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 September 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 (IRS Employer
of 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. Yes [X] 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.
32,020,357 shares of common stock outstanding as of October 31, 2002
1
ORTHOLOGIC CORP.
INDEX
Page No.
Part I Financial Information
Item 1. Unaudited Financial Statements
Condensed Consolidated Balance Sheets as of
September 30, 2002 and December 31, 2001 3
Condensed Consolidated Statements of Operations and of
Comprehensive Income for the Three months and Nine months
ended September 30, 2002 and 2001 4
Condensed Consolidated Statements of Cash Flows for the
Nine months ended September 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
Item 4. Controls and Procedures 20
Part II Other Information
Item 1. Legal Proceedings 26
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)
September 30, December 31,
2002 2001
--------- ---------
ASSETS (Unaudited)
Cash and cash equivalents $ 10,134 $ 19,503
Short-term investments 18,808 11,008
Accounts receivable, net 10,373 11,361
Inventory, net 2,841 1,507
Prepaids and other current assets 826 688
Deferred income tax 2,631 2,631
--------- ---------
Total current assets 45,613 46,698
--------- ---------
Furniture and equipment 8,564 8,325
Accumulated depreciation (6,949) (6,423)
--------- ---------
Furniture and equipment, net 1,615 1,902
Long-term investments 4,810 --
Investment in Chrysalis BioTechnology 750 750
Deposits and other assets 111 92
--------- ---------
Total assets $ 52,899 $ 49,442
========= =========
LIABILITIES & STOCKHOLDERS' EQUITY
Liabilities
Accounts payable $ 1,292 $ 776
Accrued liabilities 4,359 4,861
Accrued liabilities on CPM divestiture
and related charges 268 1,022
--------- ---------
Total current liabilities 5,919 6,659
Deferred rent 336 287
--------- ---------
Total liabilities 6,255 6,946
--------- ---------
Series B Convertible Preferred Stock -- 600
Stockholders' Equity
Common stock, $.0005 par value:
50,000,000 shares authorized; and 32,019,757 and
31,473,793 shares issued and outstanding 16 16
Additional paid-in capital 135,980 135,326
Common stock to be used for legal settlement 2,969 2,969
Accumulated deficit (92,184) (96,278)
Treasury stock at cost, 41,800 shares (137) (137)
--------- ---------
Total stockholders' equity 46,644 41,896
--------- ---------
Total liabilities and stockholders' equity $ 52,899 $ 49,442
========= =========
See Notes to Unaudited Condensed Consolidated Financial Statements.
3
ORTHOLOGIC CORP.
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS AND COMPREHENSIVE INCOME
(in thousands, except per share data)
Unaudited
Three months ended Nine months ended
September 30 September 30,
-------------------- --------------------
2002 2001 2002 2001
-------- -------- -------- --------
Revenues
Net sales $ 10,279 $ 8,007 $ 28,221 $ 33,234
Net rentals -- 574 -- 17,831
Royalties from co-promotion agreement 501 972 1,872 2,265
-------- -------- -------- --------
Total net revenues 10,780 9,553 30,093 53,330
-------- -------- -------- --------
Cost of Revenues
Cost of goods sold 1,865 1,170 4,621 6,433
Cost of rentals -- 84 -- 3,452
-------- -------- -------- --------
Total cost of revenues 1,865 1,254 4,621 9,885
-------- -------- -------- --------
Gross Profit 8,915 8,299 25,472 43,445
-------- -------- -------- --------
Operating expenses
Selling, general and administrative 7,179 7,430 20,534 40,621
Research and development 722 486 2,391 3,147
CPM divestiture and related charges (gains) (221) -- (1,047) 14,327
-------- -------- -------- --------
Total operating expenses 7,680 7,916 21,878 58,095
-------- -------- -------- --------
Operating income (loss) 1,235 383 3,594 (14,650)
Other income 169 223 537 482
-------- -------- -------- --------
Income (loss) before income taxes 1,404 606 4,131 (14,168)
Provision for income taxes 12 -- 37 8
-------- -------- -------- --------
Net Income (loss) $ 1,392 $ 606 $ 4,094 $(14,176)
======== ======== ======== ========
BASIC EARNINGS PER SHARE
Net income (loss) per common share $ 0.04 $ 0.02 $ 0.13 $ (0.45)
-------- -------- -------- --------
Weighted average number of common shares outstanding 32,719 31,467 32,615 31,352
-------- -------- -------- --------
DILUTED EARNINGS PER SHARE
Net income (loss) per common and equivalent share $ 0.04 $ 0.02 $ 0.13 $ (0.45)
-------- -------- -------- --------
Weighted shares outstanding 33,249 31,942 32,711 31,352
-------- -------- -------- --------
Consolidated Statement of Comprehensive Income
Net income (loss) $ 1,392 $ 606 $ 4,094 $(14,176)
-------- -------- -------- --------
Foreign translation adjustment -- -- -- 223
-------- -------- -------- --------
Comprehensive income (loss) $ 1,392 $ 606 $ 4,094 $(13,953)
======== ======== ======== ========
See Notes to Unaudited Condensed Consolidated Financial Statements.
