessee will assume the remaining lease obligation. If
the Company determines in the future that it cannot sublease this space for a
lease rate at least equal to what the Company pays, then a charge would be
recorded to establish a liability equal to the total of the remaining lease
obligation, reduced by any actual or probable sublease income.
RESULTS OF OPERATIONS COMPARING THREE MONTH AND SIX MONTH PERIODS ENDED JUNE 30,
2002 TO 2001
REVENUES: The Company's total revenues decreased 56.1% from $22.1 million in the
second quarter of 2001 to $9.7 million in the second quarter of 2002. Revenues
for the second quarter of 2001 included sales of $14.0 million from the divested
CPM business. Sales recorded for the bone growth stimulation products, the
OL1000 and SpinaLogic, increased by 22.2% in the second quarter of 2002 as
compared to the same period in 2001. Revenues for the bone growth stimulation
products for the second quarter of 2002 were $9.2 million compared to $7.5
million in the comparable quarter of the prior year. The Company's total
revenues decreased 55.9% from $43.8 million in the six month period ended June
30, 2001 to $19.3 million for the same period in 2002. Revenues for the six
month period ended June 30, 2001 included sales of $28.0 million from the
divested CPM business. Sales recorded for the bone growth stimulation products
increased 24.0% in the six month period ended June 30, 2002 compared to the same
period in 2001. Revenues for the bone growth stimulation products were $17.9
million for the first six months of 2002, compared to $14.5 million for the same
period in the prior year. The significant increase in bone growth stimulation
sales is related to the growth in market share for both the OL1000 and
SpinaLogic.
Hyalgan royalty revenue was $467,000 in the three month period ended June 30,
2002 compared to Hyalgan royalty revenue of $578,000 for the same period in
2001. Hyalgan royalty revenue was $1.4 million for the six month period ended
June 30, 2002 compared to fees and sales of $1.3 million for the same period in
2001. The Company anticipates receiving royalties of approximately $800,000
through the end of the fiscal year 2002, at which time the royalty agreement
will terminate.
GROSS PROFIT: Gross profit for the three months ended June 30 decreased from
$18.2 million in 2001 to $8.3 million in 2002. Gross profit, as a percent of
revenue, was 85.1% for the quarter ending June 30, 2002. Gross profit for the
same period in 2001 was 82.4%. Gross profit for the six month period ended June
30 decreased from $35.1 million in 2001 to $16.6 million in 2002. Gross profit,
as a percent of revenues was 85.7% for the six months ended June 30, 2002. Gross
profit for the same period in 2001 was 80.3%. The majority of the gross profit
decrease of $18.6 million is a direct result of the divestiture of the CPM
business, which produced $22.1 million in gross profits for the first six months
of 2001. The improvement of gross margins from 80% in 2001 to 86% in 2002 is due
to the change in product mix to higher margin products. The CPM business that is
included in the 2001 financials had a gross margin of approximately 79%.
15
SELLING, GENERAL AND ADMINISTRATIVE ("SG&A") EXPENSES: SG&A expenses decreased
60.8% from $17.1 million in the three month period ended June 30, 2001 to $6.7
million in the same period in 2002. SG&A expenses decreased 59.8% from $33.2
million in the six month period ended June 30, 2001 to $13.4 million in the same
period in 2002. The decrease is mainly attributable to the sale of the CPM
business and the variable expenses related to that business. SG&A expenses, as a
percentage of total revenues, were 68.5% in the three month period ended June
30, 2002 and 77.3% in the same period in 2001. SG&A expenses, as a percentage of
total revenues, were 69.2% in the six month period ended June 30, 2002 and 75.8%
in the same period in 2001.
RESEARCH AND DEVELOPMENT EXPENSES: Research and development expenses were
$749,000 in the three month period ended June 30, 2002, compared to $2.0 million
for the same period in 2001. Research and development expenses were $1.7 million
in the six month period ended June 30, 2002 compared to $2.7 million for the
same period in 2001. The research and development expenses for the quarter ended
June 30, 2001 included a $1 million payment to Chrysalis BioTechnology to
extend the worldwide license to include orthopedic soft tissue indications for
Chrysalin. Research and development expenses in the quarter ended June 30, 2002
are for the overall Chrysalin Product Platform include pre-clinical studies in
cartilage and continuation of the Phase I/II human clinical trial under an IND
for spinal fusion.
