SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20459

 

FORM 10-Q

 

QUARTERLY REPORT UNDER SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE QUARTER ENDED December 31, 2004

 

COMMISSION FILE NUMBER 0-20970

 

VISION-SCIENCES, INC.

(Exact name of registrant as specified in its charter)

 

 

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 requirement for the past 90 days.

 

Yes  ý                   No  o

 

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

 

Yes  o                   No  ý

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of January 31, 2005.

 

Common Stock, par value of $.01		31,163,412
(Title of Class)		(Number of Shares)

 

 

VISION-SCIENCES, INC.

TABLE OF CONTENTS

 

Part I.	Financial Information
	Item 1.	Financial Statements
		Consolidated Balance Sheets
		Consolidated Statements of Operations
		Consolidated Statement of Stockholders’ Equity
		Consolidated Statements of Cash Flows
		Notes to Consolidated Financial Statements
	Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.		Quantitative and Qualitative Disclosures about Market Risk
	Item 4.		Controls and Procedures
Part II.	Other Information
	Item 6.		Exhibits and Reports on Form 8-K
	Signatures
	Exhibits

 

2

 

PART I - FINANCIAL INFORMATION

 

Item 1: FINANCIAL STATEMENTS

 

VISION-SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

		December 31, 2004			March 31, 2004
ASSETS
Current Assets:
Cash and cash equivalents		$	689,794		$	2,714,941
Accounts receivable, net of allowance for doubtful accounts of $67,666 and $52,800, respectively		1,621,260			1,683,459
Inventories		1,751,296			1,352,716
Prepaid expenses and deposits		41,951			62,182
Total current assets		4,104,301			5,813,298
Property and Equipment, at cost:
Machinery and equipment		4,291,415			3,623,854
Furniture and fixtures		242,227			212,002
Leasehold improvements		573,780			473,411
		5,107,422			4,309,267
Less-Accumulated depreciation and amortization		3,940,355			3,728,242
		1,167,067			581,025
Advance to Three BY Ltd		—			267,500
Other assets, net of accumulated amortization of $52,214 and $47,428, respectively		76,417			66,751
Total assets		$	5,347,785		$	6,728,574
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Acceptances payable to a bank		$	59,884		$	51,766
Current portion of note payable		18,837			17,495
Accounts payable		620,480			681,998
Accrued expenses		1,145,548			970,755
Total current liabilities		1,844,749			1,722,014
Long term portion of note payable		26,313			40,614
Stockholders’ Equity:
Common stock, $.01 par value— Authorized—50,000,000 shares Issued and outstanding—31,007,563 shares at December 31, 2004 and 30,687,963 shares at March 31, 2004		310,075			306,879
Additional paid-in capital		65,150,176			64,649,956
Accumulated deficit		(61,983,528		)	(59,990,889		)
Total stockholders’ equity		3,476,723			4,965,946
Total liabilities and stockholders’ equity		$	5,347,785		$	6,728,574

 

See accompanying notes to consolidated financial statements.

 

3

 

VISION-SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

		Three Months Ended December 31,								Nine Months Ended December 31,
		2004				2003				2004				2003
Net sales		$	2,826,949			$	2,717,775			$		7,635,167		$	6,785,012
Cost of sales		2,040,079				1,826,106				5,514,894				4,333,773
Gross profit		786,870				891,669				2,120,273				2,451,239
Selling, general and administrative expenses (1)		1,103,583				847,537				2,944,640				2,655,289
Research and development expenses (1)		412,111				159,452				1,060,854				454,785
Stock-based compensation		65,843				(132,531			)	132,895				502,457
Income (Loss) from operations		(794,667			)	17,211				(2,018,116			)	(1,161,292			)
Interest income		3,862				6,681				19,936				21,393
Interest expense		(1,190			)	—				(3,891			)	—
Other income, net		5,773				3,862				9,432				11,099
Net income (loss)		$		(786,222	)	$		27,754		$	(1,992,639		)	$		(1,128,800	)
Basic and diluted net income (loss) per common share		$		(0.03	)	$		0.00		$	(0.06		)	$		(0.04	)
Shares used in computing basic and diluted net income (loss) per common share		30,976,505				30,228,794				30,912,528				30,118,564

 

(1)          Excludes non-cash stock-based compensation, as follows:

 

Research and development expenses		$	109		$	(121,114	)	$	328		$	398,449
Selling, general and administrative expenses		65,734			(11,417		)	132,567			104,008
Total		$	65,843		$	(132,531	)	$	132,895		$	502,457

 

See accompanying notes to consolidated financial statements.

 

4

 

VISION-SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(Unaudited)

 

		Common Stock					Additional Paid-in-Capital			Accumulated Deficit			Total Stockholders’ Equity			Total Comprehensive Loss
		Number		$.01
		of Shares		Par Value
Balance, March 31, 2004		30,687,963		$	306,879		$	64,649,956		$	(59,990,889	)	$	4,965,946
Exercise of stock options, net		319,600		3,196			367,325			—			370,521
Compensation expense related to non-employee non-qualified stock options							123,004			—			123,004
Compensation expense related to employee non-qualified stock options							9,891						9,891
Net loss		—		—			—			(1,992,639		)	(1,992,639		)	$	(1,992,639	)
Total comprehensive loss																$	(1,992,639	)
Balance December 31, 2004		31,007,563		$	310,075		$	65,150,176		$	(61,983,528	)	$	3,476,723

 

See accompanying notes to consolidated financial statements.

