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EX-10 - EXHIBIT 10.1 - COGENTIX MEDICAL INC /DE/ex10-1.htm



UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20459

______________________________________________

 

FORM 10-Q

(Mark One)

 

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

   

For the quarterly period ended September 30, 2014

 

or

 

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

 

For the transition period from _____ to _____

 

COMMISSION FILE NUMBER: 000-20970

 

VISION-SCIENCES, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

13-3430173

(State of incorporation)

(I.R.S. Employer
Identification Number)

   

40 Ramland Road South, Orangeburg, NY

10962

(Address of principal executive offices)

(Zip Code)

(845) 365-0600

(Registrant’s telephone number, including area code)

________________________________________________

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirement for the past 90 days. Yes ☒    No ☐

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate website, if any every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes ☒  No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer, non-accelerated filer, or smaller reporting company. See definitions of “accelerated filer”, “large accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ☐

Accelerated filer ☐

Non-accelerated filer ☐
(Do not check if a smaller reporting company)

Smaller reporting company ☒

 

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).         Yes ☐    No ☒

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of November 11, 2014:

 

Common Stock, par value of $0.01 per share

47,808,456

(Title of Class)

(Number of Shares)

 



 

 

 
 

 

 

VISION-SCIENCES, INC.

TABLE OF CONTENTS

 

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

 

 

Part I.

Financial Information

 
 

Item 1.

Financial Statements

 
   

Condensed Consolidated Statements of Operations

4

   

Condensed Consolidated Balance Sheets

5

   

Condensed Consolidated Statements of Cash Flows

6

   

Notes to Condensed Consolidated Financial Statements

7

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

17

 

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

25

 

Item 4.

Controls and Procedures

25

       

Part II.

Other Information

 

 

Item 1.

Legal Proceedings

26

 

Item 1A.

Risk Factors

26

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

26

 

Item 3.

Defaults Upon Senior Securities

26

 

Item 4.

Mine Safety Disclosures

27

 

Item 5.

Other Information

27

 

Item 6.

Exhibits

27

 

Signatures

28

 

 
2

 

 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995, which are subject to various risks and uncertainties that could cause our actual results to differ materially from those expressed or implied in such statements. Examples of forward-looking statements include statements about expectations about future financial results, future products and future sales of new and existing products, future expenditures, and capital resources to meet anticipated requirements. Generally, words such as “expect,” “believe,” “anticipate,” “may,” “will,” “plan,” “intend,” “estimate,” “could,” and other similar expressions are intended to identify forward-looking statements. The forward-looking statements are based on our future plans, strategies, projections and predictions and involve risks and uncertainties, and our actual results may differ significantly from those discussed in the forward-looking statements. Factors that might cause such a difference could include, among others, the availability of capital resources; the availability and adequacy of third-party reimbursement; government regulation; the availability of raw material components; our dependence on certain distributors and customers; our ability to effect expected sales; competition; technological difficulties; product recalls; general economic conditions and other risks detailed in this Quarterly Report on Form 10-Q and any subsequent periodic filings we make with the Securities and Exchange Commission (“SEC”). While we believe the assumptions underlying such forward-looking statements are reasonable, there can be no assurance that future events or developments will not cause such statements to be inaccurate. All forward-looking statements contained in this report are qualified in their entirety by this cautionary note.

 

We do not undertake an obligation to update our forward-looking statements to reflect future events or circumstances, except as may be required by law.

 

 
3

 

  

PART IFINANCIAL INFORMATION 

Item 1. Financial Statements

 

Vision-Sciences, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations

(in thousands, except per share amounts)

(Unaudited)

 

   

Three Months Ended

   

Six Months Ended

 
   

September 30,

   

September 30,

 
   

2014

   

2013

   

2014

   

2013

 
                                 

Net sales

  $ 4,110     $ 3,968     $ 7,862     $ 7,620  

Cost of sales

    2,852       2,773       5,455       5,345  

Gross profit

    1,258       1,195       2,407       2,275  
                                 

Selling, general, and administrative expenses

    2,358       2,050       4,849       5,100  

Research and development expenses

    341       428       877       847  

Operating loss

    (1,441 )     (1,283 )     (3,319 )     (3,672 )
                                 

Interest expense

    (106 )     (44 )     (189 )     (85 )

Other, net

    4       7       (12 )     3  

Loss before provision for income taxes

    (1,543 )     (1,320 )     (3,520 )     (3,754 )

Income tax provision

    -       3       -       3  

Net loss

  $ (1,543 )   $ (1,323 )   $ (3,520 )   $ (3,757 )
                                 

Net loss per common share - basic and diluted

  $ (0.03 )   $ (0.03 )   $ (0.08 )   $ (0.08 )
                                 

Weighted average shares used in computing net loss per common share - basic and diluted

    46,327       46,144       46,294       46,127  

 

See accompanying notes to condensed consolidated financial statements

 

 
4

 

 

Vision-Sciences, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(in thousands)

 

   

September 30,

   

March 31,

 
   

2014

   

2014

 
   

(unaudited)

         
ASSETS                

Current assets:

               

Cash and cash equivalents

  $ 1,395     $ 1,237  

Accounts receivable, less allowances of $133 and $117, respectively

    2,920       3,818  

Inventories, net

    4,221       4,194  

Prepaid expenses and other current assets

    460       455  

Total current assets

    8,996       9,704  
                 

Machinery and equipment

    3,447       3,456  

Demo equipment

    1,469       1,311  

Furniture and fixtures

    247       225  

Leasehold improvements

    372       372  

Property and equipment, at cost

    5,535       5,364  

Less—accumulated depreciation and amortization

    4,549       4,302  

Total property and equipment, net

    986       1,062  

Other assets, net

    67       67  

Total assets

  $ 10,049     $ 10,833  
                 

LIABILITIES AND STOCKHOLDERS' DEFICIT

               

Current liabilities:

               

Accounts payable

  $ 1,405     $ 1,217  

Accrued expenses

    880       918  

Accrued compensation

    514       474  

Deferred revenue

    310       210  

Capital lease obligations

    -       22  

Total current liabilities

    3,109       2,841  
                 

Convertible debt—related party, net of discount

    24,480       22,414  

Deferred revenue, net of current portion

    128       93  

Total liabilities

    27,717       25,348  
                 

Commitments and Contingencies

               

Stockholders’ deficit:

               

Preferred stock, $0.01 par value Authorized—5,000 shares; issued and outstanding - none

    -       -  

Common stock, $0.01 par value Authorized—100,000 shares; issued and outstanding—47,793 shares and 47,614 shares, respectively

    478       476  

Additional paid-in capital

    103,000       102,629  

Treasury stock at cost, 65 shares and 59 shares of common stock, respectively

    (85 )     (78 )

Accumulated deficit

    (121,061 )     (117,542 )

Total stockholders’ deficit

    (17,668 )     (14,515 )

Total liabilities and stockholders’ deficit

  $ 10,049     $ 10,833  

 

See accompanying notes to condensed consolidated financial statements

 

 
5

 

 

Vision-Sciences, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(in thousands)

(Unaudited)

 

   

Six Months Ended

 
   

September 30,

 
   

2014

   

2013

 

Cash flows from operating activities:

               

Net loss

  $ (3,520 )   $ (3,757 )

Adjustments to reconcile net loss to net cash used in operating activities:

               

Depreciation and amortization

    318       362  

Stock-based compensation expense

    349       328  

Provision for bad debt expenses

    11       7  

Amortization of debt discount

    66       -  

Loss (gain) on disposal of fixed assets

    9       (5 )

Changes in assets and liabilities:

               

Accounts receivable

    887       802  

Inventories

    (261 )     (712 )

