RITA MEDICAL SYSTEMS INC - 10-Q Quarterly Report

(In thousands, except per share amounts, unaudited)

	June 30, 2002			December 31, 2001
Assets
Current assets:
Cash and cash equivalents	$	5,355		$	7,297
Marketable securities		12,176			11,887
Accounts receivable, net of allowance for doubtful accounts of $1,220 at June 30, 2002 and $629 at December 31, 2001		4,964			5,056
Inventories, net		3,211			3,645
Prepaid assets and other current assets		844			1,282

Total current assets		26,550			29,167
Long term securities		—			4,353
Property and equipment, net		1,853			1,934
Intangibles and other assets		1,117			380

Total assets	$	29,520		$	35,834


Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	1,032		$	822
Accrued liabilities		2,684			2,675
Capital lease obligations		74			192

Total liabilities		3,790			3,689


Contingencies (Note 5)

Stockholders’ equity
Common stock, $0.001 par value		15			15
Additional paid-in capital		88,302			88,459
Deferred stock compensation		(371	)		(1,905	)
Receivable from stockholders		(63	)		(99	)
Accumulated other comprehensive income (loss)		(32	)		70
Accumulated deficit		(62,121	)		(54,395	)

Total stockholders’ equity		25,730			32,145

Total liabilities and stockholders’ equity	$	29,520		$	35,834

(In thousands, except per share data, unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2002			2001			2002			2001
Sales	$	4,806		$	3,769		$	9,224		$	7,073
Cost of goods sold		2,040			1,670			4,042			3,439

Gross profit		2,766			2,099			5,182			3,634


Operating expenses
Research and development		1,329			1,744			2,663			3,210
Selling, general and administrative		5,304			3,776			10,527			7,523

Total operating expenses		6,633			5,520			13,190			10,733


Loss from operations		(3,867	)		(3,421	)		(8,008	)		(7,099	)

Interest income and other expense, net		134			428			282			984


Net loss	$	(3,733	)	$	(2,993	)	$	(7,726	)	$	(6,115	)


Net loss per share, basic and diluted	$	(0.25	)	$	(0.21	)	$	(0.52	)	$	(0.43	)


Shares used in computing basic and diluted net loss per share		14,835			14,320			14,725			14,244

(In thousands, unaudited)

	Six Months Ended June 30,
	2002			2001
Operating activities:
Net loss	$	(7,726	)	$	(6,115	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		713			441
Stock-based compensation		344			1,020
Allowance for doubtful accounts		591			62
Allowance for inventory reserve		479			224
Changes in operating assets and liabilities
Accounts receivable		(499	)		(1,708	)
Inventory		(46	)		(84	)
Prepaid and other current assets		438			(98	)
Accounts payable and accrued liabilities		219			530

Net cash used in operating activities		(5,487	)		(5,728	)


Cash flows from investing activities:
Purchase of property and equipment		(566	)		(588	)
Purchases of short term investments		—			(8,806	)
Maturities of investments		3,963			20,140
Capitalization of patent litigation costs		(771	)		—
Other assets		3			2

Net cash provided by investing activities		2,629			10,748


Cash flows from financing activities:
Proceeds from issuance of common stock		1,034			474
Proceeds from revolving term loan		—			25
Payments on revolving term loan		—			(858	)
Payments on capital lease obligations		(118	)		(138	)

Net cash provided by (used in) financing activities		916			(497	)

Net increase (decrease) in cash and cash equivalents		(1,942	)		4,523
Cash and cash equivalents at beginning of period		7,297			12,676

Cash and cash equivalents at end of period	$	5,355		$	17,199

The accompanying unaudited condensed consolidated financial statements have been prepared by RITA Medical Systems, Inc. (the “Company”) in accordance with accounting principles generally accepted in the United States of America for interim financial information. These principles are consistent in all material respects with those applied in the Company’s financial statements contained in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2001 and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X promulgated by the Securities and Exchange Commission. However, interim financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (all of which are normal and recurring in nature, including the elimination of intercompany accounts) necessary to present fairly the financial position, results of operations and cash flows of the Company for the periods indicated. Interim results of operations are not necessarily indicative of the results to be expected for the full year or any other interim periods. These unaudited condensed consolidated financial statements should be read in conjunction with the financial statements and footnotes thereto for the year ended December 31, 2001 contained in the Company’s annual report on Form 10-K.

Basic earnings (loss) per share figures are calculated based on the weighted-average number of common shares outstanding during the period. Diluted earnings (loss) per share figures include the dilutive effect of common stock equivalents consisting of stock options, warrants and shares subject to repurchase, provided that the inclusion of such common stock equivalents is not antidilutive. For the three-month and six-month periods ended June 30, 2002 and 2001 respectively, the Company has excluded the following period end potentially dilutive securities (in thousands) from earnings per share computations because their inclusion would have the effect of reducing our loss per share:

	Three Months Ended June 30,		Six Months Ended June 30,
	2002	2001	2002	2001
Weighted average shares of common stock outstanding	14,872	14,394	14,762	14,318
Less: weighted-average shares subject to repurchase	37	74	37	74

Weighted average shares used in basic and diluted net loss per share	14,835	14,320	14,725	14,244

In July 2002, The Financial Accounting Standards Board (“FASB “) issued Statements of Financial Accounting Standards No. 146 (“SFAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities,” which is effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The standard nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity including Certain Costs Incurred in a Restructuring).” SFAS 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Examples of costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing or other exit or disposal activity. The Company does not believe adoption of this statement will materially impact its financial position or results of operations.

