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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

      

     
For the quarterly period ended     March 31, 2005
     
 
   

or

     
o   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 incorporation or organization)   (IRS Employer 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. þ Yes o No

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act): þ Yes o 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.

38,022,307 shares of common stock outstanding as of April 29, 2005.

 
 

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ORTHOLOGIC CORP.
(A Development Stage Company)
INDEX

             
        Page No.  
  Financial Information        
 
           
 
  Item 1. Financial Statements (Unaudited)        
 
           
 
  Balance Sheets as of March 31, 2005 and December 31, 2004     3  
 
           
 
  Statements of Operations for the Three months ended March 31, 2005 and 2004     4  
 
           
 
  Statements of Cash Flows for the three months ended March 31, 2005 and 2004     5  
 
           
 
  Notes to Unaudited Financial Statements     6  
 
           
 
  Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations     15  
 
           
 
  Item 3. Quantitative and Qualitative Disclosures about Market Risk     32  
 
           
 
  Item 4. Controls and Procedures     32  
 
           
  Other Information        
 
           
 
  Item 2. Unregistered Sales of Equity Securities and Use of Proceeds     32  
 
           
 
  Item 4. Submission of Matters to a Vote of Security Holders     33  
 
           
 
  Item 6. Exhibits     34  
 EXHIBIT 3.1
 EXHIBIT 3.2
 EXHIBIT 10.1
 EXHIBIT 10.2
 EXHIBIT 10.3
 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT

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PART I – Financial Information

Item 1. Financial Statements

ORTHOLOGIC CORP.
(A Development Stage Company)

BALANCE SHEETS
(in thousands)
(Unaudited)
                 
    March 31,     December 31,  
    2005     2004  
 
ASSETS
               
Current assets:
               
Cash and cash equivalents
  $ 29,993     $ 38,377  
Short-term investments
    61,828       53,642  
Accounts receivable, net
    29       34  
Prepaids and other current assets
    1,104       1,019  
     
Total current assets
    92,954       93,072  
 
               
Furniture and equipment, net
    424       478  
Escrow receivable, net
    6,857       6,828  
Long-term investments
    5,347       11,558  
Deferred income taxes – non-current
    1,106       1,106  
Trademarks
    2,142       2,142  
     
Total assets
  $ 108,830     $ 115,184  
     
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
  $ 501     $ 833  
Accrued compensation
    302       648  
Accrued taxes
    80       114  
Excess space reserve
    461       559  
Accrued clinical
    1,230       1,236  
Other accrued liabilities
    706       727  
     
Total current liabilities
    3,280       4,117  
Deferred rent and capital lease obligation
    119       137  
     
Total liabilities
    3,399       4,254  
     
 
               
Stockholders’ Equity
               
Common stock, $.0005 par value; 100,000,000 and 50,000,000 shares authorized; 38,211,642
           
and 38,011,642 shares issued and outstanding
    19       19  
Additional paid-in capital
    170,905       170,905  
Accumulated deficit
    (65,493 )     (59,994 )
     
Total stockholders’ equity
    105,431       110,930  
     
 
               
Total liabilities and stockholders’ equity
  $ 108,830     $ 115,184  
     

See notes to the financial statements

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ORTHOLOGIC CORP.
(A Development Stage Company)

STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(Unaudited)
                         
                    As a Development  
    Three months ended March 31,     Stage Company  
OPERATING EXPENSES   2005     2004     8/5/04 –3/31/05  
     
General and administrative
  $ 910     $ 555     $ 2,788  
Research and development
    5,403       3,371       13,483  
CPM divestiture and related gains
    (250 )     (111 )     (375 )
CBI in process research and development
    0       0       25,840  
 
                 
Total operating expenses
    6,063       3,815       41,736  
Interest income, net
    552       306       1,303  
 
                 
Loss from continuing operations before taxes
    (5,511 )     (3,509 )     (40,433 )
Income tax benefit
    (12 )     (294 )     (654 )
 
                 
Net loss from continuing operations
    (5,499 )     (3,215 )     (39,779 )
Discontinued operations (Note 3)
                       
Net gain on the sale of the Bone Device Business, net of tax benefit of ($363)
    0       0       2,048  
 
                 
Net income from discontinued operations
    0       0       2,048  
 
                 
NET LOSS
  $ (5,499 )   $ (3,215 )   $ (37,731 )
 
                 
 
                       
Per Share Information:
                       
Net loss from continuing operations
                       
Basic
  $ (0.14 )   $ (0.09 )        
 
                   
Diluted
  $ (0.14 )   $ (0.09 )        
 
                   
Net income from discontinued operations
                       
Basic
  $ 0.00     $ 0.00          
 
                   
Diluted
  $ 0.00     $ 0.00          
 
                   
Net loss
                       
Basic
  $ (0.14 )   $ (0.09 )        
 
                   
Diluted
  $ (0.14 )   $ (0.09 )        
 
                   
 
                       
Basic and diluted shares outstanding
    38,047       34,310          
 
                   

     See notes to the financial statements

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     ORTHOLOGIC CORP.

(A Development Stage Company)
STATEMENTS OF CASH FLOW
(in thousands)
(Unaudited)
                         
                    As a Development  
    For three months ended March 31,     Stage Company  
    2005     2004     8/5/2004 - 3/31/2005  
     
OPERATING ACTIVITIES
                       
Net loss
  $ (5,499 )   $ (3,215 )   $ (37,731 )
Non Cash items:
                       
Depreciation and amortization
    59       70       118  
Escrow account amortization
            (29 )     (48 )
Performance based stock options
                    (56 )
Deferred tax asset
                    (336 )
Gain on sale of bone stimulator business
                    (2,048 )
CBI in process R&D
                    25,840  
Net change in assets and liabilities:
                       
Accounts receivable
    5       444       57  
Prepaids and other current assets
    (85 )     (207 )     367  
Deposits and other assets
                    (75 )
Accounts payable
    (332 )     464       (219 )
Accrued liabilities
    (523 )     (2,191 )     260  
     
Cash flows used in operating activities
    (6,404 )     (4,691 )     (13,815 )
     
INVESTING ACTIVITIES
                       
Expenditures for equipment and furniture
    (5 )     (32 )     (56 )
Cash paid for assets of CBI
                    (3,668 )
Purchases of investments
    (15,135 )     (21,181 )     (59,701 )
Maturities of investments
    13,160       4,863       50,464  
     
Cash flows used in investing activities
    (1,980 )     (16,350 )     (12,961 )
     
FINANCING ACTIVITIES
                       
Net proceeds from stock exercises
            3,798       1,362  
     
Cash flows provided by financing activities
            3,798       1,362  
     
NET DECREASE IN CASH AND CASH EQUIVALENTS
    (8,384 )     (17,243 )     (25,414 )
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    38,377       82,357       55,407  
     
CASH AND CASH EQUIVALENTS, END OF PERIOD
  $ 29,993     $ 65,114     $ 29,993  
     
 
                       
Supplemental Disclosure of Non-Cash Investing Activities
                       
Cash paid during period for Interest
        $ 2        
Cash paid during period for Income taxes
        $ 1,474        
CBI Acquisition
                       
Current assets acquired
                  $ 29  
Trademarks acquired
                    2,142  
Liabilities acquired
                    (140 )
Original investment reversal
                    (750 )
In-process R&D acquired
                    25,840  
Common stock issued for acquisition
                    (23,453 )
 
                     
Cash paid for CBI acquisition
                  $ 3,668  
 
                     

See notes to the financial statements

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ORTHOLOGIC CORP.
(A Development Stage Company)

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     Description of the business.

     OrthoLogic is a drug development company focused on the healing of musculoskeletal, orthopedic, dermal and cardiovascular tissue through biopharmaceutical approaches. Our research is focused exclusively on the potential commercialization of our Chrysalin® Product Platform. Chrysalin, or TP508, is a 23-amino acid synthetic peptide representing a receptor-binding domain of the human thrombin molecule, a naturally occurring molecule in the body responsible for blood clotting and acceleration of the natural cascade of healing events in both soft tissue and bone repair.

     On August 5, 2004, we purchased substantially all of the assets and intellectual property of Chrysalis Biotechnology, Inc. (“CBI”), including its exclusive worldwide license for Chrysalin for all medical indications, for $2.5 million in cash and $25.0 million in OrthoLogic common stock (See Note 2). We became a development stage entity commensurate with the acquisition.

