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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
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(Mark One)
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended September 30, 2004
OR
|_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
Commission file number 0-19567
CARDIAC SCIENCE, INC.
-----------------------------------------------------------------
(Exact name of Small Business Issuer as specified in its charter)
DELAWARE 33-0465681
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
1900 Main Street, Suite 700, Irvine, CA 92614
- --------------------------------------------------------------------------------
(Address of principal executive offices)
Registrant's telephone number, including area code: (949) 797-3800
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
Yes |X| No |_|
Indicate by check mark if the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
Yes |X| No |_|
The number of shares of the Common Stock of the registrant outstanding as
of November 5, 2004 was 86,171,619.
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CARDIAC SCIENCE, INC.
INDEX TO FORM 10-Q
Page
No.
----
PART I. FINANCIAL INFORMATION
Item 1. Unaudited Financial Statements:
Consolidated Condensed Balance Sheets as of September 30, 2004
and December 31, 2003 1
Consolidated Condensed Statements of Operations for the three
and nine months ended September 30, 2004 and 2003 2
Consolidated Condensed Statements of Comprehensive Loss for the
three and nine months ended September 30, 2004 and 2003 3
Consolidated Condensed Statements of Cash Flows for the nine
months ended September 30, 2004 and 2003 4
Consolidated Condensed Notes to Financial Statements 5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures About Market Risk 20
Item 4. Controls and Procedures 20
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 22
Item 2. Not Applicable
Item 3. Not Applicable
Item 4. Not Applicable
Item 5. Other Information 22
Item 6. Exhibits 23
Signatures 24
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CARDIAC SCIENCE, INC.
CONSOLIDATED CONDENSED BALANCE SHEETS
(Unaudited)
In thousands, except share and per share data
September 30, December 31,
2004 2003
--------- ---------
ASSETS
Current assets:
Cash and cash equivalents $ 15,415 $ 8,871
Accounts receivable, net of allowance for doubtful accounts of
$2,769 at September 30, 2004 and $1,626 at December 31, 2003 15,454 20,410
Inventories 10,140 9,575
Prepaid expenses and other current assets 2,998 2,154
--------- ---------
Total current assets 44,007 41,010
Property and equipment, net 5,133 7,003
Goodwill 140,544 139,859
Intangible assets, net 10,171 11,626
Other assets 2,914 3,503
--------- ---------
Total assets $ 202,769 $ 203,001
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 6,514 $ 8,955
Accrued expenses 6,782 6,542
Deferred revenue 2,039 2,479
Current portion of long term obligations 24 53
Senior notes payable 49,856 --
--------- ---------
Total current liabilities 65,215 18,029
Senior notes payable -- 46,481
Deferred revenue 738 859
Other long term obligations 28 41
--------- ---------
Total liabilities $ 65,981 $ 65,410
--------- ---------
Commitments and contingencies (Note 8)
Stockholders' equity:
Common stock - $.001 par value; 160,000,000 shares authorized,
86,170,403 and 80,465,585 shares issued and outstanding at
September 30, 2004 and December 31, 2003, respectively 86 80
Additional paid-in capital 257,641 243,219
Accumulated other comprehensive income (28) (20)
Accumulated deficit (120,911) (105,688)
--------- ---------
Total stockholders' equity 136,788 137,591
--------- ---------
Total liabilities and stockholders' equity $ 202,769 $ 203,001
========= =========
The accompanying notes are an integral part of these
unaudited financial statements.
1
CARDIAC SCIENCE, INC.
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(Unaudited)
In thousands, except share and per share data
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
Net revenue $ 14,747 $ 15,728 $ 47,860 $ 44,279
Cost of revenue 6,636 6,217 20,967 18,527
------------ ------------ ------------ ------------
Gross profit 8,111 9,511 26,893 25,752
------------ ------------ ------------ ------------
Operating expenses:
Sales and marketing 5,561 4,564 18,511 12,927
Research and development 1,373 1,444 4,498 3,939
General and administrative 4,758 3,386 13,521 9,800
Amortization of intangibles 519 381 1,526 1,211
Gain on sales of assets and other, net (797) -- (1,077) --
------------ ------------ ------------ ------------
Total operating expenses 11,414 9,775 36,979 27,877
------------ ------------ ------------ ------------
Loss from operations (3,303) (264) (10,086) (2,125)
Interest and other non-operating expense, net (1,767) (1,482) (5,137) (4,366)
------------ ------------ ------------ ------------
Loss before minority interest (5,070) (1,746) (15,223) (6,491)
Minority interest in consolidated subsidiary -- -- -- (48)
------------ ------------ ------------ ------------
Loss from continuing operations (5,070) (1,746) (15,223) (6,539)
Income from discontinued operations -- 256 -- 493
------------ ------------ ------------ ------------
Net loss $ (5,070) $ (1,490) $ (15,223) $ (6,046)
============ ============ ============ ============
Loss from continuing operations per share (basic and diluted) $ (0.06) $ (0.03) $ (0.19) $ (0.10)
============ ============ ============ ============
Net loss per share (basic and diluted) $ (0.06) $ (0.02) $ (0.19) $ (0.09)
============ ============ ============ ============
Weighted average number of shares used in the computation of net loss
per share and loss from continuing operations per share 85,072,387 67,398,421 80,649,695 67,050,032
============ ============ ============ ============
The accompanying notes are an integral part of these
unaudited financial statements.
2
CARDIAC SCIENCE, INC.
CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE LOSS
(Unaudited)
In thousands
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------ ------------------------
2004 2003 2004 2003
-------- -------- -------- --------
Net loss $ (5,070) $ (1,490) $(15,223) $ (6,046)
Other comprehensive income (loss):
Foreign currency translation adjustments $ -- (189) $ (8) 73
-------- -------- -------- --------
Comprehensive loss $ (5,070) $ (1,679) $(15,231) $ (5,973)
======== ======== ======== ========
The accompanying notes are an integral part of these
unaudited financial statements
3
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(Unaudited)
In thousands
Nine Months Ended
September 30,
-------------
2004 2003
-------- --------
Cash flows from operating activities:
Net loss $(15,223) $ (6,046)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation 1,919 1,778
Amortization of intangible assets 1,526 1,211
Minority interest -- 48
Provision for allowance for doubtful accounts 1,177 286
Gain on sale of assets (1,553) --
Impairment of assets 190 --
Accrued interest and amortization of debt discount and issuance costs 5,093 4,422
Changes in operating assets and liabilities:
Accounts receivable 3,539 (7,228)
Inventories (1,137) (1,561)
Placement of Powerheart CRMs at customer locations (45) (531)
Prepaid expenses and other assets (518) (265)
Accounts payable and other liabilities (2,244) (2,505)
Deferred revenue (432) --
Net assets and liabilities held-for-sale -- (1,460)
-------- --------
Net cash used in operating activities (7,708) (11,851)
-------- --------
Cash flows from investing activities:
Purchase of property and equipment (1,044) (2,391)
Acquisition of Lifetec, net of cash acquired -- (354)
Funds in escrow to buy Artema minority interest -- (1,299)
(Increase) decrease in goodwill and intangible assets (174) 1,027
Acquisition costs paid (50) --
Refund of investment in MRL -- 3,001
Proceeds from the sale of assets, net of selling costs 2,478 1,256
-------- --------
Net cash provided by investing activities 1,210 1,240
-------- --------
Cash flows from financing activities:
Payments on long term obligations (42) (180)
Proceeds from exercise of common stock options and warrants 857 917
Proceeds from issuance of common stock, net of costs 12,235 8,364
-------- --------
Net cash provided by financing activities 13,050 9,101
-------- --------
Effect of exchange rates on cash and cash equivalents (8) 88
-------- --------
Net decrease in cash and cash equivalents 6,544 (1,422)
Cash and cash equivalents at beginning of period 8,871 15,598
-------- --------
Cash and cash equivalents at end of period $ 15,415 $ 14,176
======== ========
The accompanying notes are an integral part of these
unaudited financial statements
4
CARDIAC SCIENCE, INC.
CONSOLIDATED CONDENSED NOTES TO FINANCIAL STATEMENTS
(Unaudited)
(In thousands, except share and per share data)
1. Organization and Description of the Business
Cardiac Science, Inc. (the "Company") was incorporated in May 1991 and
develops, manufactures and markets portable automated public access
defibrillators and a fully-automatic in-hospital bedside defibrillator-monitor
that continuously monitors cardiac patients, instantly detects the onset of
life-threatening abnormal heart rhythms, and, when appropriate, delivers
defibrillation shocks within seconds and without human intervention to convert
the heart back to its normal rhythm. The Company's core technology platform
consists of its proprietary arrhythmia detection and discrimination software
("RHYTHMx(R)"), which is combined with its proprietary STAR(R) Biphasic
defibrillation hardware and electrode technology to create the only fully
automatic in-hospital cardioverter defibrillator (the "Powerheart(R) CRM(R)" or
"CRM") and a unique semi-automatic, or automated defibrillator, (the "Powerheart
AED" or "G3 AED") for use in out-of-hospital settings. The Company's
Powerheart(R) Cardiac Rhythm Module(TM) and Powerheart(R) brand AEDs are
marketed by its direct sales force and distribution network in the United States
and around the world.
On July 1, 2000, the Company acquired Cadent Medical Corporation, a
privately held company, for an aggregate of 4,500,000 shares of the Company's
common stock.
On September 26, 2001, the Company acquired Survivalink Corporation, a
privately held company, for $10,500 in cash, $25,800 in senior secured
promissory notes, and 18,150,000 shares of the Company's common stock.