4
ORTHOLOGIC CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW
(in thousands)
Unaudited
Nine months ending
September 30,
--------------------
2002 2001
-------- --------
OPERATING ACTIVITIES
Net income (loss) $ 4,094 $(14,176)
Noncash items:
Depreciation and amortization 526 798
CPM divestiture and related charges -- 9,687
Net change on other operating items
Accounts receivable 988 10,719
Inventory (1,334) 1,132
Prepaids and other current assets (138) (215)
Deposits and other assets (19) 160
Accounts payable 516 (607)
Accrued liabilities (453) 1,757
Accrued liabilities on CPM divestiture and related charges (754) (2,231)
-------- --------
Net cash provided by operating activities 3,426 7,024
-------- --------
INVESTING ACTIVITIES
Expenditures for rental fleet, equipment and furniture (239) (783)
Proceeds from sale of CPM assets -- 12,000
Purchases of investments (27,860) (15,055)
Maturities of investments 15,250 2,492
-------- --------
Net cash used in investing activities (12,849) (1,346)
-------- --------
FINANCING ACTIVITIES
Payments on capital leases -- 88
Net proceeds from stock option exercises and other 54 353
-------- --------
Net cash provided by financing activities 54 441
-------- --------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (9,369) 6,119
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 19,503 6,753
-------- --------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 10,134 $ 12,872
======== ========
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 $ 8 $ 70
Cash paid during the period for income taxes $ 42 $ 0
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. Certain reclassifications have been
made to the 2001 amounts to conform to the 2002 presentation.
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. One significant estimate is the allowance for doubtful
accounts of approximately $3.3 million and $5.8 million at September 30, 2002
and December 31, 2001, respectively, which is based primarily on trends in
historical collection statistics, consideration of current developments in
collection practices, 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. The amount of revenue, net of
sales discounts and contractual adjustments, recorded at the time of the sale is
based on an estimate of the primary third-party payors' pricing terms. The
Company records any differences between the net revenue amount recognized at the
time of the sale and the ultimate pricing by the primary third-party payor as a
subsequent adjustment to sales in the period the Company receives payment from
the third-party payor or the Company becomes aware of a change in circumstances
that warrants a change in estimate. In the opinion of management, adequate
allowances have been provided for sales discounts 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. Revenues include unbilled
receivables of $2.4 million and $1.9 million at September 30, 2002 and December
31, 2001, respectively.
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.
6
2. NEW ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 141, BUSINESS
COMBINATIONS, and SFAS No. 142, GOODWILL AND OTHER INTANGIBLE ASSETS. SFAS No.
141 prospectively prohibits the pooling of interests method of accounting for
business combinations initiated after June 30, 2001. Under SFAS 142,
amortization of goodwill and intangibles without a finite life ceases when the
new standard is adopted. The new rule also requires impairment tests on an
annual or interim basis if an event occurs or circumstances change that would
reduce the fair value of a reporting unit below its carrying value. SFAS 142
also requires the Company to complete a transitional goodwill impairment test
six months from the date of adoption. The adoption of SFAS Nos. 141 and 142 did
not have a significant impact on our operating results or financial position.
We adopted SFAS No. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF
LONG-LIVED ASSETS, effective January 1, 2002. SFAS No. 144 addresses financial
accounting and reporting for the impairment or disposal of long-lived assets and
supersedes SFAS No. 121, ACCOUNTING OF THE IMPAIRMENT OF LONG-LIVED ASSETS AND
FOR LONG-LIVED ASSETS TO BE DISPOSED OF. SFAS No. 144 requires that we evaluate
long-lived assets based on the net future cash flow expected to be generated
from the asset on an undiscounted basis whenever significant events or changes
in circumstances occur that indicate that the carrying amount of an asset may
not be recoverable. The adoption of SFAS No. 144 did not have a significant
impact on our operating results or financial position.
In June 2002, the FASB issued SFAS No. 146, ACCOUNTING FOR COSTS ASSOCIATED
WITH EXIT OR DISPOSAL ACTIVITIES. SFAS No. 146 addresses financial accounting
and reporting for costs associated with exit or disposal activities and
nullifies Emerging Issues Task Force Issue No. 94-3 ("EITF No. 94-3"), LIABILITY
RECOGNITION FOR CERTAIN EMPLOYEE TERMINATION BENEFITS AND OTHER COSTS TO EXIT AN
ACTIVITY (INCLUDING CERTAIN COSTS INCURRED IN A RESTRUCTURING). Under SFAS No.