     Prior to November 26, 2003, we developed, manufactured and marketed proprietary, technologically advanced orthopedic products designed to promote the healing of musculoskeletal bone and tissue, with particular emphasis on fracture healing and spine repair. Our product lines included bone growth stimulation and fracture fixation devices, which we sometimes refer to as our “Bone Device Business.” On November 26, 2003, we sold our Bone Device Business. Our principal business remains focused on the healing of musculoskeletal tissue, although through biopharmaceuticals approaches rather than through the use of medical devices.

     As of March 31, 2005, we had cash and cash equivalents of $30.0 million, short-term investments of $61.8 million and long-term investments of $5.3 million. We will be relying on these resources to fund the current development, testing and commercialization of our Chrysalin Product Platform. If we accelerate the development of our gel and microsphere formulations to initiate potential studies in the area of diabetic foot ulcer healing, spinal fusion and cartilage defect repair, we will need to obtain additional funding, through the possible sale of securities, licensing agreements, or other sources of funding, to continue our development program.

     In these notes, references to “we”, “our” and the “Company” refer to OrthoLogic Corp. and its subsidiaries. References to our Bone Device Business refer to our former business line of bone growth stimulation and fracture fixation devices, including the OL1000 product line, SpinaLogic®, OrthoFrame® and OrthoFrame/Mayo.

Financial Statement Presentation

     In the opinion of management, the unaudited interim financial statements include all adjustments necessary for the fair presentation of our financial position, results of operations,

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and cash flows. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the complete fiscal year. The balance sheet as of December 31, 2004 is derived from our audited financial statements included in the 2004 Annual Report on Form 10-K. These financial statements should be read in conjunction with the financial statements and notes thereto included in the 2004 Annual Report on Form 10-K.

     Development stage. Upon our acquisition of CBI on August 5, 2004, we became a development stage entity, which requires the cumulative presentation of operations since August 5, 2004. Discontinued operations relate to the sale of the Company’s bone device business in November 2003.

     Use of estimates. The significant estimates include the Chrysalis Biotechnology, Inc. purchase price allocation, discontinued operations, representations and warranties reserve, income taxes, contingencies, litigation, accrued clinical and excess space reserve.

     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. Auction-rate securities are securities with an underlying component of a long-term debt or an equity instrument. Auction-rate securities trade or mature on a shorter term than the underlying instrument based on an auction bid that resets the interest rate of the security. The Company had previously classified its auction-rate securities as cash equivalents based on the period from the purchase date to the first reset date. The Company has reclassified $2.0 million of auction-rate securities from cash equivalents to short-term marketable securities for the periods ended March 31, 2005 and December 31, 2004.

     B. 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 the 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.

     We 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 requires that we evaluate long-lived assets based on the net future cash flow expected to be generated from the asset on an undiscounted basis whenever significant events or changes in circumstances occur that indicate that the carrying amount of an asset may not be recoverable.

     C. Excess Space Reserve. We lease a facility in Tempe, Arizona and sublease portions to other tenants. We have established a reserve for the period the sublease space is anticipated to be vacant. In the opinion of management, the reserve balance of $488,000 net a discount of $27,000 at March 31, 2005 is appropriate to allow for the portion of the building that we may not have leased to a tenant.

     D. Income taxes. Under SFAS No. 109, “Accounting for Income Taxes,” income taxes are recorded based on current year amounts payable or refundable, as well as the consequences of events that give rise to deferred tax assets and liabilities. We base our estimate of current and deferred taxes on the tax laws and rates that are currently in effect in the appropriate jurisdictions. Pursuant to SFAS No. 109, we have determined that the majority of the deferred

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tax assets at March 31, 2005 require a valuation allowance. We believe it is more likely than not that we will have taxable income in the future, therefore, we believe the remaining deferred tax asset of $1.1 million will be realized as it relates to alternative minimum tax credits that do not expire.

     E. Research and development. Research and development represents costs incurred internally for research and development activities, costs incurred to fund the research activities we have contracted externally and certain milestone payments regarding the continued clinical testing of Chrysalin. All research and development costs are expensed when incurred.

     F. Accrued Clinical. Accrued clinical represents the liability recorded on a per patient basis of the costs incurred for our human clinical trials. Total patient costs are based on the specified clinical trial protocol, recognized over the period of time service is provided to the patient. We have committed to provide funding for patients at various stages in the ongoing clinical trials. We have $1.2 million accrued for services that have already been provided to the patients at March 31, 2005. We have an additional commitment of $627,000 to the clinical sites for the completion of the trials for those patients already enrolled.

     G. Stock-based compensation. At March 31, 2005, we had two stock-based employee compensation plans. We account for those plans under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. In the quarter ended March 31, 2004 we recorded a reduction of approximately $56,000 in compensation expense related to the vesting of the performance-based options.

     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. We have provided the required additional annual disclosures below which illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation (in thousands except per share data).

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    Three months ended March 31,  
    2005     2004  
Estimated weighted-average fair value of options granted during the period
  $ 2.66     $ 2.45  
     
 
               
Net loss attributable to common stockholders:
               
As reported
  $ (5,499 )   $ (3,215 )
Stock based compensation expense
    (172 )     (600 )
     
Pro forma
  $ (5,671 )   $ (3,815 )
     
 
               
Basic net loss per share:
               
As reported
  $ (0.14 )   $ (0.09 )
Pro forma
  $ (0.15 )   $ (0.11 )
Diluted net loss per share:
               
As reported
  $ (0.14 )   $ (0.09 )
Pro forma
  $ (0.15 )   $ (0.11 )
Black Scholes model assumptions:
               
Risk free interest rate
    3.9 %     2.4 %
Expected volatility
    44 %     50 %
Expected term
  2.7 Years   2.7 Years
Dividend yield
    0 %     0 %

     The sale of the Bone Device Business was considered an accelerating event for our stock-based compensation plans. Terminated employees’ unvested options vested immediately upon the sale. Our directors and employees who were retained had 75% of their unvested options vest upon the sale, with the remainder vesting over a 12 month period or on their regular vesting period, whichever is earlier.

     H. Loss per common share. Loss per common share is computed on the weighted average number of common or common and equivalent shares outstanding during each year. Basic earnings per share is computed as net loss divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects the potential dilution that could occur from common shares issuable through stock options, warrants, and other convertible securities when the effect would be dilutive.

     I. Discontinued operations. Under SFAS No. 144, “Accounting for the Impairment and Disposal of Long-Lived Assets,” discontinued operations are reported if a component of the entity is held for sale or sold during the period. The Bone Device Business qualified as a component of the entity under the standard as of the November 26, 2003 sale date. Therefore, the gain on the sale of the Bone Device Business have been presented as discontinued operations in the financial statements.

     J. Recognition of escrow receivable and indemnification. The $7.5 million of the purchase price payable to us from dj Orthopedics, LLP related to the sale of the Bone Device Business was required to be placed in escrow. 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

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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. We issued certain representations and warranties in conjunction with the sale of Bone Device Business and initially determined the discounted fair value to be approximately $1.9 million. Fair value was based on management estimates of future probable cash flows discounted at four percent, which represented the company’s rate of borrowing at the time of sale. The discount is being accreted to interest expense through November 26, 2005, which is when the portion of the purchase price allocated to the representations and warranties is required to be released from escrow. Based on the elimination of most of the potential exposure to the risks in the representations and warranties in the asset purchase agreement governing the sale of the Bone Device Business during 2004, the reserve was decreased and is included in net gain on the sale of the Bone Device Business in the statement of operations, leaving a net reserve of approximately $237,000.

     K. New Accounting Pronouncements.

     In March 2004, the Financial Accounting Standards Board (“FASB”) issued Emerging Issues Task Force Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“EITF 03-1”). EITF 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB issued Staff Position EITF 03-1-1, which delays the effective date until additional guidance is issued for the application of the recognition and measurement provisions of EITF 03-1 to investments in securities that are impaired. We do not believe that the adoption of EITF 03-1 will have a material impact on our financial condition or results of operations.

     In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123®, Share-Based Payment (“SFAS No. 123®”), which requires the compensation cost related to share-based payments, such as stock options and employee stock purchase plans, be recognized in the financial statements. SFAS No. 123® is effective for all years beginning after June 15, 2005, and, thus, will be effective for us beginning with the first quarter of fiscal year 2006. We are currently evaluating the impact of SFAS No. 123® on our financial condition and results of operations. See Note 1 for information related to the pro forma effects on our reported net income and net income per share of applying the fair value recognition provisions of the previous Statement of Financial Accounting Standards 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

     In December 2004, the FASB issued Statement of Financial Accounting Standards No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions (“SFAS No. 153”). SFAS No. 153 requires that exchanges of nonmonetary assets are to be measured based on fair value and eliminates the exception for exchanges of nonmonetary, similar productive assets, and adds an exemption for nonmonetary exchanges that do not have commercial substance. We will be required to adopt SFAS No. 153 beginning in the first quarter of fiscal 2006. We do not believe that the adoption of SFAS No. 153 will have a material impact on our financial condition or results of operations.

