U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2002
[ ] TRANSITION REPORT UNDER 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 OR OTHER JURISDICTION OF (IRS EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1275 West Washington Street, Tempe, Arizona 85281
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
Registrant's telephone number: (602) 286-5520
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.0005 per share
(TITLE OF CLASS)
Rights to purchase 1/100 of a share of Series A Preferred Stock
(TITLE OF CLASS)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that OrthoLogic
was required to file such report(s)), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether OrthoLogic is an accelerated filer.
Yes [X] No [ ]
The aggregate market value of the voting and non-voting common equity held
by non-affiliates of the registrant, based upon the closing bid price of
registrant's Common Stock as reported on the NASDAQ National Market on March 12,
2003 was approximately $112,098,877. Shares of Common Stock held by each officer
and director and by each person who owns 10% or more of the outstanding Common
Stock have been excluded in that such persons may be deemed to be affiliates.
This determination of affiliate status is not necessarily conclusive.
DOCUMENTS INCORPORATED BY REFERENCE: Portions of the registrant's proxy
statement related to its 2003 annual meeting of stockholders to be held on May
29, 2003 are incorporated by reference into Part II and III of this Form 10-K.
The number of outstanding shares of the registrant's Common Stock on March
12, 2003 was 32,873,571
ORTHOLOGIC CORP.
FORM 10-K ANNUAL REPORT
YEAR ENDED DECEMBER 31, 2002
TABLE OF CONTENTS
PART I Page
Item 1. Business...................................................... 1
Item 2. Properties.................................................... 8
Item 3. Legal Proceedings ............................................ 8
Item 4. Submission of Matters to a Vote of Security Holders........... 9
PART II
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters......................................... 10
Item 6. Selected Financial Data....................................... 11
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 12
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.... 25
Item 8. Financial Statements and Supplementary Data................... 25
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 25
PART III
Item 10. Directors and Executive Officers of the Registrant............ 26
Item 11. Executive Compensation........................................ 27
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 27
Item 13. Certain Relationships and Related Transactions................ 27
Item 14. Evaluation of Controls and Procedures......................... 27
PART IV
Item 15. Exhibits, Financial Statement Schedule and Reports on
Form 8-K.................................................... 27
SIGNATURES................................................................. S-1
CERTIFICATIONS............................................................. S-2
EXHIBIT INDEX.............................................................. E-1
FINANCIAL STATEMENTS AND SUPPLENTARY DATA.................................. F-1
PART I
ITEM 1. BUSINESS
GENERAL DEVELOPMENT OF BUSINESS
OrthoLogic Corp. was incorporated as a Delaware corporation in July 1987 as
IatroMed, Inc. and changed its name to OrthoLogic Corp. in July 1991. Unless the
context otherwise requires, references to the "Company" or "OrthoLogic" refer to
OrthoLogic Corp. and its subsidiaries. The Company's executive offices are
located at 1275 West Washington Street, Tempe, Arizona 85281, and its telephone
number is (602) 286-5520.
OrthoLogic develops, manufactures and markets proprietary, technologically
advanced orthopedic products designed to promote the healing of musculoskeletal
bone and 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 1999, the Company exercised its option to license the United States
development, marketing, and distribution rights for the fracture indications for
Chrysalin, a new tissue repair synthetic peptide. In 2000, the Company exercised
its option to license Chrysalin for all orthopedic applications worldwide.
The Company's research and development focus is on its Chrysalin product
development program. The Company has three potential Chrysalin products either
in human clinical trials or in late-stage pre-clinical development.
OrthoLogic 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.
Copies of the Company's annual reports on Form 10K, quarterly reports on
Form 10Q, current reports on Form 8K, and amendments to those reports filed or
furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of
1934 are available free of charge through our website (www.orthologic.com) as
soon as reasonably practicable after we electronically file the material with,
or furnish it to, the Securities and Exchange Commission.
PRODUCTS AND OTHER PRODUCT DEVELOPMENT
OrthoLogic's product line includes bone growth stimulation and fracture
fixation devices. The Company's OL1000 product line is sold primarily through
the Company's direct sales force supplemented by regional distributors. The
Company uses an international spine product distributor for the sales and
marketing of its bone growth stimulation device, SpinaLogic(R).
BONE GROWTH STIMULATION PRODUCTS
OL1000, OL1000 SC. The OL1000 is a U.S. Food and Drug Administration
("FDA") approved portable, noninvasive, physician-prescribed, electromagnetic
bone growth stimulator designed for patients with nonunion fractures. The OL1000
comprises two magnetic field treatment transducers (coils) and a
microprocessor-controlled signal generator that delivers a highly specific, low
energy signal to the injured area. The device is attached to the patient's arm,
leg or other area where there is a nonunion fracture. The OL1000 then evenly
distributes a magnetic field over the patient's injured area. As a result,
specific placement of the device over the nonunion fracture is not crucial for
product efficacy as it is for some of our competitors' products.
The patient wears the device for 30 minutes each day. The Company believes
the reduced treatment time leads to increased patient compliance with treatment
protocol. In addition, the micro-controller tracks the patient's daily treatment
compliance.
The OL1000 is used for the noninvasive treatment of an established nonunion
fracture acquired secondary to trauma, excluding vertebrae and all flat bones. A
nonunion fracture is considered to be established when the fracture site shows
no visibly progressive signs of healing.
1
The OL1000 SC is an FDA approved single coil device, which utilizes the
same combined magnetic field as the OL1000, is available in three sizes and is
designed to be more comfortable for patients with certain types of fractures.
SPINALOGIC(R). SpinaLogic is a portable, noninvasive, electromagnetic bone
growth stimulator, which enhances the healing process as an adjunct to spinal
fusion surgery. The Company believes that SpinaLogic offers benefits similar to
those of the OL1000 in that it is relatively easy to use, requires a small power
supply and requires only 30 minutes of treatment per day. The patient attaches
the device to the lumbar injury location where it provides localized magnetic
field treatment to the fusion site. Like the OL1000, the SpinaLogic device
contains a micro-controller that tracks the patient's daily treatment compliance
and can easily be checked by the surgeon upon follow-up visits. SpinaLogic is
approved by the FDA as an adjunct treatment for primary lumbar spinal fusions.
It is designed for single patient use and is programmed for 270 consecutive,
30-minute daily treatments.
Sales of bone growth stimulation products were 95%, 48% and 23% of the
Company's total revenues in the years ending December 31, 2002, 2001 and 2000,
respectively.
FRACTURE FIXATION DEVICES
ORTHOFRAME(R)/MAYO(R). The Company began to manufacture and distribute the
OrthoFrame line of external fixation products in 1993. The OrthoFrame/Mayo
product is an external fixation device used in conjunction with surgical
procedures. It is low profile, lightweight, and primarily sold to hospitals. The
Company temporarily ceased manufacturing this product in 2000 to improve the
product packaging, and it was relaunched in the fourth quarter of 2002.
DISCONTINUED OR DIVESTED PRODUCTS
CONTINUOUS PASSIVE MOTION ("CPM"). In July 2001 the Company sold its CPM
business. CPM devices provide controlled, continuous movement to joints and
limbs without requiring the patient to exert muscular effort and are intended to
be applied immediately following orthopedic trauma or surgery. The products are
designed to reduce swelling, increase joint range of motion, reduce the length
of hospital stay and reduce the incidence of post-trauma and post-surgical
complications. The Company's financial results reflect sales of the CPM devices
through July 11, 2001.
Sales of continuous passive motion devices were 46% and 67% of the
Company's total revenues for the year ending December 31, 2001 and 2000,
respectively. The Company had no CPM sales in the year ended December 31, 2002.
ANCILLARY ORTHOPEDIC PRODUCTS. Along with the July 2001 sale of the CPM
business, the Company sold its ancillary orthopedic product lines of bracing,
electrotherapy, cryotherapy and dynamic splinting products. The bracing line
included post-operative, custom and pre-sized functional and osteoarthritis
models. Postoperative braces are used in the early phases of post-surgical
rehabilitation, while functional braces are applied as the patient returns to
work or sports activities. Cryotherapy is used to cool the operative or injured
site in order to prevent pain and swelling. The electrotherapy line consisted of
TENS, NMES, high volt pulsed current, interferential, and biofeedback units.
HYALGAN(R) (SODIUM HYALURONATE). The Company began selling Hyalgan to
orthopedic surgeons in July 1997, under a Co-Promotion Agreement with Hyalgan's
distributor in the United States (the "Co-Promotion Agreement"). In October
2000, OrthoLogic and the Hyalgan distributor announced that both parties had
mutually agreed to terminate this agreement. In connection with the early
termination, the Company received an up-front cash payment, financial incentives
to complete the transition of the business through December 2000, and ongoing
royalties, which ended December 31, 2002.
Royalty and fee income for Hyalgan were approximately 5%, 5% and 10% of the
Company's total revenue in the years ended December 31, 2002, 2001 and 2000,
respectively.
PRODUCTS IN RESEARCH
CHRYSALIN(R). In January 1998, the Company made a minority equity
investment (less than 10%) in a biotech firm, Chrysalis BioTechnology, Inc.
("Chrysalis"), and acquired, as part of that investment, an option to license a
unique synthetic peptide called TP508, or Chrysalin.
2
Chrysalin is a 23-amino acid synthetic peptide representing a fragment of
the human thrombin molecule. Thrombin has been shown to be involved in the
healing process for both soft tissue and bone. By mimicking specific attributes
of the thrombin molecule, Chrysalin stimulates the body's natural healing
processes, resulting in accelerated tissue repair.
During 2001 the Company completed a Phase I/II human clinical trial
utilizing Chrysalin for fracture repair to test the safety and preliminary
efficacy of Chrysalin. In July 2002, the Company received authorization to begin
a Phase III human clinical trial under an Investigational New Drug ("IND")
application from the Food and Drug Administration ("FDA"). The trial will be
performed at 25 to 30 clinical sites with approximately 500 patients.
In March 2002, the Company received authorization from the FDA to commence
a Phase I/II clinical trial for a spinal fusion indication for Chrysalin. The
Company began enrolling patients during the fourth quarter of 2002. The clinical
trial will include approximately 330 patients and will be performed at 15 to 20
centers in the United States. The purpose of the study is to evaluate the safety
and preliminary efficacy of Chrysalin in combination with allograft. The patient
enrollment process is expected to take approximately 18 to 24 months with a
nine-month follow-up period. The Company also hopes to begin a Phase I/II human
clinical trial for Chrysalin for articular cartilage repair before the end of
2003.
The Company has not yet applied for FDA approval to market Chrysalin and
there is no assurance that the Company will do so or that it would receive such
approval if sought. (See "Item 1 - Business - Government Regulation).
OrthoLogic does not own the patents to Chrysalin. Chrysalin was developed
by and patented by Chrysalis BioTechnology, Inc., a company in which OrthoLogic
holds a minority equity interest. OrthoLogic obtained the worldwide rights to
use Chrysalin for all orthopedic indications through a series of licensing
agreements with Chrysalis BioTechnology, Inc.
ORTHOSOUND(TM). The Company holds patents for diagnostic and therapeutic
devices utilizing its nonthermal ultrasound technology "OrthoSound" for use in
medical applications that relate to bone, cartilage, ligament or tendon
diagnostics and healing. The Company is not currently engaged in any clinical
studies using this technology and there can be no assurance that the Company
will do so or that it would receive such approval if sought.
MARKETING AND SALES
OrthoLogic markets and sells its products to orthopedic and podiatric
surgeons in private practice, hospitals, and clinics, as well as to general
orthopedic physicians. Direct sales and marketing efforts have centered on these
groups in these locations.
The launch of SpinaLogic added a new customer base for the Company:
orthopedic spine surgeons and neurosurgeons who perform spine procedures. This
fact, in combination with a desire to quickly penetrate this new market, led the
Company in August 2000 to sign an exclusive 10-year sales agreement with DePuy
AcroMed, Inc. ("DePuy AcroMed"), a unit of Johnson and Johnson.
The Company conducts its sales efforts for the OL1000 through a combination
of direct sales representatives and select regional sales agents. Of the
Company's approximately 156 employees at December 31, 2002, approximately 52 are
involved in field sales and marketing. The Company employs a Senior Vice
President of Sales, as well as five Area Vice Presidents, to manage territory
sales and coordinate with the SpinaLogic distributors.
Through its specialized marketing and sales staff, the Company has
initiated and maintained contracts with over 400 third party payors for the
OL1000 and SpinaLogic product lines. In addition, the Company is an approved
Medicare and Medicaid provider, which accounts for approximately 16% of total
revenues.
OrthoLogic has not typically experienced seasonality in sales of the OL1000
or SpinaLogic. However, revenues from the Company's CPM business line sold in
2001 had proven to be seasonal. Historically the strongest quarters for the CPM
business were the first and fourth quarters of the calendar year. The Company
does not expect future revenues to be affected by seasonality.
3
RESEARCH AND DEVELOPMENT
Individuals within the research and development department have extensive
experience in the areas of biomaterials, bioengineering, animal modeling, and
cellular and molecular biology. Research and development efforts are focused on
product engineering, basic and pre-clinical research, and the design and conduct
of the clinical trials.
The research and development staff conducts in-house basic research
projects in the areas of bone biology, fracture healing, and spine fusion,
directed toward the clinical applications of the Chrysalin platform technology.
The staff also supports and monitors outsourced research projects in cartilage
repair and biophysical stimulation applications in tissue engineering. Both the
in-house and outsourced research and development projects provide technical
marketing support for the Company's products and explore the development of new
products and additional therapeutic applications for existing products.
The clinical affairs group within the research and development department
designs, initiates, and monitors clinical trials. The Company's clinical affairs
and regulatory groups are engaged in a Phase III clinical trial of Chrysalin for
fracture repair, a Phase I/II clinical trial of Chrysalin for spinal fusion
indication, and are pursuing further pre-clinical studies in articular
cartilage, ligament, and tendon repair.
A portion of the Company's research and development expense is from the
license payments to Chrysalis. In 2000, the Company paid Chrysalis $2.0 million
to extend its original 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. In March 2002, the Company made a $500,000 milestone payment to
Chrysalis for receiving clearance from the FDA to begin a Phase I/II trial for
spinal fusion. A pre-payment of $250,000 was made subsequent to year-end 2002 to
Chrysalis in anticipation of a potential IND filing with the FDA for a human
clinical trial for a cartilage indication. The license agreement calls for the
Company to pay certain other additional milestone payments and royalty fees,
based upon the product's development and achievement of commercial introduction.
The Company's research and development expenditures totaled $3.8 million,
$3.9 million and $4.7 million the years ended December 31, 2002, 2001 and 2000,
respectively.
MANUFACTURING
The Company assembles the OL1000 and SpinaLogic products from parts
supplied by third parties, performs tests on the components and the assembled
product, and calibrates the assembled product to specifications. The Company
purchases several components, including the magnetic field sensor employed in
the OL1000 and SpinaLogic products, from a single source. Establishing
additional or replacement suppliers for this component cannot be accomplished
quickly. Other components and materials used in the manufacture and assembly of
the OL1000 and SpinaLogic are available from multiple sources.
The Company purchases components from specialty vendors for the
OrthoFrame/Mayo external fixation product. In-house manufacturing is limited to
inspection of the components and minor assembly tasks. Assembly and packaging of
the OrthoFrame/Mayo is contracted to specialty vendors.
A third party produces Chrysalin for the Company in only limited amounts.
Because Chrysalin is currently still in the clinical trial phase and not being
sold to the public, it is manufactured by a sole supplier.
COMPETITION
The orthopedic industry is characterized by rapidly evolving technology and
intense competition. The Company has common competitors for its fracture healing
and spine stimulation businesses. In addition to surgical procedures (an
alternative to bone growth stimulation), other manufacturers of bone growth
stimulators include Electro-Biology, Inc. (EBI), a subsidiary of Biomet, Inc.,
OrthoFix International N.V., and Exogen, Inc., a subsidiary of Smith & Nephew.
New research in orthobiologics, such as the development of growth factors
like bone morphogenic proteins as well as the Company's own work with Chrysalin,
may well affect the market potential for bone growth stimulation in the future.
4
With respect to external fixation devices, the Company's primary
competitors are OrthoFix, Stryker, EBI, Smith & Nephew, Richards, Inc., Synthes,
Inc. and DePuy ACE, a division of DePuy Inc.
Many of the Company's competitors have substantially greater resources and
experience in research and development, obtaining regulatory approvals,
manufacturing, marketing and sales of medical devices and services, and
therefore represent significant competition for the Company. The Company is
aware that its competitors are conducting clinical trials for other medical
applications of their respective technologies. In addition, other companies are
developing or may develop 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.
The Company believes that competition is based on, among other factors, the
safety and efficacy of products in the marketplace, physician familiarity with
the product, ease of patient use, product reliability, reputation, price, sales
and marketing capability, and reimbursement.
Any product developed by the Company that gains the necessary regulatory
approvals would have to compete for market acceptance and market share in an
intensely competitive market. An important factor in such competition may be the
timing of market introduction of competitive products. Accordingly, the relative
speed with which the Company can develop products, complete clinical testing, as
well as any necessary regulatory approval processes, and supply commercial
quantities of the product to the market, will be critical to its competitive
success. There can be no assurance the Company can successfully compete on these
bases. See "Item 7 - Management's Discussion and Analysis of Financial Condition
and Results of Operations - Risks Related to Our Industry."
PATENTS, LICENSES AND PROPRIETARY RIGHTS
The Company's practice is to require its employees, consultants and
advisors to execute a confidentiality and non-compete agreement upon the
commencement of an employment or consulting relationship with the Company. The
agreements provide that all confidential information developed by, or made known
to, an individual during the course of the employment or consulting relationship
will be kept confidential and not disclosed to third parties except in specified
circumstances. The agreements provide that all inventions conceived by the
individual relating to the Company's business while employed by the Company
shall be the exclusive property of OrthoLogic. There can be no assurance,
however, that these agreements will provide meaningful protection for the
Company's trade secrets in the event of unauthorized use or disclosure of such
information.
