UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended March 31, 2003
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission File Number: 0-21214
ORTHOLOGIC CORP.
(Exact name of registrant as specified in its charter)
Delaware 86-0585310
(State of other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
1275 W. Washington Street, Tempe, Arizona 85281
(Address of principal executive offices) (Zip Code)
(602) 286-5520
(Registrant's telephone number, including area code)
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] [ ] No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 126-2 of the Exchange Act): [X] Yes [ ] No
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
32,889,721 shares of common stock outstanding as of April 30, 2003
ORTHOLOGIC CORP.
INDEX
Page No.
Part I Financial Information
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of March 31, 2003
and December 31, 2002 ......................................... 3
Condensed Consolidated Statements of Operations for the
Three months ended March 31, 2003 and 2002 .................... 4
Condensed Consolidated Statements of Cash Flows for the
Three months ended March 31, 2003 and 2002 .................... 5
Notes to Unaudited Condensed Consolidated Financial Statements .. 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ................... 14
Item 3. Quantitative and Qualitative Disclosures about
Market Risk ........................................... 20
Item 4. Evaluation of Controls and Procedures ................... 20
Part II Other Information
Item 1. Legal Proceedings ....................................... 26
Item 6. Exhibits and Reports .................................... 26
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ORTHOLOGIC CORP.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
March 31, December 31,
2003 2002
------------ ------------
ASSETS (Unaudited)
Current assets
Cash and cash equivalents $ 10,706 $ 11,286
Short-term investments 17,412 18,660
Accounts receivable less allowance for
doubtful accounts of $3,111 and $3,129 9,223 9,641
Inventory, net 2,716 2,568
Prepaids and other current assets 677 598
Deferred income taxes - current 1,667 1,667
------------ ------------
Total current assets 42,401 44,420
------------ ------------
Furniture and equipment 8,219 8,572
Accumulated depreciation (6,793) (7,074)
------------ ------------
Furniture and equipment, net 1,426 1,498
Long-term investments 8,239 5,659
Deferred income taxes - non-current 964 964
Investment in Chrysalis BioTechnology 750 750
Deposits and other assets 115 129
------------ ------------
TOTAL ASSETS $ 53,895 $ 53,420
============ ============
LIABILITIES & STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable $ 692 $ 477
Accrued liabilities 4,053 4,148
Accrued CPM divestiture costs 184 210
------------ ------------
Total current liabilities 4,929 4,835
Deferred rent 334 352
------------ ------------
Total liabilities 5,263 5,187
------------ ------------
STOCKHOLDERS' EQUITY
Common stock, $.0005 par value:
50,000,000 shares authorized; 32,873,871
and 32,047,021 shares issued and
outstanding 16 16
Additional paid-in capital 139,280 136,945
Common stock to be used for legal settlement -- 2,078
Accumulated deficit (90,527) (90,669)
Treasury stock at cost, 41,800 shares (137) (137)
------------ ------------
Total stockholders' equity 48,632 48,233
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 53,895 $ 53,420
============ ============
See Notes to Unaudited Condensed Consolidated Financial Statements.
3
ORTHOLOGIC CORP.
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(in thousands, except per share data)
Unaudited
Three months ended
March 31,
------------------------
2003 2002
---------- ----------
REVENUES
Net sales $ 10,372 $ 8,705
Royalties from co-promotion agreement -- 904
---------- ----------
Total net revenues 10,372 9,609
---------- ----------
COST OF GOODS SOLD 1,479 1,313
---------- ----------
GROSS PROFIT 8,893 8,296
OPERATING EXPENSES
Selling, general and administrative 7,410 6,704
Research and development 1,460 920
CPM divestiture and related gains -- (600)
---------- ----------
Total operating expenses 8,870 7,024
---------- ----------
OPERATING INCOME 23 1,272
OTHER INCOME 132 187
---------- ----------
INCOME BEFORE INCOME TAXES 155 1,459
Provision for income taxes 13 13
---------- ----------
NET INCOME $ 142 $ 1,446
========== ==========
Net income per common share - basic $ 0.00 $ 0.04
---------- ----------
Net income per common and equivalent share - diluted $ 0.00 $ 0.04
---------- ----------
Basic shares outstanding 32,809 32,515
Equivalent shares 219 785
---------- ----------
Diluted shares outstanding 33,028 33,300
---------- ----------
See Notes to Unaudited Condensed Consolidated Financial Statements.