On November 30, 2001, the Company acquired 94.7% of Artema Medical AB and
Subsidiaries ("Artema") for 4,150,976 shares of common stock and approximately
$215 in cash. During 2003, the Company acquired the remaining minority interest
for $843 in cash. On September 1, 2003, the Company transferred ownership of the
shares in Cardiac Science International A/S, its Danish operations and a
subsidiary of Artema, from Artema to Cardiac Science, Inc. in exchange for
forgiveness of intercompany debt. Then on September 21, 2003, the Company sold
100% of its shares in Artema to an outside party for $600 in cash.
On May 29, 2003, the Company acquired Lifetec Medical Limited, its U.K.
distributor, for $383 in cash.
On October 21, 2003, the Company acquired substantially all of the assets
and liabilities of Complient Corporation, a privately held company, for
10,250,000 shares of the Company's common stock.
2. Continued Existence
The accompanying consolidated condensed financial statements have been
prepared on the basis that the Company will continue as a going concern and that
it will recover its assets and satisfy its liabilities in the normal course of
business. From inception, the Company has incurred substantial losses and
negative cash flows from operations. As of September 30, 2004, the Company had
cash on hand of $15,415, negative working capital of $21,208, short and long
term debt of $49,908, and an accumulated deficit of $120,911.
The Company believes that its current cash balance, in combination with
net cash expected to be generated from operations, should fund ongoing
operations for at least twelve months. The Company's expected net cash from
operations is predicated on achieving increases in revenue from the sale of
AEDs, somewhat offset by a decrease in revenue from other products, achieving
further reductions in its cost of goods sold, controlling operating expenses and
reducing its days sales outstanding on accounts receivable ("DSO") ratio.
If the Company does not realize the expected increases in revenue and
reductions in cost of goods sold, or if operating expenses increase
substantially, or if it cannot reduce its DSO ratio, the Company may not be able
to fund its operations for the next twelve months. In addition, if the Company
is uncecessful in negotiating the financial covenants of its Senior Notes (see
note 6) the Company may not be able to fund its operations over the next twelve
months, and as such, there may be substantial doubt about the Company's ability
to continue as a going concern.
In the event that the Company requires additional funding during the next
twelve months, it will attempt to raise the required capital through either debt
or equity arrangements. The Company cannot provide any assurance that the
required capital would be available on acceptable terms, if at all, or that any
financing activity would not be dilutive to current stockholders of the Company.
If the Company is not able to raise additional funds, it may be required to
significantly curtail its operations and this would have an adverse effect on
its financial position, results of operations and cash flows.
5
3. Summary of Significant Accounting Policies
In the opinion of the Company's management, the accompanying consolidated
condensed unaudited financial statements include all adjustments (which consist
only of normal recurring adjustments) necessary for a fair presentation of its
financial position at September 30, 2004 and results of operations and cash
flows for the periods presented. Although the Company believes that the
disclosures in these financial statements are adequate to make the information
presented not misleading, certain information and disclosures normally included
in financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted and should be read in
conjunction with the Company's audited financial statements included in the
Company's 2003 Annual Report on Form 10-K. Results of operations for the nine
months ended September 30, 2004 are not necessarily indicative of results for
the full year.
Inventories
Inventories are valued at the lower of cost (estimated using the first-in,
first-out method) or market. The Company periodically evaluates the carrying
value of inventories and maintains an allowance for obsolescence to adjust the
carrying value, as necessary, to the lower of cost or market. The allowance is
based on its assessment of future product demand, historical experience, and
technical obsolescence, as well as other factors affecting the recoverability of
the asset through future sales. Inventories consist of the following as of:
September 30, 2004 December 31, 2003
------------------ -----------------
Raw materials $ 3,513 $ 3,728
Work in process 946 157
Finished goods 5,681 5,690
---------------- ----------------
$ 10,140 $ 9,575
================ ================
Goodwill and Intangibles
In accordance with Statement of Financial Accounting Standards ("SFAS")
No. 142 "Goodwill and Other Intangible Assets," goodwill and other intangible
assets with indeterminate lives are no longer subject to amortization but are
tested for impairment annually or whenever events or changes in circumstances
indicate that the asset might be impaired. The Company tests goodwill for
impairment at the consolidated level against the fair market value of the
Company. Per SFAS No. 142, the fair value of a reporting unit refers to the
amount at which the unit as a whole could be bought or sold in a current
transaction between willing parties. Quoted market prices in active markets are
the best evidence of fair value and shall be used as the basis for the
measurement, if available. The Company assesses potential impairment on an
annual basis on December 31 and compares its market capitalization to the
carrying amount of goodwill. Other intangible assets with finite lives continue
to be subject to amortization, and any impairment is determined in accordance
with SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived
Assets. Estimated intangible asset amortization expense for the years ending
December 31, 2004, 2005, 2006, 2007, 2008, and thereafter is $2,029, $2,029,
$1,982, $1,744, $1,697, and $2,145, respectively.
Goodwill and other intangible assets consist of the following as of:
September 30, 2004 December 31, 2003
------------------ -----------------
Accumulated Accumulated
Cost Amortization Net Cost Amortization Net
------------ --------------- ------------- ------------ -------------- ------------
Goodwill $ 140,544 $ -- $ 140,544 $ 139,859 $ -- $ 139,859
============ ============== ============= ============ =============== ============
Intangible assets subject
to amortization:
Patents and patent applications 10,451 (4,222) 6,229 10,396 (3,372) 7,024
Customer base 4,082 (1,259) 2,823 4,082 (894) 3,188
Covenants not to compete 726 (222) 504 726 (41) 685
URL website address 656 (130) 526 640 (32) 608
Trade name 378 (378) -- 378 (378) --
Purchased software 128 (39) 89 128 (7) 121
------------ --------------- ------------- ------------ -------------- ------------
$ 16,421 $ (6,250) $ 10,171 $ 16,350 $ (4,724) $ 11,626
============ =============== ============= ============ ============== ============
6
The increase in goodwill during the nine months ended September 30, 2004
was due to adjustments to the preliminary purchase price allocation related to
the Complient acquisition as follows:
Goodwill at December 31, 2003 $ 139,859
Additional acquisition related legal fees 50
Adjustment to net realizable value of certain fixed assets 532
Adjustment to net realizable value of other receivable 25
Unrecorded pre-acquisition liability 78
--------------
Goodwill at September 30, 2004 $ 140,544
==============
The purchase price allocation related to the Complient acquisition is now
final and there will be no further adjustments.
The following unaudited pro forma data summarizes the results of
operations for the periods indicated as if the Complient acquisition had been
completed as of the beginning of the periods presented. The pro forma data gives
effect to actual operating results prior to the acquisition, adjusted to include
the pro forma effect of amortization of identified intangible assets and the
elimination of sales to Complient prior to the acquisition.
Three Months Nine Months
Ended Ended
September 30, 2003 September 30, 2003
------------------ ------------------
Pro forma net revenue $ 18,260 $ 51,875
Pro forma net loss $ (1,992) $ (8,920)
Pro forma net loss per share (basic and diluted) $ (0.03) $ (0.12)
Pro forma weighted-averaged shares 77,648,421 77,300,032
Product Warranty
Our products are generally under warranty against defects in material and
workmanship for a period of one to seven years. We estimate warranty costs at
the time of sale based on historical experience. Estimated warranty expenses are
recorded as an accrued expense, with a corresponding provision to cost of sales.
Changes in the product warranty accrual for the nine months ended
September 30 were as follows:
2004 2003
----------- -----------
Warranty accrual, beginning of period $ 836 $ 1,604
Accruals for warranties issued during the period 1,454 242
Warranty expenditures during the period (1,713) (982)
Currency translation adjustments -- 33
----------- -----------
Warranty accrual, end of period $ 577 $ 897
=========== ============
In early April 2004, the Company received a Warning Letter from the U.S.
Food and Drug Administration (FDA) following a routine inspection of its
manufacturing facility in Minneapolis. The letter specified certain procedural
and documentation items in the Company's quality system. The Company took
corrective and preventive action to bring its quality system into compliance. In
addition, during May 2004, the Company initiated a limited, voluntary recall of
approximately 5,800 units of its older model Powerheart AEDs in order to replace
a potentially faulty capacitor component. As of September 30, 2004, the majority
of the recalled units in the U.S. have been replaced or repaired and the Company
is in the process of executing its international recall plan which represents
approximately 10% of total affected units.
Also in May 2004, the Company initiated a limited, voluntary recall of
approximately 4,800 AED batteries due to an error made by the Company's battery
supplier whereby an incorrect fuse was used in the manufacture of a certain lot
of batteries. As of September 30, 2004, the recall has been completed and
customers have received replacement batteries.
The Company estimates the cost of these voluntary recall actions could
range from $1,000 to $1,200, however, the Company has received from its
suppliers credits against existing and future amounts due to these suppliers
totaling $1,240, which have been recorded to accrued expenses to establish a
warranty accrual for these recall matters and are included in accruals for
warranties issued during the period in the table above. Actual recall related
costs incurred have been charged against this accrual and totaled approximately
$1,123 as of September 30, 2004. At this time, the Company believes its
remaining accrual related to the recall will cover any future costs.
7
Excluding the impact of the recall costs incurred and vendor credits
discussed above, the Company's warranty accrual as of September 30, 2004 would
be $460. The decrease in warranty reserve requirements in 2004 compared with
2003 results primarily from AED battery design changes which dramatically
extended the life of the battery and battery warranty policy enforcement, both
of which resulted in a significant reduction in battery replacements and
therefore, a reduction in the overall warranty reserve necessary.
Stock Based Compensation
On December 31, 2002, the Financial Accounting Standards Board ("FASB")
issued SFAS 148, Accounting for Stock-Based Compensation--Transition and
Disclosure, which amends SFAS 123, Accounting for Stock-Based Compensation. SFAS
148 allows for three methods of transition for those companies that adopt SFAS
123's provisions for fair value recognition. SFAS 148's transition guidance and
provisions for annual and interim disclosures are effective for fiscal periods
ending after December 15, 2002. The Company has not adopted fair value
accounting for employee stock options under SFAS 123 and SFAS 148.