     L. Certain reclassifications. Certain reclassifications have been made to the prior year financial statements to conform to the 2005 presentation.

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2. ASSET ACQUISITION OF CHRYSALIS BIOTECHNOLOGY, INC.

     In January 1998, we acquired a minority equity investment (less than 10%) in CBI for $750,000. As part of the transaction, we were awarded a worldwide exclusive option to license the orthopedic applications of Chrysalin, a patented 23-amino acid synthetic peptide that had shown promise in accelerating the healing process.

     On August 5, 2004, we purchased substantially all of the assets and intellectual property of CBI, including its exclusive worldwide license for Chrysalin for all medical indications for $2.5 million in cash and $25.0 million in OrthoLogic common stock issued. We issued 3,462,124 shares of OrthoLogic common stock to CBI for this transaction based on the 10-day average closing price of $7.221. Pursuant to the terms of the definitive agreement, we must issue an additional number of shares of OrthoLogic common stock valued at $7.0 million upon the occurrence of certain trigger events, which include the sale or other transactions that result in a change of control of OrthoLogic or the acceptance by the U.S. Food and Drug Administration of a new drug application for a product based on Chrysalin, if either such trigger occurs within five years of closing. The largest portion of the purchase price and acquisition costs was expensed as In-process Research and Development of $25.8 million. The remainder of the purchase price was allocated to trademarks totaling $2.1 million, liabilities of $140,000 and other assets of $29,000. If a triggering event occurs, the additional $7.0 million will be allocated in the same manner as the initial purchase price.

3. INVESTMENTS AND FAIR VALUE DISCLOSURES

     At March 31, 2005 marketable securities consisted of municipal and corporate bonds and ARS, and were classified as held-to-maturity and as available-for-sale securities, respectively. Such classification requires these securities to be reported at amortized cost unless they are deemed to be permanently impaired in value.

     A summary of the fair market value and unrealized gains and losses on these securities is as follows (in thousands):

                 
Investments with maturities – Short-term   March 31,     December 31,  
             
    2005     2004  
     
Amortized cost
  $ 61,828     $ 53,642  
Gross unrealized (loss) gain
    (244 )     (110 )
 
           
Fair value
  $ 61,584     $ 53,532  
 
           
                 
Investments with maturities – Long term   March 31,     December 31,  
             
    2005     2004  
     
Amortized cost
  $ 5,347     $ 11,558  
Gross unrealized (loss) gain
    (49 )     (74 )
 
           
Fair value
  $ 5,298     $ 11,484  
 
           

     The fair values were determined by reference to quoted market prices. On March 31, 2005 we held one security that was considered a trading security, and was therefore recognized at a market value of $48,612.

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     For our cash and cash equivalents, the carrying amount is assumed to be the fair market value because of the liquidity of these instruments. The carrying amount is assumed to be the fair value for accounts receivable, accounts payable and other accrued expenses because of the short maturity of the portfolios. Our long-term investments mature within one year of our short term investments. Therefore, management believes the fair values approximate the carrying values of these financial instruments.

4. LITIGATION

     OrthoLogic Corp. v. Maricopa County, Superior Court of the State of Arizona, Arizona Tax Court, No. TX2004-000657. On October 28, 2004, the Company filed a complaint and notice of tax appeal against Maricopa County. The Maricopa County Assessor valuated the Corporation’s leased property located at 1275 W. Washington St., Tempe, AZ 85281 and billed the Company in the amount of $229,000 for the 2004 personal property tax. The Company has paid $229,000 of the property tax bill for 2004, and accrued $57,000 for the amount due through March 31, 2005. The leased property is owned by the City of Tempe and the underlying real property is owned by Salt River Project, an agricultural improvement district. The leased property was previously exempt from personal property taxes. Upon information and belief, the Company has been taxed pursuant to a recent change in the state taxation law that allows taxation in the name of the lessee or sublessee of otherwise tax-exempt improvements located on land owned by an agricultural improvement district. The Company believes that this taxation is illegal and if legal, was applied incorrectly. The Company intends to pursue this matter vigorously.

     The Company is involved in various legal proceedings that arise in the ordinary course of business. In management’s opinion, the ultimate resolution of these other legal proceedings are not likely to have a material adverse effect on the financial position, results of operations or cash flows of the Company.

     The health care industry is subject to numerous laws and regulations of federal, state, and local governments. Compliance with these laws and regulations, specifically those relating to the Medicare and Medicaid programs, can be subject to government review and interpretations, as well as regulatory actions unknown and unasserted at this time. Recently, federal government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of regulations, which could result in the imposition of significant fines and penalties, as well as significant repayments of previously billed and collected revenues from patient services. Management believes that the Company is in substantial compliance with current laws and regulations.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

     When used in this report, the terms “OrthoLogic,” “we,” “our,” or “us” refer to OrthoLogic Corp. or OrthoLogic Corp. and its subsidiaries, as appropriate in the context.

     The following is management’s discussion of significant events in the quarter ended March 31, 2005 and factors that affected OrthoLogic’s interim financial condition and results of operations. This should be read in conjunction with our “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on

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Form 10-K for the year ended December 31, 2004 and the “Special Note Regarding Forward Looking Statements” below, following “Liquidity and Resources.”

Overview

     On November 26, 2003, we sold our Bone Device Business, which included all our revenue producing operations. After the sale, we continued our research of Chrysalin in orthopedic indications. On August 5, 2004, we purchased substantially all of the assets and intellectual property of Chrysalis Biotechnology, Inc. (“CBI”), including its exclusive worldwide license for Chrysalin for all medical indications. We are now a drug development company focused on the healing of musculoskeletal, orthopedic, dermal and cardiovascular tissue through biopharmaceutical approaches, and are considered a development stage company. Our research is focused exclusively on the potential commercialization of our Chrysalin Product Platform. Chrysalin, or TP508, is a 23-amino acid synthetic peptide representing a receptor-binding domain of the human thrombin molecule, a naturally occurring molecule in the body responsible for blood clotting and acceleration of the natural cascade of healing events in both soft tissue and bone repair. The Chrysalin molecule serves as the basis for a family of potential therapeutic products we refer to collectively as the “Chrysalin Product Platform.” We are reviewing the following potential medical applications for Chrysalin:

  •   fracture repair;
 
  •   diabetic ulcer healing;
 
  •   spine fusion;
 
  •   cartilage defect repair;
 
  •   cardiovascular repair, and
 
  •   ligament and tendon repair.

     We believe these potential indications represent market opportunities in key areas of unmet medical needs and we are developing Chrysalin formulations that may address these markets.

     Research and Development of the Chrysalin Product Platform

     Fracture Repair

     We completed patient enrollment in our Phase 3 human clinical trial evaluating the efficacy of Chrysalin in patients with unstable and/or displaced distal radius (wrist) fractures in May 2005. We enrolled a total of 502 study patients in 27 health centers throughout the United States. This primary efficacy endpoint in the trial is to measure how quickly wrist fractures in patients injected with Chrysalin heal, as measured by the removal of immobilization, which allows the patients to initiate hand therapy and regain full function of their wrists and hands. The clinical trial’s secondary efficacy endpoints include radiographic healing, as well as clinical, functional, and patient outcome parameters. To date, there have been no adverse events related to Chrysalin reported in this Phase 3 trial. We are currently collecting the data for the Phase 3 study and data permitting, expect to release initial efficacy results in the first half of 2006.

     We are also conducting a Phase 2b human clinical trial to provide dosing information to support our potential future fracture repair new drug application (“NDA”). In the quarter ended March 31, 2005, we experienced a supply disruption of the injectible form of Chrysalin used in the Phase 2b dose-ranging human clinical trial. This interruption was resolved by amending the investigational new drug (“IND”) application protocol for the Phase 2b trial to

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utilize a different supply source of Chrysalin. Enrollment in this trial has been slowed as we continue to obtain Institutional Review Board (“IRB”) approval of the amended protocol from the clinical trial sites.

     Diabetic Foot Ulcer Healing

     Our preclinical studies and initial Phase 1/2 human clinical trial evaluated Chrysalin as a potential product for diabetic ulcer healing in a saline formulation. We are currently developing a gel formulation for a Chrysalin-based product candidate for diabetic foot ulcer healing. The start date for our next human clinical trial for this indication will depend on successful completion of the gel formulation work and formulation-bridging preclinical studies, and the submission of a formulation amendment to the existing and active IND for this indication.