Prepaid expenses and other current assets

    (5 )     (117 )

Accounts payable

    188       (112 )

Accrued expenses

    (38 )     50  

Accrued compensation

    40       (96 )

Deferred revenue

    135       22  

Net cash used in operating activities

    (1,821 )     (3,228 )

Cash flows from investing activities:

               

Purchases of property and equipment

    (17 )     (46 )

Proceeds from disposal of fixed assets

    -       3  

Net cash used in investing activities

    (17 )     (43 )

Cash flows from financing activities:

               

Proceeds from issuance of convertible debt—related party

    2,000       3,000  

Proceeds from exercise of stock options

    25       -  

Common stock repurchased

    (7 )     (28 )

Payments of capital leases

    (22 )     (34 )

Net cash provided by financing activities

    1,996       2,938  

Net increase (decrease) in cash and cash equivalents

    158       (333 )

Cash and cash equivalents at beginning of period

  $ 1,237     $ 788  

Cash and cash equivalents at end of period

  $ 1,395     $ 455  
                 

Supplemental disclosure of cash flow information:

               

Cash paid during the period for:

               

Interest

  $ 1     $ 4  

Income taxes

  $ -     $ 3  
                 

Non-cash financing activities:

               

Net transfers of inventory to fixed assets for use as demonstration equipment

  $ 234     $ 187  

 

See accompanying notes to condensed consolidated financial statements

 

 
6

 

 

Vision-Sciences, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited, in thousands except number of shares and per share amounts)

 

 

Note 1. Summary of Significant Accounting Policies

 

Vision-Sciences, Inc. and its subsidiaries (the “Company,” or “our”, “us” or “we”) designs, develops, manufactures, and markets products for endoscopy – the science of using an instrument, known as an endoscope, to provide minimally invasive access to areas not readily visible to the human eye. Our products are sold throughout the world through direct sales representatives in the United States (“U.S.”) and independent distributors for the rest of the world. We are the exclusive supplier of ureteroscopes to the Endoscopy Division of Stryker Corporation (“Stryker”). Our largest geographic markets are the U.S. and Europe.

 

We are incorporated in Delaware, and are the successor to operations begun in 1987. In December 1990, Machida Incorporated (“Machida”) became our wholly-owned subsidiary. We own the registered trademarks Vision Sciences®, EndoSheath®, EndoWipe®, Slide-On® and The Vision System®. Not all products referenced in this report are approved or cleared for sale, distribution, or use.

 

Basis of Presentation and Preparation

 

We have prepared the condensed consolidated financial statements included herein according to generally accepted accounting principles in the United States of America (“U.S. GAAP”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and include, in the opinion of management, all adjustments (normal and recurring) that we consider necessary for a fair presentation of such information. We have condensed or omitted certain information and footnote disclosures normally included in financial statements pursuant to those rules and regulations. We believe, however, that our disclosures are adequate to make the information presented not misleading.

 

The results for the interim periods presented are not necessarily indicative of results to be expected for the full fiscal year. Please read these condensed consolidated financial statements in conjunction with the consolidated financial statements and the related notes included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2014.

 

Liquidity and Capital Resources

 

We have incurred substantial operating losses since our inception and there can be no assurance that we will ever achieve or sustain a profitable level of operations in the future. We anticipate that we will continue to incur negative cash flows from operations during the remainder of fiscal 2015, driven by continued investment in a direct sales force for the U.S. market, spending for marketing, revitalizing a research and development pipeline, and general business operations. As of September 30, 2014, we had cash and cash equivalents totaling approximately $1.4 million. On June 16, 2014, we issued a convertible promissory note to Lewis C. Pell, our Chairman, or the 2014 Note, that allowed us to borrow up to $5.0 million up to June 15, 2019. The 2014 Note was issued in accordance with a letter agreement dated May 29, 2014 with Mr. Pell, or the Prior Letter Agreement, that provided for up to $5.0 million of capital to be made available to us from Mr. Pell, subject to certain conditions and an expiration date of July 1, 2015. The Prior Letter Agreement was then terminated. As of September 30, 2014, we had $2.0 million in principal outstanding under the 2014 Note. On October 24, 2014 an additional $1.0 million was drawn on the 2014 Note. Pursuant to a letter agreement dated October 28, 2014 with Mr. Pell, or the Existing Letter Agreement, Mr. Pell has agreed to provide financial assistance to us in the amount of up to $2.5 million, if necessary to support our operations, for a period ending on the earlier of (i) January 1, 2016 or (ii) our raising debt or equity capital in the amount of $2.5 million or more. This financial assistance, if drawn by us, would be in the form of an additional loan, share purchase, or financing transaction, on such terms as we and Mr. Pell may determine. We have not utilized the Existing Letter Agreement. We expect that our cash at September 30, 2014, together with $3.0 million remaining to be drawn under the 2014 Note at September 30, 2014, plus the $2.5 million of capital to be made available to us under the Existing Letter Agreement, subject to certain conditions and an expiration date of January 1, 2016, should be sufficient to fund our operations through at least December 31, 2015. However, if our performance expectations fall short (including our failure to generate expected levels of sales) or our expenses exceed expectations, or if the commitment under the 2014 Note or the Existing Letter Agreement become unavailable, we will need to secure additional financing and/or reduce our expenses to continue our operations. Our failure to do so would have a material adverse impact on our prospects and financial condition. There can be no assurance that any contemplated additional financing will be available on terms acceptable to us, if at all. If required, we believe we would be able to reduce our expenses to a sufficient level to continue to operate as a going concern.

 

 
7

 

 

Summary of Significant Accounting Policies

 

Our condensed consolidated financial statements are prepared in accordance with the rules and regulations of the SEC for interim reporting and U.S. GAAP. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable, based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are any differences (other than nominal differences) between these estimates, judgments or assumptions and actual results, our financial statements will be affected.

 

In the opinion of our Company’s management, the accompanying unaudited condensed financial statements contain all adjustments (consisting of normal recurring adjustments) necessary to present fairly, in all material respects, our financial position as of September 30, 2014 and the results of operations and cash flows for the three months and six months then ended. The results of operations and cash flows for the period ended September 30, 2014 are not necessarily indicative of the results of operations or cash flows to be expected for any subsequent quarter or the full fiscal year ending March 31, 2015. As of September 30, 2014, there have been no material changes to any of the significant accounting policies described in our Report on Form 10-K for the year ended March 31, 2014.

 

The accompanying condensed consolidated financial statements reflect the accounts of the Company. All significant inter-company accounts and transactions have been eliminated in consolidation.

 

New Accounting Pronouncements

 

In May 2014, the Financial Accounting Standards Board (FASB) issued new accounting guidance, namely (“ASU”) No. 2014-09, Revenue from Contracts with Customers, on revenue recognition. The new standard provides for a five-step model to be applied to all revenue contracts with customers as well as requires additional financial statement disclosures that will enable users to understand the nature, amount, timing and uncertainty of revenue and cash flows relating to customer contracts. Companies have an option to use either a retrospective approach or cumulative effect adjustment approach to implement the standard. There is no option for early adoption. For public entities, this ASU is effective for fiscal years and interim periods within those years beginning after December 15, 2016. We are currently evaluating the impact of the new guidance on our condensed consolidated financial statements.

 

In August 2014, the FASB issued ASU 2014-15, Presentation of Financial Statements—Going Concern (Subtopic 205-40): Disclosure of Uncertainties About an Entity’s Ability to Continue as a Going Concern, which provides guidance on determining when and how to disclose going-concern uncertainties in the financial statements. The new standard requires management to perform interim and annual assessments of an entity’s ability to continue as a going concern within one year of the date on which the financial statements are issued. An entity must provide certain disclosures if conditions or events raise substantial doubt about the entity’s ability to continue as a going concern. This ASU applies to all entities and is effective for annual periods ending after December 15, 2016 and interim periods thereafter, with early adoption permitted. We are currently evaluating the impact of the new guidance on our condensed consolidated financial statements.

