e10vq
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
|
|
|
þ |
|
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006
OR
|
|
|
o |
|
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
FOR THE TRANSITION PERIOD FROM TO .
COMMISSION FILE NUMBER: 001-15063
Endocare, Inc.
(Exact name of Registrant as Specified in Its Charter)
|
|
|
DELAWARE
|
|
33-0618093 |
(State of Incorporation)
|
|
(I.R.S. Employer I.D. No.) |
201 TECHNOLOGY DRIVE, IRVINE, CALIFORNIA 92618
(Address of Principal Executive Office, Including Zip Code)
(949) 450-5400
(Registrants 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 requirements for the past 90 days. (1) Yes þ No o; (2) Yesþ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated
filer, or a non-accelerated filer. See definitions of accelerated filer and large accelerated
filer in Rule 12b-2 of the Exchange Act. (Check one):
Large Accelerated Filer o Accelerated Filer þ Non-Accelerated Filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of
the Exchange Act). Yes o No þ
The number of shares of the Registrants common stock, par value $.001 per share, outstanding
at October 31, 2006 was 30,648,934.
PART I FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
ENDOCARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
|
|
(In thousands, except per share data) |
|
Total revenues |
|
$ |
6,700 |
|
|
$ |
7,008 |
|
|
$ |
20,870 |
|
|
$ |
20,794 |
|
Costs and expenses: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Costs of revenues |
|
|
2,677 |
|
|
|
3,809 |
|
|
|
9,699 |
|
|
|
11,919 |
|
Research and development |
|
|
581 |
|
|
|
542 |
|
|
|
2,067 |
|
|
|
1,653 |
|
Selling and marketing |
|
|
3,725 |
|
|
|
3,253 |
|
|
|
11,398 |
|
|
|
9,791 |
|
General and administrative |
|
|
3,196 |
|
|
|
3,393 |
|
|
|
9,262 |
|
|
|
10,182 |
|
Impairment charge |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
26 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total costs and expenses |
|
|
10,179 |
|
|
|
10,997 |
|
|
|
32,426 |
|
|
|
33,571 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss from operations |
|
|
(3,479 |
) |
|
|
(3,989 |
) |
|
|
(11,556 |
) |
|
|
(12,777 |
) |
Interest expense, net |
|
|
1,330 |
|
|
|
562 |
|
|
|
3,375 |
|
|
|
(389 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss from continuing operations before taxes |
|
|
(2,149 |
) |
|
|
(3,427 |
) |
|
|
(8,181 |
) |
|
|
(13,166 |
) |
Tax benefit on continuing operations |
|
|
|
|
|
|
|
|
|
|
151 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss from continuing operations |
|
|
(2,149 |
) |
|
|
(3,427 |
) |
|
|
(8,030 |
) |
|
|
(13,166 |
) |
Income from discontinued operations |
|
|
|
|
|
|
537 |
|
|
|
245 |
|
|
|
1,575 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss |
|
$ |
(2,149 |
) |
|
$ |
(2,890 |
) |
|
$ |
(7,785 |
) |
|
$ |
(11,591 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) per share basic and diluted: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Continuing operations |
|
$ |
(0.07 |
) |
|
$ |
(0.11 |
) |
|
$ |
(0.27 |
) |
|
$ |
(0.45 |
) |
Discontinued operations |
|
|
|
|
|
|
0.01 |
|
|
|
0.01 |
|
|
|
0.05 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss |
|
$ |
(0.07 |
) |
|
$ |
(0.10 |
) |
|
$ |
(0.26 |
) |
|
$ |
(0.40 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average shares of common stock outstanding |
|
|
30,175 |
|
|
|
30,069 |
|
|
|
30,162 |
|
|
|
28,975 |
|
The accompanying notes are an integral part of these condensed consolidated financial statements.