The Company has adopted the disclosure-only provisions of SFAS 123,
Accounting for Stock-Based Compensation. SFAS 123 defines a fair value based
method of accounting for an employee stock option. Fair value of the stock
option is determined considering factors such as the exercise price, the
expected life of the option, the current price of the underlying stock, expected
dividends on the stock, and the risk-free interest rate for the expected term of
the option. Under the fair value based method, compensation cost is measured at
the grant date based on the fair value of the award and is recognized over the
service period. Pro forma disclosures are required for entities that elect to
continue to measure compensation cost under the intrinsic method provided by
Accounting Principles Board Opinion ("APB") 25.
Additionally, in accordance with SFAS 123 and Emerging Issues Task Force
("EITF") 96-18, Accounting for Equity Instruments That are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling Goods or Services, the
Company measures stock based non-employee compensation at fair value. There were
no non-employee grants of stock options during the three and nine month periods
ended September 30, 2004 and 2003.
Under SFAS 123, stock based compensation expense related to stock options
granted to consultants is recognized as the stock options are earned. The fair
value of the stock options granted is calculated at each reporting date using
the Black-Scholes option pricing model. As a result, the stock based
compensation expense will fluctuate as the fair market value of the Company's
stock fluctuates.
Pro forma Effect of Stock-Based Compensation
Had compensation costs been determined based upon the fair value at the
grant date, consistent with the methodology prescribed under SFAS 123, the
Company's total stock-based compensation cost, pro forma net loss, and pro forma
net loss per share, basic and diluted, would have been as follows:
Three Months Ended Nine Months Ended
September 30, September 30, September 30, September 30,
2004 2003 2004 2003
-------- -------- -------- --------
Net loss, as reported $ (5,070) $ (1,490) $(15,223) $ (6,046)
Add: Compensation expense included in reported loss -- -- -- --
Deduct: Compensation expense determined under fair
value based method $ (775) $ (958) $ (2,617) $ (2,857)
-------- -------- -------- --------
Pro forma net loss $ (5,845) $ (2,448) $(17,840) $ (8,903)
======== ======== ======== ========
Net loss per share, as reported (basic and diluted) $ (0.06) $ (0.02) $ (0.19) $ (0.09)
======== ======== ======== ========
Pro forma net loss per share (basic and diluted) $ (0.07) $ (0.04) $ (0.22) $ (0.13)
======== ======== ======== ========
The significant variables used in the Black-Scholes model for the quarter
ended September 30, 2004 were: risk free rate of 3.41%; volatility of 0.63;
dividend yield of 0%; and expected term of 4 years.
Recent Pronouncements
In December 2003, the FASB issued Interpretation No. 46R, Consolidation of
Variable Interest Entities (FIN 46R). FIN 46R requires the application of either
FIN 46 or FIN 46R by public entities to all Special Purpose Entities (SPE)
created prior to February 1, 2003 as of December 31, 2003 for calendar year-end
companies. FIN 46R is applicable to all non-SPEs created prior to February 1,
2003 at the end of the first interim or annual period ending after March 15,
2004. For all entities created subsequent to January 31, 2003, Public Entities
were required to apply the provisions of FIN 46. The adoption of FIN 46 and FIN
46R did not have a material impact on the Company's consolidated financial
position, results of operations or cash flows.
8
4. Segment reporting
The Company follows the provisions of SFAS No. 131, Disclosures about
Segments of an Enterprise and Related Information. SFAS No. 131 established
standards for reporting information about operating segments in annual financial
statements and requires selected information about operating segments in interim
financial reports issued to stockholders. It also established standards for
related disclosures about products and services, geographic areas and major
customers. An operating segment is defined as a component of an enterprise that
engages in business activities from which it may earn revenues and incur
expenses whose separate financial information is available and is evaluated
regularly by the Company's chief operating decision makers, or decision making
group, to perform resource allocations and performance assessments.
The Company's chief operating decision makers are the Executive Management
Team which is comprised of the Chief Executive Officer and senior executive
officers of the Company. Based on evaluation of the Company's financial
information, management believes that the Company operates in one reportable
segment with its various product lines that service the external defibrillation
and cardiac monitoring industry. The product lines include AEDs and related
training, services, and accessories; Powerhearts, electrodes and related
accessories; and emergency defibrillators, monitors, CPR products and related
accessories.
The Company's Executive Management Team evaluates revenue performance of
product lines, both domestically and internationally, however, operating,
strategic and resource allocation decisions are not based on product line
performance, but rather on the Company's overall performance in its operating
segment.
The following is a breakdown of net revenue by product line:
Three Months Ended Nine Months Ended
------------------ -----------------
September 30, September 30, September 30, September 30,
2004 2003 2004 2003
------- ------- ------- -------
AEDs and related accessories $12,403 $15,102 $38,290 $40,756
AED/CPR training and program management services 1,818 -- 5,600 --
------- ------- ------- -------
Total AED related revenue 14,221 15,102 43,890 40,756
Powerheart CRMs, electrodes and related accessories 240 238 827 1,001
Emergency defibrillators, monitors, training
products and accessories 286 388 3,143 2,522
------- ------- ------- -------
$14,747 $15,728 $47,860 $44,279
======= ======= ======= =======
The following is a breakdown of net sales by geographic location:
Three Months Ended Nine Months Ended
------------------ -----------------
September 30, September 30, September 30, September 30,
2004 2003 2004 2003
------- ------- ------- -------
United States $ 9,536 $12,740 $33,241 $33,816
Foreign 5,211 2,988 14,619 10,463
------- ------- ------- -------
$14,747 $15,728 $47,860 $44,279
======= ======= ======= =======
The following is a breakdown of the Company's long-lived assets by
geographic location as of:
September 30, December 31,
2004 2003
------ ------
United States $4,918 $6,758
Foreign 215 245
------ ------
$5,133 $7,003
====== ======
5. Corporate Relocation and Restructuring
During the first quarter of 2003, the Company commenced its plan to
relocate its corporate headquarters, expanded its manufacturing capacity, and
consolidated its accounting and finance functions in Irvine, California. All
expansion, relocation, and restructuring activities were completed in the second
quarter of 2003.
Costs related to severance, moving, lease termination and accelerated
depreciation of leaseholds and other assets of $718 were incurred and included
in general and administrative expenses in the accompanying consolidated
statement of operations for the nine months ended September 30, 2003.
9
The accrual represented costs recognized pursuant to SFAS 146, Accounting
for Costs Associated with Exit or Disposal Activities and SEC Staff Accounting
Bulletin ("SAB") 100, Restructuring and Impairment Charges. The Company
committed to a sufficiently detailed plan that identified significant actions to
be taken and the activities that would not be continued. The plan was completed
during the quarter ended September 30, 2003 and there were no significant
changes to the original plan. The involuntary one-time employee-termination
arrangement established the benefits to be paid to employees and specifically
identified the classifications or functions of those employees, their locations,
and their expected completion date. All employees were informed about the terms
of the benefit arrangement, including the benefits that employees would receive
upon termination (including but not limited to cash payments), in sufficient
detail to enable employees to determine the type and amount of benefits they
would receive. The Company reviewed the net book value of leasehold improvements
to be abandoned in certain facilities in accordance with SFAS 144, and
appropriately recorded an adjustment to accelerate the related depreciation over
the revised useful life through their cease-use dates.
6. Long-Term Debt
During February 2004, the Company secured a $5,000 line of credit from its
bank. The line of credit will be used to provide additional working capital, as
needed, to fund the Company's growth. The 24-month facility is collateralized by
accounts receivable, inventory, cash, and marketable securities, bears interest
at the bank's prime rate plus .75% (floor of 5%) with interest payable monthly,
and requires the Company to maintain certain financial covenants. In November
2004, the Company obtained a waiver from the bank for the quarter ended
September 30, 2004, consistent with the waivers obtained for the quarters ended
March 31, 2004 and June 30, 2004, for non-compliance with certain financial
covenants required by the agreement. There was no balance outstanding on the
line as of September 30, 2004, or through the date of this filing.
On May 29, 2002, the Company entered into a Senior Note and Warrant
Purchase Agreement ("the Agreement") with investors, pursuant to which the
investors loaned the Company $50,000. The Senior Notes (the "Notes") are due
and payable in cash on May 30, 2007, unless accelerated pursuant to the terms of
the Agreement. The Notes accrue interest at 6.9% per annum. During the first
three years of the term of the Notes, accrued and unpaid interest on the Notes
will, at the option of the Company, a) be due and payable in cash, or b) accrue
and be paid in kind, in each case quarterly in arrears, and then due on the
termination date of the Notes. After the end of the third year of the term the
Notes, any additional accrued and unpaid interest on the Notes will be due and
payable in cash quarterly in arrears, and on the termination date of the Notes.
The Notes are collateralized by all the assets of the Company and its
subsidiaries, to the extent permitted by law. In connection with the Notes, the
investors were issued warrants (the "Warrants") for the purchase of an aggregate
of 10,000,000 shares of the Company's common stock at an exercise price of $3.00
per share, and an aggregate of 3,000,000 shares of common stock at an exercise
price of $4.00 per share. The Warrants are immediately exercisable, expire by
their terms on May 30, 2009 and are subject to certain limited anti-dilution
adjustments. After two years, the Company has the right to force the exercise of
the warrants pursuant to the terms of the Agreement.