 

5

 

VISION-SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

		Nine Months Ended December 31, 2004			Nine Months Ended December 31, 2003
Cash flows from operating activities:
Net loss		$	(1,992,639	)	$	(1,128,800	)
Adjustments to reconcile net loss to net cash used for operating activities:
Depreciation and amortization		216,899			156,311
Stock compensation for non-qualified options		132,895			502,457
Changes in assets and liabilities:
Accounts receivable		62,199			(513,048		)
Inventories		(398,580		)	(134,040		)
Prepaid expenses and deposits		20,231			(35,031		)
Accounts payable		(61,518		)	391,286
Accrued expenses		174,793			65,186
Net cash used for operating activities		(1,845,720		)	(695,679		)
Cash flows used for investing activities
Increase in marketable securities		—			(299		)
Purchase of property and equipment, net of conversion of Advance to 3BY Ltd		(530,655		)	(120,106		)
Advance to Three BY Ltd		—			(267,500		)
(Increase) decrease in other assets		(14,452		)	16,666
Net cash used for investing activities		(545,107		)	(371,239		)
Cash flows provided by (used for) financing activities:
Payments on note payable for computer equipment		(12,959		)	—
Proceeds from acceptances payable to a bank		8,118			79,021
Proceeds from the sale of common stock, net		—			329,012
Exercise of stock options, net		370,521			151,707
Net cash provided by financing activities		365,680			559,740
Net decrease in cash and cash equivalents		(2,025,147		)	(507,178		)
Cash and cash equivalents, beginning of period		2,714,941			2,744,143
Cash and cash equivalents, end of period		$	689,794		$	2,236,965
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for interest		$	3,891		$	—
Supplemental Disclosure of Non-cash Items from Financing Activities:
Fair market value of non-qualified options granted in the period		$	371,101		$	1,411,550
Change in the fair market value of non-qualified options existing at the beginning of the period		$	—		$	489,269

 

See accompanying notes to consolidated financial statements.

 

6

 

VISION-SCIENCES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1.             Basis of Presentation

 

The consolidated financial statements included herein have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission and include, in the opinion of management, all adjustments (consisting only of normal and recurring adjustments) that the Company considers necessary for a fair presentation of such information.  Certain information and footnote disclosures normally included in financial statements have been condensed or omitted pursuant to such rules and regulations.  The Company believes, however, that its disclosures are adequate to make the information presented not misleading.  These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s latest annual report to stockholders.  The results for the interim periods presented are not necessarily indicative of results to be expected for the full fiscal year.

 

2.             Summary of Significant Accounting Policies

 

The accompanying consolidated financial statements reflect the application of certain accounting policies described below:

 

a.                                       Principles of Consolidation: The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries.  All material intercompany accounts and transactions have been eliminated in consolidation.

 

b.                                      Cash Equivalents: Cash equivalents are carried at market value, which includes accrued interest.  Cash equivalents are short-term, highly liquid investments with original maturities of less than three months.

 

c.                                       Marketable Securities: Marketable securities are carried at market value, which includes accrued interest.  The Company has classified its investments in marketable securities as available-for-sale securities.  At December 31, 2004, the Company had no marketable securities.

 

d.                                      Inventories:  Inventories are stated at the lower of cost or market using the first-in, first-out (FIFO) method and consist of the following:

 

		December 31, 2004			March 31, 2004
					(audited)
Raw materials		$	1,156,704		$	726,221
Work-in-process		132,124			297,220
Finished goods		462,468			329,275
		$	1,751,296		$	1,352,716

 

Work-in-process and finished goods inventories consist of material, labor, and manufacturing overhead.

 

7

 

e.                                       Depreciation and Amortization: The Company provides for depreciation and amortization using the straight-line method in amounts that allocate the cost of the assets to operations over their estimated useful lives as follows:

 

Asset Classification		Estimated Useful Life
Machinery and Equipment		3-5 Years
Furniture and Fixtures		5 Years

 

Leasehold improvements are amortized over the shorter of their estimated useful lives or the lives of the leases.

 

f.                                         Basic and Diluted Net Income (Loss) Per Common Share: Basic and diluted net income (loss) per common share is based on the weighted average number of common shares outstanding.  Shares of common stock issuable pursuant to outstanding stock options have not been considered, as their effect would be antidilutive.

 

g.                                      Revenue Recognition: The following must occur before the Company recognizes revenue: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been rendered, (3) the price is fixed or determinable, (4) collectibility is reasonably assured and (5) the fair value of undelivered elements, if any, exists.  To date the Company has not entered into any multiple element arrangements.  The Company follows Emerging Issues Task Force (“EITF”) 01-9 to record the effect on sales of any rebates offered to customers.  The Company recognizes revenue upon the passage of title that normally occurs upon shipment from our plants.

 

h.                                      Foreign Currency Transactions: In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 52, Foreign Currency Translation, the Company charges foreign currency exchange gains or losses, in connection with its purchases of products from vendors in Japan, to operations, and charges foreign exchange translation gains and losses to retained earnings.