In July 1999, the United States Patent and Trademark Office declared an interference involving us, which was provoked by RadioTherapeutics Corporation, a competitor of ours, in which the validity of a patent claim previously issued to us is being called into question. The claim being questioned is one of a number of issued patent claims that cover the curvature of the array at the tip of our disposable devices. In February 2001, the USPTO issued a decision on preliminary motions filed in the patent interference proceeding. The decision found that one of the claims in our United States Patent No. 5,536,267 (claim no. 32) is invalid. We expect to receive final confirmation of that decision later this year. In the event that the decision is confirmed, we plan to file a motion in a United States District Court requesting review of the decision. Final determination of the patent interference proceeding may take several years. If the final determination of the United States District Court results in the issuance of patent rights related to the claim to RadioTherapeutics and we were unable to obtain a license to use the relevant patent or successfully modify our disposable device, we could be unable to sell our system and our business could suffer.

The Company is also involved in a patent opposition action pending before the European Patent Office. This opposition was instituted on March 2, 2000. The principal parties are RadioTherapeutics and RITA. The factual basis alleged to underly the proceeding is the claim by RadioTherapeutics that our European patent is not valid. In the opposition, RadioTherapeutics seeks to have our patent declared invalid and to have our patent cancelled. We are defending our patent and seek to defend it as issued. On February 7, 2002, the European Patent Office determined that we are entitled to European Patent No. 0777445 that covers radiofrequency ablation technology, approving 27 claims. Both parties have appealed this ruling. A final decision is not expected in this proceeding for several years. If we do not prevail in the opposition proceeding, we could lose our only currently issued patent in Europe.

In August 2001, the Company filed a complaint in the United States District Court for the Northern District of California against RadioTherapeutics Corporation. This complaint, which is distinct from the patent interference proceeding described above, alleges that RadioTherapeutics’ radiofrequency ablation products infringe six different patents held by the Company. As of June 30, 2002, the Company has capitalized approximately $1,103,000 in litigation costs incurred in defense of its patent positions.

In April 2002, a patent infringement suit against the Company was filed in the United States District Court for the Northern District of California by RadioTherapeutics Corporation and SciMed Life Systems, Inc. (two wholly-owned subsidiaries of Boston Scientific Corporation), the Board of Regents of the University of Nebraska and UneMed Corporation. The suit alleges that certain of the Company’s products infringe a patent assigned to the University of Nebraska and licensed by UneMed and RadioTherapeutics and a patent owned by Scimed. The Company is assessing the potential impact of this suit on its financial position and results of operations.

In July 2002, a patent infringement suit against the Company was filed in the United States District Court for the Northern District of California by Boston Scientific Corporation, the University of Kansas and the University of Kansas Medical Center Research Institute. The suit alleges that certain of the Company’s products infringe a patent assigned to the University of Kansas and licensed by Boston Scientific Corporation. The Company is assessing the potential impact of this suit on its financial position and results of operations.

We believe that the outcome of our outstanding legal proceedings, claims and litigation will not have a material adverse effect on our business, results of operations or financial condition. However, such matters involve complex questions of fact and law and could involve significant costs and the diversion of resources to defend. Additionally, the results of litigation are inherently uncertain, and an adverse outcome is at least reasonably possible. We are unable to estimate the range of possible loss from outstanding litigation and other legal proceedings and no amounts have been provided for such matters in the accompanying Consolidated Financial Statements. If we are not successful in defending these claims, our business, financial condition and results of operations could be materially adversely affected.

This Management’s Discussion and Analysis of Financial Condition and Results of Operations and other parts of this Form 10-Q contain forward-looking statements that involve risks and uncertainties. Words such as “anticipates”, “expects”, “intends”, “plans”, “believes”, “seeks”, “estimates”, and similar expressions identify such forward-looking statements. These statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or forecasted. Factors that might cause such a difference include, but are not limited to, those discussed in the section entitled “Factors That May Affect Future Results” and those appearing elsewhere in this Form 10-Q. Readers are cautioned not to place undue reliance on these forward-looking statements that reflect management’s analysis only as of the date hereof. We assume no obligation to update these forward-looking statements to reflect actual results or changes in factors or assumptions affecting such forward-looking statements.

We develop, manufacture and market minimally invasive products that use radiofrequency energy to treat patients with solid cancerous or benign tumors. From inception in 1994 through 1996, our operations consisted primarily of various start-up activities, including development of technologies central to our business, recruiting personnel and raising capital. In 1997, we began commercial product shipments. In 2001, we commercially launched our StarBurst XLi family of disposable devices and significantly expanded our direct domestic sales organization and our international distribution network.