It is also the Company's policy to protect its owned and licensed
technology by, among other things, filing patent applications for the
technologies that it considers important to the development of its business. The
most important intellectual property to our current product lines is the
BioLogic(R) technology. The Company uses the BioLogic technology in its bone
growth stimulation devices through a worldwide exclusive license granted by a
corporation owned by university professors who discovered the technology. With
respect to the BioLogic technology, the delivery of such technology to the
patient and specific applications of such technology, the Company holds title to
or has exclusive worldwide license of a total of 61 BioLogic patents and design
patents in the United States, France, Switzerland, Germany, Canada, Japan,
Spain, United Kingdom, Italy and Australia. The Company's license for the
BioLogic technology extends for the life of the underlying patents, which are
due to expire over a period of years beginning in 2006 and extending through
2016. Once patents expire, competitors would be able to copy the technology and
could seek such approval from the FDA to market the technology. The BioLogic
technology license covers all improvements and applies to the use of the
technology for all medical applications in humans and animals. The license
provides for payment of royalties by the Company from the net sales revenues of
products using the BioLogic technology. The license agreement can be terminated
for breach of any material provision of the license.
The Company has been assigned and maintains 14 patents in the United
States, Europe, Canada and Japan covering methods for ultrasonic bone assessment
and therapy by noninvasively and quantitatively evaluating the status of bone
tissue IN VIVO through measurement of bone mineral density, strength and
fracture risk.
OrthoLogic does not own the patents to Chrysalin. Chrysalin was developed
by and patented by Chrysalis BioTechnology, Inc., a company in which OrthoLogic
holds a minority equity interest. OrthoLogic obtained the worldwide rights to
use Chrysalin for all orthopedic indications through a series of licensing
agreements with Chrysalis BioTechnology, Inc.
ORTHOLOGIC(R), ORTHOFRAME(R), SPINALOGIC(R), TOMORROW'S TECHNOLOGY
TODAY(R), CASELOG(R), ORTHONAIL(TM) are federally registered trademarks of the
Company.
5
No asset amounts are recorded in the Company's financial statements for
these patents, licenses and property rights.
GOVERNMENT REGULATION
The activities of the Company are regulated by foreign, federal, state and
local governments. Government regulation in the United States and other
countries is a significant factor in the development and marketing of the
Company's products and in the Company's ongoing manufacturing and research and
development activities. The Company and its products are regulated by the FDA
under a number of statutes, including the Medical Device Amendments Act of 1976
to the Federal Food, Drug and Cosmetic Act, as amended, the Safe Medical Devices
Acts of 1990 and 1992, and the Food and Drug Administration Modernization Act of
1997, as amended (collectively, 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 FDA
review, and are required to be tested under an Investigational Device Exemption
("IDE") clinical trial and approved for marketing under a Pre-Market Approval
("PMA"). To begin human clinical studies the Company must apply to the FDA for
an IDE. Generally, preclinical laboratory and animal tests are required to
establish a scientific basis for granting of an IDE. Once an IDE is granted,
clinical trials can commence, which involve rigorous data collection as
specified in the IDE protocol. After the clinical trial is completed, the data
is compiled and submitted to the FDA in a PMA application. FDA approval of a PMA
application occurs after the applicant has established safety and efficacy to
the satisfaction of the FDA. The FDA approval process may include review by an
FDA advisory panel. Approval of a PMA application includes specific requirements
for labeling of the medical device with regard to appropriate indications for
use. Among the conditions for PMA approval is the requirement that the
prospective manufacturer's quality control and manufacturing procedures comply
with the FDA regulations setting forth Good Manufacturing Practices ("GMP").
The FDA monitors compliance with these requirements by requiring
manufacturers to register with the FDA, which subjects them to periodic FDA
inspections of manufacturing facilities. In addition, the Company must comply
with post-approval reporting requirements of the FDA. If violations of
applicable regulations are noted during FDA inspections, the continued marketing
of any products manufactured by the Company may be limited or terminated. No
significant deficiencies have been noted in FDA inspections of the Company's
manufacturing facilities.
The FDC Act regulates the labeling of medical devices to indicate the uses
for which they are approved, both in connection with PMA approval and
thereafter, including any sponsored promotional activities or marketing
materials distributed by or on behalf of the manufacturer or seller. A
determination by the FDA that a manufacturer or seller is engaged in marketing
of a product for other than its approved use may result in administrative, civil
or criminal actions against the manufacturer or seller.
The OrthoFrame/Mayo Wrist Fixator is a Class II device. If a medical device
manufacturer can establish that a newly developed device is "substantially
equivalent" to a device that was legally marketed prior to May 28, 1976, the
date on which the Medical Device Amendments Act of 1976 was enacted, the
manufacturer may seek marketing clearance from the FDA to market the device by
filing a 510(k) pre-market notification with the agency. The Company obtained
510(k) pre-market notification clearance from the FDA for this device.
Regulations governing human clinical studies outside the United States vary
widely from country to country. Historically, some countries have permitted
human studies earlier in the product development cycle than the United States.
This disparity in regulation of medical devices may result in more rapid product
approvals in certain foreign countries than the United States, while approvals
in countries such as Japan may require longer periods than in the United States.
In addition, although certain of the Company's products have undergone clinical
trials in the United States and Canada, such products have not undergone
clinical studies in any other foreign country and the Company does not currently
have any arrangements to begin any such foreign studies.
As a potential new drug product, Chrysalin would be subject to clinical
trial and GMP review similar to those described for the BioLogic
technology-based products. Under the FDC Act, drug products are required to be
tested under Investigational New Drug ("IND") Phase I, II, and III clinical
trials and approved for marketing under a New Drug Application ("NDA"). To begin
human clinical trials a company must apply to the FDA for IND approval for a
product for a specific indication. Generally, pre-clinical laboratory and animal
tests are required to establish a scientific basis for granting of an IND
application. Once an IND application is granted, the clinical trial commences
and involves rigorous data collection as specified in the IND protocol(s). Data
from earlier phases may need to be reviewed by the FDA before proceeding to
later phases.
6
After all phases of the clinical trials are completed, data is compiled and
submitted to the FDA in an NDA application. FDA approval of an NDA application
occurs after the applicant has established safety and efficacy to the
satisfaction of the FDA. Approval of an NDA application includes specific
requirements for labeling, manufacturing, and controls. The approval process may
include review by an FDA advisory panel. Among conditions for NDA approval is
the requirement that the prospective manufacturer's quality control and
manufacturing procedures comply with the FDA regulations setting forth Good
Manufacturing Practices.
The process of obtaining necessary government approvals is time consuming
and expensive. There can be no assurance that the necessary approvals for new
products or applications will be obtained by the Company or, if they are
obtained, that they will be obtained on a timely basis. Furthermore, the Company
must suspend clinical trials upon a determination that the subjects or patients
are being exposed to an unreasonable health risk. The FDA may also require
post-approval testing and surveillance programs to monitor the effects of the
Company's products. In addition to regulations enforced by the FDA, the Company
is also subject to regulations under the Occupational Safety and Health Act, the
Environmental Protection Act, the Toxic Substances Control Act, the Resource
Conservation and Recovery Act and other present and potential future federal,
state and local regulations. The ability of the Company to operate profitably
will depend in part upon the Company obtaining and maintaining all necessary
certificates, permits, approvals and clearances from the United States and
foreign and other regulatory authorities and operating in compliance with
applicable regulations. Failure to comply with regulatory requirements could
have a material adverse effect on the Company's business, financial condition
and results of operations.
Regulations regarding the manufacture and sale of the Company's current
products or other products that may be developed or acquired by the Company are
subject to change. The Company cannot predict what impact, if any, such changes
might have on its business. See "Item 7 - Management's Discussion and Analysis
of Financial Condition and Results of Operations - Risks Related to Our
Industry."
Since the July 2001 sale of the CPM business, the Company no longer has
products manufactured in Canada subject to the review of the Canadian food and
drug regulatory agencies.
THIRD PARTY PAYMENT
The Company's products provided to the patient are reimbursed by a variety
of third party payors, including Medicare and private insurers. The Company is
an approved Medicare provider and is also an approved Medicaid provider for a
majority of states. The Company contracts with over 400 third party payors as an
approved provider for its fracture healing products, including the Department of
Veterans Affairs, Aetna, United Health Care and various Blue Cross/Blue Shield
organizations. Because the process of obtaining reimbursement for products
through third-party payors is longer than through direct invoicing of hospitals,
the Company must maintain sufficient working capital to support operations
during the collection cycle. In addition, third party payors as an industry have
undergone consolidation, and that trend appears to be continuing. The
concentration of such economic power may result in third party payors obtaining
additional leverage and thus could negatively affect the Company's profitability
and cash flows.
PRODUCT LIABILITY INSURANCE
The business of the Company entails the risk of product liability claims.
The Company maintains a product liability and general liability insurance policy
and an umbrella excess liability policy. There can be no assurance that
liability claims will not exceed the coverage limit of such policies or that
such insurance will continue to be available on commercially reasonable terms or
at all. Consequently, product liability claims could have a material adverse
effect on the business, financial condition and results of operations of the
Company. The Company has not experienced any product liability claims to date
resulting from its bone growth stimulation or external fixation products. To
date, liability claims resulting from the divested CPM business have not had a
material adverse effect on the Company. See "Item 7 - Management's Discussion
and Analysis of Financial Condition and Results of Operations - Risk Related to
our Business."
EMPLOYEES
As of December 31, 2002, the Company had 156 employees in its operations,
including 52 in sales and marketing, 22 in research and development clinical and
regulatory affairs, 32 in reimbursement and 50 in manufacturing, finance and
administration. The Company believes that the success of its business will
depend, in part, on its ability to identify, attract and retain qualified
7
personnel. In the future, the Company may need to add additional skilled
personnel or retain consultants in such areas as research and development,
manufacturing and marketing and sales. None of the employees are represented by
a union. The Company considers its relationship with its employees to be good.
See "Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operations - Risks Related to Our Business."
ITEM 2. PROPERTIES
The Company leases a facility in Tempe, Arizona. This facility is designed
and constructed for industrial purposes and is located in an industrial
district. The Company believes the facility is suitable for the Company's
purposes and is effectively utilized. The Company has subleased approximately 17
percent of the building through June 2005 to another company. The table below
sets forth certain information about the Company's facility.
Approx.
Location Square Feet Lease Expires Description Principal Activity
- -------- ----------- ------------- ----------- ------------------
Tempe 80,000 (1) 11/07 2-story, in an Assembly,
industrial park Administration
(1) Approximately 17% of the facility is subleased through June 2005.
The Company believes that the facility is well-maintained and adequate for
use in the foreseeable future.
ITEM 3. LEGAL PROCEEDINGS
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. During 1996, certain class actions lawsuits were filed in
the United States District Court for the District of Arizona against the Company
and certain officers and directors 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.
In early October 2000, the parties negotiated a global settlement of the
consolidated class action suits. In return for dismissal of both class actions,
and releases by a settlement class comprised of all purchasers of OrthoLogic
Common Stock during the period from January 18 through June 18, 1996, inclusive,
the settlement called for $1 million in cash and 1 million shares of newly
issued OrthoLogic Common Stock. On August 17, 2001, the superior court gave
final approval of the settlement and signed and filed a judgment of dismissal of
the action with prejudice. We are not aware of any appeal from the judgment or
other challenge to the final approval of the settlement. Pursuant to the terms
of the settlement, the cash portion of the settlement fund has already been paid
into the settlement fund, with the substantial portion of the $1 million paid
from the proceeds of the Company's directors' and officers' liability insurance
policy, and the remaining cash paid by the Company. The Company recorded a $3.6
million charge, including legal expenses, for settlement. Pursuant to the terms
of the settlement and order of the superior court, 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.
UNITED STATES OF AMERICA EX REL. DAVID BARMARK 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 relate 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 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 Barmark filed
a second amended complaint, pursuing the claim independent of the U.S.
Department of Justice.
8
The Company filed a motion to dismiss the second 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.,
filed a complaint in connection with its acquisition of certain assets used in
the Company's CPM business in July 2001 alleging, among other things, that some
of the assets purchased were overvalued 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 is defending
the matter vigorously. The Company has filed a counterclaim against OrthoRehab
for nonpayment of the contingent payment believed to be due and owing in
connection with OrthoRehab's acquisition of certain assets. The matter is
presently scheduled to be tried in Delaware in June 2003. 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.
In addition to the matters disclosed above, the Company is involved in
various other legal proceedings that arise in the ordinary course of business.
In management's opinion, the ultimate resolution of these other legal
proceedings are not likely to have a material adverse effect on the financial
position, results of operations or cash flows of the Company.
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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
9
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
MARKET INFORMATION. The Company's Common Stock commenced trading on the
NASDAQ National Market on January 28, 1993 under the symbol "OLGC." The bid
price information included herein is derived from the NASDAQ Monthly Statistical
Report, represents quotations by dealers, may not reflect applicable markups,
markdowns or commissions and does not necessarily represent actual transactions.
2002 2001
----------------- --------------------
HIGH LOW HIGH LOW
---- --- ---- ---
First Quarter $5.7400 $4.4700 $4.4375 $2.8438
Second Quarter $5.9500 $4.5100 $4.5000 $3.0000
Third Quarter $5.5000 $3.6900 $4.4600 $3.2500
Fourth Quarter $4.2500 $3.2200 $5.2800 $3.2000
As of March 12, 2003, 32,873,571 shares of the Common Stock of the Company
were outstanding and held by approximately 843 stockholders of record.
DIVIDENDS. The Company has never paid a cash dividend on its Common Stock.
The Board of Directors currently anticipates that all the Company's earnings, if
any, will be retained for use in its business and does not intend to pay any
cash dividends on its Common Stock in the foreseeable future.
EQUITY COMPENSATION PLAN INFORMATION. In January 2002 the Securities and
Exchange Commission adopted new rules for the disclosure of equity compensation
plans. The purpose of the new rules is to summarize the potential dilution that
could occur from past and future equity grants under all equity compensation
plans. The following provides tabular disclosure of the number of securities to
be issued upon the exercise of outstanding options, the weighted average
exercise price of outstanding options, and the number of securities remaining
available for future issuance under equity compensation plans, aggregated into
two categories - plans that have been approved by stockholders and plans that
have not.
Number of
Securities Remaining
Available for Future
Number of Weighted-average Issuance Under
Securities to be Exercise Price of Equity Compensation
Issued upon Outstanding Plans (Excluding
Exercise of Outstanding Options and Securities Reflected
Plan Category Options and Warrants Warrants in 1st Column)
- ------------- -------------------- -------- --------------
Equity compensation plans
approved by stockholders 3,583,037 $4.45 506,489
Equity compensation plans
not approved by stockholders 500,000 $2.92 --
---------- ----- --------
Total 4,083,037 $4.26 506,489
10
ITEM 6. SELECTED FINANCIAL DATA
SELECTED FINANCIAL DATA
The selected financial data for each of the five years in the period ended
December 31, 2002, are derived from audited financial statements of the Company.
The selected financial data should be read in conjunction with the Financial
Statements and related Notes thereto and other financial information appearing
elsewhere herein and the discussion in "Management's Discussion and Analysis of
Financial Condition and Results of Operations." The Company sold its CPM
business unit on July 11, 2001.
YEARS ENDING DECEMBER 31,
-------------------------------------------------------------
STATEMENTS OF OPERATIONS DATA 2002(1) 2001(2) 2000(3) 1999 1998
- -------------------------------------------------------------------------------------------------------------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Total revenues $ 40,389 $ 62,356 $ 90,080 $ 83,232 $ 75,369
Total cost of revenues 6,158 11,349 18,289 18,504 17,693
Operating expenses
Selling, general and administrative 26,560 46,467 71,580 61,936 72,011
Research and development 3,765 3,889 4,690 2,860 2,920
Restructuring and other charges -- -- -- (216) (399)
CPM divestiture and related charges (1,047) 14,327 -- -- --
Legal settlements -- -- 4,499 -- --
Write-off of goodwill -- -- 23,348 -- --
Net gain from discontinuation
of the co-promotion agreement -- -- (844) -- --
-------------------------------------------------------------
Total operating expenses 29,278 64,683 103,273 64,580 74,532
-------------------------------------------------------------
Operating profit (loss) 4,953 (13,676) (31,482) 148 (16,856)
Other income 661 594 303 148 354
Income tax provision (6) (12) (12) (58) (100)
-------------------------------------------------------------
NET INCOME (LOSS) 5,608 (13,094) (31,191) 238 (16,602)
Accretion of non-cash preferred stock dividend -- -- -- (824) (1,236)
-------------------------------------------------------------
Net income (loss) applicable to common
stockholders $ 5,608 $ (13,094) $ (31,191) $ (586) $ (17,838)
Net income (loss) per common share basic $ 0.17 $ (0.42) $ (1.04) $ (0.02) $ (0.71)
-------------------------------------------------------------
Net income (loss) per common share diluted $ 0.17 $ (0.42) $ (1.04) $ (0.02) $ (0.71)
-------------------------------------------------------------
Basic shares outstanding 32,642 31,464 29,855 26,078 25,291
Equivalent shares 731 -- -- -- --
-------------------------------------------------------------
Diluted shares outstanding 33,373 31,464 29,855 26,078 25,291
-------------------------------------------------------------
1. Total operating expenses in 2002 were reduced by $1.0 million as a result
of better than anticipated collection of CPM accounts receivable than what
had been originally estimated when the CPM business was sold in July 2001.
Also, during 2002 the Company paid a $500,000 milestone payment to
Chrysalis that was recorded as a research and development expense.
2. The net loss in 2001 includes $14.3 million of CPM divestiture and related
charges, and a $1.0 million payment to Chrysalis recorded as research and
development expense for a license extension for Chrysalin.
3. The net loss in 2000 includes charges of $4.5 million for the class action
legal settlement and other legal settlements; $27.3 million of additional
expenses related to the CPM business comprised of the write-off of impaired
goodwill, adjustments to accounts receivable, and other legal settlements;
and $2.0 million of research and development expense paid to Chrysalis to
obtain additional Chrysalin rights. Also, during 2000 the Company recorded
a $844,000 net gain from the discontinuation of the Co-Promotion Agreement
for Hyalgan.