 

i.                                          Income Taxes: The Company accounts for income taxes under the liability method in accordance with SFAS No. 109, Accounting for Income Taxes.  Under SFAS No. 109, deferred tax assets or liabilities are computed based upon the differences between the financial statement and income tax bases of assets and liabilities as measured by the enacted tax rates.

 

The Company has recorded a valuation allowance equal to its net deferred tax asset due to the uncertainty of realizing the benefit of this asset.

 

8

 

j.                                          Accounting for Options Issued to Non-employees: The Company accounts for non-qualified stock option agreements issued to non-employees as equity instruments, in accordance with the provisions of EITF 96-18.  In the nine months ended December 31, 2004, the Company granted non-qualified options to purchase 100,000 and 50,000 shares of the Company’s Common Stock to a consultant, with a value of approximately $241,832 and $129,269, respectively.  This value was determined using the Black-Scholes option-pricing model.  The assumptions used during the nine months ended December 31, 2004 were as follows.

 

Risk-free interest rate		.93% - 1.36%
Expected dividend yield		—
Expected levis		5 years
Expected volatility		79% - 83%

 

The Company is recognizing these amounts in its operations ratably over a two-year period, according to the vesting schedules of the options.  In the three and nine months ended December 31, 2004, the Company recognized $62,546 and $123,004, respectively of expense related to these two options as stock-based compensation in the consolidated statements of operations.

 

k.                                       Employee Stock-based Compensation Arrangements: The Company accounts for its employee stock-based compensation arrangements using the intrinsic value method under the provisions of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and Financial Interpretation No. (“FIN”) 44.  The Company does not recognize stock-based employee compensation cost when the options granted have an exercise price equal to, or greater than, the market value of the underlying common stock on the date of the grant.  The Company does recognize stock-based employee compensation cost when the options granted have an exercise price less than the market value of the underlying common stock on the date of the grant.

 

In June 2003, the Company granted options to purchase 1,295,000 shares of common stock to its employees at an exercise price of $1.04 per share.  The fair market value of the common stock on the date of grant was $1.09 per share.  As a result, the Company has recognized compensation expense for the difference between the fair market value and the option price over the life of the options.  In the three and nine months ended December 31, 2004, the Company recognized $3,297 and $9,891, respectively of expense related to these options as stock-based compensation in the consolidated statements of operations.

 

9

 

In accordance with the Financial Accounting Standards Board (FASB) Statement No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, beginning in the quarter ending March 31, 2003, the Company adopted the disclosure requirements of FASB No. 148.  Had compensation expense for all stock option grants to employees been determined under the fair value method at the grant dates, consistent with the method prescribed by SFAS No. 123, the Company’s net loss would have been increased to the pro forma amounts indicated as follows:

 

l.                                         New Accounting Standards:  In November 2004 the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4.  SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and spoilage.  This statement requires that those items be recognized as current period charges regardless of whether they meet the criterion of “so abnormal” which was the criterion specified in ARB No. 43.  In addition, this Statement requires that allocation of fixed production overheads to the cost of production be based on normal capacity of the production facilities.  This pronouncement is effective for the Company beginning October 1, 2005.  The Company has not yet assessed the impact of adopting this new standard.

 

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation.  SFAS No. 123(R) supercedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows.  Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123.  However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values.  Pro forma disclosure is no longer an alternative.  The new standard will be effective for the Company in the first interim or annual reporting period beginning after June 15, 2005.  The Company has not yet assessed the impact of adopting this new standard.

 

In December 2004 the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions.  The amendments made by SFAS No. 153 are based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of assets exchanged.  Further, the amendments eliminate the narrow exception for nonmonetary exchanges of similar productive assets and replace it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance.  Previously, Opinion No. 29 required that the accounting for an exchange of a productive asset for a similar productive asset or an equivalent interest in the same or similar productive asset should be based on the recorded amount of the asset relinquished.  The new standard will be effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005.  The Company has not yet assessed the impact of adopting this new standard.

 

		Three Months Ended December 31,						Nine Months Ended December 31,
		2004			2003			2004			2003
Net income (loss) – as reported		$	(786,222	)	$	27,754		$	(1,992,639	)	$	(1,128,800	)
Stock-based employee compensation – as reported		3,297			5,652			9,891			13,188
Pro forma stock-based employee compensation		(103,900		)	(69,000		)	(301,900		)	(207,000		)
Net loss – pro forma		$	(886,825	)	$	(35,594	)	$	(2,284,648	)	$	(1,322,612	)
Net income (loss) per share – as reported		$	(.03	)	$	—		$	(.06	)	$	(.04	)
Stock-based employee compensation – as reported		—			—			—			—
Pro forma stock-based employee compensation		—			—			(.01		)	—
Net income (loss) per share – pro forma		$	(.03	)	$	—		$	(.07	)	$	(.04	)

 

3.             Three BY Ltd.

 

In June 2003, the Company entered into a Contract Manufacturing Agreement, a Loan Agreement and a Pledge Agreement (collectively, the “3BY Agreements”) with Three BY Ltd., an Israeli company (“3BY”).  The 3BY Agreements provide for, among other things, the manufacture of certain of the Company’s products by 3BY, and a loan of up to $267,500 by the Company to 3BY for the purchase and installation of certain manufacturing equipment by 3BY, at 3BY’s facility, to be used to manufacture certain of the Company’s products.  As of December 31, 2003, the Company had advanced the complete loan.  3BY has completed the purchase and installation of the manufacturing equipment, and the Company began receiving commercial production from 3BY in the three months ending September 30, 2004.  On October 1, 2004, according to terms in the Loan Agreement, 3BY and the Company agreed that the Company would take title to the manufacturing equipment, in lieu of 3BY retaining title and paying back the advance.