CPM DIVESTITURE AND CHANGE IN ESTIMATED COLLECTABILITY OF CPM RECEIVABLES: In
January 2001, the Company announced plans to divest its CPM business to refocus
the Company on its core business of fracture healing and spinal repair. The sale
of the CPM business was completed in July 2001 for $12.0 million in cash, with
the assumption of approximately $2.0 million in liabilities. The Company may
receive up to an additional $2.5 million in cash, if certain objectives are
achieved by the purchaser of the CPM business. Because there is no reasonable
basis for estimating the degree of certainty that the objectives will be
reached, the additional contingent consideration has not and will not be
recorded in the accompanying financial statements until the cash is actually
received by the Company.
In the second quarter of 2001, the Company recorded a $14.3 million charge
to write down the CPM assets to their fair value and related charges, plus the
direct cost of selling the assets, which is included in the "CPM divestiture and
related charges" total in the accompanying Statement of Operations for the
quarter ended June 30, 2002. The charge included $6.9 million directly related
to the value of the assets and the direct selling costs, $2.8 million related to
the collectibility of the retained accounts receivable, $3.3 million for
employee severance and stay on bonuses, and $1.4 million for additional exit
charges.
The Company recorded the $6.9 million charge to write down the CPM assets
to their fair value, and account for the direct costs of selling the assets.
Fair value was assessed to be the total consideration received for the CPM net
assets, which sale closed on July 11, 2001. The Company had previously received
non-binding letters-of-intent, which had indicated higher values in the past,
but negotiations that ensued during the second quarter of 2001 resulted in a
lower final sales price for the CPM net assets.
The Company retained all the billed accounts receivable related to the CPM
business, with a net carrying value of approximately $10.8 million (net of a
$5.2 million allowance for doubtful accounts). The net carrying amount reflects
a $2.8 million charge in the second quarter to increase the allowance for
16
doubtful accounts. The collection staff and supervisors previously responsible
for the collection of these receivables were part of the employee team hired by
the purchaser of the CPM business. The purchaser requested an accelerated
transition plan to hire the majority of the Company's collection team following
the divestiture. The loss of experienced personnel, without a sufficient period
to hire and train new staff, changed the Company's estimate of what would be
collectable of the retained CPM accounts receivable. The Company hired
contractors to replace the previous collection personnel. The Company focused
the contract collection staff on working accounts that had been billed during
the most recent months. The majority of the additional reserve of $2.8 million
was applied to the balance of older CPM related receivables. Actual collection
results could differ materially from these estimates. Any difference between
estimated reimbursement and final determinations will be reflected in the period
finalized.
At December 31, 2001, the Company had collected $10.2 million of the $10.8
million of net receivables estimated during the second quarter of 2001 for the
CPM business. During the first quarter of 2002, collection results were more
favorable than anticipated, resulting in collections of approximately $900,000
for the quarter. Based on the improved collection trends during the first
quarter of 2002, the Company increased the originally estimated total
collections by $600,000, which was recognized as a gain in the Statement of
Operations for the quarter ended March 31, 2002. Collection rates during the
second quarter were again slightly better than anticipated, with collections of
approximately $400,000. Therefore, based on the ongoing favorable collection
trends, during the second quarter of 2002, the Company estimated that an
additional $226,000 would be collected in the future, which was recognized as a
gain in the Statement of Operations for the quarter ended June 30, 2002. At June
30, 2002, the approximate carrying value of the remaining CPM accounts
receivable was approximately $180,000.
In connection with the sale of the CPM business, in the second quarter of
2001, the Company notified approximately 331 of the Company's 505 employees that
their positions were being eliminated. A charge of approximately $3.3 million is
included in the "CPM divestiture and related charges" for terminated employees.