4
ORTHOLOGIC CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW
(in thousands)
Unaudited
Three months ending
March 31,
------------------------
2003 2002
---------- ----------
OPERATING ACTIVITIES
Net income $ 142 $ 1,446
Non-cash items:
Depreciation 173 173
Change in operating assets and liabilities:
Accounts receivable 418 569
Inventories (148) (328)
Prepaids and other current assets (79) (23)
Deposits and other assets 14 (38)
Accounts payable 215 246
Accrued liabilities (113) (860)
Accrued liabilities on CPM divestiture and related charges (26) (314)
---------- ----------
Net cash provided by operating activities 596 871
---------- ----------
INVESTING ACTIVITIES
Expenditures for equipment and furniture (101) (103)
Purchases of investments (7,341) (10,427)
Maturities of investments 6,009 5,277
---------- ----------
Net cash used in investing activities (1,433) (5,253)
---------- ----------
FINANCING ACTIVITIES
Net proceeds from stock option exercises 257 41
---------- ----------
Net cash provided by financing activities 257 41
---------- ----------
NET DECREASE IN CASH AND CASH EQUIVALENTS (580) (4,341)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 11,286 19,503
---------- ----------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 10,706 $ 15,162
========== ==========
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING
ACTIVITES:
Cash paid during the period for interest $ 4 $ 23
Cash paid during the period for income taxes $ 27 $ 2
Common stock issued for legal settlement $ 2,078 $ --
See Notes to Unaudited Condensed Consolidated Financial Statements.
5
ORTHOLOGIC CORP.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF THE BUSINESS. OrthoLogic Corp. ("OrthoLogic" or the
"Company") develops, manufactures and markets proprietary, technologically
advanced orthopedic products designed to promote the healing of musculoskeletal
tissue, with particular emphasis on fracture healing and spinal repair.
OrthoLogic's products are designed to enhance the healing of diseased, damaged,
degenerated or recently repaired musculoskeletal tissue. The Company's products
focus on improving the clinical outcomes and cost-effectiveness of orthopedic
procedures that are characterized by compromised healing, high-cost, potential
for complication and long recuperation time.
FINANCIAL STATEMENT PRESENTATION
In the opinion of management, the unaudited interim financial statements
include all adjustments necessary for the fair presentation of the Company's
financial position, results of operations, and cash flows. The results of
operations for the interim periods are not indicative of the results to be
expected for the complete fiscal year. The Balance Sheet as of December 31, 2002
is derived from the Company's audited financial statements included in the 2002
Annual Report on Form 10-K. These financial statements should be read in
conjunction with the financial statements and notes thereto included in the
Company's 2002 Annual Report on Form 10-K.
USE OF ESTIMATES. The preparation of the financial statements in conformity
with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenue and expenses during the reporting period. Actual results could differ
from these estimates. Significant estimates include the allowance for doubtful
accounts (approximately $3.1 million at both March 31, 2003 and December 31,
2002), which is 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 include unbilled receivables
of $560,000 and $860,000 on March 31, 2003 and December 31, 2002, respectively.
The decrease in the unbilled receivables from December 31, 2002 to March 31,
2003 was primarily the result of changes to the Company's billing processes made
in 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.
PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include
the accounts of OrthoLogic and its subsidiaries. All inter-company 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.
6
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 ("SFAS")
No. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS
effective January 1, 2002. SFAS No. 144 addresses financial accounting and
reporting for the impairment or disposal of long-lived assets, and supersedes
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 4).
E. INCOME TAXES. Under Financial Accounting Standards Board ("FASB") 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 majority of the deferred tax asset at March 31, 2003
requires a valuation allowance.
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 adopted 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 did not 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.