11
YEARS ENDING DECEMBER 31,
-------------------------------------------------------------
BALANCE SHEET DATA 2002(1) 2001(2) 2000(3) 1999 1998
- -------------------------------------------------------------------------------------------------------------------
(IN THOUSANDS)
Working capital $ 39,584 $ 40,039 $ 43,056 $ 40,865 $ 38,817
Total assets 53,420 49,442 65,035 92,203 93,980
Long term liabilities, less current
maturities 352 287 88 209 196
Stockholders' equity 48,233 41,896 51,910 73,054 68,225
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS
OF OPERATIONS
OVERVIEW
The Company's principal business is the sale of the OL1000 and SpinaLogic
bone growth stimulation devices.
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. 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 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.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
ALLOWANCE FOR DOUBTFUL ACCOUNTS. The allowance for doubtful accounts
(approximately $3.1 million and $5.8 million at December 31, 2002 and 2001,
respectively) are based primarily on trends in historical collection rates,
consideration of current events, payor mix and other considerations. On a
quarterly basis, the Company evaluates historical collection trends and tracks
the percent of billings that are typically received by the first month after
billing, the second month, etc. This quarterly analysis of collections allows
the Company to develop trends and expectations for collection rates based on
product, payor category and date of billing. If the Company identifies any
change in the collection rate or anticipates that future trends will not
correspond to previous collection experience, the reserve is adjusted to
correspond with the expected change. The Company derives a significant amount of
its revenues in the United States 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. Accounts receivable are
recorded at the expected or pre-authorized reimbursement rates. Billings are
subject to review by third-party payors and may be subject to adjustments. Any
differences between estimated reimbursement and final determinations are
reflected in the period finalized. In the opinion of management, adequate
allowances have been provided for doubtful accounts. 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.
REVENUE RECOGNITION. Revenue is recognized for sales of the OL1000 and
SpinaLogic products at the time the product is delivered to and accepted by the
patient, as verified by the patient signing a "Patient Agreement Form" accepting
financial responsibility. If the sale of either product is to a commercial
buyer, a purchase order is required, and the revenue is recognized at the time
of shipment to the commercial buyer. The Company's shipping terms are FOB
shipping point. The amount of revenue recorded at the time of sale, net of sales
discounts and contractual adjustments, is based on contractual terms. If the
Company does not have a contract with the third-party payor then the amount of
revenue recorded is the pricing expected to be approved by the third-party payor
based on historical experience with that payor. The Company records differences,
if any, between the net revenue amount recognized at the time of the sale and
the ultimate pricing by the primary third-party payor as an adjustment to sales
in the period the Company receives payments from the third-party payor or
earlier if the Company becomes aware of circumstances that warrant a change in
12
estimate. In the opinion of management, adequate allowances have been provided
for sales discounts and contractual adjustments
The Company recognizes royalties from the Co-Promotion Agreement of
Hyalgan, based on a flat royalty fee of $5 for each unit distributed by
Hyalgan's distributor between January 1, 2001 and December 31, 2002, in
accordance with the termination agreement with Hyalgan's distributor.
INVENTORY VALUATION. The Company writes-down its inventory for inventory
shrinkage and obsolescence. Inventory is written down to estimated market value
based on a number of assumptions, including future demand and market conditions.
If actual conditions used in determining these valuations change, future
additional inventory write-downs would be necessary.
INCOME TAXES. Under Financial Accounting Standards Board ("FASB") Statement
of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income
Taxes," income taxes are recorded based on current year amounts payable or
refundable, as well as the consequences of events that give rise to deferred tax
assets and liabilities. We base our estimate of current and deferred taxes on
the tax laws and rates that are currently in effect in the appropriate
jurisdiction. Changes in tax laws or rates may affect the current amounts
payable or refundable as well as the amount of deferred tax assets or
liabilities.
SFAS No. 109 requires that a valuation allowance be established when it is
more likely than not that all or a portion of a deferred tax asset will not be
realized. Changes in valuation allowances from period to period are included in
our tax provision in the period of change. In determining whether a valuation
allowance is required, we take into account all evidence with regard to the
utilization of a deferred tax asset including our past earnings history,
expected future earnings, the character and jurisdiction of such earnings,
unsettled circumstances that, if unfavorably resolved, would adversely affect
utilization of a deferred tax asset, carryback and carryforward periods, and tax
strategies that could potentially enhance the likelihood of realization of a
deferred tax asset.
The Company has accumulated approximately $64 million in federal and state
net operating loss carryforwards ("NOLs") and approximately $800,000 of general
business and alternative minimum tax credit carryforwards. Management has
evaluated the available evidence about future taxable income and other possible
sources of realization of deferred tax assets and has established a valuation
allowance of approximately $32.5 million at December 31, 2002. The valuation
allowance reduces deferred tax assets to an amount that management believes will
more likely than not be realized. We believe that the net deferred tax asset of
$2.6 million at December 31, 2002, will be realized based primarily on our
projected future earnings. However the amount of the deferred tax assets
actually realized could differ if we have little or no future earnings. 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.
INVESTMENT IN CHRYSALIS. The Company owns a minority ownership interest in
Chrysalis, which is recorded at cost. Chrysalis is not publicly traded so it is
difficult to determine the value of the investment. However, the Company does
not believe the value of its investment has been impaired. Should sometime in
the future the investment be determined to be permanently impaired, a charge to
income would be recorded in the period such a determination is made.
LEASE COST. 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 Company occupies approximately 50% of all the available lease space. The
Company had subleased the unused space to the purchaser of the CPM business. The
sublease expired in 2002. 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. The Company has a sublease agreement for approximately
17 percent of the building with a different subtenant through June 2005.
13
RESULTS OF OPERATIONS COMPARING YEAR ENDED DECEMBER 31, 2002 TO 2001
OVERVIEW. In July 2001, the Company sold its CPM and related ancillary
product business. The Statement of Operations of the Company includes the CPM
business through the sales date of July 11, 2001.
REVENUE. Revenues from net sales decreased from $41.5 million during 2001
to $38.2 million in 2002. Net sales are comprised of sales of the OL1000,
SpinaLogic, and for a portion of 2001 before the sale of the CPM business,
orthopedic rehabilitation equipment and ancillary products. Net sales for the
OL1000 increased from $15.9 million in 2001, to $19.2 million in 2002. Net sales
for SpinaLogic increased from $14.6 million in 2001 to $19.0 million in 2002.
Net sales for the CPM business were $11.0 million in 2001 with no sales in 2002.
Sales recorded for both bone growth stimulation products increased by 25.2% from
$30.5 million in 2001 to $38.2 million in 2002. The Company believes the
significant increase in bone growth stimulation sales signifies a growth in
market share for both the OL1000 and SpinaLogic products.
Net rental revenues for the CPM equipment were $17.8 million in 2001, with
no CPM rental revenue in 2002.
Hyalgan royalty revenue was $2.2 million in 2002 compared to $3.0 million
in 2001, reflecting the termination of the Co-Promotion Agreement for Hyalgan in
the fourth quarter of 2000. Under the 1997 Co-Promotion Agreement, the Company
had exclusive rights to market Hyalgan to orthopedic surgeons in the United
States. In 2000, the Company and Hyalgan's distributor mutually decided to
terminate this Co-Promotion Agreement and provided for certain royalty payments
to continue to the Company through 2002. The Company anticipates no additional
royalty payments.
OrthoLogic's total revenues decreased 35.3% from $62.4 million in 2001 to
$40.4 million in 2002. The decrease in sales is attributed to the divestiture of
the CPM business in July 2001 and the decrease in the royalty payments under the
Hyalgan termination agreement. Sales of the continuing products increased by
25.2% in 2002 over 2001 as described above.
COST OF REVENUES. Cost of revenues declined from $11.3 million to $6.2
million in 2001 and 2002, respectfully. The cost of revenue in 2001 included
$5.8 million for the divested CPM products. The cost of revenues, as a
percentage to total revenue, improved from 18.2% in 2001 to 15.2% in 2002. This
improvement in the cost of revenues is attributed to the divestiture of the CPM
business in 2001, which had a higher cost of revenues than the bone growth
stimulation business.
GROSS PROFIT. Gross profit decreased from $51.0 million in 2001 to $34.2
million in 2002. The majority of the gross profit decrease of $16.8 million is a
result of the divestiture of the CPM business, which produced a gross profit of
$23.1 million prior to the sale in July 2001. Gross profits, as a percentage of
total revenues, increased from 81.8% in 2001 to 84.8% in 2002. The gross profit
as a percentage of total revenue was 79.9% in 2001 for the CPM product line. The
improvement in gross margins between 2001 and 2002 is due to the change in
product mix to higher margin products.
SELLING,GENERAL AND ADMINISTRATIVE ("SG&A") EXPENSES. SG&A expenses
decreased 42.8% from $46.5 million in 2001 to $26.6 million in 2002. The
decrease is mainly attributable to the sale of the CPM business and the variable
expenses related to that business, such as commissions, bad debt, advertising
and support staff expenses. SG&A expenses, as a percentage of total revenues,
were 65.8% in 2002 and 74.5% in 2001. The Company recorded a charge of $400,000
in the quarter ended September 30, 2002 to establish a reserve for sub-lease
space anticipated to be vacant after the purchaser of the CPM business vacated
the building at the conclusion of its lease. The Company believes the comparison
of the SG&A expense for the year-ended December 31, 2002 to the year ended
December 31, 2001 is not meaningful due to the costs associated with the
divested CPM operation.
RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses were
$3.8 million in 2002 compared to $3.9 million in 2001. In 2002, the Company paid
a milestone payment of $500,000 to Chrysalis for receiving clearance from the
FDA to begin a Phase I/II clinical trial for spinal fusion. In 2001, the Company
paid $1.0 million to Chrysalis to extend its worldwide license to include the
rights to orthopedic "soft tissue" indications, including cartilage, tendon and
ligament repair. Research and development costs, as a percentage of total
revenue, were 6.2% in 2001 and 9.4% in 2002. A significant portion of the 2002
and 2001 research and development expense is attributed to the continuation and
expansion of the Chrysalin clinical trials. Research and development expenses
for 2002 are primarily for the overall Chrysalin product platform, which include
pre-clinical studies in cartilage and continuation of the Phase I/II human
14
clinical trial under an IND for spinal fusion and the Phase III human clinical
trial for 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 CPM invoiced receivables. 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. 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 10 of the Consolidated Financial Statements. 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
related to the CPM divestiture. The charge included $6.9 million to write down
the value of the CPM 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. 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, $226,000 and $221,000 in the quarters ended March 31,
2002, June 30, 2002 and September 30, 2002, respectively. The effect of these
changes in estimate resulted in additional income during 2002 and is included in
the "CPM Divestiture and Related Charges" line item in the 2002 Statement of
Operations. At December 31, 2002, the carrying value of the remaining CPM
accounts receivable was approximately $90,000.
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.
15
A summary of the severance and other reserve balances at December 31, 2002
and 2001 are as follows (in thousands):
Reserves Amount Charged Cash Reserves
December 31, 2001 Against Assets Paid December 31, 2002
-----------------------------------------------------------------
Severance $ 946 $ -- $ (785) $ 161
Other exit costs 76 -- (27) 49
-----------------------------------------------------------------
Total non-recurring charges $1,022 $ -- $ (812) $ 210
Initial Amount Charged Cash Reserves
Reserves Against Assets Paid December 31, 2001
-----------------------------------------------------------------
Severance $ 3,300 $ -- $(2,354) $ 946
Other exit costs 1,387 (245) (1,066) 76
-----------------------------------------------------------------
Total non-recurring charges $ 4,687 $ (245) $(3,420) $1,022
Cash requirements for the severance and exit costs were funded from the
Company's current cash balances.
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 year ended
December 31, 2001 were approximately (in thousands):
Year ended
December 31, 2001
-----------------
Net sales $11,029
Net rental 17,831
-------
Total net revenue 28,860
Cost of sale 2,219
Cost of rental 3,590
-------
Gross profit $23,051
Most operating expenses were not directly allocated between the Company's
various lines of business.
OTHER INCOME. Other income in 2002 and 2001 consisted primarily of interest
income. Other income increased from $594,000 in 2001 to $706,000 in 2002 as a
result of interest earned on the proceeds from the mid year sale of the CPM
business.
NET INCOME (LOSS). The Company had net income in 2002 of $5.6 million
compared to a net loss of $13.1 million in 2001. The net income in 2002 was the
result of the (1) higher sales of bone growth stimulation products, (2)
non-recurring Hyalgan royalty revenues of $2.2 million with no associated cost
of revenue expenses and (3) a recovery of $1.0 million of CPM receivables
previously estimated as unrecoverable.
RESULTS OF OPERATIONS COMPARING YEAR ENDED DECEMBER 31, 2001 TO 2000
OVERVIEW. In July 2001, the Company sold its CPM and related ancillary
product business. The Statement of Operations of the Company includes the CPM
business for all of 2000 and only a portion of 2001.
REVENUES. Net sales recorded for the bone growth stimulation products
increased by 48.8% from $20.5 million in 2000 to $30.5 million in 2001. The
increase in net sales is related to the introduction of SpinaLogic in 2000, a
new OL1000 model (OL1000 SC) in 2001, and changes in Medicare guidelines for
reimbursement of bone growth stimulators enacted in 2000 that allow doctors to
prescribe the bone growth simulators earlier in a patient's care. Net sales on
the CPM products declined by 48.1% from $21.2 million in 2000 to $11.0 million
in 2001 because of the sale of the CPM business. The net sales for bone growth
stimulation products nearly offset the decrease in net sales for the CPM
products with total net sales for the Company only declining slightly from $41.7
million in 2000 to $41.5 million in 2001.
16
Net rental revenues declined by 54.5% from $39.1 million in 2000 to $17.8
million in 2001 due to the sale of the CPM business.
Hyalgan royalty revenue was $3.0 million in 2001 compared to Hyalgan
co-promotion fees of $9.3 million in 2000, reflecting the termination of the
Co-Promotion Agreement with Hyalgan's distributor in the fourth quarter of 2000.
Under the 1997 Co-Promotion Agreement, OrthoLogic had exclusive rights to market
Hyalgan to orthopedic surgeons in the United States. In the fourth quarter of
2000, the Company and Hyalgan's distributor mutually decided to terminate this
Co-Promotion Agreement.
COST OF REVENUES. Cost of revenues declined from $18.3 million in 2000 to
$11.3 million in 2001. The cost of revenues, as a percentage to total revenue,
improved from 20.3% in 2000 to 18.2% in 2001. This improvement in the cost of
revenues is attributed to the divestiture of the CPM business in 2001, which had
a higher cost of revenues than the bone growth stimulation business.
GROSS PROFIT. Gross profit decreased from $71.8 million in 2000 to $51.0
million in 2001, primarily due to the lower revenues resulting from the
divestiture of the CPM business. Gross profits, as a percentage of total
revenues increased from 79.7% in 2000 to 81.8% in 2001. Gross profits from the
CPM business declined from $46.2 million in 2000 to $23.0 million in 2001 due to
the sale of the CPM business.
SELLING,GENERAL AND ADMINISTRATIVE ("SG&A") EXPENSES. SG&A expenses
decreased 35.1% from $71.6 million in 2000 to $46.5 million in 2001. The
decrease is partially attributed to the sale of the CPM business and the
variable expenses related to that business such as commissions, bad debt,
advertising and support staff expenses. In addition, in 2000, the Company
recorded a charge of approximately $3.0 million for additional bad debt related
to older CPM receivables as a result of a change in estimated collection rates.
SG&A expenses, as a percentage of total revenues, were 74.5% in 2001 and 79.5%
in 2000 due to the sale of the CPM business. The SG&A expense for 2001 is not
comparable to 2000 due to the costs associated with the divested CPM operations.
RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses were
$3.9 million in 2001, a decline of $800,000 compared to 2000. This decline is
due to higher research and development expenses in 2000 because of a $2 million
payment to Chrysalis to expand the Company's license agreement to include all
Chrysalin orthopedic indications worldwide. Research and development expenses as
a percentage of revenue increased from 5.2% in 2000 to 6.2% in 2001. In 2001,
the Company paid $1.0 million to Chrysalis to extend the worldwide license to
include the rights to orthopedic "soft tissue" indications, including cartilage,
tendon and ligament repair. A significant portion of the 2001 research and
development expense is attributed to the continuation of the Chrysalin clinical
trials.
CPM DIVESTITURE AND RELATED CHARGES. 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.
In the second quarter of 2001, the Company recorded a $14.3 million charge
related to the CPM divestiture. The charge included $6.9 million to write down
the value of the CPM 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 revenue and cost of revenue attributable to the CPM business for the
years ended December 31, 2001 and 2000 were approximately (in thousands):
Years ended
December 31,
------------------------
2001 2000
------- -------
Net sales $11,029 $21,189
Net rental 17,831 39,070
------- -------
Total net revenue 28,860 60,259
Cost of sale 2,219 6,206
Cost of rental 3,590 7,897
------- -------
Gross profit $23,051 $46,156
Most operating expenses were not directly allocated between the Company's
various lines of business.
LEGAL SETTLEMENTS. In 2000, the Company recognized an expense of $3.6
million as a result of the settlement agreement reached in the class action
lawsuit and expensed $941,000 related to other legal settlements.
17
WRITE OFF OF GOODWILL. 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. After careful consideration, the Board felt the
emphasis on the rehabilitation segment of the orthopedic business no longer fit
the Company's long-term strategic plan.
Letters of intent and results of discussions with parties interested in the
CPM business during the fourth quarter of 2000 and first quarter of 2001
indicated that the fair value of the CPM assets were below their carrying
amount. Management considered this information to be an impairment indicator
that should subject the CPM assets to impairment testing under Statement of
Financial Accounting Standard No. 121, Accounting for the Impairment of Long
Lived Assets and for Long Lived Assets to Be Disposed. Consequently, as of
December 31, 2000, the Company performed the recoverability test prescribed in
SFAS No. 121. The results of the Company's recoverability test indicated that
the $23.3 million goodwill balance was fully impaired and that all of the
tangible assets of the CPM business were recoverable. Consequently, the Company
recorded a $23.3 million goodwill impairment charge in the fourth quarter of
2000.