The severance and stay on bonus was based on years of service and position grade
level within the Company, respectively. The Company also recorded additional
exit charges of approximately $1.4 million for CPM commissions and rent related
liabilities not divested as part of the sale, concessions for prepaid rents, and
space build out costs relating to the divestiture.
A summary of the related CPM severance and other reserve balances at June
30, 2002, and 2001, are as follows:
Reserves Cash Reserves
December 31, 2001 Paid June 30, 2002
----------------- ------ -------------
Severance $ 946 $ 538 $ 408
Other exit costs 76 11 $ 65
------ ------ ------
Total non-recurring charges $1,022 $ 549 $ 473
17
Total Amount Charged Cash Reserves
Charges Against Assets Paid June 30, 2001
------- -------------- ---- -------------
Severance $3,300 -- $ (177) $3,123
Other exit costs 1,387 (245) -- 1,142
------ ------ ------ ------
Total non-recurring charges $4,687 $ (245) $ (177) $4,265
Subsequent to the sale, the Company is no longer in the CPM business.
Substantially all costs, expenses and impairment charges related to CPM exit
activities were recorded prior to the end of the second quarter of 2001. The
revenue and cost of revenue attributable to the CPM business for the six months
ended June 30, 2001 were approximately (in thousands):
Revenue $ 28,015
Cost of revenue 5,943
--------
Gross profit $ 22,072
Operating expenses were not directly allocated between the Company's
various lines of business.
OTHER INCOME. Other income consisted primarily of interest income that increased
from $130,000 in the three month period ended June 30, 2001 to $181,000 for the
same period in 2002. Other income increased from $259,000 in the six-month
period ended June 30, 2001 to $368,000 for the same period in 2002. The increase
is a result of interest earned on the Company's higher cash and investment
balances.
NET PROFIT: The Company had a net profit in the three month period ended June
30, 2002 of $1.3 million compared to a net loss of $15.0 million in the same
period in 2001. The Company had a net profit of $2.7 million for the six month
period ended June 30, 2002 compared to a net loss of $14.8 million in the same
period in 2001.
LIQUIDITY AND CAPITAL RESOURCES
On June 30, 2002 the Company had cash and equivalents of $10.5 million
compared to $19.5 million as of December 31, 2001. The Company also had $18.7
million of short-term investments as of June 30, 2002 compared to $11.0 million
at December 31, 2001. The total of both cash and cash equivalents and short-term
investments decreased to $29.2 million at June 30, 2002 compared to $30.5
million as of December 31, 2001. The Company also had long-term investments of
$3.4 million as of June 30, 2002.
In addition, the Company has an available $4.0 million accounts receivable
revolving line of credit with a bank. The Company may borrow up to 75% of the
eligible accounts receivable, as defined in the agreement. The interest rate is
at the prime rate. Interest accruing on the outstanding balance and a monthly
administration fee is due in arrears on the first day of each month. The line of
credit expires February 28, 2003. There are certain financial covenants and
18
reporting requirements associated with the loan. Included in the financial
covenants are (1) tangible net worth of not less than $30 million, (2) a quick
ratio of not less than 2.0 to 1.0, (3) a debt to tangible net worth ratio of not
less than 0.50 to 1.0, and (4) capital expenditures will not exceed more than
$7.0 million dollars during any fiscal year. The Company has not utilized this
line of credit. As of June 30, 2002, the Company was in compliance with all the
financial covenants.
Net cash provided by operations during the six month period ended June 30,
2002 was $2.2 million compared to $6.2 million for the same period in 2001. This
decline, comparing 2002 to 2001, is attributable to an increase in inventories
and decrease in accrued liabilities. The increase in inventories is due to the
Company carrying higher levels of safety stock for critical manufacturing parts
and finished goods. The decrease in liabilities is primarily due to payments for
severance and other exit costs related to the CPM divestiture as well as
payments for the Chrysalin development program.