 

Fair Value Measurements

 

The carrying amounts reflected in our condensed consolidated balance sheets for cash and cash equivalents, accounts receivable, prepaid expenses and other current assets, accounts payable, accrued expenses, accrued compensation, and capital lease obligations approximate fair value due to their short-term nature. The carrying value of our convertible debt-related party approximates fair value due to its attributes, which include, amongst others, interest and its conversion feature into common stock.

 

In determining the fair value of the convertible debt – related party, we analyzed its attributes (coupon rate, conversion price, and the percentage of market cap the face value of the debt instrument was prior to the announcement of the debt) as compared with public company convertible debt issuances in the healthcare industry. We determined the convertible debt was not issued at a discount as its fair value was equal to its face (carrying) value.

 

 
8

 

 

Concentration of Credit Risk

 

Concentration of credit risk with respect to accounts receivable relates to certain domestic and international customers to whom we make substantial sales. To reduce risk, we routinely assess the financial strength of our customers and, when appropriate, we obtain advance payments for our international sales. As a consequence, we believe that our accounts receivable credit risk exposure is limited. We maintain an allowance for potential credit losses, but historically we have not experienced any significant credit losses related to any individual customer or group of customers in any particular industry or geographic area.

 

The following table summarizes net sales to our significant customer, which accounted for more than 10% of total medical segment net sales and total accounts receivable, net:

 

   

Three Months Ended

   

Six Months Ended

 
   

September 30,

   

September 30,

 
   

2014

   

2013

   

2014

   

2013

 

Medical segment

                               

Stryker

  $ 362     $ 1,201     $ 840     $ 2,346  

Percentage of total medical segment net sales

    11 %     35 %     13 %     36 %

Percentage of total net sales

    9 %     30 %     11 %     31 %

 

                       
    As of September 30,     As of March 31,                  
   

2014

   

2014

                 

Percentage of total accounts receivable, net

    11 %     27 %                

 

Note 2.     Basic and Diluted Net Loss per Common Share

 

Basic net loss per share is calculated by dividing the net loss by the weighted average number of common shares outstanding. For all periods presented, the diluted net loss per common share is the same as basic net loss per common share, as the inclusion of other shares of stock issuable pursuant to stock options, warrants, and convertible debt would be anti-dilutive.

 

The following table summarizes equity securities that were excluded from the calculation of fully diluted loss per share as of September 30, 2014 and 2013, respectively:

 

   

September 30,

 
   

2014

   

2013

 

Convertible debt

    22,401,050       16,666,666  

Stock options

    4,305,110       4,506,775  

Warrants

    1,880,620       1,880,620  

Restricted stock

    1,387,752       207,902  

Total anti-dilutive securities

    29,974,532       23,261,963  

 

Note 3. Inventories

 

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

 

   

September 30,

2014

   

March 31,

2014

 

Raw materials

  $ 3,151     $ 3,456  

Work in process

    578       329  

Finished goods

    492       409  

Inventories, net

  $ 4,221     $ 4,194  

 

 
9

 

 

Raw materials include components purchased from independent suppliers. Most purchased components are available from multiple sources, with the exception of certain key components which are supplied to us by key suppliers, with whom we have long-term supply arrangements, but no long-term supply agreements.

 

Note 4. Supply Agreements

 

Under a three-year agreement with Stryker Corporation, or Stryker, that expires in December 2015, we are the exclusive supplier of the URT-7000 Video Ureteroscope, peripherals and accessories to Stryker in the United States.

 

From April 2011 through May 2014, Stryker had the exclusive rights to market and sell our cystoscopes, the CST- 5000 Video Cystoscope and the CST-4000 Fiber Cystoscope, and the accompanying EndoSheath disposables, peripherals and accessories, (the “Cystocscope Products”). We elected to not renew this exclusivity and to directly sell the Cystoscope Products in the U.S. We made this decision in large part because Stryker’s endoscopy sales force focuses on the operating room in hospitals, while most cystoscopy procedures are performed in physicians’ offices and ambulatory surgical centers.

 

 

Note 5. Convertible Debt – Related Party

 

Convertible Promissory Notes

 

The following table is a summary of our convertible debt – related party at September 30, 2014:

 

Convertible debt – related party

 

Gross

Principal

Amount

Outstanding

   

Unamortized

Debt

Discount

   

Net Amount

Outstanding

 

Replacement Note

  $ 20,000     $ -     $ 20,000  

2013 Note

    3,500       (1,020 )     2,480  

2014 Note

    2,000       -       2,000  
    $ 25,500     $ (1,020 )   $ 24,480  

 

Pursuant to the Prior Letter Agreement, Mr. Pell agreed to provide financial assistance to us in the amount of up to $5.0 million, if necessary to support our operations, for a period ending on the earlier of (i) July 1, 2015 or (ii) our raising debt or equity capital in the amount of $5.0 million or more. The Prior Letter Agreement provided that this financial assistance, if drawn by us, would be in the form of an additional loan, share purchase, or financing transaction, on such terms as we and Mr. Pell may determine. The Prior Letter Agreement was terminated upon the issuance of the 2014 Note.

 

Pursuant to the Prior Letter Agreement, on June 16, 2014, or the 2014 Effective Date, we issued the 2014 Note with Mr. Pell that allowed us to borrow up to $5.0 million up to June 15, 2019. The 2014 Note accrues annual interest at the rate of 1.91%. The 2014 Note must be repaid in full on or before the fifth anniversary of the 2014 Effective Date, or the 2014 Maturity Date, but may be prepaid by us at any time without penalty. We will be required to repay all amounts outstanding under the 2014 Note upon an event of default, as defined in the 2014 Note. The outstanding principal amount of the 2014 Note is convertible at any time prior to the 2014 Maturity Date, at Mr. Pell’s option, into shares of our common stock at a price of $1.11, the closing bid price of our common stock on the 2014 Effective Date. At September 30, 2014, we had outstanding principal borrowings of $2.0 million under the 2014 Note, which is included in convertible debt – related party on our condensed consolidated balance sheet. Each time we draw on any available credit under the 2014 Note, we determine if a beneficial conversion feature of the convertible debt exists. A beneficial conversion feature will arise if the $1.11 conversion price of the 2014 Note is below the per share fair value of our common stock on the date of a drawdown.

 

On September 25, 2013, or the 2013 Effective Date, we entered into a convertible promissory note, or the 2013 Note, with Mr. Pell that allowed us to borrow up to $3.5 million. The 2013 Note accrues annual interest, at the rate of 1.66%. The 2013 Note must be repaid in full on or before the fifth anniversary of the 2013 Effective Date, or the 2013 Maturity Date, but may be prepaid by us at any time without penalty. We will be required to repay all amounts outstanding under the 2013 Note upon an event of default, as defined in the 2013 Note. The outstanding principal amount of the 2013 Note is convertible at any time prior to the 2013 Maturity Date, at Mr. Pell’s option, into shares of our common stock at a price of $0.89, the closing bid price of our common stock on the 2013 Effective Date. At September 30, 2014, we had outstanding principal borrowings of $3.5 million, gross of the amount recognized as a beneficial conversion feature, under the 2013 Note, which is included in Convertible debt – related party on our condensed consolidated balance sheet.