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
7
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 was recorded in accordance with the
Co-Promotion Agreement and the Termination Agreement the Company had with
Hyalgan's distributor. The agreements with Hyalgan's distributor concluded
December 2002. The Company will receive no subsequent 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.
H. "TECHNOLOGY YOU CAN TRUST" PROGRAM. 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. The Company introduced a guarantee for the OL1000 product beginning March
1, 2003. With this program, the payments made for the product will be refunded
if there is no progression towards healing provided the treatment plan and other
certain requirements are met. The reserve is based on the percentage of
patients' who meet specific documentation and treatment requirements with a
further assessment of the historical percentages of the overall population
experiencing an unsuccessful clinical outcome using the product. The
requirements include specific adherence to product utilization compliance, the
exclusion of specific medical conditions, required documentation by the patient
and payor(s) of record and other certain requirements. At March 31, 2003, the
reserve for this program was $20,500. Management feels that adequate reserves
have been established for this program.
I. 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.
J. 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 ended 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 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 March 31, 2003, the Company has two stock-based employee compensation
plans. 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 presents pro forma disclosures required by
SFAS No. 148 of net income and basic and diluted earnings per share as if
stock-based employee compensation had been recognized during the three months
ended March 31, 2003 and 2002, as determined under the fair value method using
the Black-Scholes pricing model.
8
2003 2002
--------- ---------
Estimated weighted-average fair value of options
granted during the year $ 1.67 $ 2.57
Net income attributable to common stockholders:
As reported $ 142 $ 1,446
Stock based compensation expense $ (208) $ (220)
--------- ---------
Pro forma $ (66) $ 1,226
--------- ---------
Basic net income per share:
As reported $ 0.00 $ 0.04
Pro forma $ 0.00 $ 0.04
Diluted net income per share
As reported $ 0.00 $ 0.04
Pro forma $ 0.00 $ 0.04
Black Scholes model assumptions:
Risk free interest rate 1.7% 3.9%
Expected volatility 44% 50%
Expected term 2.7 Years 2.7 Years
Dividend yield 0% 0%
K. INCOME PER COMMON SHARE. Income 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 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.
L. NEW ACCOUNTING PRONOUNCEMENTS. 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 stand alone 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 No. 46 applies to VIEs created
or acquired after January 31, 2003. For VIEs existing at January 31, 2003, FIN
46 is effective for accounting periods beginning after June 15, 2003. The
application of FIN 46 is not expected to have a material effect on the Company's
financial statements.
2. CPM DIVESTITURE IN 2001 AND RELATED CHARGES IN THE QUARTERS ENDED MARCH 31,
2003 AND MARCH 31, 2002
CPM DIVESTITURE AND CHANGE IN ESTIMATED COLLECTABILITY OF CPM RECEIVABLES.
In July 2001, the Company announced the sale of its CPM business to OrthoRehab,
Inc. 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. Under the CPM Asset Purchase Agreement, the Company
was eligible to receive up to an additional $2.5 million of cash if certain
objectives were achieved by the purchaser of the CPM business. The Company
settled litigation with the purchaser regarding this $2.5 million contingent
payment and other matters in April 2003.
9
Under the terms of the settlement agreement, OrthoRehab, Inc. agreed to pay
$1.2 million to settle the contingent payment due to OrthoLogic, and all
outstanding claims between the two companies. An initial cash payment of
$257,000 was received in April 2003 and will be included in the "CPM divestiture
and related charges" line item on the Consolidated Statement of Operations in
the period ended June 30, 2003. The remaining $943,000 balance plus interest is
scheduled to be paid over the next 36 months, beginning in May 2003, and will be
reflected when received. The litigation is described in greater detail in Note
5.
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 in the
quarter ended March 31, 2002 which is included in the "CPM Divestiture and
Related Charges" line item in the Consolidated Statement of Operations for the
year ended December 31, 2002 ("2002 Statement of Operations").