The Company does not expect significant capital investments in 2002 and
anticipates that its cash and short term investments on hand, cash from
operations and the funds available from its $4.0 million line of credit will be
sufficient to meet the Company's presently projected cash and working capital
requirements for the next 12 months. The timing and amounts of cash used will
depend on many factors, including the Company's ability to continue to increase
revenues, reduce and control its expenditures, continue profitability and
collect amounts due from third party payors. Additional funds may be required if
the Company is not successful in any of these areas.
The Company's ability to continue funding its planned operations beyond the
next 12 months is partially dependent upon its ability to generate sufficient
cash flow to meet its obligations on a timely basis, or to obtain additional
funds through equity or debt financing, or from other sources of financing, as
may be required.
In August 2001, the Company announced that its Board of Directors
authorized a repurchase of up to 1 million shares of the Company's outstanding
shares over the next 12 months. The repurchased shares will be held as treasury
shares and used in part to reduce the dilution from the Company stock option
plans. As of June 30, 2002, the Company had repurchased 41,800 shares at a cost,
net of fees, for $137,300 or an average price of $3.28 per share.
The following table sets forth all known commitments as of June 30, 2002
and the year in which these commitments become due, or are expected to be
settled (in thousands):
ACCOUNTS PAYABLE
YEAR OPERATING LEASES AND ACCRUED LIABILITIES TOTAL
- ---- ---------------- ----------------------- -------
2002 $ 539 $ 5,890 $ 6,429
2003 $ 1,078 -- $ 1,078
2004 $ 1,078 -- $ 1,078
2005 $ 1,078 -- $ 1,078
2006 $ 1,078 -- $ 1,078
Thereafter $ 989 -- $ 989
------- ------- -------
Total $ 5,840 $ 5,890 $11,730
19
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The Company has no debt and no derivative instruments at June 30, 2002.
The Company's Canadian operations were sold as part of the CPM sale, and
the Company has no exposure to foreign exchange rates at June 30, 2002.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
The Company may from time to time make written or oral forward-looking
statements, including statements contained in the Company's filings with the
Securities and Exchange Commission and its reports to stockholders. This Report
contains forward-looking statements made pursuant to the "safe harbor"
provisions of the Private Securities Litigation Reform Act of 1995. In
connection with these "safe harbor" provisions, the Company identifies important
factors that could cause actual results to differ materially from those
contained in any forward-looking statements made by or on behalf of the Company.
Any such forward-looking statement is qualified by reference to the following
cautionary statements.
LIMITED HISTORY OF PROFITABILITY. The Company began generating revenues from the
sale of its primary product in 1994. The Company has experienced significant
operating losses since its inception and had an accumulated deficit of
approximately $93.6 million at June 30, 2002. The Company has only reported
sustained profits since the third quarter of 2001. There can be no assurance
that the Company will maintain sufficient revenues to retain net profitability
on an on-going annual basis. In addition, estimations of future profits based on
our historical financial reports may be speculative given our limited
profitability history.
DEPENDENCE ON THIRD PARTIES TO DISTRIBUTE PRODUCT. To enhance the sales of the
Company's SpinaLogic product line, the company entered into an exclusive 10-year
worldwide sales agreement with DePuy AcroMed ("DePuy AcroMed"), a unit of
Johnson and Johnson. The sales agreement provides DePuy AcroMed with the right
to terminate their sales activities on behalf of SpinaLogic without cause, by
giving OrthoLogic a minimum of 120 days written notice. Any significant change
in the distribution relationship regarding the SpinaLogic product line may have
an adverse effect on the Company's sales of SpinaLogic, its newest product on
the market. The Company relies upon the distribution of the SpinaLogic product
for a large portion of its sales.
POTENTIAL ADVERSE OUTCOME OF LITIGATION. At any given time, the Company becomes
involved in various legal proceedings that arise in the ordinary course of
business. In addition, the Company is currently involved in two other legal
proceedings UNITED STATES OF AMERICA EX. REL. DAVID BARMARK V. SUTTER CORP. AND
ORTHOLOGIC and ORTHOREHAB, INC. AND ORTHOMOTION, INC. V. ORTHOLOGIC CORPORATION
AND ORTHOLOGIC CANADA, LTD. The Company has provided a description of each
matter in Note 5 to the Notes of the Unaudited Condensed Financial Statements.