Our products are sold in the United States through our direct sales force and internationally through distribution partners. For the three months ended June 30, 2002, sales in the United States accounted for 73% of our total sales while sales in our international markets accounted for 27% of our total sales. We expect domestic sales to account for a majority of sales in future periods due to our significant investment in and the efforts of our domestic sales force. Conversely, we expect reimbursement issues in Europe and Japan to limit sales growth in these regions for the next several years. However, our international operations will continue to represent a significant, if decreasing, portion of our revenue because of the high incidence of primary liver cancer in certain Asian and European markets.

All of our revenue is derived from the sale of our disposable devices and radiofrequency generators. For the three months ended June 30, 2002, 71% of our revenue was derived from the sale of our disposable devices and 29% was derived from the sale of our generators. We will continue to focus on expanding our base of customer accounts and on increasing usage of our disposable products in our established accounts. As a result, revenue from our higher-margin disposable devices should continue to predominate our sales.

To date, essentially all of our revenue has come from products sold in the treatment of cancerous liver tumors. In 2002, we expect nominal revenue in the fourth quarter to come from the use of the RITA system sold for the treatment of patients with metastatic bone tumors, and nominal revenue at the end of 2002 from sales for the treatment of unresectable lung tumors. We are conducting research and clinical trials in other organs that may lead to additional sources of revenue in the years beyond 2002.

Our manufacturing costs consist of raw materials, including generators produced for us by third-party suppliers, labor to produce our disposable devices and to inspect incoming, in-process and finished goods, sterilization performed by an outside service provider and general overhead expenses. Gross margins are affected by production volumes, average selling prices, the sales mix of higher-margin disposable devices versus generators and the mix of domestic direct sales versus international sales, which provide for standard distributor discounts. Our gross margin for the three months ended June 30, 2002 was 58%, approximately 3% higher than our margin in the first quarter ended March 31, 2002, primarily due to higher average selling prices realized on generator sales. However, our 58% margin rate was still lower than that in the second half of 2001, due to shipment of more relatively low margin generators in connection with our generator placement program and because we recognized charges for obsolete inventory. We expect gross margins to improve in the second half of 2002 primarily as a result of continued improvements in sales mix and cost factors and also due to the acceptance of our premium-priced StarBurst XLi line of disposable devices.

For the three months ended June 30, 2002, 20% of our operating expenses were related to research and development activities, continuing a trend towards relatively less spending in this area as compared to sales and marketing activities. We expect our research and development activities to continue to grow more slowly than sales and marketing activities, at least through 2002, as we commit significantly more resources to market development and business expansion efforts. Selling, general and administrative activities represented 80% of our operating expenses for the quarter, about the same as in the first quarter and higher than in recent preceding 2001 periods, reflecting our continuing investments in our domestic sales force, international distribution activities, physician training and patient awareness programs. We also made additional provisions to our allowance for uncollectible accounts, further affecting administrative expense, as difficult economic conditions have resulted in longer collection periods with m any of our European distributors. While our investments in market growth and business development will continue to grow, we believe sales and marketing expenses will stabilize in 2002.

In connection with grants of stock options to employees and non-employees, we record deferred stock-based compensation as a component of stockholders’ equity. This stock-based compensation is amortized as charges to operations over the vesting periods of the options. We recorded amortization of deferred compensation of $0.1 million for the three months ended June 30, 2002. We expect to record additional amortization expense for deferred compensation in diminishing amounts through 2004, at which point our existing deferred stock-based compensation will be fully amortized.

We incurred a net loss of $3.7 million for the three months ended June 30, 2002. As of June 30, 2002, we had an accumulated deficit of $62.1 million. Although we are projecting continued near term sales growth, due to the high cost associated with our continued investment in research and development, expanded clinical research programs and our sales and marketing efforts, we expect to continue to incur net losses through 2002 and early in 2003. We currently expect to become modestly profitable around mid-2003. Profitability in 2003 and beyond will depend on our success in expanding product usage in our current market and in developing new markets. To the extent current or new markets do not materialize in accordance with our expectations, our sales could be lower than expected and we may be unable to achieve or sustain profitability.

We are currently involved in patent proceedings and may become a party to additional patent or product liability proceedings. The costs of such lawsuits or proceedings may be material and could affect our earnings and financial position. To date, we have capitalized certain costs related to patent proceedings. An adverse outcome in a patent lawsuit could require us to cease sales of affected products or to pay royalties and/or fees, which could harm our results of operations.

	Q2 2002		Q1 2002		Q4 2001		Q3 2001		Q2 2001
Domestic Sales	73	%	72	%	65	%	56	%	46	%
International Sales	27	%	28	%	35	%	44	%	54	%

Total Sales	100	%	100	%	100	%	100	%	100	%
Cost of goods sold	(42	%)	(45	%)	(30	%)	(40	%)	(44	%)

Gross Profit	58	%	55	%	70	%	60	%	56	%

Operating Expenses:
Research and Development	(28	%)	(30	%)	(41	%)	(44	%)	(46	%)
Selling, general and administrative	(110	%)	(118	%)	(128	%)	(108	%)	(100	%)

Total operating expenses	(138	%)	(148	%)	(169	%)	(152	%)	(146	%)


Loss from operations	(80	%)	(93	%)	(99	%)	(92	%)	(90	%)

Other income, net	2	%	3	%	5	%	9	%	11	%

Net loss	(78	%)	(90	%)	(94	%)	(83	%)	(79	%)

Sales increased 28% to $4.8 million for the quarter ended June 30, 2002 from $3.8 million for the quarter ended June 30, 2001. Domestic sales increased by 100% over the comparable prior year period, although international sales decreased by 35%. Sales of our disposable products totaled $3.4 million for the quarter, an increase of 15% over the comparable prior year period. Domestically, higher unit shipments of disposable products resulted from increased physician awareness of our technology and the efforts of our expanded sales force, although our international shipment volumes were lower due primarily to reimbursement issues in Europe and Japan. Average selling prices of disposable products benefited from the increasing proportion of domestic business in our sales mix as well as the acceptance of our premium-priced StarBurst XLi line of disposable devices. Generator sales for the quarter were 72% higher than sales in the second quarter of 2001, reflecting higher unit shipments.