On March 15, 2004, the Company amended its Senior Note and Warrant
Agreement (the "Agreement") in order to ease certain financial covenants into
2005 to reflect the Company's actual and expected financial results. In exchange
for modifying these covenants, the Company issued warrants to the holders of the
Senior Notes to purchase 500,000 shares of common stock at $3.95 per share. The
warrants were valued at $1,301 using a Black-Scholes model. The significant
assumptions used in the model were: stock price of $3.98; risk free rate of
3.2%; volatility of 0.65; dividend yield of 0%; and contractual term of seven
years. The value of the warrants was recorded as additional discount to the
Senior Notes to be amortized over the remaining term of the Senior Notes using
the effective interest method. This modification was not considered to be a
significant modification of the Agreement.
In November, the Company obtained a waiver from the Senior Note holders
for non-compliance with a financial covenant for the quarter ended September 30,
2004. In addition, based on the Company's expected results for the quarter and
year ending December 31, 2004, it anticipates that it will be in non-compliance
of certain financial covenants for those periods. Accordingly the Company has
reclassified these Senior Notes Payable to current liabilities as of September
30, 2004. The Company has entered into negotiations with the holders of the
Senior Notes to secure a waiver of any non-compliance for the quarter and year
ending December 31, 2004, as well as to restructure the financial covenants and
certain other terms of the Senior Notes for 2005. Management believes that it
will be successful in its negotiations, however, there can be no assurance that
an agreement will be reached. If the Company fails to comply with is financial
covenants and an agreement is not reached, the Senior Note holders could
exercise their rights under the Agreement, and the Company could experience
liquidity problems which would have a material adverse effect on the Company.
7. Common Stock
In July 2004, the Company completed a private placement of common stock
and warrants raising $12,370 in gross proceeds. The holders of the Senior Notes
were the lead investors. New shares of the Company's common stock of 5,219,409
were issued at a price of $2.37 per share. In addition, five year warrants to
purchase 2,087,763 shares of common stock at an exercise price of $2.84 per
share were issued. Proceeds of the offering are providing additional working
capital and are funding product development initiatives.
8. Litigation and Other Contingencies
On December 3, 2002, the Company filed a Complaint in Orange County
Superior Court against Medical Research Laboratories, Inc. ("MRL") alleging
declaratory relief and breach of contract arising out of a July 29, 2002 letter
of intent entered into between the parties. The Company alleged that MRL failed
to comply with certain conditions of closing set forth in the letter of intent
whereby the Company would acquire all of MRL's stock. MRL filed a
cross-complaint, also seeking breach of contract and declaratory relief arising
out of the same letter of intent. On February 25, 2003, the Company filed suit
against MRL for patent infringement in the United States District Court for the
District of Minnesota. The Company alleged that MRL's LifeQuest JumpStart AED
infringed the Company's patented disposable electrode pre-connect technology.
The Company settled both law suits with MRL on September 24, 2003. Under the
terms of the confidential settlement agreement, the Company received a
settlement amount from MRL and MRL received the right to license two of the
Company's patents for additional royalties.
In February 2003, the Company filed a patent infringement action against
Philips Medical Systems North America, Inc., Philips Electronics North America
Corporation and Koninklijke Philips Electronics N.V. ("Philips") in the United
States District Court for the District of Minnesota. The suit alleges that
Philips' automated external defibrillators sold under the names "HeartStart
OnSite Defibrillator", "HeartStart", "HeartStart FR2" and the "HeartStart Home
Defibrillator," infringe at least ten of the Company's United States patents. In
the same action, Philips counterclaimed for infringement of certain of its
patents and the Company has sought a declaration from the Court that the
Company's products do not infringe such patents. Many of the Philips
defibrillators' are promoted by Philips as including, among other things,
pre-connected disposable defibrillation electrodes and daily self-testing of
electrodes and battery, features that the suit alleges are key competitive
advantages of the Company's Powerheart and Survivalink AEDs and are covered
under the Company's patents. At this stage, the Company is unable to predict the
outcome of this litigation. The Company has not established an accrual for this
matter because a loss is not determined to be probable.
10
On April 30, 2003, the Company filed a Complaint against Defibtech, LLC
for patent infringement in the United States District Court for the District of
Minnesota. The Complaint alleged that Defibtech's Sentry and Reviver AEDs
infringe the Company's patented disposable electrode pre-connect technology as
well as other patents. Defibtech answered the Complaint and asserted
counterclaims alleging that the Company has engaged in activities that
constitute tortious interference with present and prospective contractual
relations, common law business disparagement and statutory business
disparagement. The Company responded to the counterclaims with a complete and
general denial of the allegations. At this stage, the Company is unable to
predict the outcome of this litigation. The Company has not established an
accrual for this matter because a loss is not determined to be probable.
On March 19, 2004, William S. Parker filed suit against the Company for
patent infringement in the United States District Court for the Eastern Division
of Michigan. The Parker patent generally covers the use of a synthesized voice
to instruct a person to perform certain tasks. The Complaint alleges that
certain of the Company's AEDs infringe the patent. The patent is now expired.
The Company has filed an Answer to the Complaint stating the patent is not
infringed and is otherwise invalid and unenforceable. The patent has been
submitted before the United States Patent and Trademark Office for
reexamination. On October 25, 2004, the District Court issued an order staying
the litigation pending resolution of the reexamination. At this stage of the
litigation, the Company is unable to predict the outcome of this litigation. The
Company has not established an accrual for this matter because a loss is not
determined to be probable.
In the ordinary course of business, various lawsuits and claims are filed
against the Company. While the outcome of these matters is currently not
determinable, management believes that the ultimate resolution of these matters
will not have a material adverse effect on the Company's operations or financial
position.
9. Disposals of Assets and Other Expenses
In May 2004, the Company sold fixed assets in connection with closing our
Ohio facility from the Complient acquisition for $23 in cash resulting in a loss
of $203 recorded to other operating expenses in the quarter ended June 30, 2004.
In June 2004, the Company sold the rights to an AED trainer that the
Company manufactured for one specific customer for $700 in cash, resulting in a
gain of $483 recorded to other operating expenses in the quarter ended June 30,
2004, adjusted down by $96 in the quarter ended September 30, 2004, for a net
gain of $387.
In July, the Company initiated a plan to streamline its international
operations by transferring certain administrative and logistics functions to the
U.S. and U.K., which resulted in headcount reductions and an accrual for
severance of $285 recorded in the quarter ended September 30, 2004
In August 2004, the Company sold the CPR Prompt product line, which
includes products such as CPR Prompt devices, manikins, and training related
equipment and supplies, for $1,875 in cash resulting in a net gain of $1,368
recorded to other operating expenses in the quater ended September 30, 2004.
In September 2004, the Company discontinued its Diascope product line,
which is manufactured by a contract manufacturer in Asia and sold only in
international markets. As of September 30, 2004, substantially all of the
inventory on hand was sold. The Company recorded an impairment of assets related
to the discontinuance of the product line of $190 to other operating expenses in
the quarter ended September 30, 2004.
11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
(In thousands, except share and per share data)
The following discussion should be read in conjunction with the
consolidated financial statements and notes thereto appearing elsewhere in this
report.
A Warning About Forward-Looking Information and the Safe Harbor Under the
Securities Litigation Reform Act of 1995
This Quarterly Report on Form 10-Q contains certain forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and
we intend that such forward looking statements be subject to the safe harbors
created thereby. In some cases, you can identify forward-looking statements by
words like "may," "will," "should," "could," "believes," "intends," "expects,"
"anticipates," "plans," "estimates," "predicts," "potential," "continue" and
similar expressions. These forward-looking statements relate to, among other
things, (i) future expenditures and results, (ii) business strategies, and (iii)
the need for, and availability of, additional financing.
The forward-looking statements included herein are based on current
expectations, which involve a number of risks and uncertainties and assumptions
regarding our business and technology. These assumptions involve judgments with
respect to, among other things, future economic and competitive conditions, and
future business decisions, all of which are difficult or impossible to predict
accurately and many of which are beyond our control. Although we believe that
the assumptions underlying the forward-looking statements are reasonable, any of
the assumptions could prove inaccurate and, therefore, there can be no assurance
that the results contemplated in forward-looking statements will be realized and
actual results may differ materially. In light of the significant uncertainties
inherent in the forward-looking information included herein, the inclusion of
such information should not be regarded as a representation by us or any other
person that our objectives or plans will be achieved. We undertake no obligation
to publicly release the result of any revisions to these forward-looking
statements that may be made to reflect events or circumstances after the date
hereof, or to reflect the occurrence of unanticipated events. Readers should
carefully review the risk factors described in the documents that we file from
time to time with the Securities and Exchange Commission, including Quarterly
Reports on Form 10-Q, Annual Reports on Form 10-K and subsequent current reports
on Form 8-K.
Results of Operations
Quarter Ended September 30, 2004 Compared to the Quarter Ended September 30,
2003
Revenue
The following is a summary of net revenue by product line for the quarters
ended September 30:
2004 2003 Change
------------------- ------------------- -------------------
Revenue:
AEDs and related accessories $12,403 84.1% $15,102 96.0% $(2,699) (17.9%)
AED/CPR training and program 1,818 12.3% -- -- 1,818 n/a
management services
------- ------- ------- ------- -------
Total AED related revenue 14,221 96.4% 15,102 96.0% (881) (5.8%)
Powerheart in-hospital defibrillators and accessories 240 1.6% 238 1.5% 2 0.8%
Patient monitors, training products and accessories 286 2.0% 388 2.5% (102) (26.3%)
------- ------- ------- ------- -------
Total net revenue $14,747 100.0% $15,728 100.0% $ (981) (6.2%)
======= ======= ======= ======= =======
Net revenue for the quarter ended September 30, 2004 decreased $981 or
6.2% compared to the quarter ended September 30, 2003. This decrease was
primarily the result of increased competition and longer sales cycles in the
domestic AED markets, somewhat offset by continued growth in AED sales
internationally and the AED/CPR training business which accounted for $1,818 in
revenue. We anticipate little to no sales of patient monitors, training
equipment and accessories in the fourth quarter due to the recent disposal of
these product lines. We expect that these decreases will be offset by an
increase in AED revenue in the fourth quarter.