At the present stage, the Company is unable to evaluate the likelihood of an
unfavorable outcome or the amount or range of potential loss, if any, which the
Company may experience. An unfavorable outcome could have a material adverse
effect on the Company's results of operations and earnings.
UNCERTAINTY OF MARKET ACCEPTANCE. The Company believes that the demand for bone
growth stimulators is still developing and the Company's success will depend in
part upon the growth of this demand. Although the Company has reported increased
20
sales for both the OL1000 and SpinaLogic for the last several quarters, there
can be no assurance that this trend will continue. The long-term commercial
success of the OL1000 and SpinaLogic and the Company's other products will also
depend in significant part upon its widespread acceptance by a significant
portion of the medical community as a safe, efficacious and cost-effective
alternative to invasive procedures. Historically, some orthopedic medical
professionals have indicated hesitancy in prescribing bone growth stimulator
products such as those manufactured by the Company. The widespread acceptance of
the Company's primary products represents a significant change in practice
patterns for the orthopedic medical community and in reimbursement policy for
third party payors. Failure of the Company's products to achieve widespread
market acceptance by the orthopedic medical community and third party payors
would have a material adverse effect on the Company's business, financial
condition and results of operations.
DEPENDENCE ON RESEARCH AND DEVELOPMENT OF ADDITIONAL INDICATIONS OF CURRENT
PRODUCTS AND INTRODUCTION OF FUTURE PRODUCTS. The Company believes that, to
sustain long-term growth, it must continue to develop and introduce additional
products and expand approved indications for its remaining products. Currently,
the Company is focused on the clinical trials of Chrysalin. Because of the
nature of the Company's business, the development and commercialization by the
Company of Chrysalin and other products will require substantial product
development, regulatory, clinical and other expenditures for years before the
Company can begin to market the product. There can be no assurance that the
Company's will be able to develop new products or expand indications for
existing products in the future or that the Company will be able to successfully
manufacture or market any new products or existing products for new indications.
Any failure by the Company to develop new products or expand indications could
have a material adverse effect on the Company's business, financial condition
and results of operations.
DEPENDENCE ON PATENTS, LICENSES AND PROPRIETARY RIGHTS. The proprietary
"Biologic" technology underlying the OL1000 and SpinaLogic is licensed to the
Company on a worldwide basis that covers all improvements and applies to the use
of the technology for all medical applications in humans and animals. The
license may be terminated if the Company breaches any material provision of such
license. The termination of such license would prevent the Company from selling
its primary products, which would materially adversely effect on the Company's
business, financial condition and results of operations.
The Company's also owns a number of patents and relies on an un-patented trade
secrets and know-how in the operation of the business. While OrthoLogic's
intellectual property used in its bone growth stimulation products has never
been legally challenged, there has been substantial litigation regarding patent
and other intellectual property rights in the orthopedic industry. The Company
could be named in such a suit challenging the validity of the scope of the
Company's proprietary rights or claiming infringement of the rights of others.
The validity and breadth of claims covered in medical technology patents
involves complex legal and factual questions and therefore may be highly
uncertain. Litigation of these matters tends to take years and could result in a
substantial cost to and diversion of the Company. In addition, if the results of
the litigation were unfavorable to the Company, the Company may be required to
seek a license of the proprietary technology required to produce the Company's
products from the other party in the suit to continue business. There can be no
assurance that licensing rights to the proprietary information will be available
at all or at a cost acceptable to the Company.
The Company generally requires its employees, consultants, advisors and
investigators to enter into confidentiality agreements which include, among
other things, an agreement to assign to the Company all inventions that were
21
developed by the employee while employed by the Company that are related to its
business. There can be no assurance, however, that these agreements will protect
the Company's proprietary information or that others will not gain access to, or
independently develop similar trade secrets or know-how.