     Spine Fusion

     Our preclinical studies on spine fusion address questions of safety and efficacy when the Chrysalin peptide is used for spine fusion surgeries. OrthoLogic is currently collecting data from its pilot Phase 1/2 clinical trial for spine fusion, which completed enrollment in the spring of 2004. We expect to have preliminary results this summer. To date, there have been no adverse events in this trial that were reported to be related to Chrysalin and patient follow-up has been excellent.

     Cartilage Defect Repair

     OrthoLogic has completed several steps necessary to submit an IND application for a Chrysalin-based product candidate for cartilage defect repair. Data permitting, we plan to submit an IND to the FDA to begin a human clinical trial for this indication.

     Cardiovascular Repair

     OrthoLogic is evaluating various delivery mechanisms for a Chrysalin product candidate for myocardial revascularization, as well as completing a series of preclinical studies to support clinical development for this indication.

     Ligament and Tendon Repair

     We began our first Chrysalin preclinical tendon repair study in collaboration with an academic institution. We expect to have data from this study during 2005.

     Outlook

     The process to obtain regulatory approval from the FDA to market a new drug is long and expensive, requiring FDA permission to proceed from one step to the next. The FDA approval process culminates in the FDA’s acceptance of a NDA, after which the new drug may be marketed to the public. Because the drug approval process is a long, multi-step procedure and a company’s progress through the process depends highly on the findings of the studies conducted at each step, it is not possible to predict an anticipated new drug application filing date or ultimate commercialization date with any confidence until quite far along in the process.

     Our development plans for the fracture repair indication had projected a potential NDA filing, data and patient enrollment permitting, before the end of 2006. Due to 1) slower enrollment in the Phase 3 human clinical trial; 2) the supply disruption of the Chrysalin-based

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injectable for the Phase 2b study, which resulted in a delay of patient enrollment; and 3) a more conservative FDA drug approval process, we do not anticipate a NDA filing for the fracture repair will occur in 2006. Furthermore, we will be unable to project when a potential NDA filing for this indication will occur prior to conducting a meeting with the FDA in the first half of 2006 to discuss preliminary efficacy data derived from the Phase 3 trial. At that time, we will have significantly more visibility in projecting the timeframe to file a NDA for this indication.

     Due to the unpredictable timing and path a research project takes to reach the NDA phase, we cannot provide estimates for the cost for any indication to reach the NDA phase until the research is quite advanced. For our acceleration of fracture repair indication, we expect to spend approximately $45 million to complete our current Phase 3 clinical trial and our Phase 2b trial. Upon successful completion of these studies, we may conclude additional research and development is needed to prepare our NDA filing. The actual funds needed may change substantially based on the results of the studies, questions from the FDA that require us to do other studies, changes in regulations and a number of other factors that are out of our control. We expect to increase our 2005 research and development expenses to approximately $28.0 million from our 2004 total of $17.1 million. We expect our aggregate 2005 cash expenditures for all our expenses to be approximately $32.0 million, which will be offset by the expected receipt of the $7.0 million escrow receivable from the sale of our bone growth stimulation business in 2003. Our $32.0 million estimate is based on current research and development plans and expected enrollment in the Phase 2b human clinical study. We are assuming our annual cash expenditures will continue to increase as we complete the fracture repair studies to support a NDA filing. If we accelerate the development of our gel and microsphere formulations to initiate potential studies in diabetic foot ulcer healing, spinal fusion and cartilage defect repair, we will need to obtain additional funding, through the possible sale of securities, licensing agreements, or other sources of funding, to continue our development program.

     OrthoLogic cautions that its future cash expenditure levels are difficult to estimate. The estimates for research and development expenditures and aggregate annual expenditures given above are based on a number of assumptions concerning the number of research projects OrthoLogic pursues, the pace at which it pursues them, the indications that are prioritized, the quality of the data collected and the requests of the FDA to expand, narrow or conduct additional clinical trials and data analysis. Changes in any of these assumptions can change OrthoLogic’s estimated cash expenditure levels significantly.

Critical Accounting Policies and Estimates

     Income Taxes: SFAS No. 109 “Accounting for Income Taxes” 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 the 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 included in past earnings history, expected future earnings, the character and jurisdiction of such earnings, unsettled circumstances that, if unfavorably resolved, would adversely affect utilization of a deferred tax asset, carryback and carryforward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred asset. We believe it is more likely than not that we will have taxable income in the future, therefore, we believe the remaining deferred tax asset of $1.1 million will be realized as it relates to alternative minimum tax credits that do not expire.

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     Discontinued Operations: Under SFAS No. 144, “Accounting for the Impairment and Disposal of Long-Lived Assets,” discontinued operations are reported if a component of the entity is held for sale or sold during the period. The Bone Device Business qualifies as a component of the entity under the standard. Therefore, the gain from the sale of the Bone Device Business and the related operational results, have been presented as discontinued operations in the financial statements.

     Liability for Representations and Warranties Made in Conjunction with the Sale of the Bone Device Business: Under FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of the Indebtedness of Others,” indemnifications, representations and warranties issued in conjunction with the sale of a business are required to be valued and recorded in the financial statements. We made certain representations and warranties in conjunction with the sale of the Bone Device Business and determined the discounted fair value to be approximately $1.9 million at the time of closing the sale. We received updated information during the third quarter of 2004 that eliminated most of the potential exposure of the representations and warranties in the Asset Purchase Agreement pursuant to which the Bone Device business was sold, substantiating a decrease in the reserve of approximately $1.7 million, leaving a net reserve of approximately $237,000. This decrease in the reserve resulted in an additional $1.7 million gain to be recognized on the sale of the Bone Device Business. The discount is being accreted to interest expense through November 26, 2005, which is when the portion of the purchase price allocated to the representations and warranties is required to be released from escrow.

     Excess Space Reserve: We lease a facility in Tempe, Arizona. This approximately 100,000 square foot facility is designed and constructed for industrial purposes and is located in an industrial district. We have subleased approximately 13,500 square feet of the building to a third party through May 2005 and another 18,900 through March 2005. We believe the facility is well-maintained and adequate for use in the foreseeable future. We believe the remainder of the facility that we are using is suitable for our purposes and is effectively utilized. While we believe the facility is well maintained and adequate for use in the foreseeable future, there can be no guarantee that a new lessee will assume the remaining lease obligation. At March 31, 2005 the reserve balance totaled $488,000, net a discount of $27,000 to accrue for the period the available sublease space is anticipated to be vacant. In the opinion of management, the reserve balance is adequate to allow for time necessary to secure an additional tenant for the building.

     Accrued Clinical: Accrued clinical represents the liability recorded on a per patient basis of the costs incurred for our human clinical trials. Total patient costs are based on the specified clinical trial protocol, recognized over the period of time service is provided to the patient. We have committed to provide funding for patients at various stages in the ongoing clinical trials. We have $1.2 million accrued for services that have already been provided to the patients as of March 31, 2005. We have an additional commitment of $627,000 to the clinical sites for the completion of the trials.

Results of Operations Comparing Three-Month Period Ended March 31, 2005 to the Corresponding Period in 2004.

     Revenues, Cost of Revenues and Gross profits: We had no revenues, costs of revenues, or gross profit from continuing operations in the first quarter of 2005 or 2004. Our former bone stimulation device business revenue is included as discontinued operations and is presented

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reflecting only the net income after tax under the line item “Income from operations of Bone Device Business, net of taxes.”

     General and Administrative (“G&A”) Expenses: G&A expenses related to our ongoing development operations increased by 64% from $555,000 in the first quarter of 2004 to $910,000 in the first quarter of 2005. Our administrative expenses during the first quarter of 2005 were higher then the same period of 2004 primarily as a result of the addition of the Galveston, Texas location with the acquisition of the CBI assets in August of 2004.

     Research and Development Expenses: Research and development expenses were $5.4 million for the first three months in 2005 compared to $3.4 million for the first three months in 2004. Our research and development expenses rose 60% in the first quarter of 2005 over the same period in 2004 primarily due to the increase in the number of patients enrolled in our Phase 3 human clinical trial and commencement of our Phase 2b dose-ranging trial for fracture repair. In addition, we increased our investment in research for new indications and related formulations after we purchased CBI. The primary focus of our current research and development work is our fracture repair indication. Following fracture repair, the second primary area of focus is the gel formulation work for a Chrysalin-based product candidate for diabetic foot ulcer healing. Our research emphasis is always subject to change based on the results of our studies and market forces, but we currently expect to continue to expand these programs. In 2005, we expect our research and development expenses to increase from the 2004 total of $17.1 million to approximately $28.0 million.