 

10

 

4.                                      Segment Information

 

The Company has three reportable segments – medical, industrial and corporate.  The medical segment designs, manufactures and sells EndoSheaths and sells endoscopes to users in the health care industry.  The industrial segment designs, manufactures and sells borescopes to a variety of users, primarily in the aircraft engine manufacturing and aircraft engine maintenance industries.  In addition, the industrial segment manufactures and repairs endoscopes for the medical segment.  The corporate segment consists of certain administrative expenses applicable to the Company as a whole and the management oversight of the Company’s investment in Vision-Sciences Ltd. (the Company’s Israeli subsidiary).

 

All segments follow the accounting policies described in the summary of significant accounting policies.  The Company evaluates segment performance based upon operating income.  Identifiable assets are those used directly in the operations of each segment.  Corporate assets include cash, marketable securities and the assets of Vision-Sciences, Ltd.  Data regarding management’s view of the Company’s segments are provided in the following tables.

 

11

 

Three months ended December 31,		Medical			Industrial			Corporate			Adjustments			Total
2004
Sales to external customers		$	2,158,084		$	668,865		$	—		$	—		$	2,826,949
Intersegment sales		—			838,159			—			(838,159		)	—
Operating income (loss)		(275,890		)	(26,833		)	(491,944		)	—			(794,667		)
Interest income (expense), net		—			—			2,672			—			2,672
Depreciation and amortization		76,379			14,664			1,506			—			92,549
Advance to 3BY Ltd.		—			—			—			—			—
Other significant non-cash items:
Stock-based compensation		62,734			62			3,047			—			65,843
Conversion of advance to fixed asset		267,500			—			—			—			267,500
Expenditures for fixed assets		131,694			—			—			—			131,694
2003
Sales to external customers		$	1,767,982		$	949,793		$	—		$	—		$	2,717,775
Intersegment sales		—			612,914			—			(612,914		)	—
Operating income (loss)		66,906			102,102			(151,797		)	—			17,211
Interest income (expense), net		—			—			6,681			—			6,681
Depreciation and amortization		38,401			10,083			—			—			48,484
Advance to 3BY Ltd.		51,000			—			—			—			51,000
Other significant non-cash items:
Stock-based compensation		321			107			(132,959		)	—			(132,531		)
Expenditures for fixed assets		69,474			—			—			—			69,474

 

Nine months ended December 31,
2004
Sales to external customers		$	5,265,728		$	2,369,439		$	—		$	—		$	7,635,167
Intersegment sales		—			1,815,373			—			(1,815,373		)	—
Operating income (loss)		(1,008,495		)	(58,463		)	(951,158		)	—			(2,018,116		)
Interest income (expense)		—			—			16,045			—			16,045
Depreciation and amortization		175,148			37,233			4,518			—			216,899
Advance to 3BY Ltd.		—			—			—			—			—
Other significant non-cash items:		—			—			—			—			—
Stock-based compensation		123,567			187			9,141			—			132,895
Conversion of advance to fixed asset		267,500			—			—			—			267,500
Expenditures for fixed assets		508,505			22,150			—			—			530,655
Total assets		3,394,262			1,456,707			777,249			(280,433		)	5,347,785
2003
Sales to external customers		$	4,438,597		$	2,346,415		$	—		$	—		$	6,785,012
Intersegment sales		—			1,169,131			—			(1,169,131		)	—
Operating income (loss)		107,581			81,332			(1,350,205		)	—			(1,161,292		)
Interest income (expense)		—			—			21,393			—			21,393
Depreciation and amortization		126,209			30,102			—			—			156,311
Advance to 3BY Ltd.		267,500			—			—			—			267,500
Other significant non-cash items:
Stock-based compensation		750			250			501,457			—			502,457
Expenditures for fixed assets		118,594			1,512			—			—			120,106
Total assets		2,207,624			1,263,363			2,454,310			(88,582		)	5,836,715

 

12

 

Item 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Executive Summary

 

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995.  Examples of forward-looking statements include statements about expectations about future financial results, future products and future sales of new and existing products, future expenditures, and capital resources to meet anticipated requirements.  Without limiting the foregoing, the words “believes”, “anticipates”, “plans”, “expects”, and similar expressions are intended to identify forward-looking statements.  These forward-looking statements involve risks and uncertainties, and our actual results may differ significantly from those discussed in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, the availability of capital resources, the availability of third-party reimbursement, government regulation, the availability of supplies, competition, technological difficulties, the continuation of our contracts with Medtronic Xomed, Inc. and Medtronic USA, Inc., general economic conditions and other risks detailed in our most recent Annual Report on Form 10-K and any subsequent periodic filings made with the Securities and Exchange Commission.  We do not undertake an obligation to update our forward-looking statements to reflect future events or circumstances.

 

We develop, manufacture and sell flexible endoscope products for the medical device and industrial device markets.  We operate in three reporting segments, medical, industrial and corporate.