NET GAIN FROM DISCONTINUATION OF CO-PROMOTION AGREEMENT. The Company
entered into an exclusive Co-Promotion Agreement with Sanofi Pharmaceuticals
Inc. at a cost of $4.0 million on June 23, 1997, for purpose of marketing
Hyalgan, a hyaluronic acid sodium salt, to orthopedic surgeons in the United
States for the treatment of pain in patients with osteoarthritis of the knee.
The Company's sales force began to promote Hyalgan in the third quarter of
1997. Fee revenue of $9.3 and $8.3 million was recognized during 2000 and 1999.
In the fourth quarter of 2000, the Company and Hyalgan's distributor mutually
agreed to terminate this Co-Promotion Agreement. The Company returned the rights
to sell Hyalgan back to Hyalgan's distributor. The Company received $3.0 million
in cash in 2000 and $1.0 million in cash in the first quarter of 2001 to
complete a successful transition of the business back to Hyalgan's distributor
by January 1, 2001, and received continuing royalties through 2002.
The Company had no further obligation to Sanofi after December 2000. As a
result, the Company recognized the entire $4.0 million payment as a component of
the net gain of $844,000. At the time the termination agreement was signed, the
carrying value of the investment in the Co-Promotion Agreement was $3.2 million.
The net gain of $844,000 was calculated as the difference between the $4.0
million of cash proceeds received from Hyalgan's distributor and the carrying
amount of the investment. The net gain was recognized in the fourth quarter of
2000.
OTHER INCOME. Other income in 2001 and 2000 consisted primarily of interest
income. Other income increased from $303,000 in 2000 to $594,000 as a result of
interest earned on the proceeds from the mid-year sale of the CPM business.
NET LOSS. The Company had a net loss in 2001 of $13.1 million compared to a
net loss of $31.2 million in 2000. The significant decline in net loss is
attributed to a one-time goodwill write off of $23.3 million in 2000 and legal
settlement expenses of $4.5 million discussed above, partially offset by the CPM
divestiture and related charges of $14.3 million in 2001.
LIQUIDITY AND CAPITAL RESOURCES
The Company has financed its operations through the public and private
sales of equity securities and from operating cash flows.
At December 31, 2002, the Company had cash and cash equivalents of $11.3
million, compared to $19.5 million at December 31, 2001. The Company also has
short-term investments of $18.7 million at December 31, 2002 compared to $11.0
million at December 31, 2001. The Company also had long-term investments of $5.7
million at December 31, 2002.
Net cash provided by operations during 2002 was $5.3 million compared to
$9.9 million in 2001. This decrease was primarily attributed to (1) collections
on the accounts receivable balance in 2001 after the CPM sale, (2) an increase
in inventories in 2002 compared to a decrease in inventories in 2001, and (3) a
payout of CPM divestiture related liabilities in 2002. These decreases in net
cash provided by operations were partially offset by a net income of $5.6
million in 2002 compared to net income (excluding the CPM divestiture) of $1.2
million in 2001. Net cash provided by operations during 2001 was $9.9 million
compared to $1.5 million in 2000. This increase was primarily attributed to (1)
a decline in net losses from $31.2 million in 2000 to $13.1 million in 2001; and
18
(2) a decrease in accounts receivable of $10.7 million in 2001, offset by a
decrease in accrued and other current liabilities by $4.8 million during 2001
primarily as a result of the CPM divestiture.
The Company also has available a $4.0 million accounts receivable revolving
line of credit with a bank. Under the line of credit, 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, 2005. There are certain financial
covenants and reporting requirements associated with the credit facility. The
financial covenants include (1) requirements to maintain tangible net worth of
not less than $30 million, (2) 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
has not utilized this line of credit. As of December 31, 2002, the Company is in
compliance with all the financial covenants.
The Company does not expect to make significant capital investments in 2003
but anticipates additional research and development expenditures related to the
anticipated clinical trials for Chrysalin in fracture repair, spinal fusion and
further studies in articular cartilage repair. The Company anticipates that its
cash and short term investments, 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, maintain profitability from operations 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
treasury shares to reduce the dilution from the Company stock option plans. As
of December 31, 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.
Subsequent to year-end December 31, 2002, on March 6, 2003, the Company
announced that it had authorized a repurchase of up to one 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 for the
Company stock plans.
The Company has been named as a defendant in certain lawsuits and product
liability claims. Management believes that the allegations are without merit and
will vigorously defend them. No costs related to the potential outcome of these
actions have been accrued. See "Item 3 -Legal Proceedings."
The following table sets forth all known commitments as of December 31,
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
------------------------------------------------------------
2003 $ 1,078 $ 4,835 $ 5,913
2004 $ 1,078 -- $ 1,078
2005 $ 1,078 -- $ 1,078
2006 $ 1,078 -- $ 1,078
2007 $ 989 -- $ 989
------------------------------------------------------------
Total $ 5,301 $ 4,835 $10,136
============================================================
Approximately, 17% of the leased facility is subleased through June 2005,
which will offset approximately 10% of the lease commitments listed above.
RISKS
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
19
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.
RISKS RELATED TO OUR INDUSTRY
THE COMPANY IS IN A HIGHLY REGULATED FIELD AND WE MUST OBTAIN GOVERNMENT
APPROVAL BEFORE SELLING ANY NEW PRODUCTS.
The Federal Drug Administration 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's current and future products and manufacturing activities are
and will be regulated under the Medical Devices Amendment Act of 1976 to the
Federal Food, Drug and Cosmetics Act, as amended, the Safe Medical Devices acts
of 1990 and 1992, and the Food and Drug Administration Modernization Act of
1997, as amended, (collectively the "FDC Act"). The Company's current BioLogic
technology-based products and fracture fixation devices are marketed for their
current uses with clearance from the FDA. Before the Company is able to market
these products for any other use, it would have to seek the approval of the FDA,
which may require lengthy and costly testing and review by the FDA. In addition,
the FDA may, if it believes the Company's products have problems unforeseen at
the time of the initial approval, require additional testing to retain FDA
approval.
Chrysalin, as a new drug, is subject to the most stringent level of FDA
review. The Company has received authorization to begin human clinical trials
for fracture repair and spinal fusion indications and is currently seeking
approval to conduct human testing for articular cartilage repair. Even if the
results of the current clinical trials are favorable, there can be no guarantee
that the FDA will grant approval of Chrysalin for the indicated uses or if it
will do so in a timely manner. In addition, changes in existing regulations or
interpretations of existing regulations or adoption of new or additional
restrictive regulations could prevent or delay obtaining regulatory approvals.
THE COMPANY MUST ADHERE TO CURRENT AND EVOLVING REGULATORY COMPLIANCE STANDARDS
IN ORDER TO MAINTAIN THE APPROVAL TO SELL ITS PRODUCTS.
The Company is also required to adhere to applicable requirements for FDA
Good Manufacturing Practices, 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. From time to time, the Company receives letters from the
FDA regarding regulatory compliance. The Company has responded to all such
letters and believes all issues raised in such letters have been resolved.
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.
ANY LIMITATIONS ON THIRD PARTY PAYMENT REIMBURSEMENT FOR THE COMPANY'S PRODUCTS
AND RELATED SERVICES WOULD ADVERSELY AFFECT THE BUSINESS AND RESULTS OF
OPERATIONS.
The Company's ability to sell products successfully in the United States
and in other countries will depend in part on the extent to which government
health administration authorities, private health insurers and other payors
continue to reimburse insureds for the cost of products and related treatment.
Cost control measures adopted by third party payors in recent years have had and
may continue to have a significant effect on the purchasing and practice
patterns of many health care providers, generally causing them to be more
selective in the purchase of medical 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.
20
The Company's products are reimbursed by most payors and recent
governmental regulations have favorably made our products available to patients
earlier in their medical treatment, however, there are generally specific
product usage requirements or documentation requirements in order for the
Company to receive reimbursement. In certain circumstances, the Company is
successful in appealing reimbursement coverage for those applications which do
not comply with the payor requirements. Significant uncertainty exists as to the
reimbursement status of newly approved health care products, and there can be no
assurance that adequate third party coverage will continue to be available to
the Company at current levels.
THE COMPANY OPERATES IN AN INTENSELY COMPETITIVE FIELD IN WHICH MANY OF ITS
COMPETITORS ARE BIGGER OR BETTER KNOWN.
The orthopedic industry is characterized by intense competition. Currently,
the Company has three major competitors selling bone growth stimulation products
approved by the FDA for the treatment of nonunion fractures, which include
Electro-Biology (EBI), a subsidiary of Biomet, Inc., Orthofix International
N.V., and Exogen, Inc., a subsidiary of Smith & Nephew. There are two
competitors, EBI and Orthofix, 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 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. See "Item 1 - Business - Research and
Development" and "Item 1 - Business - Competition."
TECHNOLOGY IN THE MEDICAL DEVICE INDUSTRY CHANGES RAPIDLY. IF THE COMPANY IS NOT
ABLE TO KEEP UP WITH TECHNOLOGICAL ADVANCES BY ITS COMPETITORS, THE BUSINESS
WILL BE HARMED.
The medical device industry is characterized by rapid and significant
technological change. There can be no assurance that the Company's competitors
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. Because of the lengthy testing period required to
develop new products and the costly FDA approval process, there can be no
assurance that the Company's new product development efforts will result in any
commercially successful products or will do so in a timely manner. A failure to
develop new products could have a material adverse effect on the Company's
business, financial condition, and results of operations. See "Item 1 - Business
- - Research and Development."
THE INDUSTRY FACES A HIGH 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, no product liability
claims have been asserted against the Company for its bone growth stimulation
products. Over the years, the Company has had limited product liability claims
associated with CPM products, all of which have been or are being managed by the
Company's insurance carrier. The Company sold the CPM business in 2001.
The Company also faces an inherent business risk of exposure to liability
claims with the current and potential Chrysalin clinical trials.
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 product liability and general liability policy is provided on an
occurrence basis. The policy is subject to annual renewal. In addition, the
21
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.
Based on the history of claims, the Company believes the levels of
insurance coverage are adequate, however, 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. See "Item 1- Business -
Product Liability Insurance."
LEGISLATIVE REFORM OF THE HEALTH CARE INDUSTRY COULD HAVE A NEGATIVE EFFECT ON
THE COMPANY'S BUSINESS.
In response to complaints from patients against insurance companies and
recent and continued expectations of rises in the cost of health care insurance
coverage, the health care industry is being reviewed and investigated by public
and private groups to (i) increase access to health care for the uninsured and
underinsured people, (ii) control the escalation of health care expenditures
within the economy and (iii) use health care reimbursement policies to help
control federal expenditures. Although this has been an ongoing public debate
for a number of years that has not resulted in substantial federal or state
legislation fundamentally changing the health care industry business model, the
Company expects public debate of these issues to continue. The Company cannot
predict which, if any, of the current reform proposals will be adopted and when
they might be adopted and what affect such reform would have on a patients'
ability to seek reimbursement for use of our product and the costs associated
with regulatory and health care program compliance.
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 and
future products as currently contemplated.
Medicare pricing for the bone growth stimulation products has remained
constant, increasing slightly over the past several years. However, Congress or
other governmental agencies could enact legislation at any time that could
negatively impact revenues.
INCREASED INVESTIGATION OF HEALTH CARE PROVIDERS.
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.
RISKS RELATED TO OUR BUSINESS
THE COMPANY IS DEPENDENT ON THE SALES OF TWO PRIMARY PRODUCTS AND HAS INVESTED
HEAVILY IN A FUTURE PRODUCT, WHICH MAY NOT BE AVAILABLE FOR SALE FOR SOME TIME.
The Company's business is focused on the sales of two primary products, the
OL1000 and SpinaLogic. 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 additional products will require substantial
product development, regulatory review, and clinical testing all of which may be
expensive and lengthy. There can be no assurance that the Company will develop
new products or expand indications for existing products in the future or that
the Company will be able to manufacture or market such products successfully.
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. See "Item 1 - Business - Products" and "Item 1 --
Business -- Competition."
IF THE MEDICAL COMMUNITY DOES NOT ACCEPT THE COMPANY'S PRODUCTS AS ALTERNATIVES
TO CURRENT PRODUCTS AND PROCEDURES, SALES WILL NOT GROW AND BUSINESS WILL BE
ADVERSELY AFFECTED.
22
The long-term commercial success of the OL1000 and SpinaLogic and the
Company's other products will depend in significant part upon their widespread
acceptance by a significant portion of the medical community as a safe,
efficacious and cost-effective alternative to invasive procedures. The Company
is unable to predict how quickly, if at all, members of the orthopedic medical
community may accept its products. 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.
Historically, some orthopedic medical professionals have indicated hesitancy in
prescribing bone growth stimulator products such as those manufactured by the
Company. Failure of the Company and its distributors to create widespread market
acceptance by the orthopedic medical community and third party payors of our
products would have a material adverse effect on the Company's business,
financial condition and results of operations. See "Item 1 - Business - Third
Party Payment."
THE COMPANY'S ABILITY TO COMPETE COULD BE JEOPARDIZED IF IT IS UNABLE TO OBTAIN
AND PROTECT ITS INTELLECTUAL PROPERTY OR RETAIN LICENSES FOR INTELLECTUAL
PROPERTY.
In this industry, a company's success depends in part on its ability to
obtain and maintain patent protection for products and processes, to preserve
its trade secrets and proprietary know-how and to operate without infringing the
proprietary rights of third parties.
While the Company holds title to numerous United States and foreign patents
and patent applications, as well as licenses to numerous United States and
foreign patents, no assurance can be given that any additional patents will be
issued or that the scope of any patent protection will exclude competitors, or
that any of the patents held by or licensed to the Company will be held valid if
subsequently challenged. See "Item 1 - Business - Patents, Licenses and
Proprietary Rights." The validity and breadth of claims covered in medical
technology patents involves complex legal and factual questions and therefore
may be highly uncertain. The Company licenses the technologies in the BioLogic
and OrthoFrame products for which it pays a royalty.
There has been substantial litigation regarding patent and other
intellectual property rights in the orthopedic industry. Litigation, which could
result in substantial cost to and diversion of effort by the Company, may be
necessary to enforce patents issued or licensed to the Company, to protect trade
secrets or know-how owned by the Company, or to defend the Company against
claimed infringement of the rights of others and to determine the scope and
validity of the proprietary rights of others. There can be no assurance that the
results of such litigation would be favorable to the Company. In addition,
competitors may employ litigation to gain a competitive advantage. Adverse
determinations in litigation could subject the Company to significant
liabilities, and could require the Company to seek licenses from third parties
or prevent the Company from manufacturing, selling or using its products, any of
which determinations could have a material adverse effect on the Company's
business, financial condition and results of operations. See "Item 1 - Business
- - Patents, Licenses and Proprietary Rights."
In addition the licenses for the technologies used by the Company in the
BioLogic and OrthoFrame products may be terminated by the licensor if the
Company breaches any material provision of such license. The termination of any
license would have a material adverse effect on the Company's business,
financial condition and results of operations.
The Company also relies on un-patented trade secrets and know-how. 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.
SALES FOR ONE OF THE COMPANY'S PRIMARY PRODUCTS DEPENDS ON THE SUCCESS OF A
DISTRIBUTOR, WHICH HAS BEEN GIVEN EXCLUSIVE DISTRIBUTION RIGHTS.
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.
23
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.
THE COMPANY'S RELIANCE ON A PRIMARY SUPPLIER COULD RESULT IN DISRUPTION OF
OPERATIONS.
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.
The Company is dependent on outside vendors for key parts and processes in
the manufacture of the OrthoFrame/Mayo. Chrysalin, which is currently only in
the clinical trial phase, is produced by a third party sole supplier.
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.
IF THE COMPANY IS SUBJECT TO AN ADVERSE OUTCOME OF LITIGATION, IT COULD AFFECT
ITS PROFITABILITY.
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 CORP., AND
ORTHOREHAB, INC. AND ORTHOMOTION, INC., V. ORTHOLOGIC CORP AND ORTHOLOGIC
CANADA, LTD. The Company has provided a description of each matter in Note 10 to
the Notes of the 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.
IF THE COMPANY IS NOT ABLE TO RETAIN AND COMPETE FOR KEY MANAGEMENT AND
TECHNICAL EMPLOYEES, ITS LONG-TERM BUSINESS WILL BE ADVERSELY AFFECTED.
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. See "Item 1 - Business - Employees."
THE RESULTS OF OPERATIONS ARE AFFECTED BY A NUMBER OF CONDITIONS, WHICH ARE
OUTSIDE THE COMPANY'S CONTROL.
The Company was founded in 1987 and only 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 $90.7 million at December 31, 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. The Company may experience fluctuations in revenues and
operating results based on such factors as demand for the Company's products;
the timing, cost and acceptance of product introductions and enhancements made
by the Company or others; levels of third party payment; alternative treatments
that currently exist or may be introduced in the future; completion of
acquisitions and divestitures; changes in practice patterns, competitive
conditions, regulatory announcements and changes affecting the Company's
products in the industry and general economic conditions. The development and
commercialization by the Company of additional products will require substantial
product development and regulatory, clinical and other expenditures. See "Item 1
- - Business - Competition."
24
THE COMPANY'S STOCK PRICE IS VOLATILE AND FLUCTUATES DUE TO A VARIETY OF
FACTORS.
The stock price has varied significantly in the past and may vary in the
future due to a number of factors including:
* fluctuations in the Company's operating results;
* developments in litigation to which the Company or a competitor is
subject;
* announcements and timing of potential acquisitions, divestitures,
conversion of preferred stock;
* announcements of technological innovations or new products by the
Company or its competitors;
* FDA and international regulatory actions;
* actions with respect to reimbursement matters;
* developments with respect to patents or proprietary rights of the
Company or competitors;
* public concern as to the safety of products developed by the Company
or others;
* changes in health care policy in the United States and
internationally;
* changes in stock market analyst recommendations regarding the Company,
other medical device companies or the medical device industry
generally; and
* general market conditions.