Cost of goods sold for the quarter ended June 30, 2002 was $2.0 million compared to $1.7 million for the quarter ended June 30, 2001. This increase was driven by increases in our reserve for obsolete inventory, which totaled $0.5 million for the quarter, compared to $0.1 million in the prior year period. These reserve provisions relate to older generation disposable devices that have been largely replaced in the market by our Starburst and Starburst Xli devices; such reserve provisions are now essentially complete. Increased quarterly costs associated with higher domestic disposable volumes and more generator placements were offset by the effect of lower international disposable shipments. Charges to cost of goods sold for amortization of deferred stock-based compensation fell to $21,000 for the quarter, compared to $146,000 in the prior year period. With sales up 28% and cost of goods sold increasing 22%, the company’s gross margin rate improved to 58% for the quarter ended June 30, 2002, compared to 56% for the quarter ended June 30, 2001.

Research and development expenses for the quarter ended June 30, 2002 were $1.3 million compared to $1.7 million for the corresponding period in 2001. This decrease was primarily attributable to reduced new product development charges. Our investment in clinical programs investigating new applications for our technology has remained relatively constant. Charges to research and development expense for amortization of deferred stock-based compensation were $58,000 for the quarter, down from $128,000 in the corresponding period in 2001.

Selling, general and administrative expenses for the quarter ended June 30, 2002 were $5.3 million as compared to $3.8 million in the corresponding period in 2001. The increase was primarily due to the major expansion of our domestic sales organization, resulting in expenses of $2.8 million for the quarter compared to expenses of $1.7 million in the prior year period. Also, provisions to our reserve for uncollectible accounts resulted in $0.5 million in increased expenses. Charges to selling, general and administrative expense for amortization of deferred stock-based compensation were $35,000 for the quarter compared to $250,000 for the corresponding period in 2001.

Sales increased 30% to $9.2 million for the six months ended June 30, 2002 from $7.1 million for the six months ended June 30, 2001. Domestic sales increased by 100% over the comparable prior year period, although international sales decreased by 32%. Sales of our disposable products totaled $6.6 million for the six months ended June 30, 2002, an increase of 24% over the comparable prior year period. Domestically, higher unit shipments of disposable products resulted from increased physician awareness of our technology and the efforts of our expanded sales force, although our international shipment volumes were lower. Average selling prices of disposable products benefited from the increasing proportion of domestic business in our sales mix as well as the acceptance of our premium-priced StarBurst XLi line of disposable devices. Generator sales for the six months ended June 30, 2002 were 50% higher than sales in the first half of 2001, reflecting higher unit shipments.

Cost of goods sold for the six months ended June 30, 2002 was $4.0 million compared to $3.4 million for the six months ended June 30, 2001. Higher costs associated with product shipments accounted for $0.5 million of this increase. Further, increases in our reserve for obsolete inventory totaled $0.7 million for the six months ended June 30, 2002, compared to $0.3 million in the prior year period. These reserve provisions relate to older generation disposable devices that have been largely replaced in the market by our Starburst and Starburst Xli devices; such reserve provisions are now essentially complete. Charges to cost of goods sold for amortization of deferred stock-based compensation fell to $56,000 for the six months, compared to $376,000 in the prior year period. With sales up 30% and cost of goods sold increasing 18%, the company’s gross margin rate improved to 56% for the six months ended June 30, 2002, compared to 51% for the six months ended June 30, 2001.

Research and development expenses for the six months ended June 30, 2002 were $2.7 million compared to $3.2 million for the corresponding period in 2001. This decrease was primarily attributable to reduced new product development charges. Our investment in clinical programs investigating new applications for our technology has remained relatively constant. Charges to research and development expense for amortization of deferred stock-based compensation were $154,000 for the six months, down from $244,000 in the corresponding period in 2001.

Selling, general and administrative expenses for the six months ended June 30, 2002 were $10.5 million as compared to $7.5 million in the corresponding period in 2001. The increase was primarily due to the major expansion of our domestic sales organization, resulting in expenses of $5.8 million for the first half compared to expenses of $3.5 million in the prior year period. Related investments in the clinical education of physicians led to an additional $0.4 million in higher charges compared with the first half of 2001. Also, provisions to our reserve for uncollectible accounts resulted in $0.6 million in increased expenses. Charges to selling, general and administrative expense for amortization of deferred stock-based compensation were approximately $72,000 for the six months compared to $400,000 for the corresponding period in 2001.