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 Consolidated Statement of Operations for the year ended December
31, 2001 ("2001 Statement of Operations") included a charge of approximately
$3.3 million in the "CPM Divestiture and Related Charges" total 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 were also included in the "CPM Divestiture and Related Charges" total
in the 2001 Statement of Operations.
A summary of the severance and other reserve balances at March 31, 2003 and
2002 are as follows (in thousands):
Reserves Amount Charged Cash Reserves
December 31, 2002 Against Assets Paid March 31, 2003
----------------- -------------- -------- --------------
Severance $ 161 $ -- $ (26) 135
Other exit costs 49 -- -- 49
-------- -------- -------- --------
Total non-recurring charges $ 210 $ -- $ (26) $ 184
Reserves Amount Charged Cash Reserves
December 31, 2001 Against Assets Paid March 31, 2002
----------------- -------------- -------- --------------
Severance $ 946 $ -- $ (314) $ 632
Other exit costs 76 -- 76
-------- -------- -------- --------
Total non-recurring charges $ 1,022 $ -- $ (314) $ 708
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.
3. CO-PROMOTION AGREEMENT FOR 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
10
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 $4.0 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 Co-Promotion 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. During the period ended March
31, 2002, the Company received $904,000 in royalty payments. 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."
4. LICENSING AGREEMENT FOR CHRYSALIN
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 the Food
and Drug Administration ("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
to evaluate the safety and preliminary efficacy of Chrysalin in combination with
11
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 the Company remains
hopeful regarding the initiation of a human clinical trial for that indication
before the end of 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 payment of $250,000 was expensed in the quarter ended March 31, 2003 and
is included in research and development and reflects a payment made 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.
5. 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 of 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 $1.0 million in cash and one 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 $1.0 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 during 2000. 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
were delivered to the settlement fund in the quarter ended March 31, 2003.
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.
12
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 Company settled the dispute in April 2003. Under the terms of the
settlement agreement, OrthoRehab, Inc. agreed to pay $1.2 million to settle all
outstanding claims between the two companies. An initial cash payment of
$257,000 has been received in April 2003 and will be included in the "CPM
divestiture and related charges" line item on the Consolidated Statement of
Operations in the period ended June 30, 2003. The remaining $943,000 balance
plus interest is scheduled to be paid over the next 36 months, beginning in May
2003, and will be reflected when received.
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.
6. LINE OF CREDIT
The Company has a $4.0 million accounts receivable revolving line of credit
with a lending institution. 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 March 31, 2003,
the Company was in compliance with all the financial covenants.
13
7. SEGMENT INFORMATION
The Company operates as one segment. The various types of revenues and cost
of goods sold are separately identified by product line in the Statement of
Operations. Operating expenses were not directly allocated between the Company's
various lines of business.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The following is management's discussion of significant factors that
affected the Company's interim financial condition and results of operations.
This should be read in conjunction with Management's Discussion and Analysis of
Financial Condition and Results of Operations included in the Company's Annual
Report on Form 10-K for the year ending December 31, 2002 and the "Special Note
Regarding Forward Looking Statements" below following Item 4.
OVERVIEW OF THE COMPANY'S 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.
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.
14
Sales of bone growth stimulation products were 100% and 90.6% of the
Company's total revenues in the quarters ended March 31, 2003 and 2002
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
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 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. Hyalgan revenues were 9.4% of the Company's
total revenues in the quarter ended March 31, 2002. There will be no subsequent
royalties.
PRODUCTS IN RESEARCH
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 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 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. 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.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
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 at both March 31, 2003 and December 31,
2002), which is 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 include unbilled receivables
of $560,000 and $860,000 on March 31, 2003 and December 31, 2002, respectively.
The decrease in the unbilled receivables from December 31, 2002 to March 31,
15
2003 was primarily the result of changes to the Company's billing processes made
in 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.
ALLOWANCE FOR DOUBTFUL ACCOUNTS. The allowance for doubtful accounts
(approximately $3.1 million at both March 31, 2003 and December 31, 2002) is
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
estimate. In the opinion of management, adequate allowances have been provided
for sales discounts and contractual adjustments
The Company recognized 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.