LIMITATIONS ON THIRD PARTY PAYMENT; UNCERTAIN EFFECTS OF MANAGED CARE. The
Company's sales of its products are affected by the extent to which acceptance
of payment for such products and related treatment will continue to be available
from government health administration authorities, private health insurers and
other payors. Changes in the terms of the reimbursement protocol for our
products, such as changes in the recommended commencement of application of our
products and the recommended duration of use, could have a significant effect on
the purchasing and practice patterns of many health care providers to proscribe
our products. In addition, payors are increasingly challenging the prices and
clinical efficacy of medical products and services. Payors may deny
reimbursement if they determine that the product used in a procedure was
experimental, was used for a non-approved indication or was unnecessary,
inappropriate, not cost-effective, unsafe, or ineffective. The Company's
products are reimbursed by most payors, however there are generally specific
product usage requirements or documentation requirements in order for the
Company to receive reimbursement. Although the Company makes allowances to
account for denials of reimbursement by payors, these allowances are estimates
and may not be accurate. There can be no assurance that adequate third party
coverage will continue to be available to the Company at current levels. In
addition, there is significant uncertainty as to the reimbursement status of any
newly approved health care products.
GOVERNMENT REGULATION. The Company's current and future products and
manufacturing activities are and will be regulated under the FDC Act. The
Company's current BioLogic technology-based products are classified as Class III
Significant Risk Devices, which are subject to the most stringent level of FDA
review for medical devices and are required to be tested under IDE clinical
trials and approved for marketing under a PMA. The Company's fracture fixation
devices are Class II devices that are marketed pursuant to 510(k) clearance from
the FDA. Chrysalin, as a new drug, is subject to clinical trial and Good
Manufacturing Practices ("GMP") review similar to those that apply to the
BioLogic technology-based products.
The FDA and comparable agencies in many foreign countries and in state and local
governments impose substantial limitations on the introduction of medical
devices through costly and time-consuming laboratory and clinical testing and
other procedures. The process of obtaining FDA and other required regulatory
approvals is lengthy, expensive and uncertain. Moreover, regulatory approvals,
if granted, typically include significant limitations on the indicated uses for
which a product may be marketed. In addition, approved products may be subject
to additional testing and surveillance programs required by regulatory agencies,
and product approvals could be withdrawn and labeling restrictions may be
imposed for failure to comply with regulatory standards or upon the occurrence
of unforeseen problems following initial marketing.
The Company is also required to adhere to applicable requirements for FDA GMP,
to engage in extensive record keeping and reporting and to make available its
manufacturing facilities for periodic inspections by governmental agencies,
including the FDA and comparable agencies in other countries. Failure to comply
with these and other applicable regulatory requirements could result in, among
other things, significant fines, suspension of approvals, seizures or recalls of
products, or operating restrictions and criminal prosecutions.
22
Changes in existing regulations or interpretations of existing regulations or
adoption of new or additional restrictive regulations could prevent the Company
from obtaining, or affect the timing of, future regulatory approvals. If the
Company experiences a delay in receiving or fails to obtain any governmental
approval for any of its current or future products or fails to comply with any
regulatory requirements, the Company's business, financial condition and results
of operations could be materially adversely affected.
DEPENDENCE ON KEY PERSONNEL. The success of the Company is dependent in large
part on the ability of the Company to attract and retain its key management,
operating, technical, marketing and sales personnel as well as clinical
investigators who are not employees of the Company. Such individuals are in high
demand, and the identification, attraction and retention of such personnel could
be lengthy, difficult and costly. The Company competes for its employees and
clinical investigators with other companies in the orthopedic industry and
research and academic institutions. There can be no assurance that the Company
will be able to attract and retain the qualified personnel necessary for the
expansion of its business. A loss of the services of one or more members of the
senior management group, or the Company's inability to hire additional personnel
as necessary, could have an adverse effect on the Company's business, financial
condition and results of operations.