Gross Margin
Cost of revenue for the quarter ended September 30, 2004 was $6,636
compared to $6,217 for the same quarter in 2003. Gross margins as a percentage
of revenue decreased to 55.0% for the quarter ended September 30, 2004 from
60.5% in the same quarter in 2003. This decrease in margin was primarily due to
a higher mix of international OEM sales which have a lower gross margin compared
to domestic direct sales and the comparatively lower margin on service revenue
(AED/CPR training and program management services) that did not exist in the
same quarter in 2003. Cost of service revenue was $1,027 for the quarter ended
September 30, 2004 with a gross margin of 43.5%. We expect our gross margin to
return to previous levels for the last quarter of the year.
12
During the quarter ended December 31, 2003, we recorded an impairment
charge of $2,917 for the write off of first generation Powerhearts and CRM
in-hospital defibrillators in inventory related to a strategic decision to
discontinue the "no cap" Powerheart in-hospital defibrillator placement model.
The majority of this inventory written off is still on hand. There was one sale
of first generation Powerhearts of $75 that had a favorable impact on our margin
in the quarter ended September 30, 2004.
Operating Expenses
The following is a summary of operating expenses as a percentage of net
revenue for the quarters ended September 30:
2004 2003 Change
---------------------- --------------------- ------------------------
Sales and marketing $ 5,561 37.7% $ 4,564 29.0% $ 997 21.8%
Research and development 1,373 9.3% 1,444 9.2% (71) (4.9)%
General and administrative 4,758 32.3% 3,386 21.6% 1,372 40.5%
Amortization 519 3.5% 381 2.4% 138 36.2%
Gain on sale of assets and other, net (797) (5.4)% -- -- (797) n/a
-------- -------- -------- -------- --------
Total operating expenses $ 11,414 77.4% $ 9,775 62.2% $ 1,639 16.8%
======== ======== ======== ======== ========
Sales and marketing expenses increased by 21.8% to $5,561 for the quarter
ended September 30, 2004. The increase is primarily attributable to higher
direct marketing programs in the U.S. ($809), expanded international direct
sales operations, primarily in the U.K and Germany ($166), new sales and
marketing expenses related to program management and training services
associated with the business acquired from Complient in October 2003 ($400), and
the establishment of an inside sales team ($148). These increases were partially
offset by a reduction in U.S. direct selling costs ($508). As anticipated, we
realized a sequential decrease in sales and marketing expense of $1,386 and a
decrease as a percent of revenue to 37.7% from 39.7% for the third quarter
compared to the second quarter of 2004 and expect further decreases in the
fourth quarter of 2004.
Research and development expenses for the quarter ended September 30, 2004
decreased by $71 or 4.9% compared to the same quarter in 2003. In the quarter
ended September 30, 2004, research and development expenses were 9.3% of
revenue, consistent with 9.2% of revenue in the same quarter in 2003. Although
resources such as headcount and project costs were allocated to different
projects in 2004 compared to 2003, the overall impact on research and
development expense was neutral for the quarter ended September 30, 2004
compared to the quarter ended September 30, 2003. We expect research and
development expenses to increase somewhat in the last quarter of the year.
General and administrative expenses increased $1,372 or 40.5% during the
quarter ended September 30, 2004 compared with the same quarter in 2003. As a
percentage of revenue, general and administrative expenses increased to 32.3% in
the quarter ended September 30, 2004 from 21.5% in the same quarter in 2003. The
absolute dollar increase was primarily comprised of new expenses, primarily
headcount and facilities, related to the Complient acquisition ($125), increased
legal costs ($239), increased accounting and consulting costs, primarily related
to Sarbanes Oxley compliance ($165), increased insurance costs ($219) and higher
bad debt expense resulting from the uncertainty as to the collectibility of
certain accounts ($467). We expect general and administrative expenses to remain
relatively constant during the fourth quarter of 2004.
Amortization of intangibles was $519 for the quarter ended September 30,
2004, an increase of $138 or 36.2% from the $381 for the same quarter in 2003.
The increase is the result of additional amortization expense of certain
identifiable intangible assets related to the Complient acquisition in October
2003. We expect amortization expense to remain constant for the balance of 2004.
Net gain on sale of assets and other costs was $797 for the quarter ended
September 30, 2004 and consisted of the gain on sale of the CPR prompt product
line ($1,368) offset by an impairment of assets related to the discontinuance of
the Diascope product line ($190), adjustment to reduce the gain on sale of a
product line in the quarter ended June 30, 2004 ($96), and severance related to
headcount reductions from consolidating our international operations ($285).
Interest and Other Non-operating Expense, Net
Net interest and other expenses increased by $285 to $1,767 for the
quarter ended September 30, 2004 compared to $1,482 for the same quarter in
2003. This increase was primarily due to higher interest expense this quarter
compared to the same quarter last year based on the average outstanding note
balance and amortization of warrants, including the additional warrants issued
in March 2004, using the effective interest rate method, both of which are
associated with the Senior Notes issued in May 2002.
13
Nine Months Ended September 30, 2004 Compared to Nine Months Ended September 30,
2003
Revenue
The following is a summary of net revenue by product line for the nine
months ended September 30:
2004 2003 Change
------------------- ------------------- ---------------------
Revenue:
AEDs and accessories $38,290 80.0% $40,756 92.0% $(2,466) (6.1%)
AED/CPR training and program
management services 5,600 11.7% -- -- 5,600 n/a
------- ------- ------- ------- -------
Total AED related revenue 43,890 91.7% 40,756 92.0% 3,134 7.7%
Powerheart in-hospital defibrillators and accessories 827 1.7% 1,001 2.3% (174) (17.4%)
Patient monitors, training products and accessories 3,143 6.6% 2,522 5.7% 621 24.6%
------- ------- ------- ------- -------
Total net revenue $47,860 100.0% $44,279 100.0% $ 3,581 8.1%
======= ======= ======= ======= =======
Net revenue for the nine months ended September 30, 2004 increased $3,581
or 8.1% compared to the nine months ended September 30, 2003. This increase was
primarily attributable to AED/CPR training and program management services of
$5,600 resulting from the acquisition of this business from Complient
Corporation in October 2003, partially offset by a decrease of $2,466 in sales
of AED products and related accessories due to increased competition and longer
sales cycles in the domestic AED markets. Revenue from AED sales internationally
increased year over year. Revenue from the sale of patient monitors, training
products and accessories increased by $621 or 24.6% for the nine months ended
September 30, 2004 compared with the same period in 2003 primarily due to the
addition of the CPR training products resulting from the Complient acquisition.
Gross Margin
Cost of revenue sold for the nine months ended September 30, 2004 was
$20,967 compared to $18,527 for the nine months ended September 30, 2003. Gross
margins as a percentage of revenue were 56.2% for the nine months ended
September 30, 2004 compared to 58.2% in the nine months ended September 30,
2003. Although we introduced our new lower material cost version Powerheart AED
G3 in August 2003, these cost savings were offset by a higher mix of
international OEM sales which have lower gross margins when compared to domestic
direct sales and lower margins on service revenue that did not exist in the same
period in 2003. Cost of service revenue was $3,399 for the nine months ended
September 30, 2004 with a gross margin of 39.3%.
During the quarter ended December 31, 2003, we recorded an impairment
charge of $2,917 for the write off of first generation Powerhearts and CRM
in-hospital defibrillators in inventory related to a strategic decision to
discontinue the "no cap" Powerheart in-hospital defibrillator placement model.
The majority of this inventory written off is still on hand. There were two
sales of first generation Powerhearts totaling $130 that had a favorable impact
on our margin in the nine months ended September 30, 2004.
Operating Expenses
The following is a summary of operating expenses as a percentage of net
revenue for the nine months ended September 30:
2004 2003 Change
---------------------- --------------------- ----------------------
Sales and marketing $ 18,511 38.7% $ 12,927 29.2% $ 5,584 43.2%
Research and development 4,498 9.4% 3,939 8.9% 559 14.2%
General and administrative 13,521 28.3% 9,800 22.1% 3,721 38.0%
Amortization 1,526 3.2% 1,211 2.8% 315 26.0%
Gain on sales of assets and other, net (1,077) (2.3%) -- -- (1,077) n/a
-------- -------- -------- -------- --------
Total operating expenses $ 36,979 77.3% $ 27,877 63.0% $ 9,102 32.7%
======== ======== ======== ======== ========
Sales and marketing expenses increased by 43.2% to $18,511 for the nine
months ended September 30, 2004. The increase is primarily attributable to
expanded international sales operations, primarily our direct sales operations
in the U.K and Germany ($1,760), new sales and marketing expenses related to
program management and training services related to the business acquired from
Complient in October 2003 ($1,667), increased U.S. marketing activities
($2,091), and the establishment of an inside sales team ($541). These increases
were partially offset by a reduction in U.S. direct selling costs ($457).
Research and development expenses for the nine months ended September 30,
2004 increased by $559 or 14.2% compared to the nine months ended September 30,
2003. The increase is primarily attributable to increased headcount and project
costs associated with the development of a standard hospital defibrillator for
GE Healthcare pursuant to a development agreement signed in July 2003, as well
as some additional costs in the first half of the year related to personnel and
activities in connection with the business acquired from Complient Corporation
in October 2003.
14
General and administrative expenses increased $3,721 or 38.0% during the
nine months ended September 30, 2004 compared with the nine months ended
September 30, 2003. The increase was primarily comprised of new expenses,
primarily headcount and facilities, related to the Complient acquisition
($1,066), increased legal costs ($942), increased accounting, consulting and
corporate governance costs ($553), higher commercial and health insurance costs
($586), and higher bad debt expense resulting from the uncertainty as to the
uncollectibility of certain accounts($891). These increases were partially
offset by a decrease in costs related to our relocation and expansion of
facilities in the first quarter of 2003 ($718).