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 introduced a guarantee for the OL1000 product beginning March
1, 2003. Management feels that adequate reserves have been established for the
program based on historical data.
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
16
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, carry-back and carry-forward 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 March 31, 2003, will be realized based primarily on our
historical and 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 was
anticipated to be vacant. The Company has a sublease agreement for approximately
17 percent of the building with a different subtenant through June 2005. In the
opinion of management, the reserve balance of $265,000 at March 31, 2003 is
adequate to allow for time necessary to acquire an additional tenant for the
building.
RESULTS OF OPERATIONS COMPARING THREE-MONTH PERIOD ENDED MARCH 31, 2003 TO THE
CORRESPONDING PERIOD IN 2002.
REVENUES. The Company's total revenues increased 7.9% from $9.6 million in
the first quarter of 2002 to $10.4 million in the first quarter of 2003.
Revenues for the first quarter of 2002 included Hyalgan royalty payments from
the termination of the Co-Promotion Agreement of $904,000. The Hyalgan royalty
payments ended December 31, 2002. Sales recorded for the bone growth stimulation
products, the OL1000 and SpinaLogic, increased by 19.1% in the first quarter of
2003 as compared to the same period in 2002. The Company believes the
significant increase in bone growth stimulation sales signifies an expansion in
the market and growth in market share for both the OL1000 and SpinaLogic
products.
17
GROSS PROFIT. Gross profit for the three months ended March 31, increased
from $8.3 million in 2002 to $8.9 million in 2003. Gross profit, as a percent of
revenue, was 85.7% for the quarter ended March 31, 2003. Gross profit for the
same period in 2002 was 86.3%. The decrease in the percentage of gross profit,
as a percent of revenues, is due to (1) increase manufacturing costs associated
with the re-launch of the Orthoframe(R)/Mayo(R) product in the fourth quarter of
2002 and (2) the elimination of the Hyalgan royalty income in 2003 which had no
corresponding cost of revenue in the same period in the previous year.
SELLING, GENERAL AND ADMINISTRATIVE ("SG&A") EXPENSES. SG&A expenses
increased 10.5% from $6.7 million in the three month period ended March 31, 2002
to $7.4 million in the same period in 2003. SG&A expenses, as a percentage of
total revenues, were 71.4% in the three month period ended March 31, 2003 and
69.8% in the same period in 2002. This increase in SG&A expenses as a percentage
of total revenues was caused by the absence in the first quarter of 2003 of
Hyalgan royalty revenues, which accounted for $904,000 of revenue in the first
quarter of 2002 and had no corresponding SG&A expenses. The primary reasons for
the increase in SG&A expenses for the three month period ended March 31, 2003
compared to the same period in the prior year were an increase in commission
expenses due to increased revenues, an increase in purchased service expenses
related to increased external reporting requirements, and an increase in legal
costs associated with the settlement of the lawsuit with OrthoRehab, Inc.
RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses were
$1.5 million in the three month period ended March 31, 2003, compared to
$920,000 for the same period in 2002. The research and development costs for the
three month period ended March 31, 2003 included a $250,000 milestone payment
made to Chrysalis BioTechnology, Inc. in anticipation of a potential IND filing
with the FDA for a human clinical trial for cartilage repair. Research and
development expenses in the quarter ended March 31, 2003 are for the overall
Chrysalin development program, which include pre-clinical studies in cartilage
and continuation of the Phase I/II human clinical trial under an IND for spinal
fusion and the Phase III human clinical trial under an IND for fracture repair.
The increase in research and development expenses is directly related to the
Chrysalin clinical trials. The Company anticipates the research and development
expenses to increase over the next several quarters as patient enrollment occurs
for the clinical trials.
OTHER INCOME. Other income consisting primarily of interest income,
decreased from $187,000 in the three-month period ended March 31, 2002 to
$132,000 for the same period in 2003. The decrease is the result of declining
interest rate returns on the investment portfolio.
NET INCOME. The Company had a net income in the three month period ended
March 31, 2003 of $142,000 compared to a net income of $1.4 million in the same
period in 2002.