3
ENDOCARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
|
|
|
|
|
|
|
|
|
|
|
September 30, |
|
|
December 31, |
|
|
|
2006 |
|
|
2005 |
|
|
|
(Unaudited) |
|
|
|
|
|
|
|
(In thousands, |
|
|
|
except per share data) |
|
ASSETS
|
Current assets: |
|
|
|
|
|
|
|
|
Cash and cash equivalents |
|
$ |
5,471 |
|
|
$ |
8,108 |
|
Accounts receivable, net |
|
|
2,955 |
|
|
|
3,549 |
|
Inventories, net |
|
|
2,457 |
|
|
|
2,462 |
|
Prepaid expenses and other current assets |
|
|
1,117 |
|
|
|
1,213 |
|
Assets of discontinued operations |
|
|
|
|
|
|
9,624 |
|
|
|
|
|
|
|
|
Total current assets |
|
|
12,000 |
|
|
|
24,956 |
|
Property and equipment, net |
|
|
1,106 |
|
|
|
1,794 |
|
Intangibles, net |
|
|
3,751 |
|
|
|
4,167 |
|
Investments and other assets |
|
|
2,401 |
|
|
|
1,320 |
|
|
|
|
|
|
|
|
Total assets |
|
$ |
19,258 |
|
|
$ |
32,237 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
LIABILITIES AND STOCKHOLDERS EQUITY
|
Current liabilities: |
|
|
|
|
|
|
|
|
Accounts payable |
|
$ |
3,352 |
|
|
$ |
2,680 |
|
Accrued compensation |
|
|
2,623 |
|
|
|
3,614 |
|
Other accrued liabilities |
|
|
3,956 |
|
|
|
6,629 |
|
Liabilities of discontinued operations |
|
|
|
|
|
|
1,461 |
|
|
|
|
|
|
|
|
Total current liabilities |
|
|
9,931 |
|
|
|
14,384 |
|
Common stock warrants |
|
|
2,082 |
|
|
|
5,023 |
|
|
|
|
|
|
|
|
Total liabilities |
|
|
12,013 |
|
|
|
19,407 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stockholders equity: |
|
|
|
|
|
|
|
|
Preferred stock, $0.001 par value; 1,000
shares authorized; none issued and
outstanding |
|
|
|
|
|
|
|
|
Common stock, $0.001 par value; 50,000
shares authorized; 30,175 and 30,089
issued and outstanding as of September
30, 2006 and December 31, 2005,
respectively |
|
|
30 |
|
|
|
30 |
|
Additional paid-in capital |
|
|
180,678 |
|
|
|
178,477 |
|
Accumulated deficit |
|
|
(173,463 |
) |
|
|
(165,677 |
) |
|
|
|
|
|
|
|
Total stockholders equity |
|
|
7,245 |
|
|
|
12,830 |
|
|
|
|
|
|
|
|
Total liabilities and stockholders equity |
|
$ |
19,258 |
|
|
$ |
32,237 |
|
|
|
|
|
|
|
|
The accompanying notes are an integral part of these condensed consolidated financial
statements.
4
ENDOCARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
|
|
|
|
|
|
|
|
|
|
|
Nine months Ended |
|
|
|
September 30, |
|
|
|
2006 |
|
|
2005 |
|
|
|
(Unaudited) |
|
|
|
(In thousands) |
|
Cash flows from operating activities: |
|
|
|
|
|
|
|
|
Net loss |
|
$ |
(7,785 |
) |
|
$ |
(11,591 |
) |
Adjustments to reconcile net loss to net cash used in operating activities: |
|
|
|
|
|
|
|
|
Gain on divestiture |
|
|
(418 |
) |
|
|
|
|
Depreciation and amortization |
|
|
1,227 |
|
|
|
2,502 |
|
Loss on disposals of fixed assets |
|
|
423 |
|
|
|
107 |
|
Stock compensation expense |
|
|
1,986 |
|
|
|
49 |
|
Costs related to assets held for sale |
|
|
|
|
|
|
(583 |
) |
Minority interests |
|
|
|
|
|
|
(214 |
) |
Interest expense related to common stock warrants |
|
|
(2,941 |
) |
|
|
625 |
|
Changes in operating assets and liabilities: |
|
|
|
|
|
|
|
|
Accounts receivable |
|
|
826 |
|
|
|
(184 |
) |
Inventories |
|
|
(330 |
) |
|
|
(368 |
) |
Prepaid expenses and other current assets |
|
|
430 |
|
|
|
(239 |
) |
Accounts payable |
|
|
392 |
|
|
|
224 |
|
Accrued compensation |
|
|
(1,013 |
) |
|
|
(151 |
) |
Other accrued liabilities |
|
|
(2,685 |
) |
|
|
(1,986 |
) |
|
|
|
|
|
|
|
Net cash used in operating activities |
|
|
(9,888 |
) |
|
|
(11,809 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash flows from investing activities: |
|
|
|
|
|
|
|
|
Purchases of property and equipment |
|
|
(144 |
) |
|
|
(246 |
) |
Proceeds from divestitures |
|
|
7,287 |
|
|
|
850 |
|
Purchases of intangible assets |
|
|
|
|
|
|
(330 |
) |
|
|
|
|
|
|
|
Net cash provided by investing activities |
|
|
7,143 |
|
|
|
274 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash flows from financing activities: |
|
|
|
|
|
|
|
|
Borrowings under the credit facility |
|
|
250 |
|
|
|
|
|
Repayments under the credit facility |
|
|
(250 |
) |
|
|
|
|
Stock options and warrants exercised |
|
|
108 |
|
|
|
81 |
|
Proceeds from sale of common stock, net of issuance costs |
|
|
|
|
|
|
14,596 |
|
|
|
|
|
|
|
|
Net cash provided by financing activities |
|
|
108 |
|
|
|
14,677 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net increase (decrease) increase in cash and cash equivalents |
|
|
(2,637 |
) |
|
|
3,142 |
|
|
Cash and cash equivalents, beginning of period |
|
|
8,108 |
|
|
|
7,985 |
|
|
|
|
|
|
|
|
|
Cash and cash equivalents, end of period |
|
$ |
5,471 |
|
|
$ |
11,127 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Non-cash activities: |
|
|
|
|
|
|
|
|
Transfer of inventory to property and equipment |
|
$ |
361 |
|
|
$ |
418 |
|
|
|
|
|
|
|
|
|
Note receivable received in divestiture |
|
$ |
1,425 |
|
|
$ |
|
|
|
|
|
|
|
|
|
The accompanying notes are an integral part of these condensed consolidated financial
statements.