Prior to August 2000, we financed our operations principally through private placements of convertible preferred stock, raising approximately $37.9 million net of expenses. On August 1, 2000, we completed our initial public offering of 3.6 million common shares at a price of $12 per share, raising approximately $39.0 million net of expenses. All outstanding convertible preferred shares were converted to common shares at that time. To a lesser extent, we also financed our operations through equipment financing and other loans, of which there was $0.1 million in principal outstanding at June 30, 2002. Also as of June 30, 2002, we had $5.4 million of cash and cash equivalents, $12.2 million of short-term marketable securities and $22.8 million of working capital.

For the six months ended June 30, 2002, net cash used in operating activities was $5.5 million, principally due to our net loss and increases in accounts receivable (prior to consideration of related reserves). Our investing activities for this period were limited to the purchase of property and equipment in the amount of $0.6 million and net purchases or sales of both short-term and long-term investment instruments. Also, we capitalized $0.8 million in costs associated with legal action we initiated in 2001 in defense of our patent rights (see Part II, “Legal Proceedings” for discussion of this and other legal proceedings). Net cash provided by financing activities was $0.9 million, principally from the issuance of common shares.

Our capital requirements depend on numerous factors including our research and development expenditures, expenses related to selling, marketing and administration as well as working capital to support business growth. Although it is difficult for us to predict future liquidity requirements with certainty, we believe that our current cash and cash equivalents will satisfy our cash requirements for at least the next 18 months. During or after this period, if cash generated by operations is insufficient to satisfy our liquidity requirements, we may need to sell additional equity or debt securities or obtain an additional credit facility. There can be no assurance that additional financing will be available to us or, if available, that such financing will be available on terms favorable to the Company and our stockholders.

In July 2002, The Financial Accounting Standards Board ("FASB") issued Statements of Financial Accounting Standards No. 146 (“SFAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities,” which is effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The standard nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity including Certain Costs Incurred in a Restructuring.” SFAS 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Examples of costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing or other exit or disposal activity. The Company does not believe adoption of this statement will materially impact its financial position or results of operations.

In July 1999, the United States Patent and Trademark Office declared an interference involving us, which was provoked by RadioTherapeutics Corporation, a competitor of ours and a wholly owned subsidiary of Boston Scientific Corporation in which the validity of a patent claim previously issued to us is being called into question. The claim being questioned is one of a number of issued patent claims that cover the curvature of the array at the tip of our disposable devices. In February 2001, the USPTO issued a decision on preliminary motions filed in the patent interference proceeding. The decision found that one of the claims in our United States Patent No. 5,536,267 (claim no. 32) is invalid. We expect to receive final confirmation of that decision later this year. In the event that the decision is confirmed, we plan to file a motion in a United States District Court requesting review of the decision. Final determination of the patent interference proceeding may take several years. If the final determination of the United States District Court results in the issuance of patent rights related to the claim to RadioTherapeutics and we were unable to obtain a license to use the relevant patent or successfully modify our disposable device, we could be unable to sell our system and our business could suffer.

On April 11, 2002, RadioTherapeutics Corporation and SciMed Life Systems, Inc., (two wholly-owned subsidiaries of Boston Scientific Corporation), the Board of Regents of the University of Nebraska, and UneMed Corporation filed a complaint against us alleging that certain of our products infringe a patent assigned to the University of Nebraska and licensed by UneMed and RadioTherapeutics and a patent owned by SciMed. Also, in a separate action initiated on July 9, 2002, Boston Scientific Corporation, the University of Kansas and the University of Kansas Medical Center Research Institute filed a complaint against us alleging that certain of our products infringe a patent assigned to the University of Kansas and licensed by Boston Scientific. In addition, we are aware of the existence of patents held by competitors in our market, which could result in additional patent lawsuits against us. In the event that we do not prevail in these lawsuits or if we are subject to additional patent litigation and we are found to infringe, we could be prevented from selling our products unless we could obtain a license or were able to redesign our products to avoid infringement. If we were unable to obtain a license or successfully redesign our products, we may be prevented from selling our products and our business could suffer.

Although we anticipate that our operating expenses will stabilize in absolute dollars for the foreseeable future, to become profitable we must continue to increase our sales. If sales do not continue to grow, we may not be able to achieve or maintain profitability in the future. In particular, we incurred net losses of $7.7 million in the first six months of 2002, $13.0 million in 2001, $12.8 million in 2000 and $7.5 million in 1999. At June 30, 2002, we had an accumulated deficit of approximately $62.1 million.

We compete directly with two companies in the domestic and international markets: RadioTherapeutics Corporation, a division of Boston Scientific Corporation, and Radionics, Inc., a division of Tyco Healthcare, which is a division of Tyco International. Boston Scientific Corporation and Tyco International are publicly traded companies with substantially greater resources than we have. Both RadioTherapeutics and Radionics sell products that use radiofrequency energy to ablate soft tissue.

In addition to competing against other companies offering products that use radiofrequency energy to ablate soft tissue, we also compete against companies developing, manufacturing and marketing alternative therapies that address both cancerous and benign tumors. If these alternative therapies prove to offer treatment options that are superior to our system, physician adoption of our products could be negatively affected and our revenues could decline.

could decline. If longer-term patient follow-up or clinical studies indicate that our procedures cause unexpected, serious complications or other unforeseen negative effects, we could be subject to significant liability. Further, because some of our data has been produced in studies that were not randomized and/or included small patient populations and because, in certain circumstances, we rely on clinical data developed by independent third party physicians, our clinical data may not be reproduced in wider patient populations.