RAPID TECHNOLOGICAL CHANGE. The medical device industry is characterized by
rapid and significant technological change. There can be no assurance that the
Company's competitors, many of whom are larger and/or more experienced in the
business, will not succeed in developing or marketing products or technologies
that are more effective or less costly, or both, and which render the Company's
products obsolete or non-competitive. In addition, new technologies, procedures
and medications could be developed that replace or reduce the value of the
Company's products. The Company's success will depend in part on its ability to
respond quickly to medical and technological changes through the development and
introduction of new products, which could take a significant amount of time due
to the high level of regulation in the medical device industry. There can be no
assurance that the Company's new product development efforts will result in any
commercially successful products. A failure to develop new products to compete
with our competitors could have a material adverse effect on the Company's
business, financial condition, and results of operations.
INTENSE COMPETITION. The orthopedic industry is characterized by intense
competition. Currently, there are three major competitors other than the Company
selling bone growth stimulation products approved by the FDA for the treatment
of nonunion fractures, and two competitors selling bone growth stimulation
products for use with spinal fusion patients. The Company estimates that one of
its competitors has a dominant share of the market for bone growth stimulation
products for non-healing fractures in the United States, and another has a
dominant share of the market for use of their device as an adjunct to spinal
fusion surgery. In addition, several large, well-established companies sell
fracture fixation devices similar in function to those sold by the Company.
Many participants in the medical technology industry, including the Company's
competitors, have substantially greater capital resources, research and
development staffs and facilities than the Company. Such participants have
developed or are developing products that may be competitive with the products
that have been or are being developed or researched by the Company. Other
companies are developing a variety of other products and technologies to be used
in the treatment of fractures and spinal fusion's, including growth factors,
bone graft substitutes combined with growth factors, and nonthermal ultrasound.
Many of the Company's competitors have substantially greater experience than the
23
Company in conducting research and development, obtaining regulatory approvals,
manufacturing, and marketing and selling medical devices. Any failure by the
Company to develop products that compete favorably in the marketplace would have
a material adverse effect on the Company's business, financial condition and
results of operations.
DEPENDENCE ON KEY SUPPLIERS. The Company purchases the microprocessor used in
the OL1000 and SpinaLogic devices from a single manufacturer. Although there are
feasible alternate microprocessors that might be used immediately, all are
produced by one single supplier. In addition, there are single suppliers for
other components used in the OL1000 and SpinaLogic devices and only two
suppliers for the magnetic field sensor employed in them. Establishment of
additional or replacement suppliers for these components cannot be accomplished
quickly. Therefore, the Company maintains sufficient inventories of such
components in an attempt to ensure availability of finished products in the
event of supply shortage or in the event that a redesign is required. The
Company maintains a supply of certain OL1000 and SpinaLogic components to meet
sales forecasts for 3 to 12 months. Any delay or interruption in supply of
components or products could significantly impair the Company's ability to
deliver its products in sufficient quantities, and therefore, could have a
material adverse effect on its business, financial condition and results of
operations. Chrysalin, which is currently only in the clinical trial phase, is
produced by a third party sole supplier.
UNCERTAINTY AND POTENTIAL NEGATIVE EFFECTS OF CHANGES IN HEALTH CARE REGULATION.
In recent years, the health care industry has experienced rapidly rising costs
at a time of increasing political pressure regarding access of health care for
the uninsured and decreasing flexibility on heath care reimbursement protocols
from heath care insurance payors. The Company anticipates that federal and state
legislatures and other health care payors will continue to review and assess
alternative health care delivery systems and methods of payment, and public
debate on related health care issues will continue. Significant changes in
health care systems are likely to have a substantial impact over time on the
manner in which the Company conducts its business and could have a material
adverse effect on the Company's business, financial condition and results of
operations and ability to market its products as currently contemplated.