146, the liability for costs associated with exit or disposal activities is
recognized and measured at fair value when the liability is incurred, rather
than at the date of a company's commitment to an exit plan. The provisions of
SFAS No. 146 are effective for exit or disposal activities that are initiated
after December 31, 2002, with earlier adoption encouraged.
3. CO-PROMOTION AGREEMENT FOR HYALGAN
The Company signed an exclusive Co-Promotion Agreement with Sanofi
Pharmaceuticals, Inc. ("Sanofi") at a cost of $4 million in June of 1997, which
provided the Company with the right to market the Hyalgan product to orthopedic
surgeons in the United States. The Company capitalized the investment in the
agreement. The Company received "Net Fee Revenue" from Sanofi for the
distribution of the product from June of 1997 through December of 2000. The Net
Fee Revenue was recorded monthly based on a calculation that determined a fee
for the distribution of each unit sold. The Net Fee Revenue was determined by
calculating Hyalgan's wholesale price, less any discounts or rebates and less
any amounts deducted for Sanofi's estimated distribution costs, returns, a
Sanofi overhead factor and a royalty factor. The Company forwarded orders for
the product to Sanofi, which handled all of the product distribution.
In the fourth quarter of 2000, the Company and Sanofi mutually agreed to
terminate this Co-Promotion Agreement. The Company signed a Termination
7
Agreement and received $4 million for the return of the rights and the
completion of a successful transition of the business back to Sanofi by January
1, 2001.
The Termination Agreement stipulated that the Company would receive
royalties based on a flat royalty fee of $5 for each unit distributed by Sanofi
during the two-year period from January 1, 2001 through December 31, 2002 up to
$5 million. During 2001 the Company received approximately $2.8 million in
royalties from Sanofi in accordance with the Termination Agreement. During the
first three quarters of 2002, the Company received an additional $1.9 million in
royalty payments. The royalty payments will end this December 2002. All of the
royalties received from Sanofi have been included in the Company's respective
Statements of Operations in the line item entitled "Royalties from co-promotion
agreement."
4. 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 by the
buyer. The Company retained and did not sell the invoiced receivables. The
Company may receive up to an additional $2.5 million in cash, due to certain
objectives achieved by the purchaser of the CPM business. 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 6 below. The Company has not recorded the additional contingent
consideration in the Company's financial statements because it is the subject of
a dispute with the purchaser of the CPM business.
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 to record additional
charges directly related to the CPM divestiture, 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
to write down the value of the assets to fair value less direct selling costs,
$2.8 million for a change in estimate regarding the collectability of the
retained accounts receivables, $3.3 million for employee severance, and $1.4
million for related exit costs.
The Company recorded the $6.9 million charge to write down the CPM assets
to their fair value less direct costs of selling the assets. Fair value was
assessed to be the total consideration received for the CPM net assets in the
sale that closed on July 11, 2001. The Company had previously received
non-binding letters-of-intent, which had indicated higher values for the CPM net
assets to be sold, but negotiations that ensued during the second quarter of
2001 resulted in a lower final sales price for the CPM net assets that were
sold.
The Company retained all the invoiced 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 recorded in the second quarter of 2001 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
8
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.
At December 31, 2001, the Company had collected $10.2 million of the $10.8
million of retained CPM receivables. During 2002, collection of these
receivables was better than anticipated. Based on the improved collection
trends, the Company revised its estimate and increased the estimated total
collections by $600,000 and $226,000 in the quarters ended March 31, 2002 and
June 30, 2002, respectively. Collections during the third quarter were again
better than expected. Therefore, based on the ongoing favorable collections,
during the quarter ended September 30, 2002, the Company revised its estimate
and now expects that an additional $221,000 will be collected. At September 30,
2002, the carrying value of the remaining CPM accounts receivable was
approximately $190,000.
In connection with the sale of the CPM business, the Company eliminated
approximately 331 of the Company's 505 positions. A charge of approximately $3.3
million is included in the "CPM divestiture and related charges" for the
severances paid to terminated employees. The Company also recorded additional
exit charges of approximately $1.4 million for CPM commissions, write offs of
prepaid rents, space build out costs relating to the purchaser's sublease with
the Company and other similar charges, and other CPM related prepaid expenses
for which no future benefits were expected to be received.
A summary of the severance and other reserve balances at September 30, 2002
and 2001 are as follows (in thousands):
Reserves Amount Charged Cash Reserves
December 31, 2001 Against Assets Paid September 30, 2002
----------------- -------------- ------- ------------------
Severance $ 946 $ -- $ (717) $ 229
Other exit costs 76 -- (37) 39
------ ------ ------- ------
Total non-recurring charges $1,022 $ -- $ (754) $ 268
Initial Amount Charged Cash Reserves
Reserves Against Assets Paid September 30, 2001
-------- -------------- ------- ------------------
Severance $3,300 $ -- $(2,058) $1,242
Other exit costs 1,387 (245) (963) 179
------ ------ ------- ------
Total non-recurring charges $4,687 $ (245) $(3,021) $1,421
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 three
months and nine months ended September 30, 2001 were approximately (in
thousands):
9
Three months ended Nine months ended
September 30, 2001 September 30, 2001
------------------ ------------------
Net revenue $ 845 $28,860
Cost of revenue (134) 5,809
------- -------
Gross profit $ 979 $23,051
Operating expenses were not directly allocated between the Company's
various lines of business.