     CPM Divestiture and Change in Estimated Collectibility of CPM Receivables: We sold the continuous passive motion (“CPM”) business in July 2001, to OrthoRehab, Inc. Under the CPM asset purchase agreement, we were eligible to receive up to an additional $2.5 million of cash if certain objectives were achieved by OrthoRehab, Inc. We settled litigation over the $2.5 million payment and other matters in April 2003. OrthoRehab, Inc. agreed to pay $1.2 million, with interest, to settle the contingent payment due to us, and all outstanding claims between the two companies. We had previously applied $917,000 towards the settlement. In February 2005, we received a settlement payment for $250,000. There will be no additional payments on the settlement.

     Interest Income, Net: Interest Income, net increased from $306,000 in the first quarter of 2004 to $552,000 in the first quarter of 2005. The net increase in interest income is due to the increase in interest rates between the two periods.

     Net Loss: We incurred a net loss in the first three months of 2005 of $5.5 million compared to a net loss of $3.2 million in the first three months of 2004. The net loss in the first quarter of 2005 is primarily related to the increased spending on our research and development programs totaling $5.4 million. The net loss in 2004 is also comprised primarily of the spending on research and development programs totaling $3.4 million for the quarter.

Liquidity and Capital Resources

     We have historically financed our operations through operating cash flows and the public and private sales of equity securities. However, with the sale of our bone stimulation device business in November 2003, we sold all of our revenue producing operations. Since that time, we have relied on our cash and investments to finance all our operations, the focus of which is research and development of our Chrysalin Product Platform. At March 31, 2005, we had cash

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and cash equivalents of $30.0 million, short-term investments of $61.8 million and long-term investments of $5.3 million.

     We currently do not expect to make significant capital investments during the remainder of 2005, but anticipate increasing our research and development expenditures related to the human clinical trials for Chrysalin in fracture repair and for further studies in diabetic foot ulcers, articular cartilage repair and cardiovascular indications. We expect our annual research and development expenses to increase from $17.1 million in 2004 to approximately $28.0 during 2005. Based on current research and development plans, we expect our 2005 cash expenditures to be approximately $32.0 million. Assuming the collection of the $7.0 million escrow balance, our net cash expenditures will be approximately $25.0 million for 2005. If we accelerate the development work for the other indications, we will need to obtain additional funding, through the possible sale of securities, licensing agreements, or other sources of funding, to continue our development program.

     Our decision to accelerate the development of additional indications for Chrysalin, and possibly identify other areas of interest for our research program, will require us to identify other resources of capital to continue our research programs. However, the timing and amounts of cash used will depend on many factors, including our ability to continue to control our expenditures related to our current research and development programs, the possibility of expanding our clinical trials or the possibility of considering other opportunities in the market.

     Our fracture repair indication studies currently make up the largest portion of our research and development expenses. We have estimated we will spend approximately $45 million more to complete our current Phase 3 and our Phase 2b clinical trials. If the results from the studies are not favorable or the FDA requires additional studies that delay our ability to complete a NDA filing, we may have to reallocate funding away from other indication research projects, delaying their development, or pursue other funding. Because research in our other indications is at an earlier phase than our fracture repair indication and the research process is long and highly unpredictable, we cannot currently estimate the cost related to the research and development of the other indications.

     The following table sets forth all known commitments as of March 31, 2005 and the year in which these commitments become due or are expected to be settled (in thousands):

                         
Year   Operating Leases (1)     Other (2)     Total (3)  
     
2005
  $ 866     $ 4,026     $ 4,892  
2006
  $ 1,149           $ 1,149  
2007
  $ 1,038           $ 1,038  
     
 
                       
Total
  $ 3,053     $ 4,026     $ 7,079  
 
                 

  (1)   A lease commitment of $3.1 million refers to our real property leases in Tempe, Arizona and Galveston, Texas. In Tempe, we occupy approximately 20% of the building. Approximately 44% of the facility is subleased through March 2005 and 18% is subleased through May of 2005.
 
  (2)   Includes the accrued clinical expenses of $1.2 million for services that have been provided to the patients. An additional commitment of $627,000 will be due to clinical sites for the completion of the trials, assuming the patients currently

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      enrolled complete the trial protocol, and is reflected in the total liabilities table above.
 
  (3)   We anticipate paying all our liabilities with our cash resources.

Risks

     OrthoLogic may from time to time make written or oral forward-looking statements, including statements contained in our filings with the Securities and Exchange Commission and our reports to stockholders. The safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 protects companies from liability for their forward looking statements if they comply with the requirements of that Act. This Quarterly Report on Form 10-Q contains forward-looking statements made pursuant to that safe harbor. These forward-looking statements relate to future events or to our future financial performance, and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. In some cases, you can identify forward-looking statements by the use of words such as “may,” “could,” “expect,” “intend,” “plan,” “seek,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue,” or the negative of these terms or other comparable terminology. You should not place undue reliance on forward-looking statements since they involve known and unknown risks, uncertainties and other factors which are, in some cases, beyond our control and which could materially affect actual results, levels of activity, performance or achievements. Factors that may cause actual results to differ materially from current expectations, which we describe in more detail in this section titled “Risks,” include, but are not limited to:

  •   unfavorable results of our product candidate development efforts;
 
  •   unfavorable results of our pre-clinical or clinical testing;
 
  •   delays in obtaining, or failure to obtain FDA approvals;
 
  •   increased regulation by the FDA and other agencies;
 
  •   the introduction of competitive products;
 
  •   impairment of license, patent or other proprietary rights;
 
  •   failure to achieve market acceptance of our products;
 
  •   the impact of present and future collaborative agreements; and
 
  •   failure to successfully implement our drug development strategy.

     If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary significantly from what we projected. Any forward-looking statement you read in this Quarterly Report on Form 10-Q reflects our current views with respect to future events and is subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, business strategy and liquidity. We assume no obligation to publicly update or revise these forward-looking statements for any reason, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

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Risks of our Business

We are a biopharmaceutical company with no revenue generating operations and high investment costs.

     We expect to incur losses for a number of years as we expand our research and development projects. There is no assurance that our current level of funds will be sufficient to support all research expenses to achieve commercialization of any of our product candidates. On November 26, 2003, we sold all of our revenue generating operations. We are now focused on developing and testing the product candidates in our Chrysalin Product Platform and have allocated most of our resources to bringing these product candidates to the market. We may invest in other orthobiologic or complementary technology in the future, but we have no current specific plans to do so at this time. We currently have no pharmaceutical products being sold or ready for sale and do not expect to be able to introduce any pharmaceutical products for at least several years. As a result of our significant research and development, clinical development, regulatory compliance and general and administrative expenses and the lack of any products to generate revenue, we expect to incur losses for at least the next several years and expect that our losses will increase as we expand our research and development activities and incur significant expenses for clinical trials. Our cash reserves, including the cash received from the sale of our bone growth stimulation device business in November 2003, are the primary source of our working capital. As of the end of the 2004 fiscal year, our cash and investments were approximately $103.6 million. At the end of the first quarter of 2005, our cash and investments were $97.2 million. Based on current research and development plans, we anticipate 2005 cash expenditures to be approximately $32 million, which will be offset by cash receipts from the anticipated receipt of the $7.0 million escrow payment. If we accelerate the development work for the other indications, we will need to obtain additional funding, through the possible sale of securities, licensing agreements, or other sources of funding to continue our development program.

     We do not expect to receive any revenue from product sales until we receive regulatory approval and begin commercialization of our product candidates. We cannot predict when that will occur or if it will occur.

     We caution that our future cash expenditure levels are difficult to forecast because the forecast is based on assumptions about the number of research projects we pursue, the pace at which we pursue them, the quality of the data collected and the requests of the FDA to expand, narrow or conduct again clinical trials and analyze data. Changes in any of these assumptions can change significantly our estimated cash expenditure levels.

Our product candidates are in various stages of development and may not be successfully developed or commercialized.

     If we fail to commercialize our product candidates, we will not be able to generate revenue. We currently do not sell any products. Our product candidates are at the following stages of development:

     
  • Acceleration of Fracture Repair
  Phase 3 human clinical trials
  • Spine Fusion
  Phase 1/2 human clinical trials
  • Cartilage Defect Repair
  Late stage pre-clinical trials
  • Tendon and Ligament Repair
  Early stage pre-clinical trials
  • Dermal Wound Healing
  Phase 1/2 human clinical trials
  • Cardiovascular Repair
  Pre-clinical trials

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We are subject to the risk that:

  •   the FDA finds some or all of our product candidates ineffective or unsafe;
 
  •   we do not receive necessary regulatory approvals;
 
  •   we are unable to get some or all of our product candidates to market in a timely manner;
 
  •   we are not able to produce our product candidates in commercial quantities at reasonable costs;
 
  •   our products undergo post-market evaluations resulting in marketing restrictions or withdrawal of our products; or
 
  •   the patients, insurance and/or physician community does not accept our products.