 

Medical Segment

 

The medical segment supplies flexible endoscopes and disposable Slide-On™ EndoSheath® Systems (“EndoSheaths”) to the Ear-Nose-Throat (“ENT”), gastrointestinal (“GI”), urology and pulmonary markets.  Health-care providers use EndoSheaths to cover the insertion tube of flexible endoscopes, such as ENT endoscopes, Trans-Nasal Esophagoscopes (“TNE”), sigmoidoscopes, cystoscopes and bronchoscopes.  We have designed the EndoSheaths to allow the health-care providers to process patients economically by permitting the providers to minimize reprocessing the endoscopes between procedures.  In addition, the EndoSheaths ensure a sterile insertion tube for each patient procedure.

 

Our strategy in the medical segment is comprised of three components: a) improve sales distribution, b) lower manufacturing costs and c) increase the number of new product offerings.

 

Sales Distribution

 

Since September 19, 2003 we have been distributing all of our products for the ENT markets in the U.S.A. and Canada through Medtronic Xomed, Inc. (“Medtronic Xomed”) as part of our exclusive distribution agreement (the “Medtronic Agreement”) with them. The initial term of the Medtronic Agreement is three years.  Thereafter, the Medtronic Agreement will be automatically renewed for successive one-year periods, unless terminated by either party upon advance written notice.  Under the Medtronic Agreement, we have granted Medtronic Xomed exclusive distribution rights in the United States and Canada to market and sell our ENT EndoSheaths, ENT endoscopes, TNE endoscopes and TNE EndoSheaths to ENT practitioners.  As of July 2004 Medtronic Xomed completed the minimum purchase requirements for the initial twelve-month period of the term, ending in August 2004 (“Year 1”).

 

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Under the Medtronic Agreement, in order to maintain its exclusive distribution rights, Medtronic Xomed is required to purchase at least 110% of the Year 1 unit volume of ENT EndoSheaths in Year 2.  Due to higher than expected inventory levels of ENT EndoSheaths at Medtronic Xomed at the end of Year 1, we currently expect Medtronic Xomed to purchase approximately 6,300 units of ENT EndoSheaths during the remaining three months of our fiscal year ending March 31, 2005 (“FY 05”), compared to approximately 140,240 units purchased by Medtronic Xomed in the first nine months of FY 05.  If Medtronic Xomed continues to sell units to end users at their current rate, they would purchase significantly less ENT EndoSheaths from us than required under the Agreement to maintain exclusivity.  There can be no assurance that Medtronic Xomed will purchase the required units to maintain exclusivity.  We have made no determination, as of December 31, 2004, as to whether we will terminate the exclusive distribution rights of Medtronic Xomed if Medtronic Xomed does not purchase the unit volume required in Year 2.  As a result of the Medtronic Agreement, the success of our ENT product lines in the domestic market is substantially dependent upon the success of the marketing and sales activities of Medtronic Xomed over which we have limited control.

 

The Medtronic Agreement does not contain any provisions for Medtronic Xomed to return unsold products, nor are there any terms related to product acceptance and warranty that are different from the normal terms we offer our other customers.  The Medtronic Agreement does provide for a discount to Medtronic Xomed for payment within 10 days of invoice date.

 

In December 2004 we concluded an agreement (the “MDT USA Agreement”) with the Urology division of Medtronic, Inc. (“MDT USA”) that provides for MDT USA to be the exclusive distributor in the United States and Canada of our flexible Cystoscope with Slide-On EndoSheath System and ancillary products to the urology market, including urogynecology.  The MDT USA Agreement runs until March 31, 2006, the “Initial Term”, and thereafter will automatically renew for successive one-year periods, unless either party notifies the other party in writing, at least ninety days prior to the end of any term, of its intent not to renew.

 

During the Initial Term, MDT USA is required to purchase $1,965,000 of our flexible Cystoscope and our Slide-On Cystoscope EndoSheath System, of which $353,500 will be purchased in FY 05 and $1,611,500 will be purchased in our fiscal year ending March 31, 2006 (“FY 06”). In the 12-month periods following the Initial Term, the MDT USA Agreement requires us and MDT USA to negotiate minimum sales values. If MDT USA fails to purchase such minimums, or if we cannot agree on such minimums, we have the right and option to terminate MDT USA’s exclusivity, or terminate the MDT USA Agreement.

 

The MDT USA Agreement does not contain any provisions for MDT USA to return unsold products, nor are there any terms related to product acceptance and warranty that are different from the normal terms we offer our other customers.  The MDT USA Agreement does provide for a discount to MDT USA for payment within 10 days of invoice date.

 

We continue to market and sell our GI product line directly to that market, and we have retained our own international network of distributors for all our medical product lines.

 

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Cost Reduction

 

During FY 04 we decided we could reduce manufacturing costs by sub-contracting the manufacture of our EndoSheaths for the GI and ENT markets to 3BY, Ltd. (“3BY”), a company in Israel.  We realized a benefit of approximately $60,000 in the six months ended December 31, 2004 as we sold the first commercial lots of sigmoidoscope EndoSheaths and ENT EndoSheaths that were manufactured by 3BY.  This cost reduction is net of depreciation expense recognized in the three months ended December 31, 2004 for the ENT equipment we took title to from 3BY effective October 1, 2004.