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 subleased from the Company approximately 50% of the
facility, which sublease expires in December 2002. During the third quarter of
2002, the purchaser of the CPM business vacated the building and it was
determined that the existing sublease will not 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. The Company recorded a charge of $400,000 in the
quarter ended September 30, 2002 to establish a reserve for the period the
available sublease space is anticipated to be vacant.
5. 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. 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.
In January 1999, the Company exercised its option to license the United
States development, marketing and distribution rights for Chrysalin for fresh
fracture indications. As part of the license agreement, and in conjunction with
FDA authorization 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 authorization from 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 later in 2002.
10
During 2001, the Company completed a Phase I/II clinical trial utilizing
Chrysalin for fresh fracture repair, and in July of 2002, announced that the FDA
had authorized a Phase III trial for that indication. The Company is currently
moving forward with an IND application for a human clinical trial for Chrysalin
for articular cartilage repair. There can be no assurance that any of these
clinical trials will result in favorable data or that NDA approvals by the FDA,
if sought, will be obtained. Significant additional costs will be necessary for
the Company to complete development of these products. Except for the $750,000
minority equity interest, all payments made to Chrysalis have been expensed as
research and development.
6. 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 equipment
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. Plaintiff Barmak is pursuing the claim independent of the U.S.
Department of Justice. The Company filed a motion to dismiss the plaintiff's
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 that purchased the CPM business from 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 in October
2002, filed a counter claim against the plaintiffs for fraud and breach of
contract. The Company intends to pursue the matter vigorously. The case
continues 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.
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 originally filed in 1996. 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 of $2.969
per share on the date of the judge's ruling approving the settlement.
11
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.
As of September 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.
7. LINE OF CREDIT
The Company has a $4 million revolving line of credit with a bank. The
Company may borrow up to 75% of eligible accounts receivable, as defined in the
agreement. The interest rate is at the lender's 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) requirements to maintain
tangible net worth of not less than $30 million, (2) a requirement for a quick
ratio of not less than 2.0 to 1.0, (3) requirements to maintain a debt to
tangible net worth ratio of not less than 0.50 to 1.0, and (4) a requirement
that capital expenditures not exceed more than $7.0 million during any fiscal
year. The Company had not utilized this line of credit. As of September 30, 2002
the Company was in compliance with all the financial covenants.
8. SERIES B CONVERTIBLE PREFERRED STOCK
As of September 30, 2002, 15,000 shares of Series B Convertible Preferred
Stock had been converted into 5,964,080 shares of common stock. Currently, there
are no remaining shares of Convertible Preferred Stock outstanding.
9. SEGMENT INFORMATION
The Company operates as one segment. The various types of revenues and cost
of goods sold are separately identified by product line in the Statement of
Operations. 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 and the "Special Note
Regarding Forward Looking Statements" below.
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 July 2001, the Company divested its CPM business. The Company's decision
to divest the CPM business was based on its desire to refocus all of its
activities on the fracture healing and spinal repair segments of the orthopedic
market. The CPM business, which was focused on the rehabilitation segment of the
orthopedic market, no longer fit in the Company's long-term strategic plans.
The CPM business was sold 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 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 6 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 condition 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 judgments that affect the
reported amounts of assets, liabilities, revenues and expenses at the date of
the financial statements. 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, income
taxes, contingencies and 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
13
making judgments about the carrying values of assets and liabilities not readily
apparent from other sources. Under different assumptions and conditions, actual
results may differ from these estimates.
DOUBTFUL ACCOUNTS: A significant estimate is the allowance for doubtful
accounts of approximately $3.3 million and $5.8 million at September 30, 2002
and December 31, 2001, respectively. Allowances for doubtful accounts are
maintained for estimated losses resulting from the inability of its customers
and third-party payors to make the required payments. Management's estimate of
the allowance is based primarily on trends in historical collection statistics
and adjusted for consideration of current developments in collection practices,
payor mix and other considerations. If the financial condition of the
third-party payors were to deteriorate, resulting in an inability to make
payments or the other considerations underlying the estimates were to change,
additional allowances might be necessary.