In addition, the stock market has from time to time experienced significant
price and volume fluctuations that are unrelated to the operating performance of
particular companies. These broad market fluctuations may adversely affect the
market price of the Company's stock.
Developments in any of these areas, which are more fully described
elsewhere in "Item 1 - Business," "Item 3 - Legal Proceedings," and "Item 7--
Management's Discussion and Analysis of Financial Condition and Results of
Operations" could cause the Company's results to differ materially from results
that have been or may be projected by or on behalf 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.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company has no debt and no derivative instruments at December 31, 2002.
The Company's Canadian operation was sold as part of the CPM sale, and
consequently the Company has no exposure to foreign exchange rates and therefore
does not use foreign currency exchange forward contracts. The Company is not
currently vulnerable to a material extent to fluctuations in interest rates,
commodity prices, or foreign exchange rates.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Consolidated balance sheets, as of December 31, 2002 and 2001, and
consolidated statements of operations, stockholders' equity and cash flows for
each of the three years in the period ended December 31, 2002, together with the
related notes and the report of Deloitte & Touche LLP, independent auditors, are
set forth on the "F" pages following this report and are incorporated herein by
reference. Other required financial information is set forth herein, as more
fully described in Part IV, Item 15 hereof.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
25
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth information regarding the executive officers
of the Company:
NAME AGE TITLE
- ---- --- -----
Thomas R. Trotter 55 Chief Executive Officer, President and Director
Sherry A. Sturman 38 Senior Vice President and Chief Financial Officer
Ruben Chairez, Ph.D. 60 Vice President of Medical Regulatory and Compliance
Jeff Culhane 35 Vice President of Manufacturing and Product Development
Shane P. Kelly 33 Senior Vice President of Sales
Donna L. Lucchesi 39 Vice President of Marketing
James T. Ryaby, Ph.D. 44 Senior Vice President and Chief Technology Officer
Thomas R. Trotter joined OrthoLogic as President and Chief Executive
Officer and a Director in October 1997. From 1988 to October 1997, Mr. Trotter
held various positions at Mallinckrodt, Inc. in St. Louis, Missouri, most
recently as President of the Critical Care Division and a member of the
Corporate Management Committee. From 1984 to 1988, he was President and Chief
Executive Officer of Diamond Sensor Systems, a medical device company in Ann
Arbor, Michigan. From 1976 to 1984, he held various senior management positions
at Shiley, Inc. (a division of Pfizer, Inc.) in Irvine, California. He holds a
B.S. degree from the University of Maryland and a Masters of Business
Administration from Pepperdine University.
Sherry A. Sturman joined OrthoLogic as Director of Finance in October 1997
and began serving as the Vice President of Administration, and Chief Financial
Officer in June 2000 and was promoted to Senior Vice President in early 2003.
From 1994 to 1997, Ms. Sturman was employed as the Chief Financial Officer for
ComCare, a large managed care company based in Phoenix. She has over fifteen
years of financial management experience in both health care and public
companies. She is a Certified Public Accountant, with a Masters in Business
Administration.
Ruben Chairez, Ph.D., joined OrthoLogic in May 1998 as Vice President,
Medical Regulatory and Clinical Affairs and is currently Vice President,
Medical, Regulatory and Compliance. From November 1993 through April 1998, Dr.
Chairez served as Vice President, Regulatory Affairs/Quality Assurance of SenDx
Medical, Inc., a manufacturer of blood gas analyzer systems. From July 1990 to
November 1993, Dr. Chairez was the Director of Regulatory Affairs with
Glen-Probe Incorporated, an in-vitro diagnostic device manufacturer.
Jeff Culhane joined OrthoLogic as Vice President, Product Development &
Engineering in June 1998. From May 1993 to June 1998, Mr. Culhane held
Industrial Design and Manager of Product Development positions at OrthoLogic
Canada (previously Toronto Medical Corp.). His related product development
experience includes bone growth stimulators, continuous passive motion devices
and cryotherapy.
Shane P. Kelly joined OrthoLogic in 1991 as a Field Sales and Service
Representative. Since then, he has held various positions within the company in
the area of sales, managed care and operations. He was named Vice President of
Sales in 2000 and was promoted to Senior Vice President in early 2003. Mr. Kelly
received an undergraduate degree in business from Tulane University and a
Masters of Business Administration in International Management from Thunderbird,
The American Graduate School of International Management.
Donna L. Lucchesi joined OrthoLogic in August 1998 as Director of Marketing
- - Injectable Products. She was promoted to Director of Marketing in February
2000 and moved into her current position as Vice President of Marketing in
January 2001. From 1990 to 1998, Ms. Lucchesi held a variety of marketing
positions at Mallinckrodt, Inc. in St. Louis, Missouri, most recently as
Director of Health Care Systems Marketing. She holds a Master's Degree in
Business Administration from Washington University.
James T. Ryaby, Ph.D., joined OrthoLogic as Director of Research in 1991
and became Vice President of Research in 1997 and was promoted to Senior Vice
President and Chief Technology Officer in early 2003. Prior to joining
OrthoLogic, he was a research scientist at Mt. Sinai School of Medicine in New
26
York, where he received his Ph.D. degree in cellular biology. His current
research interests are applications of cytokines, growth factors, and
electromagnetic fields in musculoskeletal tissue repair. Dr. Ryaby also serves
as Adjunct Professor of Bioengineering at Arizona State University.
Information in response to Item 10 is also incorporated by reference to (i)
the biographical information relating to the Company's directors under the
caption "Election of Directors" and the information relating to Section 16
compliance under the caption, "Section 16(a) Beneficial Ownership Reporting
Compliance" in the Company's definitive Proxy Statement for its Annual Meeting
of Stockholders to be held May 29, 2003 (the "Proxy Statement"). The Company
anticipates filing the Proxy Statement within 120 days after December 31, 2002.
All of the Company's executive officers and the manager of financial
analysts are members of the Disclosure Committee.
ITEM 11. EXECUTIVE COMPENSATION
The information under the heading "Executive Compensation" and
"Compensation of Directors" in the Proxy Statement is incorporated herein by
reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information under the heading "Voting Securities and Principal Holders
Thereof - Security Ownership of Certain Beneficial Owners and Management" in the
Proxy Statement is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information under the heading "Certain Transactions" in the Proxy
Statement is incorporated herein by reference.
ITEM 14. EVALUATION OF CONTROLS AND PROCEDURES
As of a date within 90 days prior to the date of filing of this report, the
Company's Chief Executive Officer and Chief Financial Officer have reviewed and
evaluated the effectiveness of our disclosure controls and procedures, which
included inquiries made to certain other employees. Based on their evaluation,
the Chief Executive Officer and Chief Financial Officer have each concluded that
the disclosure controls and procedures are effective and sufficient to ensure
that the Company records, processes, summarizes, and reports information
required to be disclosed in the periodic reports filed under the Securities
Exchange Act within the time periods specified by the Securities and Exchange
Commission's rules and forms. Subsequent to the date of their evaluation, there
have not been any significant changes in the internal controls or in other
factors that could significantly affect these controls, including any corrective
action with regard to significant deficiencies and material weaknesses.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) THE FOLLOWING DOCUMENTS ARE FILED AS PART OF THIS REPORT:
1. Financial Statements
The following financial statements of OrthoLogic Corp. and Independent
Auditors' Report are listed in addendum F:
Independent Auditors' Report
Consolidated Balance Sheets - December 31, 2002 and 2001.
Consolidated Statements of Operations - Each of the three years in the
period ended December 31, 2002.
27
Consolidated Statements of Comprehensive Income - Each of the three
years in the period ended December 31, 2002.
Consolidated Statements of Stockholders' Equity - Each of the three
years in the period ended December 31, 2002.
Consolidated Statements of Cash Flows - Each of the three years in the
period ended December 31, 2002.
Notes to Consolidated Financial Statements
2. Financial Statement Schedule
Independent Auditors Consent
Schedule II - Valuation and Qualifying Accounts
3. All management contracts and compensatory plans and arrangements are
identified by footnote after the Exhibit Descriptions on the attached
Exhibit Index.
(b) REPORTS ON FORM 8-K.
None.
(c) EXHIBITS
See the Exhibit Index immediately following the signature page of this
report, which Index is incorporated herein by reference.
(d) FINANCIAL STATEMENTS AND SCHEDULES - See Item 15(a)(1) above.
Schedule II - Valuation and Qualifying Accounts
28
Write-offs
Balance at beginning Charged to and other Balance at end
Valuation and Qualifying Accounts of period Expenses adjustments of period
--------------------------------------------------------------------
Allowance for doubtful accounts:
Balance December 31, 1999 (15,450,462)
2000 Additions charged to expense (16,348,442)
2000 Deductions to allowance 18,080,611
Balance December 31, 2000 (13,718,293)
Balance December 31, 2000 (13,718,293)
2001 Additions charged to expense (6,770,362)
2001 Deductions to allowance 14,708,614
Balance December 31, 2001 (5,780,041)
Balance December 31, 2001 (5,780,041)
2002 Additions charged to expense (1,955,667)
2002 Deductions to allowance 4,624,725
Balance December 31, 2002 (3,110,983)
Allowance for inventory shrinkage
and obsolescence:
Balance December 31, 1999 (979,802)
2000 Additions charged to expense (3,329,720)
2000 Deductions to allowance 3,063,700
Balance December 31, 2000 (1,245,822)
Balance December 31, 2000 (1,245,822)
2001 Additions charged to expense (2,286,868)
2001 Deductions to allowance 2,810,923
Balance December 31, 2001 (721,767)
Balance December 31, 2001 (721,767)
2002 Additions charged to expense (241,140)
2002 Deductions to allowance 276,134
Balance December 31, 2002 (686,773)
29
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
ORTHOLOGIC CORP.
Date: March 26, 2003 By /s/ Thomas R. Trotter
-------------------------------------
Thomas R. Trotter
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
- --------- ----- ----
/s/ Thomas R. Trotter President, Chief Executive March 26, 2003
- --------------------------- Officer and Director
Thomas R. Trotter (Principal Executive Officer)
/s/ John M. Holliman III Chairman of the Board of March 26, 2003
- --------------------------- Directors and Director
John M. Holliman III
/s/ Fredric J. Feldman Director March 26, 2003
- ---------------------------
Fredric J. Feldman
/s/ Elwood D. Howse, Jr. Director March 26, 2003
- ---------------------------
Elwood D. Howse, Jr.
/s/ Stuart H. Altman Director March 26, 2003
- ---------------------------
Stuart H. Altman, Ph.D.
/s/ Augustus A. White III Director March 26, 2003
- ---------------------------
Augustus A. White III, M.D.
/s/ Sherry A. Sturman Senior Vice President and March 26, 2003
- --------------------------- Chief Financial Officer
Sherry A. Sturman (Principal Financial and
Accounting Officer)
S-1
CERTIFICATIONS
I, Thomas R. Trotter, certify that:
1. I have reviewed this annual report on Form 10-K of OrthoLogic Corp.
("OrthoLogic")
2. Based on my knowledge, this annual 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 annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual 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 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 annual 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 annual report (the "Evaluation Date"); and
c) presented in this annual 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 the registrant's board of directors (or persons performing the
equivalent functions):
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
annual report whether 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: March 26, 2003
/s/ Thomas R. Trotter
----------------------------------------
Thomas R. Trotter
President & CEO
S-2
CERTIFICATIONS
I, Sherry A. Sturman, certify that:
1. I have reviewed this annual report on Form 10-K of OrthoLogic Corp.
("OrthoLogic")
2. Based on my knowledge, this annual 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 annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual 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 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 annual 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 annual report (the "Evaluation Date"); and
c) presented in this annual 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 the registrant's board of directors (or persons performing the
equivalent functions):
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
annual report whether 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: March 26, 2003
/s/ Sherry A. Sturman
----------------------------------------
Sherry A. Sturman
Sr. Vice President and CFO
S-3
ORTHOLOGIC CORP.
EXHIBIT INDEX TO REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002
(File No. 0-21214)
Exhibit Filed
No. Description Incorporated by Reference To: Herewith
--- ----------- ----------------------------- --------
3.1 Amended and Restated Certificate of Exhibit 3.1 to the Company's Form 10-Q for the
Incorporation quarter ended March 31, 1997 ("March 1997 10-Q")
3.2 Amended and Restated Certificate of Exhibit 3.2 to the Company's Form 10-Q for the
Incorporation dated May 9, 2000 quarter ended March 31, 2000
3.3 Certificate of Designation in respect of Exhibit 3.1 to Company's Form 10-Q for the quarter
Series A Preferred Stock ended March 31, 1997 ("March 1997 10-Q")
3.4 Bylaws of the Company Exhibit 3.4 to Company's Amendment No. 2 to
Registration Statement on Form S-1 (No. 33-47569)
filed with the SEC on January 25, 1993 ("January
1993 S-1")
4.1 Rights Agreement dated as of March 4, Exhibit 4.1 to the Company's Registration Statement
1997, between the Company and Bank of New on Form 8-A filed with the SEC on March 6, 1997
York, and Exhibits A, B and C thereto
4.2 1987 Stock Option Plan of the Company, as Exhibit 4.4 to the Company's Form 10-Q for the
amended and approved by stockholders (1) quarter ended June 30, 1997 ("June 1997 10-Q")
4.3 1987 Stock Option Plan of the Company(1) Exhibit 4.5 to the Company's June 1997 10-Q
4.4 Stock Purchase Warrant dated March 2, Exhibit 4.10 to the Company's 1997 10-K
1998, issued to Silicon Valley Bank
4.5 Antidilution Agreement dated March 2, Exhibit 4.11 to the Company's 1997 10-K
1998, by and between the Company and
Silicon Valley Bank
4.6 Amendment to Stock Purchase Warrant Exhibit 4.1 to the Company's form 10-Q for the
dated May 12, 1998, issued to Silicon quarter ended March 31, 1998
Valley Bank
4.7 Form of Warrant Exhibit 4.1 to the Company's Form 8-K filed on
July 13, 1998
4.8 Registration Rights Agreement Exhibit 4.2 to the Company's Form 8-K filed on
July 13, 1998
4.9 1987 Stock Option Plan of the Company (1) Exhibit 4.5 to the Company's June 1997 10-Q
10.1 License Agreement dated September 3, Exhibit 10.6 to January 1993 S-1
1987, between the Company and Life
Resonance's, Inc.
10.2 Form of Indemnification Agreement* Exhibit 10.16 to January 1993 S-1
10.3 License Agreement dated December 2, Exhibit 10.22 to January 1993 S-1
1992, between Orthotic Limited
Partnership and Company
10.4 Co-promotion Agreement dated June 23, Exhibit 10.1 to the Company's June 1997 10-Q
1997, by and between the Company and
Sanofi Pharmaceuticals, Inc.
10.5 Single-tenant Lease-net dated June 12, Exhibit 10.2 to the Company's Form 10-Q for the
1997, by and between the Company and quarter ended September 30, 1997 ("September
Chamberlain Development, L.L.C. 1997 10-Q")
10.6 Registration Rights Agreement dated Exhibit 10.45 to the Company's 1997 10-K
March 2, 1998, by and between the
Company and Silicon Valley Bank
10.7 Licensing Agreement with Chrysalis Exhibit 10.1 to the Company's September 1998 10-Q
BioTechnology, Inc.
10.8 1998 Management Bonus Program Exhibit 10.2 to the Company's September 1998 10-Q
E-1
10.9 Securities Purchase Agreement Exhibit 10.1 to the Company's Form 8-K filed on
July 13, 1998
10.10 First Amendatory Agreement to March 4, Exhibit 10.1 to the Company's Form 8-K filed
1997, Rights Agreement August 24, 1999
10.11 Credit and Security Agreement between Exhibit 10.18 to the Company's 1999 form 10/KA
the Company and Wells Fargo Business
Credit, Inc. dated February 28, 2000
10.12 Termination of Co-Promotion Agreement/ Exhibit 10.20 to the Company's form 10K for the
Hyalgan between the Company and Sanofi year ended December 31, 2001
Pharmaceuticals, Inc.
10.13 Amendment of Marketing and Distribution Exhibit 10.1 to the Company's form 10Q for the
Agreement Effective July 12, 2000. (2) quarter ended June 30, 2000.
10.14 Employment Agreement effective December Exhibit 10.22 to the Company's form 10Q for the
4, 2000 between the Company and Shane quarter ended March 31, 2001.
Kelly. (1)
10.15 Employment Agreement effective January Exhibit 10.23 to the Company's form 10Q for the
2, 2001 between the Company and Donna quarter ended March 31, 2001.
Lucchesi. (1)
10.16 Asset Purchase Agreement effective May Exhibit 10.1 to the Company's form 10Q for the
8, 2001 between the Company, OrthoLogic quarter ended September 30, 2002.
Canada, Ltd. and OrthoRehab Inc.
10.17 First Amendment to the May 8, 2001 Exhibit 10.2 to the Company's form 10Q for the
Asset Purchase Agreement. quarter ended September 30, 2002.
10.18 Employment Agreement effective June 1, Exhibit 10.21 to the form 10K for the fiscal year
2001 between the Company and James ended December 31, 2001
Ryaby. (1)
10.19 Employment Agreement effective Exhibit 10.22 to the form 10K for the fiscal year
May 1, 2001 between the Company and ended December 31, 2001
Sherry Sturman. (1)
10.20 Employment Agreement effective July 9, Exhibit 10.23 to the form 10K for the fiscal year
2001 between the Company and Jeff ended December 31, 2001
Culhane. (1)
10.21 Employment Agreement effective Exhibit 10.24 to the form 10K for the fiscal year
May 1, 1998 between the Company and ended December 31, 2001
Ruben Chairez. (1)
10.22 Employment Agreement effective July 15, Exhibit 10.1 to the Company's form 10Q for the
2002 between the Company and Thomas R. fiscal year ended December 31, 2002.