In addition, our product development programs may be curtailed, redirected or eliminated at any time for many reasons, including:

  •   adverse or ambiguous results;
 
  •   undesirable side effects which delay or extend the trials;
 
  •   inability to locate, recruit, qualify and retain a sufficient number of patients for our trials;
 
  •   regulatory delays or other regulatory actions;
 
  •   difficulties in obtaining sufficient quantities of the particular product candidate or any other components needed for our pre-clinical testing or clinical trials;
 
  •   change in the focus of our development efforts; and
 
  •   re-evaluation of our clinical development strategy.

We cannot predict whether we will successfully develop and commercialize any of our product candidates. If we fail to do so, we will not be able to generate revenue.

Our product candidates are all based on the same chemical peptide, Chrysalin. If one of our product candidates reveals safety or fundamental inefficacy issues in clinical trials, it could impact the development path for all our other current product candidates.

     The development of each of our product candidates in the Chrysalin Product Platform is based on our knowledge and understanding of how the human thrombin molecule contributes to the repair of soft tissue and bone. While there are important differences in each of the product candidates in terms of their purpose (fracture repair, spine fusion, cartilage repair, etc.), each product candidate is focused on accelerating the repair of soft tissue and bone and is based on the ability of Chrysalin to mimic specific attributes of the human thrombin molecule to stimulate the body’s natural healing processes.

     Since we are developing the product candidates in the Chrysalin Product Platform in parallel, we expect to learn from the results of each trial and apply some of our findings to the development of the other product candidates in the platform. If one of the product candidates has negative clinical trial results or is shown to be ineffective, it could impact the development path or future development of the other product candidates in the platform. If we find that one of the biopharmaceutical product candidates is unsafe, it could impact the development of our other product candidates in clinical trials.

Our rights to Chrysalin are licensed from the University of Texas and if the license is invalid or unenforceable, we may lose our rights to use the Chrysalin technology, which would ultimately prevent us from commercializing and selling any Chrysalin-based products.

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     Our rights to the development, use and marketing of all of our therapeutic products within the Chrysalin Product Platform were previously governed by a series of sub-licensing agreements from Chrysalis Biotechnology, Inc. Upon the closing of the 2004 acquisition, the license agreements with Chrysalis were replaced by a direct license agreement with the University of Texas, which we and Chrysalis negotiated in conjunction with the acquisition. Under this direct license, we expanded our previous license for Chrysalin from a license for only orthopedic indications to a license for any and all indications. In return, we must pay the University of Texas continuing royalties and sublicense fees for any income received under the Chrysalin license. We are currently required to pay various other fees in connection with filing and maintaining patents. The license agreement will expire upon the expiration of all licensed patents, and is not subject to termination by the University of Texas, except for fraud by us or a payment default following assignment of the license by us. If we lose our rights to Chrysalin under the license agreement, we would be unable to continue our product development programs and our business and prospects would be materially harmed.

If we cannot protect the Chrysalin patent or our intellectual property generally, our ability to develop and commercialize our products will be severely limited.

     Our success will depend in part on the University of Texas’ and our ability to maintain and enforce patent protection for Chrysalin and each product resulting from Chrysalin. Without patent protection, other companies could offer substantially identical products for sale without incurring the sizable discovery, development and licensing costs that we have incurred. Our ability to recover these expenditures and realize profits upon the sale of products would then be diminished.

     Chrysalin is patented and there have been no successful challenges to the Chrysalin patent. However, if there were to be a challenge to the patent or any of the patents for product candidates, a court may determine that the patents are invalid or unenforceable. Even if the validity or enforceability of a patent is upheld by a court, a court may not prevent alleged infringement on the grounds that such activity is not covered by the patent claims. Any litigation, whether to enforce our rights to use our or our licensors’ patents or to defend against allegations that we infringe third party rights, will be costly, time consuming, and may distract management from other important tasks.

     As is commonplace in the biotechnology and pharmaceutical industry, we employ individuals who were previously employed at other biotechnology or pharmaceutical companies, including our competitors or potential competitors. To the extent our employees are involved in research areas which are similar to those areas in which they were involved at their former employers, we may be subject to claims that such employees and/or we have inadvertently or otherwise used or disclosed the alleged trade secrets or other proprietary information of the former employers. Litigation may be necessary to defend against such claims, which could result in substantial costs and be a distraction to management and which may have a material adverse effect on us, even if we are successful in defending such claims.

     We also rely in our business on trade secrets, know-how and other proprietary information. We seek to protect this information, in part, through the use of confidentiality agreements with employees, consultants, advisors and others. Nonetheless, we cannot assure that those agreements will provide adequate protection for our trade secrets, know-how or other proprietary information and prevent their unauthorized use or disclosure. To the extent that consultants, key employees or other third parties apply technological information independently developed by them or by others to our proposed products, disputes may arise as to the

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proprietary rights to such information, which may not be resolved in our favor. The risk that other parties may breach confidentiality agreements or that our trade secrets become known or independently discovered by competitors, could adversely affect us by enabling our competitors, who may have greater experience and financial resources, to copy or use our trade secrets and other proprietary information in the advancement of their products, methods or technologies.

Some of our product candidates are in early stages of development and may never be commercialized.

     Research, development and pre-clinical testing are long, expensive and uncertain processes. Other than indications for fracture repair, spine fusion, and diabetic ulcer healing, none of our other Chrysalin product candidates has reached clinical trial testing. Our development of Chrysalin for the repair of cartilage defects, ligaments and tendons, and cardiovascular repair is currently in pre-clinical testing or the research stage. Our future success depends, in part, on our ability to complete pre-clinical development of these and other product candidates and advance them to the clinical trials.

     If we are unsuccessful in advancing our early stage product candidates into clinical testing for any reason, our business prospects will be harmed.

The loss of our key management and scientific personnel may hinder our ability to execute our business plan.

     As a small company with 40 employees, our success depends on the continuing contributions of our management team and scientific personnel, and maintaining relationships with the network of medical and academic centers in the United States that conduct our clinical trials. We are most highly dependent on the services of Dr. James Ryaby, our Senior Vice-President and Chief Technology Officer, whom we consider our key scientific employee. A long time employee of OrthoLogic, Dr. Ryaby oversees all of our clinical trials. Like all companies in our field, we face intense competition in our hiring efforts with other pharmaceutical and biotechnology companies, as well as universities and nonprofit research organizations, and we may have to pay higher salaries to attract and retain qualified personnel. The loss of one or more members of our current management team or any of our scientific personnel, could delay our business plan. The loss of Dr. Ryaby could cause a substantial delay in implementing our business plan. We do not maintain key man insurance on Dr. Ryaby.

We face an inherent risk of liability in the event that the use or misuse of our products results in personal injury or death.

     The use of our product candidates in clinical trials, and the sale of any approved products, may expose us to product liability claims, which could result in financial losses. Our clinical liability insurance coverage may not be sufficient to cover claims that may be made against us. In addition, we may not be able to maintain insurance coverage at a reasonable cost or in sufficient amounts or scope to protect us against losses. Any claims against us, regardless of their merit, could severely harm our financial condition, strain our management and other resources and adversely impact or eliminate the prospects for commercialization of the product which is the subject of any such claim.

Our stock price is volatile and fluctuates due to a variety of factors.

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     Our stock price has varied significantly in the past (from a low of $3.28 to a high of $8.96 since January 1, 2003) and may vary in the future due to a number of factors, including:

  •   fluctuations in our operating results;
 
  •   developments in litigation to which we or a competitor is subject;
 
  •   announcements and timing of potential acquisitions, divestitures, and conversions of preferred stock,
 
  •   announcements of technological innovations or new products by us or our competitors;
 
  •   FDA and international regulatory actions;
 
  •   actions with respect to reimbursement matters;
 
  •   developments with respect to our or our competitors’ patents or proprietary rights;
 
  •   public concern as to the safety of products developed by us or others;
 
  •   changes in health care policy in the United States and internationally;
 
  •   changes in stock market analyst recommendations regarding us, other drug development companies or the pharmaceutical industry generally; and
 
  •   general market conditions.

     In addition, the stock market has from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the market price of our stock.