UNBILLED REVENUE: The Company's revenues included unbilled receivables of
$2.4 million and $1.9 million at September 30, 2002 and December 31, 2001,
respectively. Unbilled receivables are recognized as revenue when there is
evidence of an arrangement with both the patient and the third-party payor, and
delivery of the product has occurred. 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. The amount of revenue, net of sales
discounts and contractual adjustments, recorded at the time of the sale is based
on an estimate of the primary third-party payors' pricing terms. 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 identified.
REVENUE RECOGNITION: The Company recognizes revenue when the product is
placed on the patient, or, if the sale is to a commercial buyer, when title
passes to the commercial buyer, which is at the time of shipment. The Company's
shipping terms are FOB shipping point for products sold to commercial buyers.
Reductions to revenues are estimated based on historical experience and are in
the form of sales discounts and adjustments from certain third-party payors,
health maintenance organizations and preferred provider organizations. The
Company records any differences between the net revenue amount recognized at the
time of the sale and the ultimate pricing by the primary third-party payor as a
subsequent adjustment to sales in the period the Company receives payments from
the third-party payor or the Company becomes aware of circumstances that warrant
a change in estimate. In the opinion of management, adequate allowances have
been provided for sales discounts and contractual adjustments. Changes to
estimated revenues are recognized in the period in which the Company becomes
aware of circumstances that warrant a change in estimate.
The Company recognizes royalties from the Co-Promotion Agreement of
Hyalgan, based on a flat royalty fee of $5 for each unit distributed by Sanofi
between January 1, 2001 and December 31, 2002 up to $5 million in accordance
with the Termination Agreement.
INVENTORY VALUATION: The Company writes-down its inventory for inventory
shrinkage and obsolescence for the difference between the cost of the inventory
and the estimated value which, in turn, is based on a number of factors,
including future demand and market conditions. If conditions used in determining
these valuations changes, future additional inventory write-downs would be
necessary.
14
DEFERRED TAX VALUATION: 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.
MINORITY INTEREST VALUATION: 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 permanently impaired, a charge to income would be
recorded in the period such a determination is made.
LEASE COSTS: 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 subleased from the Company approximately
50% of the facility, which sublease expires in December 2002. During the third
quarter of 2002, the purchaser of the CPM business vacated the building and it
was determined that the existing sublease will not 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. The Company recorded a charge of $400,000 in the
quarter ended September 30, 2002 to establish a reserve for the period the
available sublease space is anticipated to be vacant.
RESULTS OF OPERATIONS COMPARING THREE-MONTH AND NINE-MONTH PERIODS ENDED
SEPTEMBER 30, 2002 TO CORRESPONDING PERIODS IN 2001.
REVENUES: The Company's total revenues increased 12.5% from $9.6 million in
the third quarter of 2001 to $10.8 million in the third quarter of 2002.
Revenues for the third quarter of 2001 included sales of $845,000 from the
divested CPM business. Sales recorded for the bone growth stimulation products,
the OL1000 and SpinaLogic, increased by 33.8% in the third quarter of 2002 as
compared to the same period in 2001. Revenues for the bone growth stimulation
products for the third quarter of 2002 were $10.3 million compared to $7.7
million in the comparable quarter of the prior year. The Company's total
revenues decreased 43.7% from $53.3 million in the nine month period ended
September 30, 2001 to $30.1 million for the same period in 2002. Revenues for
the nine-month period ended September 30, 2001 included sales of $28.9 million
from the divested CPM business. Sales recorded for the bone growth stimulation
products increased 27.0% in the nine-month period ended September 30, 2002
compared to the same period in 2001. Revenues for the bone growth stimulation
products were $28.2 million for the first nine months of 2002, compared to $22.2
million for the same period in the prior year. The Company believes the
significant increase in bone growth stimulation sales signifies a growth in
market share for both the OL1000 and SpinaLogic products.
Hyalgan royalty revenue was $501,000 in the three month period ended
September 30, 2002 compared to $972,000 for the same period in 2001. Hyalgan
royalty revenue was $1.9 million for the nine-month period ended September 30,
2002 compared to $2.3 million for the same period in 2001. The Company
anticipates receiving additional royalties of approximately $300,000 through the
end of the fiscal year 2002, at which time the royalty agreement will terminate.
15
GROSS PROFIT: Gross profit for the three months ended September 30
increased from $8.3 million in 2001 to $8.9 million in 2002. Gross profit, as a
percent of revenue, was 82.4% for the quarter ending September 30, 2002. Gross
profit for the same period in 2001 was 86.5%. Gross profits for the three months
ended September 30, 2002 were lower than the previous two quarters, due to
increased costs of the manufacturing process required to re-launch the Company's
OrthoFrame/Mayo Wrist Fixator product during the fourth quarter 2002. Gross
profit for the nine-month period ended September 30 decreased from $43.4 million
in 2001 to $25.5 million in 2002. Gross profit, as a percent of revenues was
84.7% for the nine months ended September 30, 2002. Gross profit for the same
period in 2001 was 81.4%. The majority of the gross profit decrease of $17.9
million is a direct result of the divestiture of the CPM business, which
produced $23.1 million in gross profits for the first nine months of 2001. The
improvement of gross margins from 81.4% in 2001 to 84.7% in 2002 is due to the
change in product mix to higher margin products. The CPM business for the year
ended December 31, 2001 had a gross margin of approximately 79.9%.