5
ENDOCARE, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Tabular numbers in thousands, except per share data)
(Unaudited)
1. Organization and Operations
We are a medical device company focused on developing, manufacturing and selling cryoablation
products which have the potential to assist physicians in improving and extending life by use in
the treatment of cancer and other tumors. We were formed in 1990 as a research and development
division of Medstone International, Inc. (Medstone), a manufacturer of shockwave lithotripsy
equipment for the treatment of kidney stones. Following our incorporation under the laws of the
state of Delaware in 1994, we became an independent, publicly-owned corporation upon Medstones
distribution of our stock to the existing stockholders on January 1, 1996.
Through February 10, 2006, we also offered vacuum therapy systems for non-pharmaceutical
treatment of erectile dysfunction through our wholly-owned subsidiary Timm Medical Techologies,
Inc. (Timm Medical), which was sold to a third party effective February 10, 2006 (see Note 4 -
Sale of Timm Medical). The operating results of Timm Medical through the date of sale are
included in discontinued operations.
2. Basis of Presentation
Following the rules and regulations of the Securities and Exchange Commission (the SEC), we
have omitted footnote disclosures in this report that would substantially duplicate the disclosures
contained in our annual audited financial statements. The accompanying condensed consolidated
financial statements should be read together with the consolidated financial statements and the
notes thereto included in our Annual Report on Form 10-K, filed with the SEC on March 16, 2006.
The accompanying condensed consolidated financial statements reflect all adjustments,
consisting solely of normal recurring accruals, needed to present fairly the financial results for
these interim periods. The condensed consolidated results of operations presented for the interim
periods are not necessarily indicative of the results for a full year. All intercompany
transactions and accounts have been eliminated in consolidation.
3. Recent Operating Results and Liquidity
Since inception, we have incurred losses from operations and have reported negative cash
flows. As of September 30, 2006, we had an accumulated deficit of $173.5 million and cash and cash
equivalents of $5.5 million. We do not expect to reach break-even or cash flow positive
operations in 2006, and we expect to continue to generate losses from operations for the
foreseeable future, although such losses are expected to decline.
As more fully discussed below in Note 9 Commitment and Contingencies, even though we
recently resolved the investigations of our historical accounting and financial reporting through
our settlements in July 2006 with the SEC and U.S. Department of Justice (DOJ), we still have
obligations to indemnify and advance the legal fees for our former officers and former directors in
connection with the ongoing investigations related to those individuals. The amount of those legal
fees may exceed the reimbursement due to us from our directors and officers liability insurance,
and the excess may have a material adverse effect on our results of operations and our liquidity.
For the year ended December 31, 2005 and the nine months ended September 30, 2006, we incurred
$1.1 million and $0.2 million (net of insurance reimbursement), respectively, in legal expenses,
related to these matters. We also face large cash expenditures in the future related to past due
state and local sales and use tax obligations, for which we estimated and accrued $2.8 million as
of September 30, 2006. We currently are in negotiations with various states to resolve past due
taxes. However, there is no
assurance that these obligations will be reduced as a result of the negotiations or that we
will be allowed to pay the amounts due over an extended period of time.
We have continued to experience year-over-year growth in cryosurgical disposable products
sales and procedure fee revenues. As a result of the shift in the revenue mix from cryoablation
procedure fees to sales of cryoablation
6
disposable products, which have a lower average selling
price and cost of sales per procedure, we have experienced a significant increase in gross margins
as a percentage of revenues although the gross profit dollars per case generally are the same. We
have significantly reduced our operating expenses through streamlining our corporate organization,
elimination or deferral of some longer-term research and development and clinical and marketing
activities, reconfiguration of our products to reduce manufacturing costs, transferring
manufacturing to lower cost suppliers and, in general, better controlling operating expenses.
We intend to continue investing in our sales and marketing efforts to physicians in order to
raise awareness and gain further acceptance of our technology. This investment is required in order
to increase physicians usage of our technology in the treatment of prostate and renal cancers,
lung and liver cancers and in the management of pain from bone metastases. Such costs will be
reported as current period charges under generally accepted accounting principles.