 

 
10

 

 

During each draw upon the 2013 Note, a beneficial conversion feature was recorded as a result of the market price of our common stock increasing after the 2013 Effective Date. The following table summarizes the unamortized beneficial conversion feature amounts recorded as of September 30, 2014:

 

Date

 

Borrowing

Amount

   

Convertible

Shares

   

Share Price

on

Borrowing

Date

   

Unamortized Beneficial

Conversion

 Feature

 

October 7, 2013

  $ 1,000       1,123,595     $ 0.95     $ 55  

November 26, 2013

    1,000       1,123,595       1.01       113  

January 21, 2014

    1,000       1,123,595       1.39       508  

March 13, 2014

    500       561,799       1.54       344  
    $ 3,500       3,932,584             $ 1,020  

 

The beneficial conversion feature amounts were recorded as a convertible debt discount with a corresponding increase to additional paid-in capital. The amounts are being amortized using the effective interest rate method from the borrowing date to the Maturity Date. At September 30, 2014, we expect to recognize the unamortized convertible debt discount balance of $1.0 million over a period of approximately four years.

 

On September 19, 2012, or the Replacement Note Effective Date, we entered into a convertible promissory note, or the Replacement Note, with Mr. Pell that allowed us to borrow up to $20.0 million. The Replacement Note (i) consolidated and restructured the $15.0 million in aggregate borrowings collectively outstanding under an Amended and Restated Loan Agreement, dated September 30, 2011, between us and Mr. Pell, or the Original Agreement, and a separate promissory note, dated July 25, 2012, between us and Mr. Pell, and (ii) provided for up to $5.0 million in additional borrowings.

 

The Replacement Note accrues annual interest, payable annually, at the rate of 0.84%. The Replacement Note must be repaid in full on or before the fifth anniversary of the Replacement Note Effective Date, or the Replacement Note Maturity Date, but may be prepaid by us at any time without penalty. We will be required to repay all amounts outstanding under the Replacement Note upon an event of default, as defined in the Replacement Note.

 

The outstanding principal amount of the Replacement Note is convertible at any time prior to the Replacement Note Maturity Date, at Mr. Pell’s option, into shares of our common stock at a conversion price of $1.20 per share, which was the closing bid price of our common stock on the Replacement Note Effective Date. At September 30, 2014, we had $20.0 million in outstanding principal borrowings under the Replacement Note, which is reflected as convertible debt – related party on our condensed consolidated balance sheet.

 

Pursuant to the Original Agreement, Mr. Pell received warrants to purchase an aggregate of 1,880,620 shares of our common stock at a weighted average exercise price of $1.86 per share. All of the warrants are vested and expire on the later of September 30, 2016 or one year after the termination of the Original Agreement and repayment of all amounts due and payable under the Original Agreement.

 

Amortization of the convertible debt discount and interest expense related to the accrued interest on outstanding borrowings are recorded as interest expense in our condensed consolidated statement of operations. Interest expense for the three months ended September 30, 2014 and 2013, respectively, was comprised of:

 

   

Three months ended

   

Six months ended

 
   

September 30,

   

September 30,

 
   

2014

   

2013

   

2014

   

2013

 

Amortization of convertible debt discount

  $ (40 )   $ -     $ (66 )   $ -  

Interest expense

    (66 )     (44 )     (123 )     (85 )
    $ (106 )   $ (44 )   $ (189 )   $ (85 )

 

 
11

 

 

At September 30, 2014, we had an aggregate amount of $376 thousand in accrued interest under the 2014 Note, the 2013 Note and the Replacement Note, which is included in accrued expenses on our condensed consolidated balance sheet.

 

Existing Letter Agreement

 

Pursuant to the Existing Letter Agreement, Mr. Pell has agreed to provide financial assistance to us in the amount of up to $2.5 million, if necessary to support our operations, for a period ending on the earlier of (i) January 1, 2016 or (ii) our raising debt or equity capital in the amount of $2.5 million or more. This financial assistance, if drawn by us, would be in the form of an additional loan, share purchase, or financing transaction, on such terms as we and Mr. Pell may determine. We have not utilized the Existing Letter Agreement.

 

 

Note 6. Stock-Based Awards

 

We maintain the following stockholder-approved equity incentive plans:

 

 

The 2000 Stock Incentive Plan (the “2000 Plan”) authorized the issuance of up to 4,500,000 shares of common stock covering several different types of awards, including stock options, restricted shares, stock appreciation rights, and performance shares.

 

The 2007 Stock Incentive Plan (the “2007 Plan”) authorized the issuance of up to 5,000,000 shares of common stock covering several different types of awards, including stock options, restricted shares, stock appreciation rights, and other stock-based awards. On July 26, 2012, our stockholders approved an amendment to the 2007 Plan further increasing the number of authorized shares issuable under the plan to 7,000,000 shares of common stock.

 

The 2003 Director Option Plan (the “2003 Plan”) authorized the issuance of up to 450,000 shares of common stock covering the annual automatic grant, unless waived, of 10,000 stock options per outside director per year. The 2003 Plan also provides for granting newly elected or appointed outside directors a one-time grant of 10,000 stock options.

 

The stock option plans provide that options may be granted at an exercise price of 100% of fair market value of our common stock on the date of grant, may be exercised in full or in installments, at the discretion of our Board of Directors (the “Board”) or its Compensation Committee (the “Compensation Committee”), and must be exercised within ten years from date of grant. We recognize stock-based compensation expense on a straight-line basis over the requisite service period based on fair values, generally four years. We use historical data to estimate expected employee behaviors related to option exercises and forfeitures and included these expected forfeitures as a part of the estimate of stock-based compensation expense as of the grant date.

 

 
12

 

 

Stock Options

 

The following table summarizes stock options activity for the six months ended September 30, 2014:

 

   

Number

of Shares

   

Exercise

Price Range

   

Weighted

Average

Exercise Price

   

Weighted

Average

Remaining

Contractual Life

 

Outstanding at April 1, 2014

    4,377,874     $0.85 $4.88     $ 1.78       6.0  

Granted

    830,000     0.90  1.25       1.06          

Exercised

    (25,000

)

  0.97  0.97       0.97          

Canceled

    (877,764

)

  0.95  4.30       2.40          

Outstanding at September 30, 2014

    4,305,110     $0.85  $4.88     $ 1.52       6.4  

Vested and expected to vest at September 30, 2014

    4,262,557     $0.85  $4.88     $ 1.53       6.4  

Exercisable at September 30, 2014

    3,260,194     $0.85  $4.88     $ 1.64       5.5  

 

The weighted average fair value of options granted during the six months ended September 30, 2014 and 2013 was $0.73 and $0.68 per share, respectively.

 

The total intrinsic value (the excess of the market price over the exercise price) was approximately $12 thousand for stock options outstanding, $10 thousand for stock options exercisable, and $12 thousand for stock options vested and expected to vest as of September 30, 2014. The total intrinsic value for stock options exercised during the six months ended September 30, 2014 was approximately $5 thousand. There were no stock options exercised during the six months ended September 30, 2013.

 

We do not expect to realize any tax benefits from future disqualifying dispositions, if any. 

 

Restricted Stock

 

We determine stock-based compensation expense for performance based restricted stock based upon the fair value of our common stock at the date of grant and recognize expense based upon the most probable outcome as to whether the performance targets will be achieved and the stock-based compensation being earned.

 

The following table summarizes restricted stock activity for the six months ended September 30, 2014:

 

   

Number

of Shares

   

Weighted

Average

Grant Price

 

Nonvested at April 1, 2014

    1,325,402     $ 1.06  

Granted

    473,605       1.08  

Vested

    (91,450 )     1.38  

Forfeited

    (319,805 )     1.05  

Nonvested at September 30, 2014

    1,387,752     $ 1.05  

 

We grant restricted stock awards to certain executive officers, certain management employees and certain members of our Board. 