SELLING, GENERAL AND ADMINISTRATIVE ("SG&A") EXPENSES: SG&A expenses
decreased 2.7% from $7.4 million in the three month period ended September 30,
2001 to $7.2 million in the same period in 2002. SG&A expenses decreased 49.5%
from $40.6 million in the nine month period ended September 30, 2001 to $20.5
million in the same period in 2002. The nine-month period ended September 30,
2002 is not comparable to the same period in 2001, due to the cost of the CPM
operations and the $400,000 charge for the sublease discussed above. SG&A
expenses, as a percentage of total revenues, were 66.7% in the three month
period ended September 30, 2002 and 77.1% in the same period in 2001. SG&A
expenses, as a percentage of total revenues, were 68.1% in the nine month period
ended September 30, 2002 and 76.2% in the same period in 2001. The SG&A expense
for the quarter ended September 30, 2002 is not comparable to the same period in
2001, due to the costs associated with the divested CPM operations. In addition,
the Company recorded a charge of $400,000 in the quarter ended September 30,
2002 to establish a reserve for an anticipated period the sublease space may be
vacant.
RESEARCH AND DEVELOPMENT EXPENSES: Research and development expenses were
$722,000 in the three month period ended September 30, 2002, compared to
$486,000 for the same period in 2001. Research and development expenses were
$2.4 million in the nine-month period ended September 30, 2002 compared to $3.1
million for the same period in 2001. The research and development costs for the
nine months ended September 30, 2002 included a $500,000 milestone payment made
to Chrysalis BioTechnology, Inc. to begin a Phase I/II human clinical trial of
Chrysalin for spinal fusion. The research and development expenses for the nine
months ended September 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 September 30, 2002 are for the overall Chrysalin Product Platform, which
include pre-clinical studies in cartilage and continuation of the Phase I/II
human clinical trial under an IND for spinal fusion and the Phase III human
clinical trial under an IND for fracture repair.
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 by the
buyer. The Company retained and did not sell the invoiced receivables. The
16
Company may receive up to an additional $2.5 million in cash, due to certain
objectives achieved by the purchaser of the CPM business. 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 6 to the Notes to Unaudited Condensed Consolidated Financial
Statement. The Company has not recorded the additional contingent consideration
in the Company's financial statements because it is the subject of a dispute
with the purchaser of the CPM business.
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 to record additional
charges directly related to the CPM divestiture, 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
to write down the value of the assets to fair value less direct selling costs,
$2.8 million for a change in estimate regarding the collectability of the
retained accounts receivable, $3.3 million for employee severance, and $1.4
million for related exit costs.
The Company recorded the $6.9 million charge to write down the CPM assets
to their fair value less direct costs of selling the assets. Fair value was
assessed to be the total consideration received for the CPM net assets in the
sale that closed on July 11, 2001. The Company had previously received
non-binding letters-of-intent, which had indicated higher values for the CPM net
assets to be sold, but negotiations that ensued during the second quarter of
2001 resulted in a lower final sales price for the CPM net assets that were
sold.
The Company retained all the invoiced 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 recorded in the second quarter of 2001 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.
At December 31, 2001, the Company had collected $10.2 million of the $10.8
million of retained CPM receivables. During 2002, collection of these
receivables was better than anticipated. Based on the improved collection
trends, the Company revised its estimate and increased the estimated total
collections by $600,000 and $226,00 in the quarters ended March 31, 2002 and
June 30, 2002, respectively. Collections during the third quarter were again
better than expected. Therefore, based on the ongoing favorable collections,
during the quarter ended September 30, 2002, the Company revised its estimate
and now expects that an additional $221,000 would be collected. At September 30,
2002, the carrying value of the remaining CPM accounts receivable was
approximately $190,000.
In connection with the sale of the CPM business, the Company eliminated
approximately 331 of the Company's 505 positions. A charge of approximately $3.3
million is included in the "CPM divestiture and related charges" for the
severances paid to terminated employees. The Company also recorded additional
exit charges of approximately $1.4 million for CPM commissions, write offs of
concessions for prepaid rents, space build out costs relating to the purchaser's
sublease with the Company and other similar charges, and other CPM related
prepaid expenses for which no future benefits were expected to be received.