On October 25, 2006, we entered into an agreement with Fusion Capital Fund II, LLC (Fusion
Capital) pursuant to which we have the right to sell to Fusion Capital up to $16.0 million worth
of common stock over a two year period at prices determined based upon the market price of our
common stock at the time of each sale without any fixed discount in $100,000 increments every third
business day. We can sell additional $150,000 increments to Fusion Capital every second business
if the trading price of our common stock is at least $1.50 per share. This $150,000 increment can
be further increased at graduation levels up to $1.0 million if the market price of our common
stock increases from $1.50 to $6.00. We can commence these sales after we complete the registration
process with the SEC. If the price of our stock is below $1.00 per share, the obligation for Fusion
Capital to buy any shares of stock is automatically suspended. Under the terms of the agreement we
issued 473,957 shares of common stock to Fusion Capital as a commitment fee See Note 12
Subsequent Events for further discussion.
We will use existing cash reserves, as well as future proceeds from sales, if any, of common
stock to Fusion Capital, to finance our projected operating and cash flow needs, along with
continued expense management efforts. In addition, we may borrow funds under our line of credit
with our bank as long as we remain in compliance with the representations, warranties, covenants
and borrowing conditions set forth in the agreements governing the line of credit. This line of
credit permits us to borrow up to the lesser of $4.0 million or amounts available under the
Borrowing Base. The Borrowing Base is (i) 80 percent of our eligible accounts receivable, plus
(ii) the lesser of 30 percent of the value of our eligible inventory or $500,000. The credit
facility includes a subjective acceleration clause and a requirement to maintain a lockbox with the
lender to which all collections are deposited. At September 30, 2006, we were not in compliance
with the minimum tangible net worth requirement under the credit facility. We are in the process of
requesting a waiver from the lender. However, there is no assurance that a waiver will be issued.
We had no amounts outstanding under this line of credit at September 30, 2006.
We believe that the financing with Fusion Capital and our line of credit with our bank will
provide us with the capital resources that we need to reach the point where our operations will
generate positive cash flows. However, our cash needs are not entirely predictable and the
availability of funds from Fusion Capital and our bank are subject to many conditions, including
certain subjective acceleration clauses and other provisions, some of which are predicated on
events that are not within our control. Accordingly, we cannot guarantee the availability of these
capital resources or that they will be sufficient to fund our ongoing operations to the point where
our operations will generate positive cash flows.
Despite the availability of funds from Fusion Capital and our bank, our independent auditors
may issue a qualified opinion, to the effect that there is substantial doubt about our ability to
continue as a going concern due to subjective acceleration provisions and conditions that must be
met in order to access the funds. A qualified opinion itself could have a material adverse effect
on our business, financial condition, results of operations and cash flows.
4. Sale of Timm Medical
We acquired Timm Medical in February 2002. During 2003, we divested certain non-core product
lines of Timm Medical. In July 2004, we began actively marketing Timm Medical to potential buyers
as part of an overall plan to raise additional capital. We reported Timm Medical as an asset held
for sale effective July 31, 2004 and recorded an impairment charge totaling $5.9 million to reduce
the carrying value of Timm Medical to fair value, less costs to sell. Following the completion of
our $15.6 million private placement in March 2005 (see Note 5 Private Placement of Common Stock
and Warrants), we reclassified Timm Medical as held and used in the first quarter of 2005 as we
were no longer seeking a buyer and had ceased all marketing efforts. As a result of this change in
plan,
7
included in net income from discontinued operations for the nine months ended September 30,
2005 is $0.4 million in depreciation and amortization expense for fixed assets and intangibles for
the period from July 31, 2004 to March 31, 2005 and $0.6 million income as a result of the
elimination of the estimated costs to sell, which was previously recorded as a component of the
impairment charge in 2004.
In late 2005, we received substantive expression of interest from Plethora Solutions Holdings
plc (Plethora), a company listed on the London Stock Exchange, to acquire Timm Medical and the
parties entered into a Stock Purchase Agreement on January 13, 2006. The transaction closed on
February 10, 2006. We did not receive significant direct cash flows from Timm Medical and had no
significant continuing involvement in its operations after the sale. In accordance with Statement
of Financial Accounting Standard (SFAS) No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, the assets and liabilities of Timm Medical were classified as discontinued
operations in the condensed consolidated financial statements for each period presented. The assets
and liabilities of Timm Medical as of December 31, 2005 have been classified as current. Sale
proceeds (net of $0.6 million in transaction costs) totaled $8.9 million and resulted in a gain on
sale of $0.4 million in the first quarter of 2006. Gross proceeds of $9.5 million include cash of
$8.1 million and a two-year, five percent promissory note secured by the assets of Timm Medical.
The note is convertible into Plethoras ordinary shares at any time at our option. If Plethoras
shares trade above a specified price for 20 consecutive days, Plethora has the option to require
conversion. Net cash proceeds from the divestiture were $7.2 million (after $0.6 million in
transaction costs and $0.3 million in cash of Timm Medical as of the date of disposition).