Trotter. (1)(2)
21.1 Subsidiaries of Registrant Exhibit 21.1 to the form 10K for the fiscal year
ended December 31, 2001
23.1 Independent Auditor's Consent and Report X
on Schedule
99.1 Chief Executive Officer's certification X
pursuant to 18 U.S.C. section 1350, as
adopted pursuant to section 906 of the
Sarbanes-Oxley Act of 2002.
99.2 Chief Financial Officer's certification X
pursuant to 18 U.S.C. section 1350, as
adopted pursuant to section 906 of the
Sarbanes-Oxley Act of 2002.
(1) Management contract or compensatory plan or arrangement
(2) Filed under confidential treatment request with the Securities and Exchange
Commission.
* The Company has entered into a separate indemnification agreement with each
of its current direct and executive officers that differ only in party
names and dates. Pursuant to the instructions accompanying Item 601 of
Regulation S-K, the Company has filed the form of such indemnification
agreement.
E-2
INDEPENDENT AUDITORS' REPORT
BOARD OF DIRECTORS AND STOCKHOLDERS
ORTHOLOGIC CORP.
TEMPE, ARIZONA
We have audited the accompanying consolidated balance sheets of OrthoLogic
Corp. and subsidiaries as of December 31, 2002 and 2001, and the related
consolidated statements of operations, comprehensive income (loss),
stockholders' equity, and cash flows for each of the three years in the period
ended December 31, 2002. Our audits also included the financial statement
schedule listed in the Index at Item 15. These financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of OrthoLogic Corp. and
subsidiaries at December 31, 2002 and 2001, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2002 in conformity with accounting principles generally accepted in the
United States of America. Also, in our opinion, such financial statement
schedule, when considered in relation to the basic consolidated financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.
As discussed in Note 2 to the consolidated financial statements, the
Company changed its method of accounting for goodwill and other intangible
assets with indefinite lives as required by Statement of Financial Accounting
Standards No. 142, "Goodwill and Other Intangible Assets," which was effective
January 1, 2002.
Deloitte & Touche LLP
Phoenix, Arizona
January 29, 2003
F-1
ORTHOLOGIC CORP.
CONSOLIDATED BALANCE SHEETS
December 31,
------------------------------
2002 2001
------------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 11,286,345 $ 19,502,751
Short-term investments 18,659,773 11,008,444
Accounts receivable less allowance for doubtful accounts,
$3,110,983 and $5,780,041 9,640,573 11,361,861
Inventories, net 2,567,706 1,506,889
Prepaids and other current assets 598,251 687,555
Deferred income taxes - current 1,666,947 2,630,659
------------------------------
Total current assets 44,419,595 46,698,159
------------------------------
Furniture and equipment, net 1,498,337 1,901,928
Long-term investments 5,659,442 --
Deferred income taxes - non-current 963,712 --
Deposits and other assets 128,575 91,752
Investment in Chrysalis BioTechnology 750,000 750,000
------------------------------
TOTAL ASSETS $ 53,419,661 $ 49,441,839
==============================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 477,338 $ 775,783
Accrued compensation 2,290,366 2,415,470
Other accrued liabilities 1,857,305 2,445,492
Accrued CPM divestiture costs 210,201 1,021,994
------------------------------
Total current liabilities 4,835,210 6,658,739
------------------------------
Deferred rent and capital lease obligation 351,630 287,131
------------------------------
Total liabilities 5,186,840 6,945,870
------------------------------
Commitments and contingencies (Notes 3,9,10,12 and 13)
Series B Convertible Preferred Stock, $1,000 per value; 600 shares
issued and outstanding; liquidation preference, $600,000
at December 31, 2001 -- 600,000
STOCKHOLDERS' EQUITY
Common stock, $.0005 par value;
50,000,000 shares authorized; and 32,047,021 and
31,805,418 shares issued and outstanding 16,045 15,924
Additional paid-in capital 136,944,815 136,216,495
Common stock to be used for legal settlement 2,078,125 2,078,125
Accumulated deficit (90,668,864) (96,277,275)
Treasury stock at cost, 41,800 shares (137,300) (137,300)
------------------------------
Total stockholders' equity 48,232,821 41,895,969
------------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 53,419,661 $ 49,441,839
==============================
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
F-2
ORTHOLOGIC CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ending December 31,
-----------------------------------------------
2002 2001 2000
-----------------------------------------------
REVENUES
Net sales $ 38,158,721 $ 41,507,670 $ 41,699,626
Net rental -- 17,830,606 39,069,630
Royalties and fee revenue from co-promotion agreement 2,229,959 3,017,516 9,310,648
-----------------------------------------------
Total revenues 40,388,680 62,355,792 90,079,904
-----------------------------------------------
COST OF REVENUES
Cost of goods sold 6,157,895 7,758,654 10,392,292
Costs of rentals -- 3,590,297 7,897,143
-----------------------------------------------
Total cost of revenues 6,157,895 11,348,951 18,289,435
-----------------------------------------------
GROSS PROFIT 34,230,785 51,006,841 71,790,469
OPERATING EXPENSES
Selling general and administrative 26,560,254 46,467,358 71,580,178
Research and development 3,765,199 3,888,838 4,689,588
CPM divestiture and related charges (1,047,423) 14,327,315
Legal settlements -- -- 4,498,847
Write-off of goodwill -- -- 23,348,074
Net gain from discontinuation of co-promotion
agreement -- -- (844,424)
-----------------------------------------------
Total operating expenses 29,278,030 64,683,511 103,272,263
OPERATING INCOME (LOSS) 4,952,755 (13,676,670) (31,481,794)
OTHER INCOME
Interest and other income 705,877 682,319 450,792
Interest expense (44,410) (88,296) (147,372)
-----------------------------------------------
Total other income 661,467 594,023 303,420
-----------------------------------------------
INCOME (LOSS) BEFORE INCOME TAXES 5,614,222 (13,082,647) (31,178,374)
Income tax provision (5,811) (12,000) (12,175)
-----------------------------------------------
NET INCOME (LOSS) $ 5,608,411 $ (13,094,647) $ (31,190,549)
-----------------------------------------------
Net income (loss) per common share - basic $ 0.17 $ (0.42) $ (1.04)
===============================================
Net income (loss) per common share - diluted $ 0.17 $ (0.42) $ (1.04)
===============================================
Basic shares outstanding 32,641,798 31,463,502 29,855,397
===============================================
Equivalent shares 730,762 -- --
===============================================
Diluted shares outstanding 33,372,560 31,463,502 29,855,397
===============================================
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
Years Ending December 31,
-----------------------------------------------
2002 2001 2000
-----------------------------------------------
Net income (loss) applicable to common stockholders $ 5,608,411 $ (13,094,647) $ (31,190,549)
Foreign translation adjustment -- 222,762 (47,957)
-----------------------------------------------
Comprehensive income (loss) applicable to
common stockholders $ 5,608,411 $ (12,871,885) $ (31,238,506)
===============================================
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
F-3
ORTHOLOGIC CORP.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
ADDITIONAL
PAID IN
CAPITAL AND
COMMON STOCK
COMMON STOCK TO BE USED ACCUMULATED
------------------------ FOR LEGAL COMPREHENSIVE ACCUMULATED TREASURY
SHARES AMOUNT SETTLEMENT LOSS DEFICIT STOCK TOTAL
------------------------------------------------------------------------------------------------
Balance December 31, 1999 27,637,593 $ 13,818 $125,206,621 $ (174,805) $(51,992,079) $ 73,053,555
Exercise of common stock options 91,637 46 186,428 186,474
Conversion of Preferred Stock 2,620,711 1,310 6,938,690 6,940,000
Common stock to be used for legal
settlement 2,968,750 2,968,750
Foreign translation adjustment (47,957) (47,957)
Net loss (31,190,549) (31,190,549)
------------------------------------------------------------------------------------------------
Balance December 31, 2000 30,349,941 15,174 135,300,489 (222,762) (83,182,628) 51,910,273
Exercise of common stock options 124,407 63 354,818 354,881
Conversion of Preferred Stock 1,072,870 537 2,639,463 2,640,000
Common stock issued in connection
with legal settlement 300,000 150 (150)
Foreign translation adjustment 222,762 222,762
Treasury stock repurchases (41,800) $ (137,300) (137,300)
Net loss (13,094,647) (13,094,647)
------------------------------------------------------------------------------------------------
Balance December 31, 2001 31,805,418 15,924 138,294,620 (96,277,275) (137,300) 41,895,969
Exercise of common stock options 43,927 22 128,419 128,441
Conversion of Preferred Stock 197,676 99 599,901 600,000
Net Income 5,608,411 5,608,411
------------------------------------------------------------------------------------------------
Balance December 31, 2002 32,047,021 $ 16,045 $139,022,940 $ -- $(90,668,864) $ (137,300) $ 48,232,821
================================================================================================
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
F-4
ORTHOLOGIC CORP.
CONSOLIDATED STATEMENTS OF CASH FLOW
Years Ending December 31,
-----------------------------------------------
2002 2001 2000
-----------------------------------------------
OPERATING ACTIVITIES
Net income (loss) $ 5,608,411 $ (13,094,647) $ (31,190,549)
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Depreciation and amortization 701,767 970,428 5,325,111
Common Stock issued for legal settlement -- -- 2,968,750
Write-off of Goodwill -- -- 23,348,074
Loss from CPM divestiture and related charges -- 14,327,315 --
Elimination of foreign currency adjustment -- 222,762 --
Change in operating assets and liabilities:
Accounts receivable 1,721,288 10,728,353 319,568
Inventories (1,060,817) 1,962,616 (700,210)
Prepaids and other current assets 89,304 (79,039) (32,239)
Deposits and other assets (36,823) 246,316 428,518
Accounts payable (298,445) (587,380) 461,151
Accrued and other current liabilities (1,460,585) (4,841,732) 574,852
-----------------------------------------------
Net cash provided by operating activities 5,264,100 9,854,992 1,503,026
-----------------------------------------------
INVESTING ACTIVITIES
Expenditures for rental fleet, equipment and furniture (298,176) (806,730) (1,861,658)
Proceeds from sale of CPM assets -- 12,000,000 --
Officer note receivable -- -- 157,800
Purchase of investments (40,178,238) (19,747,657) (35,354,087)
Maturities of investments 26,867,467 11,231,592 33,111,708
Sale of Hyalgan rights - discontinuation of
co-promotion agreement -- -- 3,155,576
-----------------------------------------------
Net cash (used in) provided by investing activities (13,608,947) 2,677,205 (790,661)
-----------------------------------------------
FINANCING ACTIVITIES
Payments under long-term debt and capital lease obligations -- -- (121,172)
Treasury stock purchases (137,300) --
Net proceeds from stock options exercised 128,441 354,881 138,517
-----------------------------------------------
Net cash provided by financing activities 128,441 217,581 17,345
NET INCREASE IN CASH AND CASH EQUIVALENTS (8,216,406) 12,749,778 729,710
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 19,502,751 6,752,973 6,023,263
-----------------------------------------------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 11,286,345 $ 19,502,751 $ 6,752,973
===============================================
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND
FINANCING ACTIVITIES:
Conversion of series B Preferred Stock to Common Stock $ 600,000 $ 2,640,000 $ 6,940,000
Cash paid during the year for interest $ 44,410 $ 88,296 $ 91,467
Cash paid during the year for income taxes $ (62,085) $ (27,193) $ 12,175
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
F-5
ORTHOLOGIC CORP.
NOTES TO FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2002, 2001 and 2000
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF THE BUSINESS. OrthoLogic 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 sold its continuous passive motion ("CPM")
business. CPM devices provide controlled, continuous movement to joints and
limbs and are designed to reduce swelling, increase joint range of motion,
reduce the length of hospital stay and reduce the incidence of post-trauma and
post-surgical complications. The Company's financial results reflect sales of
the CPM devices through July 11, 2001.
In 1999, the Company exercised its option to license the United States
development, marketing, and distribution rights for the fracture indications for
Chrysalin(TM), a new tissue repair synthetic peptide. In 2000, the Company
exercised its options to license Chrysalin(TM) worldwide for all orthopedic
applications. The Company's research and development focus is on its Chrysalin
product development program. The Company has three potential Chrysalin products
either in human clinical trials or in late-stage pre-clinical development.
The Company also distributed HYALGAN(R) (sodium hyaluronate), a therapeutic
injectable for relief of pain from osteoarthritis of the knee under the terms of
an exclusive Co-Promotion Agreement with Hyalgan's United States distributor,
Sanofi Synthelabo, Inc. The rights to distribute this product began in 1997 and
were terminated in October 2000. The Company received royalties from Hyalgan's
distributor through December 2002. There will be no future royalties.
During the years ended December 31, 2002, 2001, and 2000, the Company
reported net income (losses) of $5.6 million, $(13.1) million and $(31.2)
million, respectively. The Company anticipates that its cash and short-term
investments on hand, cash provided from operations and the funds available from
the revolving line of credit (Note 9) will be sufficient to meet the Company's
presently projected cash and working capital requirements for the next 12
months. There can be no assurance, however, that this will prove to be the case.
The timing and amounts of cash used will depend on many factors, including the
cost of research and development activities and the Company's ability to
maintain profitability and collect amounts billed to Medicare and private
insurers. The Company's ability to continue funding its planned operations
beyond the next 12 months is dependent on 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, as may be required.
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 (approximately $3.1 million and $5.8 million at December 31, 2002 and
2001, respectively), which are based primarily on trends in historical
collection rates, consideration of current events, payor mix and other
considerations. The Company derives a significant amount of its revenues in the
United States 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 included unbilled receivables
of $860,000 and $1.9 million on December 31, 2002 and 2001, respectively. The
decrease in the unbilled receivables from 2001 to 2002 primarily results from
changes to the Company's billing processes during 2002. Billings are subject to
review by third party payors and may be subject to adjustments. Any differences
between estimated reimbursement and final determinations are reflected in the
period finalized. In the opinion of management, adequate allowances have been
provided for doubtful accounts and contractual adjustments.
F-6
PRINCIPLES OF CONSOLIDATION The consolidated financial statements include
the accounts of OrthoLogic and its subsidiaries. All intercompany accounts and
transactions have been eliminated. The Company prepares its consolidated
financial statements in accordance with accounting principles generally accepted
in the United States of America. The following briefly describes the significant
accounting policies used in the preparation of the financial statements of the
Company:
A. CASH AND CASH EQUIVALENTS. Cash and cash equivalents consist of cash on
hand and cash deposited with financial institutions, including money market
accounts, and commercial paper purchased with an original maturity of three
months or less.
B. INVENTORIES. Business inventories are stated at the lower of cost (first
in, first out method) or market. The Company writes-down its inventory for
inventory shrinkage and obsolescence. Inventory is written down to estimated
market value based on a number of assumptions, including future demand and
market conditions.
C. FURNITURE AND EQUIPMENT. Furniture and equipment are stated at cost or,
in the case of leased assets under capital leases, at the present value of
future lease payments at inception of the lease. Depreciation is calculated on a
straight-line basis over the estimated useful lives of the various assets, which
range from three to seven years. Leasehold improvements and leased assets under
capital leases are amortized over the life of the asset or the period of the
respective lease using the straight-line method, whichever is the shortest.
The Company adopted Statement of Financial Accounting Standards No. 144,
ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS ("SFAS No. 144")
effective January 1, 2002. SFAS No. 144 addresses financial accounting and
reporting for the impairment or disposal of long-lived assets, and supersedes
Statement of Financial Accounting Standards No. 121, ACCOUNTING OF THE
IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF.
SFAS No. 144 requires that the Company 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 the Company's
operating results or financial position.
D. INVESTMENT IN CHRYSALIS. The Company owns a minority ownership interest
in Chrysalis, which is recorded at cost (see Note 13).
E. INCOME TAXES. Under Financial Accounting Standards Board ("FASB")
Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for
Income Taxes", income taxes are recorded based on current year amounts payable
or refundable, as well as the consequences of events that give rise to deferred
tax assets and liabilities. The Company bases its estimate of current and
deferred taxes on the tax laws and rates that are currently in effect in the
appropriate jurisdiction. Pursuant to SFAS No. 109, the Company has determined
that the deferred tax asset at December 31, 2002 requires a valuation allowance
(see Note 7).
F. RESTRUCTURING AND OTHER RELATED CHARGES. The Company recorded
restructuring charges during the second quarter of 2001 using the authoritative
guidance in 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). In
June 2002, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 146, ACCOUNTING FOR COSTS ASSOCIATED WITH
EXIT OR DISPOSAL ACTIVITIES ("SFAS No. 146"). The provisions of SFAS No. 146 are
effective for exit or disposal activities that are initiated after December 31,
2002, with earlier adoption encouraged. The Company will adopt SFAS No. 146
effective January 1, 2003. SFAS No. 146 addresses financial accounting and
reporting for costs associated with exit or disposal activities and nullifies
EITF No. 94-3. Under SFAS No. 146, the liability for costs associated with exit
or disposal activities is recognized and measured initially at fair value only
when the liability is incurred, rather than at the date the Company committed to
the exit plan. The adoption of SFAS No. 146 is not expected to have a
significant impact on the Company's operating results or financial position.
G. REVENUE. Revenue is recognized for sales of the OL1000 and SpinaLogic
products at the time the product is delivered to and accepted by the patient, as
verified by the patient signing a "Patient Agreement Form" accepting financial
responsibility. If the sale of either product is to a commercial buyer, a
purchase order is required, and the revenue is recognized at the time of
shipment to the commercial buyer. The Company's shipping terms are FOB shipping
point.
Rental revenue for the divested CPM products was recorded over the period
the equipment was utilized by the patient. Ancillary products for the divested
CPM business were sold to both patients and commercial buyers. Revenue for the
F-7
sale of the ancillary products provided to patients was recognized at the time
the patient accepted the product by signing a "Patient Agreement Form." CPM
ancillary products sold to commercial buyers required a purchase order, and were
recorded as a sale at the time the product was shipped "FOB shipping point."