LIQUIDITY AND CAPITAL RESOURCES
On March 31, 2003, the Company had cash and equivalents of $10.7 million
compared to $11.3 million as of December 31, 2002. The Company also had $17.4
million of short-term investments as of March 31, 2003 compared to $18.7 million
at December 31, 2002. The total of both cash and cash equivalents and short-term
investments decreased to $28.1 million at March 31, 2003 compared to $29.9
million as of December 31, 2002. The Company also had long-term investments of
$8.2 million, as of March 31, 2003, mostly consisting of government-backed
securities with maturities of fewer than 18 months, compared to long-term
investments of $5.7 million as of December 31, 2002.
The total of cash and cash equivalents, short-term investments, and
long-term investments increased to $36.4 million at March 31, 2003 compared to
$35.6 million at December 31, 2002. The most important factors in the increase
in total cash and investments were a decrease in accounts receivable ($418,000),
proceeds from stock options exercised ($257,000), and an increase in accounts
payable ($215,000) during the three months ended March 31, 2003.
In addition, the Company has a $4.0 million accounts receivable revolving
line of credit with a bank. The Company may borrow up to 75% of the eligible
accounts receivable, as defined in the agreement. The interest rate is at the
prime rate. Interest accruing on the outstanding balance and a monthly
18
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 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 March 31, 2003, the Company was in
compliance with all the financial covenants.
Net cash provided by operations during the three-month period ended March
31, 2003 was $596,000 compared to $871,000 for the same period in 2002. The
primary reason for this decline is due to the decrease in net income from $1.4
million in the quarter ended March 31, 2002 compared to net income of $142,000
in the quarter ended March 31, 2003. The decrease in net income was primarily
caused by (1) the absence of Hyalgan revenue in the period ended March 31, 2003
with corresponding revenues of $904,000 in the same period in 2002, (2) an
increase in research and development expenses from $920,000 in the quarter ended
March 31, 2002 to expenses of $1.5 million in the same period in 2003, and (3)
the recovery of $600,000 in collected receivables from the divested CPM business
in the quarter ended March 31, 2002. The net income decrease was partially
offset by a decrease in the payout of accrued liabilities of $139,000 in the
quarter ended March 31, 2003 compared to a payment of $1.2 million in the
quarter ended March 31, 2002. The decrease in liabilities is primarily due to
the timing of payments of standard expenses and non-recurring payments in 2002
for severance and other residual exit costs related to the CPM divestiture.
The Company does not expect to make significant capital investments in 2003
and anticipates that its cash and short term investments on hand, cash from
operations and the funds available from its $4.0 million line of credit will be
sufficient to meet the Company's presently projected cash and working capital
requirements for the next 12 months. The amount of cash the Company will be
required to use in the next 12 months will depend on many factors, including the
Company's ability to continue to increase revenues, reduce and control its
expenditures, continue profitability and collect amounts due from third-party
payors. Additional funds may be required if the Company is not successful in any
of these areas. 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.
In March 2003, the Company announced that its Board of Directors authorized
a repurchase of up to one million of the Company's outstanding shares over the
subsequent 12 months. The repurchased shares will be held as treasury shares to
reduce the dilution from the Company stock option plans. No shares were
repurchased as of March 31, 2003 under this plan. The repurchase period will end
March 6, 2004. Previously, 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 following table sets forth all known commitments as of March 31, 2003
and the year in which these commitments become due, or are expected to be
settled (in thousands):
OPERATING ACCOUNTS PAYABLE
YEAR LEASES AND ACCRUED LIABILITIES TOTAL
---- ------ ----------------------- ------
2003 $ 809 $4,929 $5,738
2004 $1,078 -- $1,078
2005 $1,078 -- $1,078
2006 $1,078 -- $1,078
Thereafter $ 989 -- $ 989
------ ------ ------
Total $5,032 $4,929 $9,961
19
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company has no debt outstanding and no derivative instruments at March
31, 2003.
The Company's Canadian operations were sold as part of the CPM asset sale,
and consequently the Company has no exposure to foreign currency exchange rate
risks at March 31, 2003.