17
A summary of the severance and other reserve balances at September 30, 2002 and
2001 are as follows (in thousands):
Reserves Amount Charged Cash Reserves
December 31, 2001 Against Assets Paid September 30, 2002
----------------- -------------- ------- ------------------
Severance $ 946 $ -- $ (717) $ 229
Other exit costs 76 (37) 39
------- ------- ------- -------
Total non-recurring charges $ 1,022 $ -- $ (754) $ 268
Initial Amount Charged Cash Reserves
Reserves Against Assets Paid September 30, 2001
-------- -------------- ------- ------------------
Severance $ 3,300 $ -- $(2,058) $ 1,242
Other exit costs 1,387 (245) (963) 179
------- ------- ------- -------
Total non-recurring charges $ 4,687 $ (245) $(3,021) $ 1,421
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 three
months and nine months ended September 30, 2001 were approximately (in
thousands):
Three months ended Nine months ended
September 30, 2001 September 30, 2001
------------------ ------------------
Net revenue $ 845 $28,860
Cost of revenue (134) 5,809
------- -------
Gross profit $ 979 $23,051
Operating expenses were not directly allocated between the Company's
various lines of business.
OTHER INCOME. Other income consisting primarily of interest income, decreased
from $223,000 in the three-month period ended September 30, 2001 to $169,000 for
the same period in 2002. The decrease is the result of declining interest rate
returns on the investment portfolio. Other income increased from $482,000 in the
nine-month period ended September 30, 2001 to $537,000 for the same period in
2002. The increase is a result of interest earned on the Company's higher cash
and investment balances.
18
NET PROFIT: The Company had a net profit in the three month period ended
September 30, 2002 of $1.4 million compared to a net profit of $606,000 in the
same period in 2001. The Company had a net profit of $4.1 million for the nine
month period ended September 30, 2002 compared to a net loss of $14.2 million in
the same period in 2001.
LIQUIDITY AND CAPITAL RESOURCES
On September 30, 2002, the Company had cash and equivalents of $10.1
million compared to $19.5 million as of December 31, 2001. The Company also had
$18.8 million of short-term investments as of September 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 $28.9 million at September 30, 2002
compared to $30.5 million as of December 31, 2001. The Company also had
long-term investments of $4.8 million, as of September 30, 2002, mostly
consisting of government-backed securities with maturities of fewer than 18
months.
In addition, the Company has a $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
lender's 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
reporting requirements associated with the loan. Included in the financial
covenants are (1) requirements to maintain tangible net worth of not less than
$30 million, (2) a requirement for a quick ratio of not less than 2.0 to 1.0,
(3) requirements to maintain a debt to tangible net worth ratio of not less than
0.50 to 1.0, and (4) a requirement that capital expenditures will not exceed
more than $7.0 million dollars during any fiscal year. The Company had not
utilized this line of credit. As of September 30, 2002, the Company was in
compliance with all the financial covenants.
Net cash provided by operations during the nine-month period ended
September 30, 2002 was $3.4 million compared to $7.0 million for the same period
in 2001. The primary reason for this decline is due to the collection of CPM
receivables during the nine-month period ended September 30, 2001 and an
increase in inventories because the Company is now carrying inventory parts and
finished goods for the re-launch of its OrthoFrame/Mayo Wrist Fixator product
during the fourth quarter of 2002. The decrease in liabilities is primarily due
to non-recurring payments in 2001 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 to make 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 amount of cash the Company will be
required to use in the next 12 months 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.
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 subsequent 12 months. The repurchased shares are held as
19
treasury shares to reduce the dilution from the Company stock option plans. As
of September 30, 2002, the Company had repurchased 41,800 shares at a cost, net
of fees, of $137,300 or an average price of $3.28 per share. The repurchase
period ended in August 2002.
The following table sets forth all known commitments as of September 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 $ 270 $ 5,919 $ 6,189
2003 $ 1,078 -- $ 1,078
2004 $ 1,078 -- $ 1,078
2005 $ 1,078 -- $ 1,078
2006 $ 1,078 -- $ 1,078
Thereafter $ 989 -- $ 989
------- ------- -------
Total $ 5,571 $ 5,919 $11,490
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The Company has no debt and no derivative instruments at September 30,
2002.
The Company's Canadian operations were sold as part of the CPM asset sale,
and consequently the Company has no exposure to foreign exchange rates at
September 30, 2002.
ITEM 4. EVALUATION OF CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures, which are
designed to ensure that material information related to OrthoLogic Corp. is made
known to the disclosure committee on a regular basis. In response to recent
legislation and proposed regulations, we reviewed our internal control structure
and our disclosure controls and procedures. Although we believe our pre-existing
disclosure controls and procedures are adequate to enable compliance with our
disclosure obligations, as a result of such review, we implemented minor
changes, primarily to formalize and document the procedures already in place. We
also established a disclosure committee consisting of certain members of the
Company's senior management.