We agreed to retain certain assets and liabilities of Timm Medical, including all tax
liabilities totaling $1.1 million, obligations and rights to a $2.7 million note receivable from
the sale of Timm Medicals urinary incontinence product line in 2003, certain litigation to which
Timm Medical is a party and ownership of Urohealth BV (Timm Medicals wholly-owned subsidiary with
insignificant operations). Assets and liabilities we retained and their related revenues and
expenses are excluded from discontinued operations. The stock purchase agreement requires an
indemnification escrow of $1.4 million (proceeds from the note receivable under certain
circumstances in conjunction with the notes payment terms) to indemnify Plethora against certain
claims and liabilities.
Assets and liabilities of discontinued operations as of December 31, 2005 include the
following:
|
|
|
|
|
Assets: |
|
|
|
|
Cash, inventories and other current assets |
|
$ |
1,216 |
|
Property and equipment, net |
|
|
75 |
|
Goodwill, net |
|
|
4,552 |
|
Intangibles, net |
|
|
3,716 |
|
Other assets |
|
|
65 |
|
|
|
|
|
Total assets |
|
$ |
9,624 |
|
|
|
|
|
|
|
|
|
|
Liabilities: |
|
|
|
|
Accounts payable and other current liabilities |
|
$ |
942 |
|
Other accrued liabilities |
|
|
519 |
|
|
|
|
|
Total liabilities |
|
|
1,461 |
|
|
|
|
|
|
|
|
|
|
Net assets |
|
$ |
8,163 |
|
|
|
|
|
Revenues for Timm Medical were $1.0 million (for the period from January 1, 2006 through date
of sale, February 10, 2006) and $2.5 million and $6.9 million for the three months and nine months
ended September 30, 2005, respectively. Income from discontinued operations for the nine months
ended September 30, 2006 includes a $0.4 million gain on disposal and is net of $0.2 million in
taxes.
5. Private Placement of Common Stock and Warrants
On March 11, 2005, we completed a private placement of 5,635,378 shares of our common stock
and detachable warrants to purchase 3,944,748 common shares at an offering price of $2.77 per
share, for aggregate gross proceeds of $15.6 million. Transaction costs were $1.0 million,
resulting in net proceeds of $14.6 million. Of the total warrants, 1,972,374 have an initial
exercise price of $3.50 (Series A warrants) per share and 1,972,374 have an initial exercise price
of $4.00 (Series B warrants) per share. The warrants expire on March 11, 2010 unless exercised
8
before then. One current member and one former member of our management team made personal
investments totaling $0.7 million in the aggregate, and a member of our board of directors invested
$0.3 million.
The warrants initially are exercisable at any time during their term for cash only. The
warrants may be exercised on a cashless exercise basis in limited circumstances after the first
anniversary of the closing date if there is not an effective registration statement covering the
resale of the shares underlying the warrants. Each warrant is callable by us at a price of $0.01
per share underlying such warrant if our stock trades above certain dollar thresholds ($6.50 for
the Series A warrants and $7.50 for Series B warrants) for 20 consecutive days commencing on any
date after the effectiveness of the registration statement, provided that (a) we provide 30-day
advanced written notice (Notice Period), (b) we simultaneously call all warrants on the same terms
and (c) all common shares issuable are registered. Holders may exercise their warrants during the
Notice Period and warrants which remain unexercised will be redeemed at $0.01 per share.
Upon exercise, we will pay transaction fees equal to six percent of the warrant proceeds under
an existing capital advisory agreement.
Pursuant to the terms of the registration rights agreement, we filed with the SEC a
registration statement on Form S-2 under the Securities Act of 1933, as amended, covering the
resale of all of the common stock purchased and the common stock underlying the issued warrants.
The S-2 registration statement was declared effective September 28, 2005. We subsequently filed a
post-effective amendment on Form S-3, which was declared effective March 28, 2006.
The registration rights agreement provides that if a registration statement is not filed
within 30 days of closing or does not become effective within 90 days thereafter, then in addition
to any other rights the holders may have, we will be required to pay each holder an amount in cash,
as liquidated damages, equal to one percent of the aggregate purchase price paid by such holder per
month. We incurred liquidated damages through September 28, 2005, when the S-2 registration
statement was declared effective. In the second and third quarters of 2005, we incurred an
aggregate of $0.6 million of total liquidated damages, which were included in general and
administrative expenses in the respective periods.
Under the registration rights agreement, we could incur similar liquidated damages in the
future (equal to one percent of the aggregate purchase price paid by each affected holder per
month) if holders are unable to make sales under the registration statement (for example, if we
fail to keep the registration statement current as required by SEC rules or if future amendments to
the registration statement are not declared effective in a timely manner).