RISK OF PRODUCT LIABILITY CLAIMS. The Company faces an inherent business risk of
exposure to product liability claims in the event that the use of its technology
or products is alleged to have resulted in adverse effects. To date, the Company
has been involved in only limited product liability claims related to its former
CPM products. The Company maintains a product liability and general liability
insurance policy with coverage of an annual aggregate maximum of $2.0 million
per occurrence. The Company's product liability and general liability policy is
provided on an occurrence basis. The policy is subject to annual renewal. In
addition, the Company maintains an umbrella excess liability policy, which
covers product and general liability with coverage of an additional annual
aggregate maximum of $25.0 million. There can be no assurance that liability
claims will not exceed the coverage limits of such policies or that such
insurance will continue to be available on commercially reasonable terms or at
all. If the Company does not or cannot maintain sufficient liability insurance,
its ability to market its products may be significantly impaired. In addition,
product liability claims could have a material adverse effect on the business,
financial condition and results of operations of the Company.
The Company cautions that the foregoing list of important factors is not
exclusive. The Company does not undertake to update any forward-looking
statement that may be made from time to time by or on behalf of the Company.
24
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
See "Note 5 - Litigation" of the Notes to the Unaudited Condensed
Consolidated Financial Statements above.
Item 2. Changes in Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
The annual meeting of the stockholders of the Company was held on May 17, 2002
to vote on: the election of Class II Directors (Proposal 1) and the ratification
of Deloitte & Touche LLP as independent accountant for the fiscal year ending
December 31, 2002 (Proposal 2). The results are as follow:
Withheld Broker
For Authority Non-Votes
--- --------- ---------
Proposal 1
John M. Holliman III 30,344,973 193,590 0
Augustus A. White III, M.D. 30,355,214 183,349 0
Broker
For Against Abstained Non-Votes
--- ------- --------- ---------
Proposal 2 30,207,351 307,506 23,706 0
A more detailed discussion of each proposal is included in the Company's Proxy
Statement for the 2002 Annual Meeting of Stockholders.
The Company's directors continuing in office are Stuart H. Altman, Ph.D.,
Frederick J. Feldman, Ph.D., Elwood D. Howse, Jr, and Thomas R. Trotter.
25
Item 5. Other Information
None.
Item 6. Exhibits and Reports
(a) Exhibit Index
10.25 Asset Purchase Agreement effective May 8, 2001 between the
Company, OrthoLogic Canada Ltd., and OrthRehab Inc. (1)
10.26 First Amendment to the May 8, 2001 Asset Purchase
Agreement (1)
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
-- Thomas A. Trotter
99.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
-- Sherry A. Sturman
(b) Reports on Form 8-K
None.
- ----------
(1) These exhibits were originally filed as Exhibits 10.1 and 10.2 to a July
11, 2001 Form 8-K with confidential portions redacted in reliance on a
confidentiality order by the Securities and Exchange Commission. In
accordance with the order's expiration on August 11, 2002, OrthoLogic is
filing these exhibits in complete form.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
ORTHOLOGIC CORP.
- -----------------------------
(Registrant)
SIGNATURE TITLE DATE
- --------- ----- ----
/s/ Thomas R. Trotter President and Chief Executive Officer August 9, 2002
- ----------------------------- (Principal Executive Officer)
Thomas R. Trotter
/s/ Sherry A. Sturman Vice-President and Chief Financial Officer August 9, 2002
- ----------------------------- (Principal Financial and Accounting Officer)
Sherry A. Sturman
27
ORTHOLOGIC CORP.
EXHIBIT INDEX TO QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2002
Incorporated by Filed
Exhibit No Description Reference to: Herewith
- ---------- ----------- ------------- --------
10.25 Asset Purchase Agreement effective May 8, 2001 between the X
Company, OrthoLogic Canada Ltd., and OrthRehab Inc. (1)
10.26 First Amendment to the May 8, 2001 Asset Purchase X
Agreement (1)
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted X
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
-- Thomas A. Trotter
99.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted X
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
-- Sherry A. Sturman
- ----------
(1) These exhibits were originally filed as Exhibits 10.1 and 10.2 to a July
11, 2001 Form 8-K with confidential portions redacted in reliance on a
confidentiality order by the Securities and Exchange Commission. In
accordance with the order's expiration on August 11, 2002, OrthoLogic is
filing these exhibits in complete form.