ITEM 4. 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.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
The Company may from time to time make written or oral forward-looking
statements, including statements contained in the Company's filings with the
Securities and Exchange Commission and its reports to stockholders. This Report
contains forward-looking statements made pursuant to the "safe harbor"
provisions of the Private Securities Litigation Reform Act of 1995. In
connection with these "safe harbor" provisions, the Company identifies important
factors that could cause actual results to differ materially from those
contained in any forward-looking statements made by or on behalf of the Company.
Any such forward-looking statement is qualified by reference to the following
cautionary statements.
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.
20
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 may receive 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.
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.
21
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 non-thermal 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.
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
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
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."
22
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 effect such reform would have on a patient's
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.
THERE IS AN INCREASE IN THE 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.
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.
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
23
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.
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 licenses, and has filed a number of patent applications, 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. 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.
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.
24
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 the 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 one legal proceeding: UNITED STATES OF AMERICA
EX REL. DAVID BARMARK V. SUTTER CORP., UNITED STATES ORTHOPEDIC CORP., AND
ORTHOLOGIC CORP., ET AL. The Company has provided a description of this matter
in Note 5 to the Notes to Unaudited Condensed Consolidated 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.
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 $90.5 million at March 31, 2003. 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
25
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.
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:
o fluctuations in the Company's operating results;
o developments in litigation to which the Company or a competitor is
subject;
o announcements and timing of potential acquisitions, divestitures,
conversion of preferred stock;
o announcements of technological innovations or new products by the
Company or its competitors;
o FDA and international regulatory actions;
o actions with respect to reimbursement matters;
o developments with respect to patents or proprietary rights of the
Company or competitors;
o public concern as to the safety of products developed by the Company
or others;
o changes in health care policy in the United States and
internationally;
o changes in stock market analyst recommendations regarding the Company,
other medical device companies or the medical device industry
generally; and
o 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 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.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
See "Note 5 - Litigation" of the Notes to the Unaudited Condensed
Consolidated Financial Statements above, which is incorporated hereto.
Item 6. Exhibits and Reports
(a) Exhibit Index
See Exhibit List following this report
(b) Reports on Form 8-K
None.
26
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
ORTHOLOGIC CORP.
(Registrant)
SIGNATURE TITLE DATE
- --------- ----- ----
/s/ Thomas R. Trotter President and Chief Executive Officer May 12, 2003
- ------------------------ (Principal Executive Officer)
Thomas R. Trotter
/s/ Sherry A. Sturman Senior Vice-President and Chief Financial Officer May 12, 2003
- ------------------------ (Principal Financial and Accounting Officer)
Sherry A. Sturman
27
Certification of CEO Pursuant to Securities Exchange Act Rules 13a - 14 and
15d - 14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
I, Thomas R. Trotter, the Chief Executive Officer of OrthoLogic Corp., certify
that:
1. I have reviewed this quarterly report on Form 10-Q of OrthoLogic Corp.
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
/s/ Thomas R. Trotter
- ----------------------------------
Thomas R. Trotter
President and Chief Executive Officer
Date: May 12, 2003
28
Certification of CFO Pursuant to Securities Exchange Act Rules 13a - 14 and
15d - 14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
I, Sherry A. Sturman, the Chief Financial Officer of OrthoLogic Corp., certify
that:
1. I have reviewed this quarterly report on Form 10-Q of OrthoLogic Corp.
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
/s/ Sherry A. Sturman
- ----------------------------------
Sherry A. Sturman
Chief Financial Officer
Date: May 12, 2003
29
ORTHOLOGIC CORP.
EXHIBIT INDEX TO QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002
Incorporated by Filed
Exhibit No Description Reference to: Herewith
- ---------- ----------- ------------- --------
99.1 Certification pursuant to 18 U.S.C. X
Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act
of 2002.
-- Thomas R. Trotter
99.2 Certification pursuant to 18 U.S.C. X
Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act
of 2002.
-- Sherry A. Sturman
99.3 "Technology you can Trust Program" X
Guarantee
30