 

New Products

 

In FY 04 we received clearance from the U.S. Food and Drug Administration, (“FDA”) to market a number of new products to the ENT market.  In general, we designed these products to allow the ENT physician to perform procedures in their offices, using their standard laryngoscopes, as opposed to the current practice of traveling to hospitals to use special ENT endoscopes to perform the procedures.  Under the current reimbursement procedures of the Centers for Medicare & Medicaid Services (“CMS”), a governmental agency under the U.S. Department of Health and Human Services, the ENT physician will receive a higher reimbursement by performing the procedures in their offices than they receive when they perform them in a hospital.

 

In April 2004 we received clearance from the Food & Drug Administration to market our Flexible Cystoscope with Slide-On EndoSheath System. We plan to continue to introduce products during FY 05 that enhance the practice efficiency of physicians and also ensure a sterile insertion tube for each patient procedure.

 

Industrial Segment

 

The industrial segment designs, manufactures and sells flexible endoscopes, termed borescopes, for industrial users, and manufactures and repairs flexible endoscopes for the medical segment.  The industrial segment users consist primarily of companies in the aircraft engine manufacturing and maintenance markets and the defense market.

 

Corporate Segment

 

The corporate segment consists of certain administrative and business development activities applicable to the company as a whole.

 

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Critical Accounting Policies and Estimates

 

This discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States.  See the Notes to the Consolidated Financial Statements included elsewhere herein.  Certain of our accounting policies require the application of judgment in selecting the appropriate assumptions for calculating financial estimates.  By their nature these judgments are subject to an inherent degree of uncertainty.  We periodically evaluate the judgments and estimates used for our critical accounting policies to ensure that such judgments and estimates are reasonable for our interim and year-end reporting requirements.  These judgments and estimates are based upon our historical experience, current trends and information available from other sources, as appropriate.  If different conditions result from those assumptions used in our judgment, the results could be materially different from our estimates.  Our critical accounting policies include the following:

 

Revenue Recognition

 

We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (SAB 104) and EITF 00-21, Revenue Arrangements with Multiple Deliverables. These pronouncements require that five basic criteria must be met before revenue can be recognized: (1) persuasive evidence that an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and determinable; (4) collectibility is reasonably assured and (5) the fair value of undelivered elements, if any, exists.  Determination of criterion (4) is based on management’s judgment regarding the collectibility of invoices for products and services delivered to customers.  Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected.

 

We account for the rebate we granted to Medtronic Xomed in accordance with EITF 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).  This pronouncement requires that a vendor recognize rebates as a reduction of revenue based on a systematic and rational allocation of the cost of honoring rebates earned and claimed to each of the underlying revenue transactions that result in progress by the customer toward earning the rebate.  Accordingly, as of September 30, 2004, we recognized an allowance of $39,000 for the estimated rebate that would accrue to Medtronic Xomed for sales of ENT EndoSheaths that were in Medtronic Xomed’s inventory at that date that would be sold to new customers under the rebate program.  Subsequent to September 30, 2004, we recognize revenue on sales of ENT EndoSheaths to Medtronic Xomed, net of an estimated sales allowance related to that rebate program.  Measurement of the total rebate is based on the estimated number of customers that will ultimately earn rebates under the offer.  Determination of the number of customers that will earn rebates and the amount of those rebates is based on management’s judgment.  We review our estimates of the number of customers that will earn benefits under the rebate program each fiscal quarter.  If different conditions result from those assumptions used in our judgment, the results could be materially different from our estimates.

 

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Options Issued to Non-employees

 

We account for non-qualified options issued to non-employees as equity instruments, in accordance with the provisions of EITF 96-18.  Fair values for these non-qualified options are derived from pricing models that consider current market and contractual prices for the underlying financial instruments, as well as time value, yield curve and volatility factors underlying the positions.  Pricing models and their underlying assumptions impact the amount and timing of the value of these non-qualified options, and the use of different pricing models or assumptions could produce different financial results.  We use the Black-Scholes option-pricing model for determining the value of non-qualified options issued to non-employees, and we expense that value over the vesting period of the non-qualified options.

 

We account for certain non-qualified options granted to employees to purchase our common stock in accordance with Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees.  If the fair market value of the underlying stock at the date of grant is greater than the option price, we recognize compensation expense for the difference between the market price and the option price over the vesting period of the options.

 

Income Taxes

 

Under our income tax policy, we record the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts recorded in the accompanying consolidated balance sheets, as well as operating loss and tax credit carryforwards.  The evaluation of the recoverability of any tax assets recorded on the balance sheet is subject to significant judgment.  We have provided valuation allowances for all our deferred tax assets to date.