Since the liquidated damages under the registration rights agreement could in some cases
exceed a reasonable discount for delivering unregistered shares, we have classified the warrants as
a liability until the earlier of the date the warrants are exercised or expire. In accordance with
EITF 00-19, Accounting for Derivative Financial Instruments Indexed To, and Potentially Settled In,
a Companys Own Stock, we have allocated a portion of the offering proceeds to the warrants based
on their fair value. EITF 00-19 also requires that we revalue the warrants as a derivative
instrument periodically to compute the value in
connection with changes in the underlying stock price and other assumptions, with the change
in value recorded as interest expense. We determined the fair value of the warrants as follows as
of September 30, 2006:
|
|
|
First, we used the Black-Scholes option-pricing model with the following assumptions:
an expected life equal to the remaining contractual term of the warrants (3.50 years); no
dividends; a risk free rate of 4.61 percent, which equals the yield on Treasury bonds at
constant (or fixed) maturity equal to the remaining contractual term of the warrants; and
volatility of 58.6 percent. Under these assumptions, the Black-Scholes option-pricing model
yielded a value of $0.61 for each of the Series A warrants and $0.54 for each of the Series
B warrants, for an aggregate value of $2.2 million; |
|
|
|
|
Second, since the warrants are limited in the amount of realizable profit to the
holders as a result of the call provision described above, we reduced the value of the
warrants to account for the probability that the stock price will reach or exceed $6.50 and
$7.50, respectively (i.e., the prices above which we have the right to call the Series A
and Series B warrants, effectively compelling the holders to exercise their warrants). We
used a statistical formula to calculate the probability that our stock price will reach or
exceed $6.50 and $7.50, respectively. Based on this formula, we calculated that, for the
Series A warrants, the probability that the |
9
|
|
|
stock price of $6.50 will be reached or
exceeded is approximately 2.0 percent. Similarly, we calculated that, for the Series B
warrants, the probability that the stock price of $7.50 will be reached or exceeded is
approximately 0.6 percent. Based on these probabilities, we reduced the valuation of each
of the Series A warrants to $0.59 (which equals one minus 2.0 percent, multiplied by $0.61)
and we reduced the valuation of each of the Series B warrants to $0.53 (which equals one
minus 0.6 percent, multiplied by $0.54). This yields an aggregate value of the warrants
equal to $2.2 million; and |
|
|
|
|
Third, we further reduced the value of the warrants on the assumption that our stock
price on the day that the warrants are exercised will be affected by dilution as a result
of the additional stock introduced into the market. Given that we have approximately 30.2
million shares outstanding, we calculated that the exercise of the warrants will result in
dilution of approximately 6.2 percent. Using the dilution figure of 6.2 percent, we reduced
the value of each of the Series A warrants to $0.56 and the Series B warrants to $0.50.
This yields an aggregate value of the warrants equal to $2.1 million. As a result of this
fair value calculation, we recorded a reduction to net interest expense of $1.2 million and
$2.9 million, respectively, for the three and nine months ended September 30, 2006
(compared to reduction of interest expense of $0.5 million and net interest expense of
$0.6 million, respectively, for the three and nine months ended September 30, 2005), which
represents the change in the fair value of the warrants from June 30, 2006 and December 31,
2005, respectively, primarily as a result in the decrease in the fair value of the
underlying stock. |
|
|
|
|
The $1.2 million reduction in the fair value of the warrants during the third quarter of 2006
from $3.3 million at June 30, 2006 to $2.1 million at September 30, 2006 is primarily the
result of the decrease in the our share price from $2.50 at June 30, 2006 to $2.00 at
September 30, 2006 and the decrease in the overall volatility of our common shares. The $2.9
million reduction to net interest expense for the nine months ended September 30, 2006
includes a $0.8 million ($0.03 per basic and diluted share) reduction in the fair value of
the warrants as calculated at December 31, 2005 due to changes in the methodology we used to
measure volatility in conjunction with the adoption of SFAS No. 123R, Share Based Payment as
further discussed in Note 7 Stock-Based Compensation below. This reduction was a change
in estimate and was recorded in 2006 first quarter operations. |
Upon the earlier of the warrant exercise or expiration date, the warrant liability will be
reclassified into stockholders equity. Until that time, the warrant liability will be recorded at
fair value based on the methodology described above. We do not expect that the warrants will be
exercised within the next 12 months based on the current trading prices of our common stock and
have classified the warrants as a non-current liability at September 30, 2006. Changes in fair
value during each period will be recorded as interest expense.
6. Capital Stock and Net Loss Per Share
Basic net loss per share is computed by dividing net loss by the weighted average number of
common shares outstanding for the respective periods. Diluted loss per share, calculated using the
treasury stock method, gives effect to the potential dilution that could occur upon the exercise of
certain stock options and warrants that were outstanding during the respective periods presented.
For periods when we reported a net loss, these potentially dilutive common shares were excluded
from the diluted loss per share calculation because they were anti-dilutive.
7. Stock-Based Compensation
As of September 30, 2006, we have five stock-based employee compensation plans and one
non-employee director stock-based compensation plan. Prior to January 1, 2006, we accounted for
stock-based compensation for those plans under the recognition and measurement provisions of
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) as
permitted by SFAS No. 123, Accounting for Stock Based Compensation. Compensation expense recorded
under APB 25 has not been significant since we generally grant options with an exercise price equal
to the fair value of our common stock on the date of grant.