The amount of revenue recorded at the time of sale is based on contractual
terms, or if the Company does not have a contract with the third-party payor,
then the amount of revenue recorded is the pricing expected to be approved by
the third-party payor, based on historical experience with that payor. The
Company records differences, if any, between the net revenue amount recognized
at the time of the sale and the ultimate pricing by the primary third-party
payor as an adjustment to sales in the period the Company receives payments from
the third-party payor or earlier if the Company becomes aware of circumstances
that warrant a change in estimate.
Royalties and co-promotion fee revenue is recorded in accordance with the
Co-Promotion Agreement and the Termination Agreement the Company had with
Hyalgan's distributor (see Note 12). The agreements with Hyalgan's distributor
concluded December 2002. The Company will receive no further Hyalgan related
revenues.
The Company maintains a warranty reserve for the expected cost to replace
or repair products. Warranty costs are recorded in cost of goods sold. The
Company does not offer price protection or rebates to any of its customers.
H. RESEARCH AND DEVELOPMENT. Research and development represents both costs
incurred internally for research and development activities, as well as costs
incurred by the Company to fund the research activities with which the Company
has contracted and certain milestone payments regarding the continued clinical
testing of Chrysalin. All research and development costs are expensed when
incurred.
I. STOCK-BASED COMPENSATION. In December 2002, the Financial Accounting
Standards Board issued Statement of Financial Accounting Standards No. 148,
ACCOUNTING FOR STOCK-BASED COMPENSATION - TRANSITION AND DISCLOSURE ("SFAS No.
148") which is effective for fiscal years ending after December 15, 2002. SFAS
No. 148 amends SFAS No. 123 to provide alternative methods of transition to SFAS
No. 123's fair value method of accounting for stock-based employee compensation
if a company elects to account for its equity awards under this method. SFAS No.
148 also amends the disclosure provisions of SFAS No. 123 and APB Opinion No.
28, INTERIM FINANCIAL REPORTING, to require disclosure of the effects of an
entity's accounting policy with respect to stock-based employee compensation on
reported net income and earnings per share in both annual and interim financial
statements. The Company will provide the comparative interim annual pro forma
disclosures required by SFAS No. 148 beginning in first quarter 2003 and has
provided the required additional annual disclosures below. The Company is
currently evaluating the impact if it were to adopt the fair value method of
accounting for stock-based employee compensation under all three methods.
At December 31, 2002, the Company has two stock-based employee compensation
plans, which are described more fully in Note 8. The Company accounts for those
plans under the recognition and measurement principles of APB Opinion No. 25,
ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and related Interpretations. No
stock-based employee compensation cost is reflected in net income, as all
options granted under those plans had an exercise price equal to the market
value of the underlying common stock on the date of grant. The following table
illustrates the effect on net income and earnings per share if the Company had
applied the fair value recognition provisions of FASB Statement No. 123,
ACCOUNTING FOR STOCK-BASED COMPENSATION, to stock-based employee compensation
(in thousands except per share data).
F-8
2002 2001 2000
----------------------------------------
Estimated weighted-average fair value of options
granted during the year $ 1.87 $ 1.71 $ 1.49
Net income (loss) attributable to common stockholders:
As reported $ 5,608 $ (13,095) $ (31,191)
Stock based compensation expense $ (838) $ (1,320) $ (1,572)
---------- ---------- ----------
Pro forma $ 4,770 $ (14,415) $ (32,763)
---------- ---------- ----------
Basic net income (loss) per share:
As reported $ 0.17 $ (0.42) $ (1.04)
Pro forma $ 0.15 $ (0.46) $ (1.10)
Diluted net income (loss) per share
As reported $ 0.17 $ (0.42) $ (1.04)
Pro forma $ 0.14 $ (0.46) $ (1.10)
Black Scholes model assumptions:
Risk free interest rate 2.0% 3.5% 5.5%
Expected volatility 51% 60% 70%
Expected term 2.6 Years 5 Years 5 Years
Dividend yield 0% 0% 0%
The table above presents pro forma net income and basic and diluted
earnings per share as if compensation expense had been recognized for stock
options granted in the three year period ended December 31, 2002, as determined
under the fair value method used in the Black-Scholes pricing model, and
includes the effect of shares issued under the employee stock purchase plan.
J. INCOME (LOSS) PER COMMON SHARE. Income (loss) per common share is
computed on the weighted average number of common or common and equivalent
shares outstanding during each year. Basic earnings per share is computed as net
income (loss) divided by the weighted average number of common shares
outstanding during the period. Diluted earnings per share reflects the potential
dilution that could occur from common shares issuable through stock options,
warrants, and other convertible securities when the effect would be dilutive.
K CERTAIN RECLASSIFICATIONS. Certain reclassifications have been made to
the prior year financial statements to conform to the 2002 presentation.
L. NEW ACCOUNTING PRONOUNCEMENTS. In November 2002, the FASB issued
Interpretation No. 45 ("FIN 45"), GUARANTOR'S ACCOUNTING AND DISCLOSURE
REQUIREMENTS FOR GUARANTEES, INCLUDING INDIRECT GUARANTEES OF THE INDEBTEDNESS
OF OTHERS, which clarifies the requirements of SFAS No. 5, ACCOUNTING FOR
CONTINGENCIES, relating to a guarantor's accounting for and disclosures of
certain guarantees issued. FIN 45 requires enhanced disclosures for certain
guarantees. FIN 45 also requires certain guarantees that are issued or modified
after December 31, 2002, to be initially recorded on the balance sheet at fair
value. For guarantees issued on or before December 31, 2002, liabilities are
recorded when and if payments become probable and estimable. The Company had no
guarantees at December 31, 2002. As the financial statement recognition
provisions are effective prospectively, the Company cannot reasonably estimate
the impact of adopting FIN 45 until guarantees are issued or modified in future
periods, at which time the related results will be initially reported in the
financial statements.
In January 2003, the FASB issued Interpretation No. 46 ("FIN 46"),
CONSOLIDATION OF VARIABLE INTEREST ENTITIES, which clarifies the application of
Accounting Research Bulletin No. 51, CONSOLIDATED FINANCIAL STATEMENTS, relating
to consolidation of certain entities. First, FIN 46 will require identification
of the Company's participation in variable interest entities ("VIEs"), which are
defined as entities with a level of invested equity that is not sufficient to
fund future activities to permit it to operate on a standalone basis. For
entities identified as a VIE, FIN 46 sets forth a model to evaluate potential
consolidation based on an assessment of which party to the VIE (if any) bears a
majority of the exposure to its expected losses, or stands to gain from a
majority of its expected returns. Interpretation 46 applies to variable interest
entities created or acquired after January 31, 2003. For variable interest
entities existing at January 31, 2003, Interpretation 46 is effective for
accounting periods beginning after June 15, 2003. The application of
Interpretation 46 is not expected to have a material effect on the Company's
financial statements.
F-9
2. CPM DIVESTITURE IN 2001 AND RELATED CHARGES IN 2001 AND 2002
In July 2001, the Company announced the sale of its CPM business. The
Company received $12.0 million in cash, with the purchaser assuming
approximately $2.0 million in liabilities in connection with the sale of certain
CPM related assets that had been recorded in the Company's financial statements
at a carrying value of approximately $20.7 million. The Company recorded a $6.9
million charge to write down the CPM assets to their fair value less direct
costs of selling the assets, all of which is included in the "CPM Divestiture
and Related Charges" total in the accompanying 2001 Statement of Operations. The
Company may receive up to an additional $2.5 million of cash, if certain
objectives are achieved by the purchaser of the CPM business. The Company is
currently in litigation with the purchaser regarding this $2.5 million
contingent payment and other matters (see Note 10). Because there is no
reasonable basis for estimating the degree of certainty that these objectives
will be reached, the additional contingent consideration has not and will not be
recorded in the accompanying financial statements until cash is actually
received by the Company.
The Company retained all the billed accounts receivable related to the CPM
business. The collection staff and supervisor previously responsible for the
collection of these receivables were part of the employee team that was 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
collectible of the retained CPM accounts receivable. As a result, a charge of
$2.8 million was recognized in 2001 to write down the carrying value of the
retained CPM accounts receivable and is included in the "CPM Divestiture and
Related Charges" total in the accompanying 2001 Statement of Operations.
At December 31, 2001, the Company had collected $10.2 million of the
remaining $10.8 million of the retained CPM receivables. During 2002, collection
of these receivables was better than anticipated. Based on the improved
collection trends, the Company revised its estimates and increased the estimated
total collection of the retained CPM accounts receivable by $600,000, $226,000,
and $221,000 in the quarters ended March 31, 2002, June 30, 2002 and September
30, 2002, respectively. The effect of these changes in estimate resulted in
additional income during 2002 and is included in the "CPM Divestiture and
Related Charges" line item in the 2002 Statement of Operations. As of December
31, 2002, the net value of the remaining CPM accounts receivable was
approximately $94,000.
In connection with the sale of the CPM business, the Company notified
approximately 331 of the Company's 505 employees that their positions were being
eliminated. The accompanying 2001 Statement of Operations includes a charge of
approximately $3.3 million included in the "CPM Divestiture and Related Charges"
total in the accompanying 2001 Statement of Operations for severance and related
benefits. 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 by the Company. These additional exit costs are
also included in the "CPM Divestiture and Related Charges" total in the
accompanying 2001 Statement of operations.
A summary of the severance and other exit cost reserve balances at December
31, 2002 and 2001 are as follows (in thousands):
Reserves Amount Charged Cash Reserves
December 31, 2001 Against Assets Paid December 31, 2002
------------------------------------------------------------------------
Severance $ 946 $ -- $ (785) $ 161
Other exit costs 76 -- (27) 49
-------------------------------------------------------------------
Total non-recurring charges $ 1,022 $ -- $ (812) $ 210
Initial Amount Charged Cash Reserves
Reserves Against Assets Paid December 31, 2001
----------------------------------------------------------------------
Severance $ 3,300 $ -- $ (2,354) $ 946
Other exit costs 1,387 (245) (1,066) 76
-------------------------------------------------------------------
Total non-recurring charges $ 4,687 $ (245) $ (3,420) $ 1,022
F-10
Cash requirements for the severance and exit costs were funded from the
Company's current cash balances.
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, 2001. The
revenue and cost of revenue attributable to the CPM business for the following
fiscal year ending December 31 were (in thousands):
Years ended
December 31,
------------------------------
2001 2000
------------------------------
Net sales $ 11,029 $ 21,189
Net rental 17,831 39,070
------------------------------
Total net revenue 28,860 60,259
Cost of sale 2,219 6,206
Cost of rental 3,590 7,897
------------------------------
Gross profit $ 23,051 $ 46,156
Most operating expenses were not directly allocated between the Company's
various lines of business.
During the fourth quarter of 2000, the Company recorded a charge of
approximately $3.0 million of additional bad debt expense for a change in the
estimated collectability of older receivables of the CPM business.
During the fourth quarter of 2000, the Company recorded a charge of $23.3
million for the write-off of goodwill related to the CPM business. Letters of
intent and results of discussions with third parties during the fourth quarter
of 2000 indicated that the fair value of the CPM assets were below their
carrying amount. Management considered this information to be an impairment
indicator that should subject the CPM assets to impairment testing prescribed
under Statement of Financial Accounting Standard No. 121, ACCOUNTING FOR THE
IMPAIRMENT OF LONG LIVED ASSETS AND FOR LONG LIVED ASSETS TO BE DISPOSED. The
Company performed the recoverability test as of December 31, 2000, which
indicated that the $23.3 million goodwill balance was fully impaired.
The Company adopted SFAS No. 141 effective January 1, 2002. In addition to
requiring that the purchase method of accounting be used for all business
combinations initiated after June 30, 2001, SFAS No. 141 also provides guidance
on the types of acquired intangible assets that are to be recognized and
reported separately from goodwill. The adoption of SFAS No. 141 did not have an
effect on the Company's financial statements.
The Company also adopted SFAS No. 142 effective January 1, 2002. SFAS No.
142 addresses how intangible assets should be accounted for after they have been
initially recognized in the financial statements. SFAS No. 142 also requires
that goodwill and certain other intangible assets with indefinite useful lives
no longer be amortized, but instead be tested for impairment at least annually.
The adoption of SFAS No. 142 did not affect the Company's financial statements
as all goodwill and certain other intangible assets were written off as of
December 31, 2000.
F-11
At December 31, 2002, 2001 and 2000, goodwill and other intangible assets,
all related to the CPM business, consisted of the following (in thousands except
per share data):
For the years ended December 31,
----------------------------------------
2002 2001 2000
---------- ---------- ----------
Reported net income (loss) $ 5,608 $ (13,095) $ (31,191)
Add back: Goodwill amortization -- -- 1,296
---------- ---------- ----------
Adjusted net income (loss) $ 5,608 $ (13,095) $ (29,895)
Basic earnings (loss) per share $ 0.17 $ (0.42) $ (1.04)
Goodwill amortization -- -- 0.04
---------- ---------- ----------
Adjusted net income (loss) $ 0.17 $ (0.42) $ (1.00)
3. LICENSE AGREEMENTS
The Company uses the BioLogic technology in its bone growth stimulation
devices through a worldwide exclusive license granted by a corporation owned by
university professors who discovered the technology. The Company's license for
the BioLogic technology extends for the life of the underlying patents, which
are due to expire over a period of years beginning in 2006 and extending through
2016. The license provides for payment of royalties by the Company from the net
sales of products using the BioLogic technology. The royalty percentages vary
but generally range from 0.5% to 7% of the sales amount for licensed products.
The royalty percentage under the different agreements decrease when either a
certain sales dollar amount is reached or royalty amount is paid. Royalty
expense under these agreements totaled $200,000, $106,000 and $382,000 in 2002,
2001, and 2000, respectively.
4. INVESTMENTS AND FAIR VALUE DISCLOSURES
At December 31, 2002, marketable securities consisted of municipal and
corporate bonds and were classified as held-to-maturity securities. Such
classification requires these securities to be reported at amortized cost unless
they are deemed to be permanently impaired in value.
F-12
A summary of the fair market value and unrealized gains and losses on these
securities is as follows:
INVESTMENTS WITH MATURITIES - SHORT TERM DECEMBER 31
----------------------------
2002 2001
------------ ------------
Amortized costs $ 18,659,773 $ 11,008,444
Gross unrealized gains 90,684 --
Gross unrealized losses -- (88,709)
------------ ------------
Fair value $ 18,750,457 $ 10,919,735
============ ============
INVESTMENTS WITH MATURITIES - LONG TERM DECEMBER 31
------------
2002
------------
Amortized costs $ 5,659,442
Gross unrealized gains 26,164
Gross unrealized losses --
------------
Fair value $ 5,685,606
============
SFAS No. 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS,
requires that the Company disclose estimated fair values for its financial
instruments. Fair value estimates are made at a specific point in time and are
based on relevant market information and information about financial
instruments; they are subjective in nature and involve uncertainties, matters of
judgements, and therefore, cannot be determined with precision. These estimates
do not reflect any premium or discount that could result from offering for sale
at one time the Company's entire holdings of a particular instrument. Since the
fair market values above are estimated at December 31, 2002, the amounts that
will actually be realized or paid in settlement of the instruments could be
significantly different.
For the Company's cash and cash equivalents, the carrying amount is assumed
to be the fair market value because of the liquidity of these instruments. The
carrying amount is assumed to be the fair value for accounts receivable,
accounts payable and other accrued expenses because of the short maturity of the
portfolios. Therefore, management believes the fair values approximate the
carrying values of these financial instruments.
5. INVENTORIES
Inventories consisted of the following:
DECEMBER 31,
--------------------------
2002 2001
----------- -----------
Raw materials $ 1,640,980 $ 828,541
Work in progress 177,376 410,569
Finished goods 1,436,123 989,546
----------- -----------
3,254,479 2,228,656
Less allowance for shrinkage and obsolescence (686,773) (721,767)
----------- -----------
Total $ 2,567,706 $ 1,506,889
=========== ===========
F-13
6. FURNITURE AND EQUIPMENT
Equipment and furniture consisted of the following:
DECEMBER 31,
--------------------------
2002 2001
----------- -----------
Machinery and equipment $ 2,086,002 $ 2,095,908
Computer equipment 4,769,592 4,513,159
Furniture and fixtures 994,016 994,016
Leasehold improvements 722,762 721,638
----------- -----------
8,572,372 8,324,721
----------- -----------
Less accumulated depreciation and amortization (7,074,035) (6,422,793)
----------- -----------
Total $ 1,498,337 $ 1,901,928
=========== ===========
Depreciation expense for the years ended December 31, 2002, 2001 and 2000
was $701,767, $970,428 and $3,851,586, respectively.
7. INCOME TAXES
The components of deferred income taxes at December 31 are as follows:
(In thousands) DECEMBER 31,
--------------------
2002 2001
--------------------
Allowance for bad debts $ 1,051 $ 2,272
Other accruals and reserves 616 1,397
Valuation allowance -- (1,038)
--------------------
Total current 1,667 2,631
--------------------
Net operating loss and general business credit
carryforwards 25,489 25,081
Deferred revenue 645 963
Difference in basis of fixed assets (306) (369)
Nondeductible accruals and reserves 183 159
Difference in basis of intangibles 7,464 7,839
Valuation allowance (32,511) (33,673)
--------------------
Total non current 964 --
--------------------
Total deferred income taxes $ 2,631 $ 2,631
====================
The provision for income taxes are as follows YEARS ENDED DECEMBER 31
(in thousands): -----------------------
2002 2001 2000
-----------------------
Current $ 6 $ 12 $ 12
Deferred -- -- --
-----------------------
Income Tax Provisions $ 6 $ 12 $ 12
SFAS No. 109 requires that a valuation allowance be established when it is
more likely than not that all or a portion of a deferred tax asset will not be
realized. Changes in valuation allowances from period to period are included in
F-14
the tax provision in the period of change. In determining whether a valuation
allowance is required, the Company takes into account all evidence with regard
to the utilization of a deferred tax asset included in past earnings history,
expected future earnings, the character and jurisdiction of such earnings,
unsettled circumstances that, if unfavorably resolved, would adversely affect
utilization of a deferred tax asset, carryback and carryforward periods, and tax
strategies that could potentially enhance the likelihood of realization of a
deferred tax asset. Management has evaluated the available evidence about future
taxable income and other possible sources of realization of deferred tax assets
and has established a valuation allowance of approximately $32.5 million at
December 31, 2002. The valuation allowance reduces deferred tax assets to an
amount that management believes will more likely than not be realized. The
Company believes that the net deferred tax asset of $2.6 million at December 31,
2002, will be realized based primarily on our projected future earnings.