Amortization of intangibles was $1,526 for the nine months ended September
30, 2004, an increase of $315 or 26.0% from the $1,211 for the nine months ended
September 30, 2003. The increase is primarily the result of additional
amortization expense of certain identifiable intangible assets related to the
Complient acquisition in October 2003.
Net gain on sale of assets and other costs was $1,077 for the nine months
ended September 30, 2004 and consisted of the gain on sale of the CPR Prompt
product line ($1,368) and the AED trainer product ($387), offset by a loss on
sales of fixed assets ($203), an impairment of assets related to the
discontinuance of the Diascope product line ($190) and severance related to
headcount reductions from consolidating our international operations ($285).
Interest and Other Non-Operating Expense, Net
Net interest and other expenses increased by $771 to $5,137 for the nine
months ended September 30, 2004 compared to $4,366 for the nine months ended
September 30, 2003. This increase was primarily due to higher interest expense
in 2004 compared to 2003 based on the average outstanding note balance and
amortization of warrants using the effective interest rate method, both of which
are associated with the senior notes payable issued in May 2002.
Liquidity and Capital Resources
September 30, December 31,
2004 2003
---- ----
Working capital $ (21,208) $ 22,981
Current ratio (current assets to current liabilities) 0.67 : 1.0 2.3 : 1.0
Cash and cash equivalents $ 15,415 $ 8,871
Accounts receivable, net $ 15,454 $ 20,410
Inventories $ 10,140 $ 9,575
Short-term and long-term borrowings $ 49,908 $ 46,575
The decrease in our current ratio and working capital is due to the
reclassification of the Senior Notes to current liabilities due to the
anticipated non-compliance with certain financial covenants for the quarter and
year ending December 31,2004. The increase in cash and cash equivalents is
primarily due to proceeds from our private placement of common stock in July
2004.
At September 30, 2004, our days sales outstanding on accounts receivable
("DSO") was approximately 95 days compared to approximately 88 days at June 30,
2004 and 105 days at December 31, 2003. We anticipate that our DSO will average
approximately 90 days during 2004, which is a decrease from late 2003 resulting
from more aggressive collection efforts and a decrease in the revenue mix for
sales in the indirect distribution channel in 2004 compared with 2003.
In February 2004, we secured a $5,000 line of credit with Silicon Valley
Bank. The line of credit will be used to provide additional working capital, as
needed, to fund our continued growth. This 24-month facility is collateralized
by accounts receivable, inventory and cash and cash equivalents, has an interest
rate of the bank's prime rate plus .75% (with a floor of 5%) payable monthly,
and requires us to maintain certain financial covenants. In November 2004, we
obtained a waiver from the bank for the quarter ended September 30, 2004 for
non-compliance with certain financial covenants required by the line of credit
agreement. There was no outstanding balance on the line at September 30, 2004 or
through the date of this filing.
On May 29, 2002, we entered into a Senior Note and Warrant Purchase
Agreement ("the Agreement") with investors, pursuant to which the investors
loaned us $50 million. The Senior Notes (the "Notes") are due and payable in
cash on May 30, 2007, unless accelerated pursuant to the terms of the Agreement.
The Notes accrue interest at 6.9% per annum. During the first three years of the
term of the Notes, accrued and unpaid interest on the Notes will, at the option
, a) be due and payable in cash, or b) accrue and be paid in kind, in each case
quarterly in arrears, and then due on the termination date of the Notes. After
the end of the third year of the term the Notes, any additional accrued and
unpaid interest on the Notes will be due and payable in cash quarterly in
arrears, and on the termination date of the Notes. The Notes are collateralized
by all the assets of the Company and its subsidiaries, to the extent permitted
by law. In connection with the Notes, the investors were issued warrants (the
"Warrants") for the purchase of an aggregate of 10,000,000 shares of our common
stock at an exercise price of $3.00 per share, and an aggregate of 3,000,000
shares of common stock at an exercise price of $4.00 per share. The Warrants are
immediately exercisable, expire by their terms on May 30, 2009 and are subject
to certain limited anti-dilution adjustments. After two years, we have the right
to force the exercise of the warrants pursuant to the terms of the Agreement.
From inception, our sources of funding for operations and mergers and
acquisition activity were derived from placements of debt and equity securities.
In 2001, we raised approximately $37,000 in a series of private equity
placements and through the exercise of outstanding options and warrants. In May
2002, we entered into a Senior Note and Warrant Purchase Agreement with
investors pursuant to which the investors loaned us $50,000. We in turn repaid
the $26,468 plus accrued interest in senior promissory notes relating to the
Survivalink acquisition. In September 2003, we raised $8,375 in a private equity
placement of 2,233,334 shares of our common stock at $3.75 per share to a small
group of institutional and accredited investors. In connection with this
offering, we also issued 223,333 five-year warrants with an exercise price of
$5.00 per share. In July 2004, we raised gross proceeds of $12,370 in a private
equity placement of 5,219,409 shares of our common stock at $2.37 per share. In
connection with this offering, we issued five-year warrants to purchase
2,087,763 shares of common stock at a price of $2.84 per share.
15
In March 2004, we amended the Senior Note and Warrant Agreement (the
"Agreement") in order to ease certain financial covenants into 2005 to reflect
our actual and expected financial results. In exchange for these modifications,
we issued the note holders 500,000 additional warrants to purchase shares of
common stock at $3.95 per share. The warrants were valued at $1,301 using a
Black-Scholes model. The significant assumptions used in the model were: stock
price of $3.98; risk free rate of 3.2%; volatility of 0.65; dividend yield of
0%; and contractual term of seven years. The value of the warrants was recorded
as additional discount to the Senior Notes to be amortized over the remaining
term of the Senior Notes using the effective interest method. This modification
was not considered to be a significant modification of the Agreement.
In November, we obtained a waiver from the Senior Note holders for
non-compliance with a financial covenant for the quarter ended September 30,
2004. In addition, based on our expected results for the quarter and year ending
December 31, 2004, we anticipate that we will be in non-compliance of certain
financial covenants for those periods. Accordingly we have reclassified these
Senior Notes Payable to current liabilities as of September 30, 2004. We have
entered into negotiations with the holders of the Senior Notes to secure a
waiver of any non-compliance for the quarter and year ending December 31, 2004
periods, as well as to restructure the financial covenants and certain other
terms of the Senior Notes for 2005. Management believes that it will be
successful in its negotiations, however, there can be no assurance that an
agreement will be reached. If we fail to comply with the financial covenants and
an agreement is not reached, the Senior Note holders could exercise their rights
under the Agreement, and we could experience liquidity problems which would have
a material adverse effect.
Cash used in operating activities for the nine months ended September 30,
2004 decreased by $4,143 or 35.0% to $7,708 from $11,851 for the same period in
2003. This decrease was primarily attributable to a $10,767 reduction in cash
used in accounts receivable and a $1,460 reduction in cash used in net assets
and liabilities held for sale, offset by an increase in our net loss for the
period of $9,177.
Cash provided by investing activities for the nine months ended September
30, 2004 of $1,210 decreased by $30 or 2.4% compared to cash provided by
investing activities of $1,240 for the same period in 2003. This change was
primarily attributable to the refund of the MRL investment of $3,001 and the
goodwill cash adjustment of $1,027 in the nine months ended September 2003,
substantially offset by the funds placed in escrow to buy the minority interest
in Artema of $1,299 in the nine months ended September 30, 2003 and a decrease
in purchases of property and equipment of $1,347 period over period and an
increase in proceeds from sales of assets period over period.
Cash provided by financing activities for the nine months ended September
30, 2004 increased by $3,949 or 43.4% compared to the same period in 2003. This
increase was primarily due to an increase in proceeds from the private
placements of common stock year over year.
The accompanying consolidated condensed financial statements have been
prepared on the basis that we will continue as a going concern and that we will
recover our assets and satisfy our liabilities in the normal course of business.
From inception, we have incurred substantial losses and negative cash flows from
operations. As of September 30, 2004, the Company had cash on hand of $15,415,
negative working capital of 21,208, short and long term debt of $49,908, and an
accumulated deficit of $120,911.
We believe that our current cash balance, in combination with net cash
expected to be generated from operations, will fund ongoing operations for at
least twelve months. Our expected net cash from operations is predicated on
achieving increases in revenue from the sale of AEDs, somewhat offset by a
decrease in revenue from other products, achieving further reductions in our
cost of goods sold, controlling operating expenses and reducing our DSO ratio.
If we do not realize the expected increases in revenue and reductions in
cost of goods sold, or if operating expenses increase substantially, or if we
cannot reduce our DSO ratio, we may not be able to fund our operations for the
next twelve months. In addition, if we are unsuccessful in negotiating the
financial covenants of our Senior Notes , we may not be able to fund our
operations over the next twelve months, and as such, there may be substantial
doubt about our ability to continue as a going concern.
In the event that we require additional funding during the next twelve
months, we will attempt to raise the required capital through either debt or
equity arrangements. We cannot provide any assurance that the required capital
would be available on acceptable terms, if at all, or that any financing
activity would not be dilutive to current stockholders of the Company. If we are
not able to raise additional funds, we may be required to significantly curtail
our operations and this would have an adverse effect on our financial position,
results of operations and cash flows.
Off-Balance Sheet Arrangements
We do not have any material off-balance sheet arrangements other than
non-cancelable operating leases entered into in the ordinary course of business.
For liquidity purposes, we choose to lease our facilities, automobiles, and
certain equipment instead of purchasing them.