On May 18, 2006 we adopted the Employee Deferred Stock Unit Program and the Non-employee
Director Deferred Stock Unit Program. Under the terms of the employee program, certain eligible
employees have the option to elect to receive all or a portion of their annual bonus (at a minimum
of 25 percent) in deferred stock units in lieu of cash. In addition each participating employee
will also receive an additional premium in stock at a
10
percentage determined by the Compensation
Committee of our board of directors. That percentage premium for 2006 is 20 percent. Irrevocable
deferral elections are made during a designated period no later than June 30 of each year. The
units vest upon the determination of the bonus achieved and the number of stock units earned in the
first quarter of the following fiscal year. The stock price to determine the number of shares to be
issued is the fair market value of the stock on the date on which the deferred stock units are
granted. In 2006, the date of grant was June 23, 2006, on which date the closing stock price was
$2.70. Compensation expense related to the bonus program is recorded pro rata during the
performance year based on the estimated incentives achieved, whether payable in cash or in stock
units. The portion of bonus payable in stock units is recorded as additional paid-in-capital. The
estimated value of the incentives is periodically adjusted based on current expectations regarding
the levels of achievement.
Under the directors plan, members of the board of directors can choose to have all or a
portion of their director fees paid in fully vested deferred stock units (at a minimum of 25
percent) commencing July 1, 2006. Additionally, directors may choose to have up to 50 percent of
their deferred stock units paid in cash at the date of issuance. Annual deferral elections are made
in December for the following year. During 2006, elections were made in June. Deferred stock units
are granted each quarter based on the director fees earned in the prior quarter and the fair market
value of the stock on the date of grant. The first grant was made in October 2006 for the
September 30, 2006 quarter. Directors fees, whether payable in cash or in stock units, are
expensed when incurred. In the current quarter, the entire amount of the directors fees has been
recorded as a liability. After the grant date (October 2006), we will record up to the maximum
amount that can be taken in cash as a liability.
Common shares underlying the vested stock units in the employee and director plans are issued
at the earlier of the payout date specified by the participant (which is at least two years from
the date of grant), a change in control event as defined, or the month following the participants
death.
Effective January 1, 2006, we adopted SFAS No. 123 (revised 2004), Share Based Payment (SFAS
No. 123R) using the modified prospective transition method. Among other items, SFAS No. 123R
eliminates the use of the intrinsic value method of accounting under APB 25 and requires companies
to recognize in the financial statements the cost of employee services received in exchange for
awards of equity instruments based on the grant date fair value of those awards. Under the
modified prospective method, we recognize compensation cost in the financial statements beginning
with the effective date based on the requirements of SFAS No. 123R for all share-based payments
granted, modified or settled after January 1, 2006, and based on the requirements of SFAS No. 123
for all unvested awards granted prior to the effective date.
We will continue to use the Black-Scholes standard option pricing model and the single option
award approach to measure the fair value of the stock options granted to employees. In conjunction
with the adoption of SFAS No. 123R, we modified certain assumptions and estimation methodologies
for inputs to the Black-Scholes valuation calculations in accordance with the requirements of SFAS
No. 123R and Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment. These changes primarily
include the following:
|
a. |
|
We increased the expected term from five years to 6.25 years using the shortcut
method under SAB 107 (an expected term based on the mid point between the vesting date
and the end of the contractual term). The use of the short cut method is permitted
through December 31, 2007. We will convert to company-specific experience on or before
January 1, 2008. The options have a maximum contractual term of 10 years and vest
pro-rata over four years, which is the requisite service period. |
|
|
b. |
|
While we continue to use historical volatility (based on daily trading prices) to
estimate the fair value of options granted, we have increased the period over which
volatility is measured from three years to 6.25 years. We have excluded the period from
October 24, 2002 to January 16, 2003 (inclusive) during which our common stock
experienced unusually high volatility as a result of announcement of our failure to file
the September 30, 2002 Form 10-Q, temporary suspension of trading, delisting of our
shares from NASDAQ, and an investigation commenced by the SEC. |
|
|
c. |
|
These changes resulted in a net decrease in volatility from previous estimates.
Average volatility for options granted in 2005 and during the nine months ended September
30, 2006 was approximately 90.3 percent and 69.5 percent, respectively. We did not
incorporate implied volatility since there are no actively traded option contracts on our
common stock and sufficient data for an accurate measure of implied volatility were not
available. |
11
|
d. |
|
Prior to January 1, 2006, we accounted for forfeitures as they occurred.