Risks of our Industry

We are in a highly regulated field with high investment costs and high risks.

     Our Chrysalin Product Platform is currently in the human testing phase for three potential products and earlier pre-clinical testing phases for two other potential products. The FDA and comparable agencies in many foreign countries impose substantial limitations on the introduction of new pharmaceuticals 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. Chrysalin, as a new drug, is subject to the most stringent level of FDA review.

     Even after we have invested substantial funds in the development of our three Chrysalin products and even if the results of our current clinical trials are favorable, there can be no guarantee that the FDA will grant approval of Chrysalin for the indicated uses or that it will do so in a timely manner.

     If we successfully bring one or more products to market, there is no assurance that we will be able to successfully manufacture or market the products or that potential customers will buy them if, for example, a competitive product has greater efficacy or is deemed more cost effective. In addition, the market in which we will sell any such products is dominated by a number of large corporations that have vastly greater resources than we have, which may impact our ability to successfully market our products or maintain any technological advantage we might develop. We also would be subject to changes in regulations governing the manufacture and marketing of our products, which could increase our costs, reduce any competitive advantage we may have and/or adversely affect our marketing effectiveness.

The results of our late stage clinical trials may be insufficient to obtain FDA approval, which could result in a substantial delay in our ability to generate revenue.

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     Positive results from pre-clinical studies and early clinical trials do not ensure positive results in more advanced clinical trials. If we are unable to demonstrate that a product candidate will be safe and effective in advanced clinical trials involving larger numbers of patients, we will be unable to submit the NDA necessary to receive approval from the FDA to commercialize that product.

     We are currently conducting a Phase 3 human clinical trial on Chrysalin for fracture repair indications. If we fail to achieve the primary endpoints in this Phase 3 clinical trial or the results are ambiguous, we will have to determine whether to redesign our Chrysalin fracture repair product candidate and our protocols and continue with additional testing, or cease activities in this area. Redesigning the product candidate could be extremely costly and time-consuming. A substantial delay in obtaining FDA approval or termination of the Chrysalin fracture repair product candidate could result in a delay in our ability to generate revenue.

Patients may discontinue their participation in our clinical studies, which may negatively impact the results of these studies and extend the timeline for completion of our development programs.

     As with all clinical trials, we are subject to the risk that patients enrolled in our clinical studies may discontinue their participation at any time during the study as a result of a number of factors, including, withdrawing their consent or experiencing adverse clinical events, which may or may not be judged related to our product candidates under evaluation. We are subject to the risk that if a large number of patients in any one of our studies discontinue their participation in the study, the results from that study may not be positive or may not support a NDA for regulatory approval of our product candidates.

     In addition, the time required to complete clinical trials is dependent upon, among other factors, the rate of patient enrollment. Patient enrollment is a function of many factors, including:

  •   the size of the patient population;
 
  •   the nature of the clinical protocol requirements;
 
  •   the diversion of patients to other trials or marketed therapies;
 
  •   our ability to recruit and manage clinical centers and associated trials;
 
  •   the proximity of patients to clinical sites; and
 
  •   the patient eligibility criteria for the study.

Even if we obtain marketing approval, our products will be subject to ongoing regulatory oversight, which may affect our ability to successfully commercialize any products we may develop.

     Even if we receive regulatory approval of a product candidate, the approval may be subject to limitations on the indicated uses for which the product is marketed or require costly post-marketing follow-up studies. After we obtain marketing approval for any product, the manufacturer and the manufacturing facilities for that product will be subject to continual review and periodic inspections by the FDA and other regulatory agencies. The subsequent discovery of previously unknown problems with the product, or with the manufacturer or facility, may result in restrictions on the product or manufacturer, including withdrawal of the product from the market.

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     If we fail to comply with applicable regulatory requirements, we may be subject to fines, suspension or withdrawal of regulatory approvals, product recalls, seizure of products, operating restrictions and criminal prosecution.

Our product candidates may not gain market acceptance among physicians, patients and the medical community, including insurance companies and other third party payors. If our product candidates fail to achieve market acceptance, our ability to generate revenue will be limited.

     Even if we obtain regulatory approval for our products, market acceptance will depend on our ability to demonstrate to physicians and patients the benefits of our products in terms of safety, efficacy, and convenience, ease of administration and cost effectiveness. In addition, we believe market acceptance depends on the effectiveness of our marketing strategy, the pricing of our products and the reimbursement policies of government and third-party payors. Physicians may not prescribe our products, and patients may determine, for any reason, that our product is not useful to them. Insurance companies and other third party payors may determine not to reimburse for the cost of the therapy. If any of our product candidates fails to achieve market acceptance, our ability to generate revenue will be limited.

Our success also depends on our ability to operate and commercialize products without infringing on the patents or proprietary rights of others.

     Third parties may claim that we or our licensors or suppliers are infringing their patents or are misappropriating their proprietary information. In the event of a successful claim against us or our licensors or suppliers for infringement of the patents or proprietary rights of others, we may be required to, among other things:

  •   pay substantial damages;
 
  •   stop using our technologies;
 
  •   stop certain research and development efforts;
 
  •   develop non-infringing products or methods; and
 
  •   obtain one or more licenses from third parties.

     A license required under any such patents or proprietary rights may not be available to us, or may not be available on acceptable terms. If we or our licensors or suppliers are sued for infringement, we could encounter substantial delays in, or be prohibited from, developing, manufacturing and commercializing our product candidates.

The pharmaceutical industry is subject to stringent regulation, and failure to obtain regulatory approval will prevent commercialization of our products.

     Our research, development, pre-clinical and clinical trial activities and the manufacture and marketing of any products that we may successfully develop are subject to an extensive regulatory approval process by the FDA and other regulatory agencies in the United States and abroad. The process of obtaining required regulatory approvals for drugs is lengthy, expensive and uncertain, and any such regulatory approvals may entail limitations on the indicated usage of a drug, which may reduce the drug’s market potential.

     In order to obtain FDA approval to commercialize any product candidate, a NDA must be submitted to the FDA demonstrating, among other things, that the product candidate is safe and effective for use in humans for each target indication. Our regulatory submissions may be

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delayed, or we may cancel plans to make submissions for product candidates for a number of reasons, including:

  •   negative or ambiguous pre-clinical or clinical trial results;
 
  •   changes in regulations or the adoption of new regulations;
 
  •   unexpected technological developments; and
 
  •   developments by our competitors that are more effective than our product candidates.

     Consequently, we cannot assure that we will make our submissions to the FDA in the timeframe that we have planned, or at all, or that our submissions will be approved by the FDA. Even if regulatory clearance is obtained, post-market evaluation of our products, if required, could result in restrictions on a product’s marketing or withdrawal of a product from the market as well as possible civil and criminal sanctions.

     Clinical trials are subject to oversight by institutional review boards and the FDA to ensure compliance with the FDA’s good clinical practice regulations, as well as other requirements for good clinical practices. We depend, in part, on third-party laboratories and medical institutions to conduct pre-clinical studies and clinical trials for our products and other third-party organizations, usually universities, to perform data collection and analysis, all of which must maintain both good laboratory and good clinical practices. If any such standards are not complied with in our clinical trials, the FDA may suspend or terminate such trial, which would severely delay our development and possibly end the development of a product candidate.

     We also currently and in the future will depend upon third party manufacturers of our products, which are and will be required to comply with the applicable FDA Good Manufacturing Practice regulations. We cannot be certain that our present or future manufacturers and suppliers will comply with these regulations. The failure to comply with these regulations may result in restrictions in the sale of, or withdrawal of the products from the market. Compliance by third parties with these standards and practices are outside of our direct control.

     In addition, we are subject to regulation under state and federal laws, including requirements regarding occupational safety, laboratory practices, environmental protection and hazardous substance control, and may be subject to other local, state, federal and foreign regulation. We cannot predict the impact of such regulations on us, although they could impose significant restrictions on our business and require us to incur additional expenses to comply.

If our competitors develop and market products that are more effective than ours, or obtain marketing approval before we do, our commercial opportunities will be reduced or eliminated.

     Competition in the pharmaceutical and biotechnology industries is intense and is expected to increase. Several biotechnology and pharmaceutical companies, as well as academic laboratories, universities and other research institutions, are involved in research and/or product development for various treatments for or involving fracture repair, diabetic ulcer healing, spine fusion surgery, cartilage defect repair, cardiovascular repair and ligament and tendon repair. Many of our competitors have significantly greater research and development capabilities, experience in obtaining regulatory approvals and manufacturing, marketing, financial and managerial resources than we have. We are currently aware of the following development efforts by our competitors:

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  •   Acceleration of Fracture Repair: While there is currently no drug product approved by the FDA for acceleration of fracture repair, at least one large pharmaceutical company, Pfizer, Inc., received FDA clearance to begin human clinical trials in the United States for this indication.
 