 

 
13

 

 

Stock-Based Compensation Expense

 

We estimated the fair value of the stock options granted on the date of grant using a Black-Scholes valuation model that used the weighted average assumptions noted in the following table. The risk-free interest rate assumption we use is based upon United States Treasury interest rates appropriate for the expected life of the awards. The expected life (estimated period of time that we expect employees, consultants and directors to hold their stock options) was estimated based on historical rates for two group classifications, (i) employees and consultants and (ii) outside directors. Expected volatility was based on historical volatility of our stock price for a period equal to the stock option’s expected life and calculated on a daily basis. The expected dividend rate is zero since we do not currently pay cash dividends on our common stock and do not anticipate doing so in the foreseeable future.

 

   

Three Months Ended

September 30,

   

Six Months Ended

September 30,

 
   

2014

   

2013

   

2014

   

2013

 

Risk-free interest rate

    2.0

%

    1.4

%

    2.0

%

    1.2

%

Expected life (in years)

    6.5       5.1       6.6       5.5  

Expected volatility

    78

%

    75

%

    77

%

    80

%

Expected dividend yield

    --       --       --       --  

 

The following table summarizes stock-based compensation recorded in our condensed consolidated statements of operations for the three and six months ended September 30, 2014 and 2013, respectively:

 

   

Three Months Ended

   

Six Months Ended

 
   

September 30,

   

September 30,

 
   

2014

   

2013

   

2014

   

2013

 

Cost of sales

  $ 22     $ 12     $ 38     $ 42  

Selling, general and administrative expenses

    166       (244 )     289       265  

Research and development expenses

    7       5       22       21  

Total stock-based compensation expense

  $ 195     $ (227 )   $ 349     $ 328  

 

At September 30, 2014, unrecognized stock-based compensation expense related to stock options was approximately $0.7 million and is expected to be recognized over a weighted average period of approximately 3.2 years, while unrecognized stock-based compensation expense related to nonvested (restricted stock) awards was approximately $0.5 million, which is expected to be recognized over a weighted average period of approximately 3.0 years.

 

Note 7. Treasury Stock

 

The following table summarizes treasury stock activity for the six months ended September 30, 2014 and 2013:

 

Six Months Ended

 

Number

of Shares

Repurchased

   

Cost

   

Weighted

Average

Purchase

Price

 

September 30, 2014

    6     $ 7     $ 1.22  
                         

September 30, 2013

    26     $ 28     $ 1.11  

 

The shares were purchased from certain management employees to cover income tax withholdings upon the lapse of restrictions on their restricted stock awards.

 

Note 8. Segment Information

 

We have two reportable segments, medical and industrial. Each of these operating segments has unique characteristics. Management evaluates the revenue and profitability performance of each of our product lines to make operating and strategic decisions. We have no intersegment revenue.

 

Our medical segment designs, develops, manufactures, and markets our advanced line of endoscopy-based products, including our state-of-the-art flexible endoscopes, and our EndoSheath technology (referred to as a sheath or EndoSheath disposable) for a variety of specialties and markets.

 

 
14

 

 

Our industrial segment, through our wholly-owned subsidiary Machida, designs, manufactures, and sells borescopes to a variety of users, primarily in the aircraft engine manufacturing and aircraft engine maintenance industries. A borescope is an instrument that uses optical fibers for the visual inspection of narrow cavities. Our borescopes are used to inspect aircraft engines, casting parts and ground turbines, among other items.

 

The following table presents key financial highlights, by reportable segments:

 

Three Months Ended September 30, 2014

 

Medical

   

Industrial

   

Adjustments*

   

Consolidated

 

Net sales

  $ 3,267     $ 843     $ -     $ 4,110  

Gross profit

    1,023       235       -       1,258  

Operating loss

    (1,435

)

    (6

)

    -       (1,441

)

Interest expense, net

    (106 )     -       -       (106 )

Depreciation and amortization

    151       1       -       152  

Stock-based compensation expense

    186       9       -       195  

Expenditures for fixed assets

    (8 )     -       -       (8 )
                                 

As of September 30, 2014

                               

Total assets

    10,542       1,865       (2,358

)

    10,049  
                                 

Three Months Ended September 30, 2013

                               

Net sales

  $ 3,399     $ 569     $ -     $ 3,968  

Gross profit

    981       214       -       1,195  

Operating loss

    (1,345

)

    62       -       (1,283

)

Interest expense, net

    (44 )     -       -       (44 )

Depreciation and amortization

    170       3       -       173  

Stock-based compensation expense

    (221

)

    (6 )     -       (227

)

Expenditures for fixed assets

    46       -       -       46  
                                 

As of September 30, 2013

                               

Total assets

    11,240       1,333       (1,840

)

    10,733  

 

Six Months Ended September 30, 2014

 

Medical

   

Industrial

   

Adjustments*

   

Consolidated

 

Net sales

  $ 6,327     $ 1,535     $ -     $ 7,862  

Gross profit

    1,921       486       -       2,407  

Operating loss

    (3,273

)

    (46

)

    -       (3,319

)

Interest expense, net

    (189 )     -       -       (189 )

Depreciation and amortization

    314       4       -       318  

Stock-based compensation expense

    328       21       -       349  

Expenditures for fixed assets

    17       -       -       17  
                                 

Six Months Ended September 30, 2013

                               

Net sales

  $ 6,428     $ 1,192     $ -     $ 7,620  

Gross profit

    1,774       501       -       2,275  

Operating loss

    (3,732

)

    60       -       (3,672

)

Interest expense, net

    (85 )     -       -       (85 )

Depreciation and amortization

    355       7       -       362  

Stock-based compensation expense

    309       19       -       328  

Expenditures for fixed assets

    46       -       -       46  

 

 
15

 

 

   

As of September 30,

 

* Adjustments

 

2014

   

2013

 

Intercompany eliminations

  $ (1,672

)

  $ (1,154

)

Investment in subsidiaries

    (686

)

    (686

)

Total adjustments

  $ (2,358

)

  $ (1,840

)

 

Note 9. Subsequent Events

 

On October 24, 2014, we drew down another $1.0 million under the 2014 Note. As of November 13, 2014, we had $3.0 million in principal outstanding under the 2014 Note.

  

 
16

 

 

Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations

 

Executive Summary

 

Business Overview

 

Vision-Sciences, Inc. and its subsidiaries, or the Company, or our, us, or we, designs, develops, manufactures, and markets products for endoscopy – the science of using an instrument, known as an endoscope, to provide minimally invasive access to areas not readily visible to the human eye. We operate in two segments: medical and industrial.

 

Medical Business Segment

 

Our medical segment designs, manufactures, and sells our advanced line of endoscopy-based products, including our flexible fiber and video endoscopes and our EndoSheath technology, for a variety of specialties and markets. Our proprietary reusable flexible endoscope is combined with a single-use, sterile protective EndoSheath disposable that is placed over the patient contact area of the scope. Our “always sterile” EndoSheath technology reduces the risks of cross-contamination associated with the reuse (or “reprocessing”) of conventional endoscopes, which are difficult, costly, and time-consuming to clean and disinfect or sterilize.

 

We target five market spaces for our endoscopes and our EndoSheath technology:

 

 

Urology – we manufacture, market, and sell our video and fiber cystoscopes, digital processing units, EndoSheath technology, peripherals and accessories to urologists. We also supply our video ureteroscopes to the Endoscopy Division of Stryker Corporation, or Stryker.

 

Pulmonology (Critical Care)– we manufacture, market, and sell our video and fiber bronchoscopes (an endoscope that allows detailed viewing of the lungs), digital processing units, EndoSheath technology, peripherals and accessories to intensivists, pulmonologists, thoracic surgeons, and other airway-related physicians.