 

Results of Operations

 

Net Sales

Q3 05 Compared to Q3 04

Net sales for the three months ended December 31, 2004 (“Q3 05”) were $2,826,949, an increase of $109,174, or 4%, compared to the three-month period ended December 31, 2003 (“Q3 04”).  During Q3 05, net sales of the medical segment increased by $390,102, or 22%, to $2,158,084, and net sales of the industrial segment decreased by $280,928, or 30%, to $668,865, compared to Q3 04.  In the medical segment, the net sales and changes in net sales by market were as follows ($000’s):

 

Market		Q3 05			Q3 04			Increase (Decrease)			Percent
ENT		$	1,646		$	1,572		$	74		5	%
GI		78			120			(42		)	(36	)%
Urology		263			—			263			100	%
Pulmonary		28			21			7			33	%
Other		143			55			88			159	%
Total		$	2,158		$	1,768		$	390		22	%

 

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Medical Sales – ENT Market

 

Net sales to the ENT market include products for domestic and international customers as follows:

 

ENT Market		Q3 05			Q3 04			Increase (Decrease)			Percent
Domestic		$	1,080		$	1,208		$	(128	)	(11	)%
International		566			364			202			55	%
Total ENT		$	1,646		$	1,572		$	74		5	%

 

We further delineate products sold to the domestic ENT market as follows:

 

ENT Products		Q3 05			Q3 04			Increase (Decrease)			Percent
Slide-On EndoSheaths		$	151		$	453		$	(302	)	(67	)%
Endoscopes		911			657			254			39	%
Other products		18			98			(80		)	(82	)%
Total Domestic		$	1,080		$	1,208		$	(128	)	(11	)%

 

The primary reason for the decrease in net sales of ENT products to the domestic market was the completion in July 2004 by Medtronic Xomed of its minimum purchase requirements for Year 1 of the Medtronic Agreement.  As a result, Medtronic Xomed had higher than expected levels of inventory of ENT endoscopes and ENT Slide-On EndoSheaths (“ENT SOS”) and has not purchased as much of those products since that time.  Medtronic Xomed did resume purchases of those products in Q3 05, but at a significantly slower rate than Q3 04.  We expect sales of ENT SOS to Medtronic Xomed in the remainder of FY 05 to continue to be slow, as Medtronic Xomed has sufficient inventory to support their average monthly sales for approximately six months.  The lower sales of these products were partially offset by the purchase by Medtronic Xomed of new products, including our TNE Bx endoscope and our ENT-1000 small diameter flexible endoscope and companion EndoSheaths for these endoscopes.

 

To attempt to increase the sales of our ENT SOS, Medtronic Xomed has initiated three programs.  Two of these programs were generated internally at Medtronic Xomed and we do not participate in them at all.  We have assumed responsibility for a third program, a rebate that we agreed to provide Medtronic Xomed a cash rebate for sales of ENT SOS to new users who commit to large annual purchases of ENT SOS.  The rebate program is designed to continue for one year, will be renewable by mutual agreement and will vary with the price charged by Medtronic Xomed to individual users.  We are accounting for this rebate program under EITF 01-9.  For the three months ended September 30, 2004 we reduced sales by approximately $39,000 for the estimated potential maximum rebate to be granted to Medtronic Xomed for sales by Medtronic Xomed after September 1, 2004 of ENT SOS that they had paid for, and were in their inventory on September 30, 2004.

 

We continue to provide for the potential maximum rebate for current sales to Medtronic Xomed. Although the rebate program has not proved successful to date in reducing the inventory of ENT SOS at Medtronic Xomed, we plan to continue the program for the aforementioned one year.

 

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Under the Medtronic Agreement, in order to maintain its exclusive distribution rights, Medtronic Xomed is required to purchase at least 110% of the Year 1 unit volume of ENT SOS in Year 2.  There can be no assurance, however, that Medtronic Xomed will purchase the required units to maintain its exclusive distribution rights.  As a result of the Medtronic Agreement, the success of our domestic ENT product lines will continue to be substantially dependent upon the success of the marketing and sales activities of Medtronic Xomed, over which we have limited control.

 

Sales of the TNE Bx, TNE D and ENT-1000 endoscopes and companion EndoSheaths totaled approximately $843,000 in Q3 05, reflecting continued market penetration by Medtronic Xomed of the TNE D and ENT-1000 products, and the initial shipments of our TNE Bx endoscope and companion EndoSheaths.  We expect sales of the TNE D and ENT-1000 products will be higher in the fourth quarter of FY 05, while sales of the TNE Bx products to slow, reflecting the time it will take Medtronic Xomed to launch the products to their sales force.

 

Both the TNE D and TNE Bx are products designed to allow ENT physicians to perform procedures in their offices using topical anesthetics, compared to having to perform the same procedures in hospitals where patients are consciously sedated, thereby increasing patient throughput.  Being able to see more patients, and under reimbursement procedures allowed by CMS, physicians can generate more revenue by performing these procedures in their offices, compared to in a hospital environment.  The reimbursement rates are greater for the physician, but less overall, as there is no reimbursement for the hospital.  Patients benefit also, as they avoid being consciously sedated and they experience the procedures with an insertion tube covered with our sterile EndoSheath.  These are new procedures for ENT physicians, and communicating the benefits of them to the ENT physician is time-consuming.  We believe our relationship with Medtronic Xomed is critical to the marketing and distribution process, as Medtronic Xomed possesses greater sales and marketing abilities than we have.