However, the amount of the deferred tax assets actually realized could differ if
we have little or no future earnings.
The Company has accumulated approximately $64 million in federal and state
net operating loss carryforwards ("NOLs") and approximately $800,000 of general
business and alternative minimum tax credit carryforwards. The federal and state
NOLs expire from 2007 to 2022.
A reconciliation of the difference between the provision (benefit) for
income taxes and income taxes at the statutory U.S. federal income tax rate is
as follows for the year ending December 31 (in thousands):
YEARS ENDED DECEMBER 31,
--------------------------------------
2002 2001 2000
---------- ---------- ----------
Income tax (benefit) at statutory rate $ 1,950 $ (4,578) $ (10,912)
State income taxes (benefit) 201 (589) (1,559)
Change in valuation allowance (2,201) 5,926 7,611
Other 56 (747) 4,872
---------- ---------- ----------
Net provision $ 6 $ 12 $ 12
========== ========== ==========
8. STOCKHOLDERS' EQUITY
The number of common shares reserved for issuance under the 1987 Option
Plan is 4,160,000 shares. This plan expired during October 1997. In May 1997,
the stockholders adopted a new Stock Option Plan (the "1997 Option Plan"), which
replaced the 1987 Option Plan. The 1997 Option Plan reserved for issuance
1,040,000 shares of Common Stock. Over 1998, 1999, 2000 and 2001 the Board and
Shareholders approved amendments to the 1997 Plan that increased the number of
shares of Common Stock reserved for issuance by 375,000, 275,000, 1,000,000 and
500,000 shares, respectively. Two types of options may be granted under the 1997
Option Plan: options intended to qualify as incentive stock options under
Section 422 of the Internal Revenue Code ("Code") and other options not
specifically authorized or qualified for favorable income tax treatment by the
Code. All eligible employees may receive more than one type of option. Any
director or consultant who is not an employee of the Company shall be eligible
to receive only nonqualified stock options under the 1997 Option Plan.
In October 1989, the Board of Directors (the "Board") approved that in the
event of a takeover or merger of the Company in which 100% of the equity of the
Company is purchased, 75% of all unvested employee options will vest, with the
balance vesting equally over the ensuing 12 months, or according to the
individual's vesting schedule, whichever is earlier. If an employee or holder of
stock options is terminated as a result of or subsequent to the acquisition,
100% of that individual's stock option will vest immediately upon employment
termination.
Options are granted at prices that are equal to the current fair value of
the Company's Common Stock at the date of grant. The vesting period is generally
related to length of employment and all incentive stock options lapse upon
termination of employment if not exercised within a 90-day period (or one year
after death or disability or the date of termination if terminated for cause).
F-15
A summary of the status of the Option Plans as of December 31, 2002, 2001,
and 2000, and changes during the years then ended is:
2002 2001 2000
------------------------------------------------------------------------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
SHARES EXERCISE PRICE SHARES EXERCISE PRICE SHARES EXERCISE PRICE
------------------------------------------------------------------------------------------
Fixed options outstanding
at the beginning of year 3,871,700 $ 4.30 3,625,846 $ 4.85 3,488,913 $ 5.24
Granted 310,200 3.60 1,348,850 3.40 762,400 3.33
Exercised (43,927) 2.92 (124,407) 2.87 (125,990) 2.37
Forfeited (54,936) 3.87 (978,589) 5.27 (499,477) 5.92
----------- ----------- -----------
Outstanding at end of year 4,083,037 $ 4.26 3,871,700 $ 4.30 3,625,846 $ 4.85
=========== =========== ===========
Options exercisable at year-end 3,179,034 $ 4.44 2,711,137 $ 4.62 2,734,347 $ 5.09
=========== =========== ===========
The following table summarizes information about fixed stock options
outstanding at December 31, 2002:
OUTSTANDING EXERCISABLE
- ----------------------------------------------------------------------- -------------------------------
NUMBER WEIGHTED WEIGHTED NUMBER WEIGHTED
RANGE OF OUTSTANDING AVERAGE REMAINING AVERAGE EXERCISABLE AVERAGE
EXERCISE PRICES AS OF 12/31/02 CONTRACTUAL LIFE EXERCISE PRICE AS OF 12/31/02 EXERCISE PRICE
- ----------------------------------------------------------------------- -------------------------------
$ 1.81 $ 2.53 444,500 4.61 $ 2.29 435,332 $ 2.29
$ 2.63 $ 3.02 436,250 7.89 $ 2.86 309,167 $ 2.88
$ 3.06 $ 3.19 414,687 8.06 $ 3.16 276,874 $ 3.17
$ 3.25 $ 3.50 621,900 7.49 $ 3.35 378,397 $ 3.26
$ 3.53 $ 3.63 456,000 7.79 $ 3.58 346,313 $ 3.58
$ 3.93 $ 4.56 427,900 8.22 $ 4.10 245,151 $ 3.98
$ 4.70 $ 5.38 454,050 5.57 $ 5.11 370,050 $ 5.16
$ 5.50 $ 5.63 495,500 4.92 $ 5.59 485,500 $ 5.60
$ 5.81 $ 12.75 236,250 3.42 $ 6.79 236,250 $ 6.79
$ 17.38 $ 17.38 96,000 3.34 $ 17.38 96,000 $ 17.38
- -------------------------------------------------------------------- -------------------------
$ 1.81 $ 17.38 4,083,037 6.53 $ 4.26 3,179,034 $ 4.44
==================================================================== =========================
In January 2002, the Securities and Exchange Commission adopted new rules
for the disclosure of equity compensation plans. The purpose of the new rules is
to summarize the potential dilution that could occur from past and future equity
grants under all equity compensation plans. The following provides tabular
disclosure of the number of securities to be issued upon the exercise of
outstanding options, the weighted average exercise price of outstanding options,
and the number of securities remaining available for future issuance under
equity compensation plans, aggregated into two categories - plans that have been
approved by stockholders and plans that have not.
F-16
Number of
Securities Remaining
Available for Future
Number of Weighted-average Issuance Under
Securities to be Exercise Price of Equity Compensation
Issued upon Outstanding Plans (Excluding
Exercise of Outstanding Options and Securities Reflected
Plan Category Options and Warrants Warrants in 1st Column)
- ---------------------------------------------------------------------------------------------------
Equity compensation plans
approved by stockholders 3,583,037 $ 4.45 506,489
Equity compensation plans
not approved by stockholders 500,000 2.92 --
----------- ------- -----------
4,083,037 $ 4.26 506,489
In July 1998, the Company completed a private equity placement with two
investors, an affiliate of Credit Suisse First Boston Corp. and Capital Ventures
International. Under the terms of the purchase agreement, OrthoLogic sold 15,000
shares of Series B Convertible Preferred Stock for $15 million (before costs).
The Series B Convertible Preferred Stock was convertible into shares of Common
Stock. Each share of Series B Convertible Preferred Stock was convertible into
Common Stock at a per share price equal to the lesser of the average of the 10
lowest closing bids during the 30 days prior to conversion or $3.0353.
In connection with the private placement of the Series B Convertible
Preferred Stock, OrthoLogic issued to the purchasers warrants to purchase 40
shares of Common Stock for each share of Series B Convertible Preferred Stock,
exercisable at $5.50. These warrants expire in 2008. The warrants were valued at
$1,093,980. Additional costs of the private placement were approximately
$966,000. Both the value of the warrants and the cost of the equity offering
were recognized over the 10-month conversion period as an "accretion of non-cash
Preferred Stock dividends." The Company filed a registration statement covering
the underlying Common Stock.
Proceeds from the private placement were used to fund new product
opportunities, including SpinaLogic and Chrysalin, as well as to complete the
re-engineering of the Company's key business processes.
In August 2001, the Company announced that it 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 treasury shares and used in part to
reduce the dilution from the Company stock option plans. As of December 31,
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.
At December 31, 2002, there were 2,000,000 shares of Preferred Stock
authorized and there were no warrants for Preferred Stock outstanding.
At the close of business on December 31, 2002, 15,000 shares of Series B
Convertible Preferred Stock had been converted into 5,944,260 shares of Common
Stock.
9. COMMITMENTS
The Company is obligated under non-cancelable operating lease agreements
for its office, manufacturing and research facilities. Rent expense for the
years ended December 31, 2002, 2001, and 2000, was approximately $1.0 million
(offset by $570,000 for rent received from the buyer of the CPM business under a
sublease agreement), $1.5 million and $1.8 million, respectively. The sublease
agreement ended in December 2002.
F-17
The following table sets forth the obligated base payments:
2003 $1,078,000
2004 1,078,000
2005 1,078,000
2006 1,078,000
2007 989,000
----------
$5,301,000
==========
Approximately, 17% of the leased facility is subleased through June 2005,
which will offset approximately 10% of the lease commitments listed above.
The Company signed an exclusive worldwide sales agreement for a 10-year
period, beginning August 18, 2000, with DePuy AcroMed, a unit of Johnson and
Johnson, whereby DePuy AcroMed will assume sales responsibility for SpinaLogic,
the Company's device used as an adjunctive treatment after lumbar spinal fusion
surgeries, in return for a commission. OrthoLogic is responsible for product
development, testing and quality control, general inventory risk, distribution,
regulatory approvals, customer service, shipping, patient fitting, and billing
and collection activities. As such, the Company records the gross revenues for
orders received from DePuy AcroMed representatives. OrthoLogic pays DePuy
AcroMed a commission of the net sales price for the sale of all SpinaLogic
products. Net sales price is defined as the amounts invoiced less any
contractual discounts, taxes or government charges. This sales agreement began
with full implementation in 2000.
On February 28, 2000, the Company obtained a $10.0 million accounts
receivable revolving line of credit with a lending institution. At the Company's
request, the revolving line of credit was reduced to $4.0 million on September
24, 2001. 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 was extended in 2002
and expires February 28, 2005. There are certain financial covenants and
reporting requirements associated with the line of credit. Included in the
financial covenants are (1) tangible net worth of not less than $30.0 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 December 31, 2002, the Company was in
compliance with all the financial covenants.
10. LITIGATION
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. During 1996, certain class actions lawsuits were filed in
the United States District Court for the District of Arizona against the Company
and certain officers and directors 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.
In early October 2000, the parties negotiated a global settlement of the
consolidated class action suits. In return for dismissal of both class actions,
and releases by a settlement class comprised of all purchasers of OrthoLogic
Common Stock during the period from January 18 through June 18, 1996, inclusive,
the settlement called for $1 million in cash and 1 million shares of newly
issued OrthoLogic Common Stock. On August 17, 2001, the superior court gave
final approval of the settlement and signed and filed a judgment of dismissal of
the action with prejudice. We are not aware of any appeal from the judgment or
other challenge to the final approval of the settlement. Pursuant to the terms
of the settlement, the cash portion of the settlement fund has already been paid
into the settlement fund, with the substantial portion of the $1 million paid
from the proceeds of the Company's directors' and officers' liability insurance
policy, and the remaining cash paid by the Company. The Company recorded a $3.6
million charge, including legal expenses, for settlement. Pursuant to the terms
of the settlement and order of the superior court, 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
F-18
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.
UNITED STATES OF AMERICA EX REL. DAVID BARMARK 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 relate 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 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 Barmark filed
a second amended complaint, pursuing the claim independent of the U.S.
Department of Justice.
The Company filed a motion to dismiss the second 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.,
filed a complaint in connection with its acquisition of certain assets used in
the Company's CPM business in July 2001 alleging, among other things, that some
of the assets purchased were overvalued 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 is defending
the matter vigorously. The Company has filed a counterclaim against OrthoRehab
for nonpayment of the contingent payment believed to be due and owing in
connection with OrthoRehab's acquisition of certain assets. The matter is
presently scheduled to be tried in Delaware in June 2003. 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.
In addition to the matters disclosed above, the Company is involved in
various other legal proceedings that arise in the ordinary course of business.
In management's opinion, the ultimate resolution of these other legal
proceedings are not likely to have a material adverse effect on the financial
position, results of operations or cash flows of the Company.
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.
11. 401(K) PLAN
The Company adopted a 401(k) plan (the "Plan") for its employees on July 1,
1993. The Company may make matching contributions to the Plan on behalf of all
Plan participants, the amount of which is determined by the Board of Directors.
The Company matched approximately $95,000, $144,000 and $195,000 in 2002, 2001,
and 2000 respectively.
F-19
12. CO-PROMOTION AGREEMENT - HYALGAN
In June 1997, the Company signed an exclusive Co-Promotion Agreement with
Sanofi Synthelabo, Inc. ("Sanofi") at a cost of $4.0 million, which provided the
Company with the right to market the Hyalgan product to orthopedic surgeons in
the United States. The Company capitalized the $4.0 million investment in the
agreement. From June 1997 through December 2000, the Company earned a fee from
Sanofi for each unit of the Hyalgan product sold. The fee earned from Sanofi was
contractually determined and was based on Sanofi's wholesale price for the
Hyalgan product, 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. Sanofi did this calculation, prior to sending the Company the
fee revenue earned for the promotion of the product. The Company forwarded
orders for the product to Sanofi, which handled the product distribution.
Co-promotion fee revenue of $9.3 million was recognized by the Company in 2000.
In the fourth quarter of 2000, the Company and Sanofi mutually agreed to
terminate this Co-Promotion Agreement. The Company signed a Termination
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 Company had no further obligation to Sanofi after December 2000. As
a result, the Company recognized the entire $4.0 million payment as a component
of the net gain of $844,000. At the time the Termination Agreement was signed,
the carrying value of the investment in the Agreement was $3.2 million. The net
gain of $844,000 is calculated as the difference between the $4.0 million of
cash proceeds received from Sanofi and the carrying amount of the investment.
The net gain was recognized in the fourth quarter of 2000 and presented as a
separate line item in the 2000 Statement of Operations entitled "Net gain from
discontinuation of co-promotion agreement".
The Termination Agreement stipulated that the Company would receive
royalties of $5 for each unit of the Hyalgan product distributed by Sanofi
during the two-year period from January 1, 2001 through December 31, 2002.
During 2001 the Company received approximately $3.0 million in royalties from
Sanofi in accordance with the Termination Agreement. During 2002, the Company
received an additional $2.2 million in royalties. The royalty payments ended
December 2002. All of the royalties and co-promotion fees received from Sanofi
have been included in the Company's respective Statements of Operations in the
line item entitled "Royalties and fee revenue from co-promotion agreement."
13. CHRYSALIS LICENSING AGREEMENT
In January 1998, the Company 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 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 began enrolling patients during the fourth quarter of
2002. The clinical trial will include approximately 330 patients and will be
performed at 15 to 20 centers in the United States. The purpose of the study is
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to evaluate the safety and preliminary efficacy of Chrysalin in combination with
allograft. The patient enrollment process is expected to take approximately 18
to 24 months with a nine-month follow-up period.
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 trial will be performed at
25 to 30 clinical sites with approximately 500 patients. In addition, the
Company is currently moving forward with an IND application for a human clinical
trial for Chrysalin for articular cartilage repair and hopes to begin a Phase
I/II human clinical trial during 2003. There can be no assurance that any of
these clinical trials will result in favorable data or that New Drug Application
("NDA") approvals by the FDA, if sought, will be obtained.
A pre-payment of $250,000 was made subsequent to year-end 2002 to Chrysalis
in anticipation of a potential IND filing with the FDA for a human clinical
trial for a cartilage indication.
At this stage of research, the Company is not yet able to apply for FDA
approval to market Chrysalin. The process of obtaining necessary government
approvals is time consuming and expensive. There can be no assurance that the
necessary approvals for new products or applications will be obtained by the
Company or, if they are obtained, that they will be obtained on a timely basis.
Significant additional costs for the Company will be necessary to complete
development of these products.
OrthoLogic does not own the patents to Chrysalin. Chrysalin was developed
by and patented by Chrysalis. Except for the $750,000 minority equity investment
in Chrysalis, all payments made to Chrysalis have been expensed as research and
development. The license agreement with Chrysalis calls for the Company to pay
certain other additional milestone payments and royalty fees, based upon the
product's development and achievement of commercial introduction.
14. RELATED PARTY TRANSACTIONS
At December 31, 1999, the Company had an outstanding note receivable from
an officer of the Company for approximately $158,000. The loan was increased by
approximately $81,000 in January 2000. The principal and interest of both loans
were paid in full in 2000.
15. CONDENSED CONSOLIDATED QUARTERLY RESULTS (UNAUDITED)
First Quarter Second Quarter Third Quarter Fourth Quarter
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2002 2001 2002 2001 2002 2001 2002 2001
------ ------ ------ ------- ------ ------ ------ ------
(in thousands, except for per share data)
Net revenues 9,609 21,682 9,705 22,094 10,780 9,553 10,295 9,027
Gross profit 8,296 16,949 8,262 18,195 8,915 8,299 8,758 7,564
Operating income (loss) 1,272 142 1,087 (15,176) 1,235 383 1,359 974
Net income (loss) 1,446 204 1,256 (14,986) 1,392 606 1,514 1,081
Net income (loss) per share:
Basic 0.04 0.01 0.04 (0.48) 0.04 0.02 0.05 0.03
Diluted 0.04 0.01 0.04 (0.48) 0.04 0.02 0.05 0.03
In July 2001, the Company sold its CPM and related ancillary product
business. The Statements of Operations of the Company include the CPM business
through the sales date of July 11, 2001. In the second quarter of 2001, the
Company recognized a $14.3 million charge related to the divestiture of the CPM
business (see Note 2).
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