 

Surgery– we manufacture, market, and sell our TNE (trans-nasal esophagoscopy) video endoscope, digital processing units, EndoSheath technology, peripherals and accessories to general surgeons, primarily bariatric and gastroesophageal reflux disease (“GERD”) surgeons.

 

Gastroenterology – we manufacture, market, and sell our TNE video endoscope, digital processing units, EndoSheath technology, peripherals and accessories to gastroenterology (“GI”) physicians, ear, nose, and throat (“ENT”) physicians and others with a GI focus as part of their practice.

 

ENT (ear, nose, and throat) – we manufacture, market, and sell our ENT video and fiber endoscopes, digital processing units, peripherals and accessories to ENT physicians and speech pathologists.

 

All of our products, with the exception of our ureteroscopes, are sold directly by our sales force in the United States, and by international distributors in the rest of the world. Our ureteroscopes are sold to Stryker, who then distributes them in the United States.

 

From April 2011 through May 2014, Stryker had the rights to market and sell our cystoscopes, the CST- 5000 Video Cystoscope and the CST-4000 Fiber Cystoscope, and the accompanying EndoSheath technology, peripherals and accessories. We decided to not renew this exclusivity and to directly sell the cystoscopes, their EndoSheaths, peripherals and accessories in the U.S. to maximize our revenue and margins. We made this decision in large part because Stryker’s endoscopy direct sales force focuses on the operating room in hospitals, while most cystoscopy procedures are performed in physicians’ offices and ambulatory surgical centers. We believe that our U.S. sales force will be able to maximize revenue potential by focusing on these call points (physicians’ offices and ambulatory surgical centers). We expect that we will benefit by realizing the full gross profit contribution, which was previously shared with Stryker.

 

Our goal is to become a customer-centric organization with a focus on enhancing stockholder value. We are doing this by:

 

 

Increasing the competencies and capabilities of our sales force in the U.S. by adding proven medical-surgical device sales professionals and expanding our international distribution network in promising territories;

 

Targeting office-based clinics and ambulatory surgical centers, as well as acute care facilities, that recognize patient safety and the patient experience as a primary value position;

 

 
17

 

 

 

Capitalizing on our extensive and relevant library of published clinical studies and peer reviewed papers on the efficacy and safety of our EndoSheath technology; and

 

Enhancing our professional educational programs to allow healthcare professionals to teach other healthcare professionals about our EndoSheath technology.

 

Industrial Business Segment

 

Our industrial segment, through our wholly-owned subsidiary Machida, designs, manufactures, and sells borescopes to a variety of users, primarily in the aircraft engine manufacturing and aircraft engine maintenance industries. A borescope is an instrument that uses optical fibers for the visual inspection of narrow cavities.  Our borescopes are used to inspect aircraft engines, casting parts and ground turbines, among other items.

 

Machida’s quality line of borescopes includes a number of advanced standard features normally found only in custom designed instruments. We were the first to offer a flexible borescope with a grinding attachment, allowing users to “blend” or smooth small cracks in turbine blades of jet engines without disassembling the engine, saving our customers significant expense and delay.

 

Debt Arrangements – Related Party

 

Convertible Promissory Notes

 

Pursuant to a May 29, 2014 letter agreement between us and Mr. Lewis C. Pell, our Chairman, or the Prior Letter Agreement, Mr. Pell agreed to provide financial assistance to us in the amount of up to $5.0 million, if necessary to support our operations, for a period ending on the earlier of (i) July 1, 2015 or (ii) our raising debt or equity capital in the amount of $5.0 million or more. The Prior Letter Agreement provided that this financial assistance, if drawn by us, would be in the form of an additional loan, share purchase, or financing transaction, on such terms as we and Mr. Pell may determine. The Prior Letter Agreement was terminated upon the issuance of the 2014 Note (as defined below).

 

On June 16, 2014, or the 2014 Effective Date, we entered into a convertible promissory note, or the 2014 Note, with Mr. Pell, in accordance with the Prior Letter Agreement. The 2014 Note accrues annual interest at the rate of 1.91%. The 2014 Note must be repaid in full on or before the fifth anniversary of the 2014 Effective Date, or the 2014 Maturity Date, but may be prepaid by us at any time without penalty. We will be required to repay all amounts outstanding under the 2014 Note upon an event of default, as defined in the 2014 Note. The outstanding principal amount of the 2014 Note is convertible at any time prior to the 2014 Maturity Date, at Mr. Pell’s option, into shares of our common stock at a price of $1.11, the closing bid price of our common stock on the 2014 Effective Date. As of September 30, 2014, we had outstanding principal borrowings of $2.0 million under the 2014 Note, which is included in convertible debt – related party on our condensed consolidated balance sheet. On October 24, 2014, we drew down another $1 million under the 2014 Note.

 

On September 25, 2013, or the 2013 Effective Date, we entered into a convertible promissory note, or the 2013 Note, with Mr. Pell that allowed us to borrow up to $3.5 million. The 2013 Note accrues annual interest, at the rate of 1.66%. The 2013 Note must be repaid in full on or before the fifth anniversary of the 2013 Effective Date, or the 2013 Maturity Date, but may be prepaid by us at any time without penalty. We will be required to repay all amounts outstanding under the 2013 Note upon an event of default, as defined in the 2013 Note. The outstanding principal amount of the 2013 Note is convertible at any time prior to the 2013 Maturity Date, at Mr. Pell’s option, into shares of our common stock at a price of $0.89, the closing bid price of our common stock on the 2013 Effective Date. At September 30, 2014, we had outstanding principal borrowings of $3.5 million, gross of the amount recognized as a beneficial conversion feature, under the 2013 Note, which is included in convertible debt – related party on our condensed consolidated balance sheet.

 

On September 19, 2012, or the Replacement Note Effective Date, we entered into a convertible promissory note, or the Replacement Note, with Mr. Pell that allowed us to borrow up to $20.0 million. The Replacement Note (i) consolidated and restructured the $15.0 million in aggregate borrowings collectively outstanding under an Amended and Restated Loan Agreement, dated September 30, 2011, between us and Mr. Pell, or the Original Agreement, and a separate promissory note, dated July 25, 2012, between us and Mr. Pell, and (ii) provided for up to $5.0 million in additional borrowings.

 

 
18

 

 

The Replacement Note accrues annual interest, payable annually, at the rate of 0.84%. The Replacement Note must be repaid in full on or before the fifth anniversary of the Replacement Note Effective Date, or the Replacement Note Maturity Date, but may be prepaid by us at any time without penalty. We will be required to repay all amounts outstanding under the Replacement Note upon an event of default, as defined in the Replacement Note.

 

The outstanding principal amount of the Replacement Note is convertible at any time prior to the Replacement Note Maturity Date, at Mr. Pell’s option, into shares of our common stock at a conversion price of $1.20 per share, which was the closing bid price of our common stock on the Replacement Note Effective Date. At September 30, 2014, we had $20.0 million in outstanding principal borrowings under the Replacement Note, which is reflected as convertible debt – related party on our condensed consolidated balance sheet.

 

At September 30, 2014, we had an aggregate amount of $376 thousand in accrued interest under the 2014 Note, the 2013 Note and the Replacement Note, which is included in accrued expenses on our condensed consolidated balance sheet.

 

During each draw upon the 2013 Note, a beneficial conversion feature was recorded as a result of the market price of our common stock increasing after the Effective Date. The beneficial conversion feature amounts were recorded as a convertible debt discount with a corresponding increase to additional paid-in capital. The amounts are being amortized over a five-year period from the borrowing date to the Maturity Date. At September 30, 2014, the unamortized convertible debt discount balance was $1.0 million and is expected to be recognized over a period of approximately 4.0 years.