Our success depends significantly on our ability to protect our proprietary rights to the technologies used in our products, and yet we may be unable to do so. A number of companies in our market, as well as universities and research institutions, have issued patents and have filed patent applications that relate to the use of radiofrequency energy to ablate soft tissue. Our pending United States and foreign patent applications may not issue or may issue and be subsequently successfully challenged by others and invalidated. In addition, our pending patent applications include claims to material aspects of our products that are not currently protected by issued patents. Both the patent application process and the process of managing patent disputes can be time consuming and expensive.

In the event a competitor infringes upon our patent or other intellectual property rights, enforcing those rights may be difficult and time consuming. Even if successful, litigation to enforce our intellectual property rights or to defend our patents against challenge could be extensive and time consuming and could divert our management’s attention. We may not have sufficient resources to enforce our intellectual property rights or to defend our patents against a challenge. In addition, confidentiality agreements executed by our employees, consultants and advisors may not be enforceable or may not provide meaningful protection for our trade secrets or other proprietary information in the event of unauthorized use or disclosure. If we are unable to protect our intellectual property rights we could lose market share to a competitor and our business could suffer.

We are substantially dependent on a limited number of significant distributors in our international markets, and if we lose these distributors and fail to attract additional distributors, our international revenues could decline. ITX Corporation, formerly known as Nissho Iwai Corporation, is our primary distributor in Asia. It accounted for 44 percent of our international revenues for the six months ended June 30, 2002 and 31 percent of our international revenues in 2001. M.D.H. s.r.l. Forniture Ospedaliere, our distributor in Italy, accounted for 27 percent of our international revenues for the six months ended June 30, 2002 and 17 percent of our international revenues for 2001. Because international revenues accounted for 28 percent of our total revenues for the six months ended June 30, 2002 and these two distributors represented 71 percent of that total, the loss of either distributor or a significant decrease in unit purchases by either distributor could cause revenues to decline substantially. If we are unable to attract additional international distributors, our international revenues may not grow.

We sell our products in international markets through third-party distributors over whom we have limited control, and, if they fail to adequately support our products, our sales could decline. If our distributors or we terminate our existing agreements, finding companies to replace them could be an expensive and time-consuming process and sales could decrease during any transition period.

We are aware that some of our international distributors have built up inventory of our disposable devices. As a result, future sales of our newer generation disposable devices by these distributors could be negatively impacted. In addition, while these distributors have no price protection and no right of return relating to purchased products, if we permit the return of any of these products, we will have to adjust our revenues relating to these products.

In recent quarters we have significantly increased our reserve for uncollectible accounts to address the risk associated with longer collection periods that have arisen principally with our European distributors. If difficult economic conditions persist, and our collection experience worsens as a result, we may need to further adjust our reserve for uncollectible accounts in future periods, thereby reducing profits.

Certain of the markets outside the United States in which we sell our products require that specific reimbursement codes be obtained before reimbursement for procedures using our products can be approved. As a result, in countries where specific reimbursement codes are strictly required and have not yet been issued, reimbursement has been denied on that basis. ITX, our distributor in Japan, is seeking to obtain reimbursement coverage in Japan, but to date has not yet received this approval. If we are unable to either obtain the required reimbursement codes or develop an effective strategy to resolve the reimbursement issue, physicians may be unwilling to purchase our products which could negatively impact our international revenues.

Physicians, hospitals and other health care providers may be reluctant to purchase our products if they do not receive substantial reimbursement for the cost of the procedures using our products from third-party payors, such as Medicare, Medicaid and private health insurance plans. Even though in February of 2002 we were successful in establishing a new CPT code related to liver procedures with the American Medical Association, a payor still may not reimburse adequately for the procedure or product. In addition, there is no specific reimbursement code for radiofrequency ablation of tumors in other organs. Further, we believe the advent of fixed payment schedules has made it difficult to receive reimbursement for disposable products, even if the use of these products improves clinical outcomes. Fixed payment schedules typically permit reimbursement for a procedure rather than a device. If physicians believe that our system will add cost to a procedure but will not add sufficient offsetting economic or clinical benefits, physician adoption could be slowed.

We are highly dependent on the principal members of our management, operations and research and development staff. Our future success will depend in part on the continued service of these individuals and our ability to identify, hire and retain additional personnel, including sales and marketing staff. The market for qualified management personnel in Northern California, where our offices are located, is competitive and is expected to continue to be competitive. Because the environment for good personnel is so competitive, costs related to compensation may increase significantly. If we are unable to attract and retain the personnel we need to support and grow our business, our business will suffer.

We manufacture medical devices that are used on patients in both minimally invasive and open surgical procedures and, as a result, we may be subject to product liability lawsuits. To date, we have not been subject to a product liability claim; however, any product liability claim brought against us, with or without merit, could result in the increase of our product liability insurance rates or the inability to secure coverage in the future. In addition, we could have to pay any amount awarded by a court in excess of policy limits. Finally, even a meritless or unsuccessful product liability claim could be time consuming and expensive to defend and could result in the diversion of management’s attention from managing our core business.