After the formation of our disclosure committee and within 90 days prior to
the filing of this report, the disclosure committee carried out an evaluation of
the effectiveness of the design and operation of the Company's disclosure
controls and procedures. Based upon that evaluation, the disclosure committee
concluded that the Company's disclosure controls and procedures are effective in
causing material information to be recorded, processed, summarized, and reported
by management of the Company on a timely basis and to ensure that the quality
and timeliness of the Company's public disclosures complies with its SEC
disclosure obligations.
20
There were no significant changes in the Company's internal controls or in
other factors that could significantly affect these internal controls after the
date of our most recent evaluation.
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 experienced
significant operating losses since its inception and had an accumulated deficit
of approximately $92.2 million at September 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 in August 2000 with DePuy AcroMed ("DePuy
AcroMed"), a unit of Johnson and Johnson. The sales agreement provides DePuy
AcroMed with the right to terminate its sales activities on behalf of SpinaLogic
without cause, by giving OrthoLogic a minimum of 120 days written notice. Any
significant change in the business relationship or termination of the sales
agreement with DePuy AcroMed may have a material adverse effect on the Company's
sales of SpinaLogic. The Company relies upon the distribution of the SpinaLogic
product for a large portion of its sales.
The Company relies on distributors and sales representatives to sell the
OL1000. There can be no guarantees that the terms of the distribution and sales
representative contracts will be renewed as they currently exist.
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 6 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.
21
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 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 hesitated to prescribe bone growth stimulator
products such as those manufactured by the Company. The widespread acceptance of
the Company's primary products would represent 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. 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 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.
HEALTHCARE LAW AND REGULATIONS. The healthcare 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 healthcare
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.
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 affect the Company's
business, financial condition and results of operations.
The Company owns a number of patents and relies on unpatented 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
22
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 resources by 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
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 prescribe
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, however these products are 510(k) clearance exempt. Chrysalin, as a new
drug, is subject to clinical trial (IND/NDA) and Good Manufacturing Practices
("GMP") review more stringent and regulated than 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
23
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.
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
24
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, marketing
and promotional 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
fusions, 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 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. The Company
could also face increased competition from new companies entering this
marketplace.
DEPENDENCE ON KEY SUPPLIERS. The Company purchases several key electronic
components used in the OL1000 and SpinaLogic devices from single manufacturers.
Although there are feasible alternates that might be used immediately, the
supply for these components may not be available. 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 6 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.
The Company is dependent on outside vendors for key parts in the
manufacture of the OrthoFrame/Mayo, an external fixation product used in
conjunction with surgical procedures, which was re-launched by the Company's
sales force in October 2002.
UNCERTAINTY AND POTENTIAL NEGATIVE EFFECTS OF CHANGES IN HEALTHCARE
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.
25
The Company runs the risk of reduced revenues should it be determined that
the Company's products will be subject to any new rulings and regulations in the
areas of Medicare Competitive Bidding and/or Inherent Reasonableness of Price.
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.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
See "Note 6 - Litigation" of the Notes to the Unaudited Condensed
Consolidated Financial Statements above, which is incorporated hereto.
Item 6. Exhibits and Reports
(a) Exhibit Index
See Exhibit List following this report
(b) Reports on Form 8-K
None.
26
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 November 12, 2002
- --------------------- Officer (Principal Executive
Thomas R. Trotter Officer)
/s/ Sherry A. Sturman Vice-President and Chief Financial November 12, 2002
- --------------------- Officer (Principal Financial and
Sherry A. Sturman Accounting Officer)
27
Certification of CEO Pursuant to Securities Exchange Act Rules 13a - 14 and
15d - 14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
I, Thomas R. Trotter, the Chief Executive Officer of OrthoLogic Corp., certify
that:
1. I have reviewed this quarterly report on Form 10-Q of OrthoLogic Corp.
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 12, 2002
/s/ Thomas R. Trotter
- -------------------------------------
President and Chief Executive Officer
28
Certification of CFO Pursuant to Securities Exchange Act Rules 13a - 14 and
15d - 14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
I, Sherry A. Sturman, the Chief Financial Officer of OrthoLogic Corp., certify
that:
1. I have reviewed this quarterly report on Form 10-Q of OrthoLogic Corp.
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 12, 2002
/s/ Sherry A. Sturman
- ---------------------------------
Chief Financial Officer
29
ORTHOLOGIC CORP.
EXHIBIT INDEX TO QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002
Incorporated by Filed
Exhibit No Description Reference to: Herewith
- ---------- ----------- ------------- --------
10.1 Amended and Restated X
Employment Agreement
Chief Executive Officer (1) (2)
Dated July 15, 2002
99.1 Certification pursuant to 18 U.S.C. X
Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act
of 2002. -- Thomas R. Trotter
99.2 Certification pursuant to 18 U.S.C. X
Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act
of 2002. -- Sherry A. Sturman
(1) Management Contract or Compensatory Plan.
(2) Filed under confidential treatment request with the Securities and Exchange
Commission.
30