 

The following table is a summary of our convertible debt – related party at September 30, 2014:

 

Convertible debt – related party

 

Gross

Principal

Amount

Outstanding

   

Unamortized

Debt

Discount

   

Net Amount

Outstanding

 

Replacement Note

  $ 20,000     $ -     $ 20,000  

2013 Note

    3,500       (1,020 )     2,480  

2014 Note

    2,000       -       2,000  
    $ 25,500     $ (1,020 )   $ 24,480  

 

 

The scheduled maturities of principal amounts of our Convertible debt – related party at September 30, 2014 were $20.0 million due September 19, 2017, $3.5 million due September 25, 2018 and $2.0 million due June 16, 2019.

 

Existing Letter Agreement

 

Pursuant to a letter agreement dated October 28, 2014 with Mr. Pell, or the Existing Letter Agreement, Mr. Pell has agreed to provide financial assistance to us in the amount of up to $2.5 million, if necessary to support our operations, for a period ending on the earlier of (i) January 1, 2016 or (ii) our raising debt or equity capital in the amount of $2.5 million or more. This financial assistance, if drawn by us, would be in the form of an additional loan, share purchase, or financing transaction, on such terms as we and Mr. Pell may determine. We have not utilized the Existing Letter Agreement.

 

 

Critical Accounting Policies and Estimates

 

The preparation of our condensed consolidated financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Management evaluates these estimates and assumptions on an ongoing basis. Estimates are based on historical experience, when available, and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

Management believes that, of its significant accounting policies, an understanding of the following critical accounting policies is important in obtaining an overall understanding of the condensed consolidated financial statements.

 

 
19

 

 

Revenue Recognition

 

We recognize revenue in accordance with the Financial Accounting Standards Board (the “FASB”) Accounting Standards Codification (“ASC”) 605 (Topic 605, Revenue Recognition). ASC 605 requires that five basic criteria must be met before revenue can be recognized:

 

1.     persuasive evidence that an arrangement exists;

2.     delivery has occurred or services were rendered;

3.     the fee is fixed and determinable;

4.     collectability is reasonably assured; and

5.     the fair value of undelivered elements, if any, exists.

 

Determination of criterion (4) above is based on management’s judgment regarding the collectability of invoices for products and services delivered to customers. Should changes in conditions cause management to determine this criterion is not met for certain future transactions, revenue recognized for any reporting period could be adversely affected. We recognize revenue when title passes to the customer, generally upon shipment of our products F.O.B. shipping point. Revenue for service repairs of equipment is recognized after service has been completed, and service contract revenue is recognized ratably over the term of the contract.

 

For products sold to Stryker we recognize revenue in a two-step process. The first step is recognition of revenue for our cost to manufacture these products when title passes to Stryker, generally upon shipment of our products F.O.B. shipping point. The second step is recognition of revenue for our specified margin of Stryker’s gross profit after Stryker sells the products to its end customers, based upon reports received from Stryker monthly. Stryker is not required to purchase any required minimum amount of products from us.

 

Stock Based Compensation

 

We account for stock-based awards issued to employees in accordance with the provisions of ASC 718 (Topic 718, Compensation – Stock Compensation). We recognize stock-based compensation expense on a straight-line uniform basis over the service period of the award, which is generally four years for employees. We use historical data to estimate expected employee behaviors related to option exercises and forfeitures and include these expected forfeitures as a part of the estimate of stock-based compensation expense as of the grant date. For stock-based awards with performance-based vesting conditions, we are also required to estimate the probability of the vesting conditions being met. Stock-based awards issued to consultants are accounted for in accordance with the provisions of ASC 718 and ASC 505-50 (Subtopic 50 “Equity-Based Payments to Non-Employees” of Topic 505, Equity). Options granted to consultants are periodically revalued as the options vest, and are recognized as an expense over the related period of service or the vesting period, whichever is longer. Under the provisions of ASC 718, members of the Board are considered employees for calculation of stock-based compensation expense.

 

Allowance for Doubtful Accounts

 

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. This allowance is used to report trade receivables at estimated net realizable value. We rely on prior experience to estimate cash that ultimately will be collected from the gross receivables balance at period-end. We maintain a specific allowance for customer accounts that will likely not be collectible due to customer liquidity issues. We also maintain an allowance for estimated future collection losses on existing receivables, determined based on historical trends.

 

Inventories

 

Inventories are stated at the lower of cost or market using the first-in, first-out (“FIFO”) method. If cost exceeds market, inventory is reported at its estimated fair market value based upon our historical experience with inventory becoming obsolete due to age, changes in technology, and other factors. We record a write-down for inventories of components that have become obsolete, slow moving, or are in excess of anticipated demand or net realizable value. We perform a detailed review of inventory each fiscal quarter that considers multiple factors, including demand forecasts, product life cycle status, product development plans, and current sales levels. Inventories consist of raw materials, work in process, and finished goods.

 

 
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Beneficial Conversion Feature 

 

We account for beneficial conversion features in accordance with the provisions of ASC 470-20 (Subtopic 20 “Debt with Conversions and Other Options” of Topic 470, Debt). A beneficial conversion feature exists if the fair value of the underlying common stock is above the conversion price of the instrument on the commitment date. The difference in the common stock and conversion prices results in a beneficial conversion feature, a nondetachable conversion feature that is in the money at the commitment date. This resulting benefit is recorded as a convertible debt discount, with a corresponding increase to additional paid-in capital, and amortized using the effective interest method over the period from the commitment date (borrowing date) to the maturity date of the convertible debt.

 

Warranty Obligations

 

We provide for the estimated cost of warranties at the time the related revenue is recognized based on the number of units sold, historical and anticipated rates of warranty claims, and cost per claim. We periodically assess the adequacy of our recorded warranty liabilities and adjust the amounts as necessary. Warranty expense is recorded in cost of sales in our consolidated statement of operations.

 

Results of Operations (Dollars in thousands, except per share amounts)

 

Net Sales

 

In the medical segment, we track sales of our endoscopes and EndoSheath technology by market. We also track sales of peripherals and accessories that can be sold to more than one market. Net sales by operating segment and by market/category for the three and six months ended September 30, 2014 and 2013, respectively, were as follows:

 

   

Three Months Ended

           

Six Months Ended

         
   

September 30,

           

September 30,

         

Market/Category

 

2014

   

2013

   

Change

   

2014

   

2013

   

Change

 

Urology

  $ 1,928     $ 1,681       15 %   $ 3,701     $ 3,542       4 %

ENT

    510       403       27 %     761       743       2 %

TNE

    76       355       -79 %     257       558       -54 %

Pulmonology

    227       395       -43 %     592       481       23 %

Repairs, peripherals, and accessories

    526       565       -7 %     1,016       1,104       -8 %

Total medical sales

    3,267       3,399       -4 %     6,327       6,428       -2 %

Total industrial sales

    843       569       48 %     1,535       1,192       29 %

Net sales

  $ 4,110     $ 3,968       4 %   $ 7,862     $ 7,620       3 %

 

 Net sales increased $0.1 million, or 4%, to $4.1 million for the three months ended September 30, 2014 compared with $4.0 million during the prior-year period. In our medical segment, increases in our sales to the urology and ENT markets were offset by decreases in sales to the TNE and pulmonology markets, resulting in a decrease of 4%, or $0.1 million, to $3.3 million, compared with $3.4 million during the prior-year period. Industrial segment sales increased 48% or $0.2 million, to $0.8 million, primarily due to the addition of new customers.