It is critical to our sales effort to train a sufficient number of physicians and to instruct them properly in the procedures that utilize our products. We have established formal physician training programs and rely on physicians to devote adequate time to understanding how and when our products should be used. If physicians are not properly trained, they may misuse or ineffectively use our products. This may result in unsatisfactory patient outcomes, patient injury and related liability or negative publicity that could have an adverse effect on our product sales.

We have significantly expanded our direct sales force in the United States over the past eighteen months and may increase it in the future. There is intense competition for skilled sales and marketing employees, especially for people who have experience selling disposable devices and generators to the physicians in our target market, and we may be unable to hire skilled individuals to sell our products. Any inability to build and effectively manage our direct sales force could negatively impact our growth.

Securities class action litigation is often brought against a company after a period of volatility in the market price of its stock. If our future quarterly operating results are below the expectations of securities analysts or investors, the price of our common stock would likely decline. Stock price fluctuations may be exaggerated if the trading volume of our common stock is low. Any securities litigation claims brought against us could result in substantial expense and divert management’s attention from our core business.

If we fail to execute our sales strategy and develop further our products, our business could suffer. To manage anticipated growth in operations, we must increase our quality assurance staff for both our generators and our disposable devices and expand our manufacturing staff and facility for our disposable devices. Our systems, procedures and controls may not be adequate to support our expected growth in operations.

To be successful, we must manufacture our products in substantial quantities in compliance with regulatory requirements at acceptable costs. If we do not succeed in manufacturing quantities of our disposable devices that meet customer demand, we could lose customers and our business could suffer. At the present time, we have limited high-volume manufacturing experience. Our manufacturing operations are currently focused on the in-house assembly of our disposable devices. As we increase our manufacturing volume and the number of product designs for our disposable devices, the complexity of our manufacturing processes will increase. Because our manufacturing operations are primarily dependent upon manual assembly, if demand for our system increases we will need to hire additional personnel and may need to purchase additional equipment. If we are unable to sufficiently staff our manufacturing operations or are otherwise unable to meet customer demand for our products, our business could suffer.

Because there is only one supplier that provides us with a component that we include in our disposable devices, a disruption in the supply of this component could negatively affect revenues. This supplier is the only source of this component. If we were unable to remedy a disruption in supply of this component within twelve months, we could be required to redesign the handle of our disposable devices, which could divert engineering resources from other projects or add to product costs. In addition, a new or supplemental filing with applicable regulatory authorities may require clearance prior to our marketing a product containing new materials. This clearance process may take a substantial period of time, and we may be unable to obtain necessary regulatory approvals for any new material to be used in our products on a timely basis, if at all. This could also create supply disruptions that could negatively affect our business.

We are subject to a host of federal, state, local and international regulations regarding the manufacture and marketing of our products. In particular, our failure to comply with FDA regulations could result in, among other things, seizures or recalls of our products, an injunction, substantial fines and/or criminal charges against our employees and us. The FDA’s medical device reporting regulations require us to report

Sales of our products outside the United States are subject to foreign regulatory requirements that vary from country to country. The time required to obtain approvals from foreign countries may be longer than that required for FDA approval or clearance, and requirements for foreign licensing may differ from FDA requirements. For example, some of our newer products have not received approval in Japan. Any failure to obtain necessary regulatory approvals for our new products in foreign countries could negatively affect revenues.

Unless we are exempt, we must obtain the appropriate FDA approval or clearance before we can sell a new medical device in the United States. This can be a lengthy and time-consuming process. To date, all of our products have received clearances from the FDA through premarket notification under Section 510(k) of the Federal Food, Drug and Cosmetic Act. However, if the FDA requires us to submit a new premarket notification under Section 510(k) for modifications to our existing products, or if the FDA requires us to go through a lengthier, more rigorous examination than we now expect, our product introductions or modifications could be delayed or canceled which could cause our revenues to be below expectations. The FDA may determine that future products will require the more costly, lengthy and uncertain premarket approval process. In addition, modifications to medical device products cleared via the 510(k) process may require a new 510(k) submission. We have made minor modifications to our system. Using the guidelines established by the FDA, we have determined that some of these modifications do not require us to file new 510(k) submissions. If the FDA disagrees with our determinations, we may not be able to sell the RITA system until the FDA has cleared new 510(k) submissions for these modifications. In addition, we intend to request additional label indications, such as approvals or clearances for the ablation of tumors in additional organs, including lung, bone and breast, for our current products. The FDA may either deny these requests outright, require additional extensive clinical data to support any additional indications or impose limitations on the intended use of any cleared product as a condition of approval or clearance. Therefore, obtaining necessary approvals or clearances for these additional applications could be an expensive and lengthy process.

We may need to raise additional funds for our business operations and to execute our business strategy. We may seek to sell additional equity or debt securities or to obtain an additional credit facility. The sale of additional equity or convertible debt securities could result in additional dilution to our stockholders. If additional funds are raised through the issuance of debt securities, these securities could have rights that are senior to holders of common stock and could contain covenants that would restrict our operations. Any additional financing may not be available in amounts or on terms acceptable to us, if at all.