Contractual Obligations and Other Commercial Commitments
We had no material commitments for capital expenditures as of September
30, 2004.
The following table presents our expected cash requirements for
contractual obligations outstanding as of September 30, 2004:
Less than After
Total 1 Year 1-3 Years 4-5 Years 5 Years
----- ------ --------- --------- -------
Senior notes payable, including interest $ 69,945 $ 62,876 $ 7,068 $ -- --
Other long-term obligations 52 24 24 4 --
Non-cancelable operating leases 5,953 1,447 2,970 1,536 --
------------ ------------ ------------ ------------ -------------
$ 75,950 $ 64,347 $ 10,062 $ 1,540 $ --
============ ============ ============ ============ =============
The senior notes payable have been reclassified to current liabilities as of
September 30, 2004 due to anticipated non-compliance with certain financial
covenants. Therefore, the principal amount of the note is shown in the less than
1 year column in the table above. However, the company expects to negotiate the
financial covenants with the lender and does not anticipate having to pay off
the notes in the next twelve months. Therefore future interest expense on the
notes has been included in the table above.
16
Income Taxes
As of December 31, 2003, we have research and experimentation credit carry
forwards for federal and state purposes of approximately $3,000 and $1,000,
respectively. These credits begin to expire in 2006 for federal purposes and
carry forward indefinitely for California state purposes. We have capital loss
carry forwards of approximately $1,000 for both federal and state purposes which
begin to expire in 2004 for federal purposes and carry forward indefinitely for
state purposes. We also have approximately $134,000 and $74,000, respectively,
of federal and state net operating loss carry forwards which will begin to
expire in 2006 and 2005, respectively. The utilization of net operating loss and
tax credit carry forwards will be limited under the provisions of Internal
Revenue Code Sections 382 and 1503 and similar state provisions. The limitations
could result in the expiration of our net operating loss carry forwards and
research and experimentation credit carry forwards before full utilization.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amount of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amount of revenue and expenses for
each period.
The following represents a summary of our critical accounting policies,
defined as those policies that we believe are: (a) the most important to the
portrayal of our financial condition and results of operations, and (b) that
require our most difficult, subjective or complex judgments, often as a result
of the need to make estimates about the effects of matters that are inherently
uncertain.
Valuation of Accounts Receivable
We maintain an allowance for uncollectible accounts receivable to estimate
the risk of extending credit to customers. The allowance is estimated based on
customer compliance with credit terms, the financial condition of the customer,
and collection history, where applicable. Additional allowances could be
required if the financial condition of our customers were to be impaired beyond
our estimates.
Valuation of Inventory
Inventory is valued at the lower of cost (estimated using the first-in,
first-out method) or market. We periodically evaluate the carrying value of
inventories and maintain an allowance for obsolescence to adjust the carrying
value, as necessary, to the lower of cost or market. The allowance is based on
our assessment of future product demand, historical experience and technical
obsolescence, as well as other factors affecting the recoverability of the asset
through future sales. Unfavorable changes in estimates of obsolete inventory
would result in an increase in the allowance and a decrease in gross profit.
Goodwill and Other Intangibles
In accordance with SFAS No. 142 "Goodwill and Other Intangible Assets,"
goodwill and other intangible assets with indeterminate lives are no longer
subject to amortization but are tested for impairment annually or whenever
events or changes in circumstances indicate that the asset might be impaired. We
test goodwill for impairment at the consolidated level against the fair market
value of the Company. Per SFAS No. 142, the fair value of a reporting unit
refers to the amount at which the unit as a whole could be bought or sold in a
current transaction between willing parties. Quoted market prices in active
markets are the best evidence of fair value and shall be used as the basis on
the last day of the year for the measurement, if available. We assess potential
impairment on an annual basis on the last day of the year and compare our market
capitalization to the carrying amount of goodwill. A significant decrease in our
stock price could indicate a material impairment of goodwill which, after
further analysis, could result in a material charge to operations. To date, we
have not determined or recorded an impairment of goodwill since our market
capitalization at the date of the impairment tests has never been less than the
carrying amount of goodwill. Other intangible assets with finite lives continue
to be subject to amortization, and any impairment is determined in accordance
with SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived
Assets.
Valuation of Long-Lived Assets
In accordance with SFAS No. 144, long-lived assets and intangible assets
with determinate lives are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. We evaluate potential impairment by comparing the carrying amount
of the asset with the estimated undiscounted future cash flows associated with
the use of the asset and its eventual disposition. Should the review indicate
that the asset is not recoverable, our carrying value of the asset would be
reduced to its estimated fair value, which is generally measured by future
discounted cash flows. In our estimate, no provision for impairment is currently
required on any of our long-lived assets.
17
Valuation of Warrants
We periodically issue warrants in connection with debt issuances and in
exchange for goods and services. We follow the guidance of APB No. 14
"Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants"
for warrants we issue in connection with debt. We follow the guidance in EITF
No. 96-18 "Accounting for Equity Instruments That are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services" and
EITF No. 01-9 "Accounting for Consideration Given by a Vendor to a Customer
(Including a Reseller of the Vendor's Products)" for warrants we issue in
exchange for or in connection with goods and services. Management considers a
number of factors, including independent valuations, when determining the fair
value of warrants issued. We estimate the fair value of warrants issued using
the Black-Scholes model. Of the various assumptions considered by the
Black-Scholes model, the volatility and the risk free rate used require us to
make certain assumptions and estimations. We estimate volatility using a
statistical method based on the historical daily stock price for the historical
period equal to the expected life of the warrant being valued. The risk free
interest rate is determined using the treasury note rate for the number of years
corresponding to the expected life of the warrant being valued. Potentially, the
value of warrants could be materially different if different assumptions were
used and under different markets conditions.
Revenue Recognition
We record revenue in accordance with Securities and Exchange Commission
("SEC") Staff Accounting Bulletin No. 104, Revenue Recognition in Financial
Statements (SAB 104). SAB 104 requires that product sales be recognized when
there is persuasive evidence of an arrangement which states a fixed and
determinable price and terms, delivery of the product has occurred in accordance
with the terms of the sale, and collectibility of the sale is reasonably
assured. We record product sales when we have received a valid customer purchase
order for product at a stated price, the customer's credit is approved, and we
have shipped the product to the customer whereby title and risk have passed to
the customer.
We are not contractually obligated to repurchase any inventory from
distributors or end user customers. Some of our customers are distributors that
sell goods to third party end users. For certain identified distributors where
collection may be contingent on the distributor's resale, revenue recognition is
deferred and recognized on a "sell through" basis. The determination of whether
sales to distributors are contingent on resale is subjective because we must
assess the financial wherewithal of the distributor to pay us regardless of
resale. For sales to distributors, we consider several factors, including past
payment history, where available, trade references, bank account balances, Dun &
Bradstreet reports and any other financial information provided by the
distributor, in assessing whether the distributor has the financial wherewithal
to pay regardless of, or prior to, resale of the product and that collection of
the receivable is not contingent on resale.
We offer limited volume price discounts and rebates to certain
distributors. Volume price discounts are on a per order basis based on the size
of the order and are netted against the revenue recorded at the time of
shipment. We have no arrangements that provide for volume discounts at a later
date, such as based on meeting certain quarterly or annual purchase levels.
Rebates are paid quarterly or annually based on sales performance and are
accrued for at the end of a reporting period. To date, all rebate arrangements
have been immaterial.
We follow the guidance of EITF No. 00-21 "Accounting for Revenue
Arrangements with Multiple Deliverables." In accordance, we consider our program
management packages and training and other services as separate units of
accounting when sold with an AED based on the fact that the items have value to
the customer on a stand alone basis and could be acquired from another vendor.
Training and AED program management service revenue is deferred and recognized
at the time the training occurs. AED program management services pursuant to
agreements that existed with Complient customers pursuant to annual or
multi-year terms are deferred and amortized straight-line over the related
contract period.
Upfront license fees are deferred and recognized to revenue using the
straight-line method over the term of the related license agreement. Royalty
revenue are due and payable quarterly (generally 60 days after period end)
pursuant to the related license agreements. An estimate of royalty revenue is
recorded quarterly in the period it is earned based on the prior quarter's
historical results adjusted for any new information or trends known to
management at the time of estimation.
Product Warranty
Products sold are generally covered by a warranty against defects in
material and workmanship for a period of one to seven years. We accrue a
warranty reserve to estimate the risk of incurring costs to provide warranty
services. The accrual is based on our historical experience and our expectation
of future conditions. An increase in warranty claims or in the costs associated
with servicing those claims would result in an increase in the accrual and a
decrease in gross profit.
18
Litigation and Others Contingencies
We regularly evaluate our exposure to threatened or pending litigation and
other business contingencies. Because of the uncertainties related to the amount
of loss from litigation and other business contingencies, the recording of
losses relating to such exposures requires significant judgment about the
potential range of outcomes. We have had ongoing legal expenses related to the
Philips matter which have been material and are expected to continue to be
material to our results of operations. At this stage of the litigation, as well
as for the other cases pending, we have not established an accrual because a
loss is not determined to be probable. As additional information about current
or future litigation or other contingencies becomes available, we will assess
whether such information warrants the recording of additional expense relating
to these contingencies. To be recorded as expense, a loss contingency must
generally be both probable and measurable. If a loss contingency is material but
is not both probable and estimable, we will disclose it in the notes to the
financial statements.
Recent Accounting Pronouncements
In December 2003, the FASB issued Interpretation No. 46R, Consolidation of
Variable Interest Entities (FIN 46R). FIN 46R requires the application of either
FIN 46 or FIN 46R by public entities to all Special Purpose Entities (SPE)
created prior to February 1, 2003 as of December 31, 2003 for calendar year-end
companies. FIN 46R is applicable to all non-SPEs created prior to February 1,
2003 at the end of the first interim or annual period ending after March 15,
2004. For all entities created subsequent to January 31, 2003, Public Entities
were required to apply the provisions of FIN 46. The adoption of FIN 46 and FIN
46R did not have a material impact on our consolidated financial position,
results of operations or cash flows.