 

Net sales increased $0.2 million, or 3%, to $7.9 million for the six months ended September 30, 2014 compared with $7.6 million during the prior-year period. During the six months ended September 30, 2014, our medical segment’s net sales of $6.3 million decreased by $0.1 million, or 2%, as increased sales to the urology, pulmonology and ENT markets were offset by decreases in sales to the TNE market and a decline in repairs, peripherals and accessories. Our industrial segment’s net sales of $1.5 million increased by $0.3 million or 29%, primarily due to the addition of new customers.

 

 

 
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The following table summarizes net sales by market/category and by product for our medical operating segment for the three and six months ended September 30, 2014 and 2013, respectively:

 

   

Three Months Ended

           

Six Months Ended

         
   

September 30,

           

September 30,

         

Market/Category

 

2014

   

2013

   

Change

   

2014

   

2013

   

Change

 

Urology

                                               

Endoscopes

  $ 520     $ 975       -47 %   $ 1,262     $ 2,011       -37 %

EndoSheath disposables

    1,408       706       99 %     2,439       1,531       59 %

Total urology market

    1,928       1,681       15 %     3,701       3,542       4 %

ENT

                                               

Endoscopes

    510       403       27 %     761       743       2 %

TNE

                                               

Endoscopes

    37       302       -88 %     162       455       -64 %

EndoSheath disposables

    39       53       -26 %     95       103       -8 %

Total TNE market

    76       355       -79 %     257       558       -54 %

Pulmonology

                                               

Endoscopes

    160       358       -55 %     470       388       21 %

EndoSheath disposables

    67       37       81 %     122       93       31 %

Total pulmonology market

    227       395       -43 %     592       481       23 %

Repairs, peripherals, and accessories

    526       565       -7 %     1,016       1,104       -8 %

Total medical sales

  $ 3,267     $ 3,399       -4 %   $ 6,327     $ 6,428       -2 %

Product

                                               

Endoscopes

  $ 1,227     $ 2,038       -40 %   $ 2,655     $ 3,597       -26 %

EndoSheath disposables

    1,514       796       90 %     2,656       1,727       54 %

Repairs, peripherals, and accessories

    526       565       -7 %     1,016       1,104       -8 %

Total medical sales

  $ 3,267     $ 3,399       -4 %   $ 6,327     $ 6,428       -2 %

 

Net sales to the urology market of $1.9 million and $3.7 million for the three and six months ended September 30, 2014, respectively, increased by $0.2 million, or 15%, and by $0.2 million, or 4%, compared with their prior-year periods. Prior to May 2014, Stryker had the rights to market and sell our cystoscopes, the CST- 5000 Video Cystoscope and the CST-4000 Fiber Cystoscope, and the accompanying EndoSheath technology, peripherals and accessories. During May 2014, we began to market and sell the cystoscopes, their EndoSheaths, peripherals and accessories direct in the U.S. Lower sales of endoscopes have resulted from this changeover. However, this decrease has been more than offset by increased sales of Endosheath disposables.

 

Net sales to the ENT market of $0.5 million and $0.8 million for the three and six months ended September 30, 2014, respectively, increased by $0.1 million, or 27%, and $20 thousand or 2%, respectively, compared with their prior-year periods. In September 2014, we announced the introduction of a new ENT-7000 model that features the smallest diameter insertion tube available at 2.4mm in size.

 

Net sales to the TNE market of $0.1 million and $0.3 million for the three and six months ended September 30, 2014, respectively, decreased by $0.3 million, or 79%, and $0.3 million, or 54%, respectively compared with their prior-year periods. Our salesforce has been focused with the changes in the urology market discussed above, contributing to a decline in sales activity in this market.

 

Net sales to the pulmonology market of $0.2 million for the three months ended September 30, 2014 decreased by $0.2 million, or 43%, compared with the prior-year period. However, sales for the six months ended September 30, 2014 of $0.6 million increased by $0.1 million, or 23%, from the same period one year ago. The increase was primarily due to the launch of a new video-based bronchoscope and digital processing unit, the BRS-5100.

 

 
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Net sales of all repairs, peripherals, and accessories for the three months ended September 30, 2014 of $0.5 million were within $39 thousand of the prior-year period, while sales for the six months ended September 30, 2014 decreased by $0.1 million, or 8%, compared with the prior-year period.

 

Gross Profit (Net Sales Less Cost of Sales)

 

Gross profit by operating segment for the three and six months ended September 30, 2014 and 2013, respectively, was as follows:

 

   

Three Months Ended

           

Six Months Ended

         
   

September 30,

           

September 30,

         

Gross Profit

 

2014

   

2013

   

Change

   

2014

   

2013

   

Change

 

Medical

  $ 1,023     $ 981       4 %   $ 1,921     $ 1,774       8 %

As percentage of net sales

    31.3 %     28.9 %             30.4 %     27.6 %        

Industrial

    235       214       10 %     486       501       -3 %

As percentage of net sales

    27.9 %     37.6 %             31.7 %     42.0 %        

Gross profit

  $ 1,258     $ 1,195       5 %   $ 2,407     $ 2,275       6 %

Gross profit margin percentage

    30.6 %     30.1 %             30.6 %     29.9 %        

 

The gross profit margin percentage of 30.6% for the three and six months ended September 30, 2014 increased from 30.1% and 29.9% for the prior-year periods, respectively. The increase was due to an improved margin in the medical products segment, resulting from cost savings efforts as a result of our direct selling of cystoscopes, their EndoSheaths, peripherals and accessories direct in the U.S., somewhat offset by declines in the industrial products segment’s gross margins.

 

Operating Expenses (Selling, General, and Administrative (“SG&A”) and Research and Development (“R&D”)

 

Operating expenses by operating segment for the three and six months ended September 30, 2014 and 2013, respectively were as follows:

 

   

Three Months Ended

           

Six Months Ended

         
   

September 30,

           

September 30,

         

Operating Expenses

 

2014

   

2013

   

Change

   

2014

   

2013

   

Change

 

SG&A expenses

                                               

Medical

  $ 2,117     $ 1,898       12 %   $ 4,317     $ 4,659       -7 %

Industrial

    241       152       59 %     532       441       21 %

Total SG&A expenses

    2,358       2,050       15 %     4,849       5,100       -5 %

R&D expenses

                                               

Medical

    341       428       -20 %     877       847       4 %

Industrial

    -       -       -       -       -       -  

Total R&D expenses

    341       428       -20 %     877       847       4 %

Total operating expenses

  $ 2,699     $ 2,478       9 %   $ 5,726     $ 5,947       -4 %

 

Selling, General, & Administrative (“SG&A”) Expenses

 

Selling, general and administrative (“SG&A”) expenses were $2.4 million for the three months ended September 30, 2014, an increase of $0.3 million, or 15%, compared with the prior-year period. The increase was primarily attributable to the prior-year period which included the reversal of stock-based compensation expense related to the resignation of our former chief executive officer. SG&A expenses were $4.8 million for the six months ended September 30, 2014, a decrease of $0.3 million, or 5%, compared with the prior-year period, primarily attributable to our cost savings measures and that the prior-year period included severance expenses from our former chief executive officer.

 

 
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Research & Development (“R&D”) Expenses

 

Research and development (“R&D”) expenses were $0.3 million for the three months ended September 30, 2014, a decrease of $0.1 million, or 20%, over the same period last year, primarily attributable to lower product development costs and the timing of expenses. For the six months ended September 30, 2014, R&D expenses increased $30 thousand, or 4%, over the same period last year.

 

Other Expense

 

Other (expense) income for the three and six months ended September 30, 2014 and 2013, respectively, were as follows:

 

   

Three Months Ended

           

Six Months Ended

         
   

September 30,

           

September 30,

         

Other Expense

 

2014

   

2013

   

Change

   

2014

   

2013

   

Change

 

Interest expense

    (106 )     (44 )     141 %     (189 )     (85