Because our executive officers and directors, and their respective affiliates, own approximately 28 percent of our outstanding common stock, these stockholders may, as a practical matter, be able to exert significant influence over matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combinations. This concentration of voting stock could have the effect of delaying or preventing a change in control.

On July 9, 2002, Boston Scientific Corporation, the University of Kansas and the University of Kansas Medical Center Research Institute filed a complaint against us in United States District Court for the Northern District of California. The principal parties in the dispute are Boston Scientific Corporation, the University of Kansas, the University of Kansas Medical Center Research Institute and RITA. The factual basis alleged to underlie the claim is that certain of our products infringe a patent licensed by Boston Scientific from the University of Kansas. The complaint seeks unspecified monetary damages and injunctive relief.

On August 27, 2001 we filed a complaint against RadioTherapeutics Corporation in the United States District Court for the Northern District of California. The principal parties in the proceeding are RadioTherapeutics and RITA. The factual basis underlying the proceeding is our claim that the sale by RadioTherapeutics of its radiofrequency ablation products infringes six of our patents. On October 17, 2001, RadioTherapeutics filed an answer and affirmative defenses to our complaint denying certain of the allegations in the complaint and asserting counterclaims requesting declaratory relief that RadioTherapeutics is not infringing our patents and that our asserted patents are invalid and unenforceable. RadioTherapeutics has also moved to stay the litigation pending the outcome of the patent interference proceeding described below. Our complaint seeks treble damages against RadioTherapeutics for its sale of radiofrequency ablation products, as well as temporary and permanent injunctive relief enjoining RadioTherapeutics from further infringement of our patents.

We are also involved in a patent interference proceeding before the Board of Patent Appeals and Interferences of the United States Patent and Trademark Office. On July 16, 1999 the United States Patent and Trademark Office declared an interference between a claim of one of our issued patents and claims of a patent application controlled by RadioTherapeutics. The principal parties in the proceeding are RadioTherapeutics and RITA. The factual basis alleged to underlie the claim is the determination by the commissioner of the United States Patent and Trademark Office that our patent and the RadioTherapeutics patent application interfere. In the interference proceeding, RadioTherapeutics seeks to invalidate our patent claim and to establish the patentability of the claims in their patent application. We seek to maintain the priority of our patent claim.

We are also involved in a patent opposition pending before the European Patent Office. This opposition was instituted on March 2, 2000. The principal parties are RadioTherapeutics and RITA. The factual basis alleged to underlie the proceeding is the claim by RadioTherapeutics that our European patent is not valid. In the opposition, RadioTherapeutics seeks to have our patent declared invalid and to have our patent cancelled. We are defending our patent and seek to defend it as issued. On February 7, 2002, the European Patent Office determined that we are entitled to Patent No. 0777445 covering radiofrequency ablation technology, approving 27 claims. Both parties have appealed this ruling.

10.26		Amendment dated April 19, 2002 to Employment Agreement with Barry Cheskin dated March 21, 1997.

10.27		Amendment dated April 17, 2002 to Employment Agreement with Daniel Balbierz dated March 19, 1998.

10.28		Separation Agreement with Eric Mueninghoff dated April 22, 2002.

99.1		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

99.2		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

10.26		Amendment dated April 19, 2002 to Employment Agreement with Barry Cheskin dated March 21, 1997.

10.27		Amendment dated April 17, 2002 to Employment Agreement with Daniel Balbierz dated March 19, 1998.

10.28		Separation Agreement with Eric Mueninghoff dated April 22, 2002.

99.1		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

99.2		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Delaware		94-3199149
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

		Page
PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets—June 30, 2002 and December 31, 2001	3
	Condensed Consolidated Statements of Operations—three and six months ended June 30, 2002 and 2001	4
	Condensed Consolidated Statements of Cash Flows—six months ended June 30, 2002 and 2001	5
	Notes to Unaudited Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	9
Item 3.	Quantitative and Qualitative Disclosures About Market Risk.	20

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	20
Item 2.	Changes in Securities and Use of Proceeds	20
Item 3.	Defaults Upon Senior Securities	20
Item 4.	Submission of Matters to a Vote of Security Holders	21
Item 5.	Other Information	21
Item 6.	Exhibits and Reports on Form 8-K	21

SIGNATURES		22

EXHIBIT INDEX		23

	Three and Six Months Ended June 30,
	2002	2001
Options and warrants	2,664	2,422
Common shares subject to repurchase	37	74

	2,701	2,496

	June 30, 2002		December 31, 2001
Raw materials	$	1,031	$	1,017
Work-in-process		344		377
Finished goods		1,836		2,251

	$	3,211	$	3,645

Payments due in the remainder of 2002		$ 77
Less imputed interest (including warrants)		(3)

Present value of future minimum capital lease payments		$ 74

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Remainder of 2002		$ 270
2003		539
2004		360

Total of future minimum operating lease payments		$1,169

John Gilbert		(10,928,449 votes for, 5,581 votes withheld)
Gordon Russell		(10,914,027 votes for, 20,003 votes withheld)

RITA MEDICAL SYSTEMS, INC

By:		/S/ DONALD STEWART


Donald Stewart Chief Financial Officer and Vice President, Finance and Administration