 

We further delineate products sold to the international ENT market as follows:

 

ENT Products		Q3 05			Q3 04			Increase (Decrease)			Percent
Slide-On EndoSheaths		$	381		$	267		$	114		43	%
Endoscopes		185			97			88			91	%
Other products		—			—			—			—	%
Total International		$	566		$	364		$	202		55	%

 

The increase in net sales to international distributors is primarily due to higher unit volume of ENT SOS, along with higher unit average selling prices.  Effective April 1, 2004 we increased prices approximately 8% for ENT SOS and 5% for ENT endoscopes.  Unit sales of ENT SOS to the international distributors were 58,920 in Q3 05, an increase of 14,125 units, compared to sales in Q3 04.  Included in the units sold in Q3 05 were 440 units for the ENT-1000 endoscope, not available for sale in Q3 04.  The higher demand came from our major distributors in Europe and Australia.  We expect unit demand from these distributors will remain consistent with prior years for the remainder of FY 05 and in the year ending March 31, 2006 (“FY 06”).

 

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Unit sales of ENT endoscopes in Q3 05 to international distributors were 39, compared to 28 in Q3 04.  Unit sales in Q3 05 included 13 units of the ENT-1000, not available for sale in Q3 04.  In addition, we sold 4 TNE D endoscopes to our international distributors in Europe.  We are in the early stages of selling TNE endoscopes to our distributors, and we plan to increase our marketing efforts by hosting symposiums for physicians where they can experience the benefits that our products can have on the efficiency of their practices and the protection our products offer patients.  Sales of endoscopes are dependent upon a variety of factors, including the timing requirements of end users, foreign exchange rates, sales promotions of international competitors and other factors.

 

In addition, we plan to continue to sign agreements favorable to us with distributors in countries where we do not have a presence.  However, there can be no assurance we will be able to consummate these agreements on terms that are beneficial to us.

 

Medical Sales – Other Markets

 

Net sales to the GI market declined in Q3 05, compared to Q3 04, due primarily to lower demand for our proprietary sigmoidoscope EndoSheaths due to the aging of the installed base of our sigmoidoscopes and the continued insufficiency of reimbursement rates to physicians to support the use of the products.  We expect this decline to continue during FY 05 and FY 06.

 

The increase in sales of urology products reflects the initial shipments of our new Flexible Cystoscope (“CST-2000”) with Slide-On EndoSheath System to MDT USA and to shipments to international distributors in Europe and Australia.  We believe the CST-2000 and EndoSheath System can significantly enhance the practice efficiency of urologists by allowing them to avoid the tedious and time-consuming reprocessing of conventional cystoscopes, and presents the significant benefit of a sterile insertion tube for each patient.  In addition, the use of our CST-2000 with Slide-On EndoSheath System avoids the need to reprocess endoscopes with harsh chemicals, one of which has been contraindicated for use on patients with bladder cancer.

 

Industrial Segment

 

The increase in net sales of the industrial segment was due to lower demand for new borescopes, offset partially by higher demand for repairs of borescopes.

 

9 Months 05 Compared to 9 Months 04

Net sales for the nine months ended December 31, 2004 (“9M 05”) were $7,635,167, an increase of $850,155, or 13%, compared to the nine-month period ended December 31, 2003 (“9M 04”).  During 9M 05 net sales of the medical segment increased by $827,131, or 19% to $5,265,728, and net sales of the industrial segment increased by $23,024, or 1%, to $2,369,439, compared to 9M 04.  In the medical segment net sales and changes in net sales by market were as follows ($000’s):

 

Market		9M 05			9M 04			Increase (Decrease)			Percent
ENT		$	4,288		$	3,804		$	484		13	%
GI		248			418			(170		)	(41	)%
Urology		358			—			358			100	%
Pulmonary		35			53			(18		)	(34	)%
Other		336			163			173			106	%
Total		$	5,265		$	4,438		$	827		19	%

 

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Medical Sales – ENT Market

 

Sales to the ENT market include products for domestic and international customers as follows:

 

ENT Market		9M 05			9M 04			Increase (Decrease)			Percent
Domestic		$	2,752		$	2,389		$	363		15	%
International		1,536			1,415			121			9	%
Total ENT		$	4,288		$	3,804		$	484		13	%

 

We further delineate products sold to the domestic ENT market as follows:

 

ENT Products		9M 05			9M 04			Increase (Decrease)			Percent
Slide-On EndoSheaths		$	1,101		$	1,347		$	(246	)	(18	)%
Endoscopes		1,539			944			595			63	%
Other products		112			98			14			14	%
Total Domestic		$	2,752		$	2,389		$	363		15	%

 

Net sales of ENT SOS decreased in the nine months ended December 31, 2004, because of the reasons discussed above.  The increase in net sales of endoscopes for the period reflects net sales in Q3 05 of our TNE Bx endoscope and also higher sales in 9M 05 of our ENT-1000 endoscope, offset partially by lower net sales of our ENT-2000 endoscope to Medtronic Xomed.  The increase in net sales of other products reflects sales of products to ENT physicians for the diagnosis of swallowing disorders.

 

We further delineate products sold to the international ENT market as follows:

 

ENT Products		9M 05			9M 04			Increase (Decrease)			Percent
Slide-On EndoSheaths		$	1,138		$	1,098		$	40		4	%
Endoscopes		394			317			77			24	%
Other products		4			—			4			100
Total International		$	1,536		$	1,415		$	121		9	%

 

The higher net sales of ENT SOS and endoscopes to the international market were due primarily to the causes in Q3 05 as explained above.

 

Industrial Segment

 

The increase in net sales for the 9M 05 compared to 9M 04 was due to higher demand for repairs of borescopes, offset by lower demand for new borescopes.

 

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