  •   Diabetic Ulcer Healing: To our knowledge, there are two corporate sponsored clinical trials underway on new drug substances for diabetic ulcer healing. These early stage clinical trials are being conducted by Genentech on recombinant human vascular endothelial growth factor, and by King Pharmaceuticals on an adenosine A2A receptor agonist. One gene therapy company, Selective Genetics, has initiated an early stage human clinical trial on platelet derived growth factors in the United States for the diabetic ulcer indication.
 
  •   Spine Fusion: Although there are already many products approved by the FDA for use in spinal fusion, only two approved products, InFuse from Medtronic and OP-1 from Stryker, both bone morphogenetic proteins (“BMPs”), include a bioactive component. We believe other growth factor-based products are in the development stage, and may be in human clinical trials in the United States.
 
  •   Cartilage Defect Repair: Several products with bioactive components are in the development stage for this indication, including BMPs. However, we believe no company has yet received FDA authorization to begin human clinical trials in the United States for this indication.

Our competitors may succeed in developing products that are more effective than the ones we have under development or that render our proposed products or technologies noncompetitive or obsolete. In addition, certain of such competitors may achieve product commercialization before we do. If any of our competitors develops a product that is more effective than one we are developing or plan to develop, or is able to obtain FDA approval for commercialization before we do, we may not be able to achieve significant market acceptance for certain products of ours, which would have a material adverse effect on our business.

Healthcare reform and restrictions on reimbursements may limit our financial returns.

     Our ability to successfully commercialize our products may depend in part on the extent to which government health administration authorities, private health insurers and other third party payors will reimburse consumers for the cost of these products. Third party payors are increasingly challenging both the need for, and the price of, novel therapeutic drugs and uncertainty exists as to the reimbursement status of newly approved therapeutics. Adequate third party reimbursement may not be available for our drug products to enable us to maintain price levels sufficient to realize an appropriate return on our investments in research and product development, which could restrict our ability to commercialize a particular drug candidate.

     We caution that the foregoing list of important factors is not exclusive. We do not undertake to update any forward-looking statement that may be made from time to time by or on behalf of us. The foregoing list of important factors is not exclusive and may not be up to date.

     Developments in any of these areas could cause our results to differ materially from results that have been or may be projected by us.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

     We had no debt outstanding and no derivative instruments at March 31, 2005.

     Our investment portfolio is used to preserve our capital until it is required to fund our operations. All of these investment instruments are classified as held-to-maturity. We do not own derivative financial instruments in our investment portfolio. Our investment portfolio contains instruments that are subject to the risk of a decline in interest rates. We maintain a non-trading investment portfolio of investment grade, liquid debt securities that limits the amount of credit exposure of any one issue, issuer or type of instrument. Due to the short duration and conservative nature of these instruments, we do not believe that we have a material exposure to interest rate risk.

     We have deposited our cash with national banking institutions, which we believe are stable. Even though our accounts in each of these banks have balances in excess of the $100,000 limit that is insured by the Federal Deposit Insurance Corporation, we believe these accounts are not subject to significant market risk due to bank failure.

Item 4. Controls and Procedures

Disclosure Controls and Procedures

     Our Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Form 10-Q, which included inquiries made of certain other employees. Based on their evaluation, the Chief Executive Officer and Chief Financial Officer have each concluded that, as of the end of such period, our disclosure controls and procedures are effective and provide reasonable assurance that we record, process, summarize, and report information required to be disclosed in the reports we file under the Securities Exchange Act of 1934 within the time periods specified by the Securities and Exchange Commission’s rules and forms. We have performed extensive financial reporting and data system reviews of internal controls to formalize and standardize the documentation of these operating procedures.

Internal Control Over Financial Reporting

     There have not been any changes in our internal control over financial reporting during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Part II – Other Information

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

     In connection with the execution of an employment agreement with our new President and Chief Executive Officer, Dr. James M. Pusey, on March 3, 2005, we granted to Dr. Pusey 200,000 unregistered shares of restricted stock which are subject to performance based vesting criteria and options to purchase 300,000 shares of common stock outside our 1997 Stock Option Plan. We issued the restricted shares, which are subject to restrictions on transferability and forfeiture, and granted the options without registration in reliance on the exemption provided by Section 4(2) under the Securities Act of 1933, as amended, for transactions not involving a public offering.

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Item 4. Submission of Matters to a Vote of Security Holders.

     The annual meeting of the stockholders of the Company was held on April 15, 2005 to vote on:

  •   Proposal 1: The election of two directors as Class II directors to serve until the Annual Meeting of Stockholders to be held in the year 2008 or until their respective successors are elected;
 
  •   Proposal 2: A proposal to amend the Company’s Amended and Restated Certificate of Incorporation to increase the number of authorized shares of Common Stock from 50,000,000 to 100,000,000; and
 
  •   Proposal 3: A proposal to ratify the appointment of Deloitte & Touche LLP as independent auditors of the Company for the fiscal year ending December 31, 2005.

The results were as follows:

                                         
                    Withheld             Broker Non-  
    For     Against     Authority     Abstained     Votes  
Proposal 1:
                                       
John M. Holliman, III
    34,185,129               1,111,683                  
Augustus A. White III., M.D., Ph.D.
    34,258,124               1,038,688                  
Proposal 2:
                                       
Amendment to the Company’s Amended and Restated Certificate of Incorporation to increase the number of authorized shares of Common Stock from 50,000,000 to 100,000,000
    33,022,478       1,918,470               355,864          
Proposal 3:
                                       
Ratify and approve the appointment of Deloitte & Touche LLP
    33,952,401       993,954               350,457          

A more detailed discussion of each proposal is included in the OrthoLogic Corp. Proxy Statement for the 2005 Annual Meeting of Stockholders.

Directors continuing in office are Stuart H. Altman, Ph.D., Michael D. Casey, Fredric J. Feldman, Ph.D., Elwood D. Howse, Jr., Augustus A. White III, M.D., Ph.D., John M. Holliman III and Dr. James M. Pusey, who was appointed by the Company’s Board of Directors at its April 15, 2005 meeting to fill the vacancy caused by the departure of Thomas R. Trotter.

Item 6. Exhibits

     See Exhibit List following this report

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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/ James M. Pusey
James M. Pusey
  President and Chief Executive Officer
(Principal Executive Officer)
  May 9, 2005
/s/ Sherry A. Sturman
Sherry A. Sturman
  Senior Vice-President and Chief
Financial Officer
(Principal Financial and Accounting
Officer)
  May 9, 2005

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OrthoLogic Corp.
Exhibit Index to Quarterly Report on Form 10-Q
For the Quarterly Period Ended March 31, 2005

             
Exhibit           Filed
No.   Description   Incorporated by Reference To:   Herewith
           
3.1
  Amended and Restated Certificate of Incorporation, executed April 15, 2005       X
           
3.2
  Amended Certificate of Designation of Series A Preferred Stock, executed April 15, 2005       X
           
3.3
  Bylaws of the Company   Exhibit 3.4 to Company’s Amendment No. 2 to Registration Statement on Form S-1 (No. 33-47569) filed with the SEC on January 25, 1993    
           
4.1
  Rights Agreement dated as of March 4, 1997, between the Company and Bank of New York, and Exhibits A, B and C thereto   Exhibit 4.1 to the Company’s Registration Statement on Form 8-A filed with the SEC on March 6, 1997    
           
4.2
  1987 Stock Option Plan of the Company, as amended and approved by stockholders(1)   Exhibit 4.4 to the Company’s Form 10-Q for the quarter ended June 30, 1997 (“June 1997 10-Q”)    
           
4.3
  1997 Stock Option Plan of the Company(1)   Exhibit 4.5 to the Company’s June 1997 10-Q    
           
10.1
  Actions by the Board related to the maximum 2005 discretionary cash bonus to Sherry A. Sturman(1)       X
           
10.2
  Actions by the Board related to the 2005 base salary compensation of James T. Ryaby(1)       X
           
10.3
  Actions by the Board related to the maximum 2005 discretionary cash bonus to James T. Ryaby(1)       X
           
31.1
  Certification of Chief Executive Officer Pursuant to Securities Exchange Act Rule 13a-14       X
           
31.2
  Certification of Chief Financial Officer Pursuant to Securities Exchange Act Rule 13a-14       X
           
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  Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350*        

* Furnished herewith

(1) Management contract or compensatory plan or arrangement

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