19
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate and Market Risk.
We do not use derivative financial instruments in our investment
portfolio. We are averse to principal loss and try to ensure the safety and
preservation of our invested funds by limiting default risk, market risk, and
reinvestment risk. We attempt to mitigate default risk by investing in only the
safest and highest credit quality securities. At September 30, 2004, we invested
our available cash in money market securities of high credit quality financial
institutions.
Interest expense on our existing long-term debt commitments is based on a
fixed interest rate and therefore it is unaffected by fluctuations in interest
rates. However, our line of credit with our bank bears interest at our bank's
prime rate plus .75% and if we ever draw down upon the line of credit, the
outstanding balance could be affected by fluctuations in interest rates.
Foreign Currency Exchange Rate Risk.
The majority of our international sales are made through our international
sales office in Copenhagen primarily in U.S. dollars, however, some sales to the
U.K. are in pounds and to Germany in Euros, and thus may be adversely affected
by fluctuations in currency exchange rates. Additionally, fluctuations in
currency exchange rates may adversely affect foreign demand for our products by
increasing the price of our products in the currency of the countries in which
the products are sold. The majority of inventory purchases, both components and
finished goods, in our foreign operations are made in U.S. dollars. The
functional currency of our foreign operations in Denmark, the U.K. and Germany
is the U.S. dollar and therefore, the financial statements of these operations
are maintained in U.S. dollars. Any assets and liabilities in foreign
currencies, such as bank accounts and certain payables, are remeasured in U.S.
dollars at period-end exchange rates in effect. Any transactions in foreign
currencies, such as wages paid in local currencies, are remeasured in U.S.
dollars using an average monthly exchange rate. Any resulting gains and losses
are included in operations and were not material in any period.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures.
Our management, including the Chief Executive Officer, Chief Financial
Officer and Vice President Finance, conducted an evaluation during the most
recent quarter of the effectiveness of our disclosure controls and procedures
(as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Securities Exchange
Act of 1934 as amended). Based on that evaluation, the Chief Executive Officer,
Chief Financial Officer and Vice President Finance concluded that the disclosure
controls and procedures were effective in ensuring that all material information
required to be disclosed in the reports we file and submit under the Securities
and Exchange Act of 1934, as amended, have been made known to them on a timely
basis and that such information has been properly recorded, processed,
summarized and reported, as required.
Changes in Internal Controls.
There have been no significant changes in our internal controls over
financial reporting during the most recent fiscal quarter that materially
affected, or are reasonably likely to materially affect, our internal controls
over financial reporting.
Sarbanes-Oxley Section 404 Compliance.
Section 404 of the Sarbanes-Oxley Act of 2002 (the "Act") will require us
to include an internal control report from management in our Annual Report on
Form 10-K for the year ended December 31, 2004 and in subsequent Annual Reports
thereafter. The internal control report must include the following: (1) a
statement of management's responsibility for establishing and maintaining
adequate internal control over financial reporting, (2) a statement identifying
the framework used by management to conduct the required evaluation of the
effectiveness of our internal control over financial reporting, (3) management's
assessment of the effectiveness our internal control over financial reporting as
of December 31, 2004, including a statement as to whether or not internal
control over financial reporting is effective, and (4) a statement that our
independent registered public accounting firm has issued an attestation report
on management's assessment of internal control over financial reporting.
Our management acknowledges its responsibility for establishing and
maintaining internal controls over financial reporting and seeks to continually
improve those controls. In addition, in order to achieve compliance with Section
404 of the Act within the required timeframe, we have been conducting a process
to document and evaluate our internal controls over financial reporting since
2003. In this regard, we have dedicated internal resources, engaged outside
consultants and adopted a detailed work plan to: (i) assess and document the
adequacy of internal control over financial reporting; (ii) take steps to
improve control processes where required; (iii) validate through testing that
controls are functioning as documented; and (iv) implement a continuous
reporting and improvement process for internal control over financial reporting.
We believe our process for documenting, evaluating and monitoring our internal
control over financial reporting is consistent with the objectives of Section
404 of the Act.
20
During the quarter ended September 30, 2004, we commenced testing of our
internal controls. Our documentation and testing to date has identified certain
gaps in the documentation, design and effectiveness of internal controls over
financial reporting that we are in the process of remediating. Given the risks
inherent in the design and operation of internal controls over financial
reporting, we can provide no assurance as to our conclusions at December 31,
2004 with respect to the effectiveness of our internal controls over financial
reporting.
It should be noted that any system of controls, however well designed and
operated, can provide only reasonable, and not absolute, assurance that the
objectives of the control system are met. In addition, the design of any control
system is based in part upon certain assumptions about the likelihood of future
events. Because of these and other inherent limitations of control systems,
there can be no assurance that any design will succeed in achieving its stated
goals under all potential future conditions, regardless of how remote.
21
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
In February 2003, we filed a patent infringement action against Philips
Medical Systems North America, Inc., Philips Electronics North America
Corporation and Koninklijke Philips Electronics N.V. ("Philips") in the United
States District Court for the District of Minnesota. The suit now charges that
Philips' automated external defibrillators sold under the names "HeartStart
OnSite Defibrillator", "HeartStart", "HeartStart FR2" and the "HeartStart Home
Defibrillator," infringe at least ten of our United States patents. In the same
action, we also sought a declaration from the Court that our products do not
infringe several of Philips' patents and Philips counterclaimed for infringement
of the same patents. Many of the Philips Defibrillators' are promoted by Philips
as including, among other things, pre-connected disposable defibrillation
electrodes and daily self-testing of electrodes and battery, features that the
suit alleges are key competitive advantages of our Powerheart and Survivalink
AEDs and are covered under our patents. At this stage, we are unable to predict
the outcome of this litigation. We have not established an accrual for this
matter because a loss is not determined to be probable.
On April 30, 2003, we filed a Complaint against Defibtech, LLC for patent
infringement in the United States District Court for the District of Minnesota.
The Complaint alleged that Defibtech's Sentry and Reviver AEDs infringe our
patented disposable electrode pre-connect technology as well as other patents.
Defibtech answered the Complaint and asserted counterclaims alleging that we
have engaged in activities that constitute tortious interference with present
and prospective contractual relations, common law business disparagement and
statutory business disparagement. We responded to the counterclaims with a
complete and general denial of the allegations. At this stage, we are unable to
predict the outcome of this litigation. We have not established an accrual for
this matter because a loss is not determined to be probable.
On March 19, 2004, William S. Parker filed suit against us for patent
infringement in the United States District Court for the Eastern Division of
Michigan. The Parker patent generally covers the use of a synthesized voice to
instruct a person to perform certain tasks. The Complaint alleges that certain
of our AEDs infringe the Patent. The patent is now expired. We have filed an
Answer to the Complaint stating the patent is not infringed and is otherwise
invalid and unenforceable. The patent has been submitted before the United
States Patent and Trademark Office for reexamination. On October 25, 2004, the
District Court issued an order staying the litigation pending resolution of the
reexamination. At this stage of the litigation, we are unable to predict the
outcome of this litigation. We have not established an accrual for this matter
because a loss is not determined to be probable.
Item 5. Other Information
In early April, we received a Warning Letter from the U.S. Food and Drug
Administration (FDA) following a routine inspection of our manufacturing
facility in Minneapolis. The letter specified certain procedural and
documentation items in our quality system. We took corrective and preventive
action to bring our quality system into compliance. In addition, during May
2004, we initiated a limited voluntary recall of approximately 5,800 units of
our older model Powerheart AEDs in order to replace a potentially faulty
capacitor component. As of September 30, 2004, the majority of the recalled
units in the U.S. have been replaced or repaired and we are in the process of
executing our international recall plan which represents approximately 10% of
total affected units.
Also in May 2004, we initiated a limited, voluntary recall of 4,800 AED
batteries due to an error made by our battery supplier whereby an incorrect fuse
was used in the manufacture of a certain lot of batteries. As of September 30,
2004, the recall has been completed and customers have received replacement
batteries.
We estimate the cost of these voluntary recall actions could range from
$1,000 to $1,500. We have received from our suppliers credits against existing
and future amounts due to these suppliers totaling $1,240, which have been
recorded to accrued expenses to establish a warranty accrual for these recall
matters. Actual recall related costs incurred to date have been charged against
this accrual and totaled approximately $1,123 as of September 30, 2004. At this
time, we believe the remaining accrual related to the recall will cover any
future costs.
22
Item 6. Exhibits
Exhibit 10.12 Second Amended and Restated Employment Agreement
by and between Cardiac Science and Raymond W. Cohen, dated August 20, 2004
Exhibit 10.13 Second Amended and Restated Employment Agreement by
and between Cardiac Science and Roderick C. de Greef, dated August 20, 2004
Exhibit 10.14 Second Amended and Restated Employment Agreement by
and between Cardiac Science and Howard Evers, dated August 20, 2004
Exhibit 31.1 Chief Executive Officer's Certification as required by
Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 31.2 Chief Financial Officer's Certification as required by
Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 32.1 Chief Executive Officer's Certification as required by
Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2 Chief Financial Officer's Certification as required by
Section 906 of the Sarbanes-Oxley Act of 2002
23
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this 10-Q report to be signed on its behalf by the
undersigned thereunto duly authorized.
CARDIAC SCIENCE, INC.
-----------------------------------------
(Registrant)
Date: November 9, 2004 /s/ RODERICK DE GREEF
-----------------------------------------
Roderick de Greef
(Duly Authorized Officer and
Principal Financial Officer)
24