Compensation expense related to unvested forfeited options was reversed in the period the
employee was terminated. Upon adoption of SFAS No. 123R, we have estimated an average
forfeiture rate of approximately 33.7 percent based on historical experience from 2001
through September 30, 2006. Stock-based compensation expense recorded in the 2006 periods
is net of expected forfeitures. We will periodically assess the forfeiture rate. Changes
in estimates will be recorded in the period of adjustment, if any. During the three
months ended September 30, 2006, we increased the estimated forfeiture rate from 25
percent to 33 percent as a result of our periodic review of estimated forfeiture rates
compared to historical experience. The change in estimate resulted in a cumulative
adjustment to reduce stock-based compensation expense during the three months ended
September 30, 2006 by $0.4 million. |
We have no unamortized deferred compensation relating to outstanding option grants since we
generally award stock options to our employees with exercise prices equal to the fair value of the
underlying common stock on the date of grant. Due to our continuing losses, we do not recognize
deferred tax assets related to our stock-based compensation and we have not recorded benefits for
tax deductions in excess of recognized compensation costs (required to be recorded as financing
cash flows) due to the uncertainty of when we will generate taxable income to realize such
benefits.
As a result of adopting SFAS No. 123R, our loss from continuing operations and net loss for
the three and nine months ended September 30, 2006 was $65,000 (zero per basic and diluted share)
and $1.8 million ($0.06 per basic and diluted share) greater, respectively, than if we had
continued to account for stock-based compensation under APB 25 and its related interpretations. Of
the $1.8 million recorded during the nine months ended September 30, 2006, $32,000 was expensed as
cost of goods sold, $92,000 was included in research and development expenses, $0.4 million in
selling and marketing expenses and $1.2 million in general and administration expenses. The
$65,000 expense recorded for the three months ended September 30, 2006 and the $1.8 million expense
recorded for the nine months
ended September 30, 2006 includes a $0.4 million ($0.01 per basic and diluted share) reduction
in to the stock compensation expense as calculated through June 30, 2006 due to changes in our
estimated forfeiture rate in conjunction with the provisions of SFAS No. 123R, Share Based
Payment. This reduction is a change in estimate and is recorded in operations for the three and
nine months ended September 30, 2006. As of September 30, 2006, there was $3.4 million (net of
estimated forfeitures) of total unrecognized compensation costs related to unvested stock-based
compensation arrangements granted under the stock option plans. That cost is expected to be
amortized on a straight-line basis over a weighted average period of 1.3 years less any stock
options forfeited prior to vesting. As of September 30, 2006, stock compensation cost capitalized
as inventory was insignificant.
Prior to January 1, 2006, we accounted for stock-based employee compensation plans in
accordance with APB 25 and followed the pro forma disclosure requirements set forth in SFAS No.
123. The following table illustrates the effect on net loss and loss per share for the three and
nine months ended September 30, 2005 as if we had applied the fair value recognition provisions of
SFAS No. 123 to stock-based employee compensation. The amounts in the table below include
stock-based compensation expense related to Timm Medical which was not significant (dollars in
thousands, except per share amounts):
|
|
|
|
|
|
|
|
|
|
|
Three Months |
|
|
Nine Months |
|
|
|
Ended |
|
|
Ended |
|
|
|
September |
|
|
September |
|
|
|
30, 2005 |
|
|
30, 2005 |
|
Net loss, as reported |
|
$ |
(2,890 |
) |
|
$ |
(11,591 |
) |
Add: Stock-based employee
compensation expense included in
reported net loss for all awards |
|
|
|
|
|
|
|
|
Less: Total stock-based employee
compensation expense determined
under fair value based method for
all awards |
|
|
(936 |
) |
|
|
(2,756 |
) |
|
|
|
|
|
|
|
Net loss, as adjusted |
|
$ |
(3,826 |
) |
|
$ |
(14,347 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic and diluted loss per share: |
|
|
|
|
|
|
|
|
As reported |
|
$ |
(0.10 |
) |
|
$ |
(0.40 |
) |
As adjusted |
|
$ |
(0.13 |
) |
|
$ |
(0.50 |
) |
12
Weighted average expected volatility for stock options granted prior to December 31, 2005 was
based on daily trading prices from April 2003 and an expected term of five years. The average
volatility for options granted during the nine months ended September 30, 2006 and 2005 was 69.5
percent and 90.3 percent, respectively. The risk free interest rate reflected the yield on zero
coupon U.S. treasuries at the date of grant, based on the median time the options granted are
expected to be outstanding. The risk free interest rate during the nine months ended September 30,
2006 and 2005 was an average of 4.57 percent and 3.9 percent, respectively. No expected dividend
yield is used because we have not historically paid dividends and do not intend to pay dividends in
the foreseeable future.
The weighted average fair value for stock options granted during the nine months ended
September 30, 2006 and September 30, 2005 was $1.90 and $2.41 respectively.
The following is a summary of the stock option activity for the nine months ended September
30, 2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Remaining |
|
|
|
|
|
|
Number of |
|
|
Weighted |
|
|
Contractual |
|
|
Aggregate |
|
|
|
Options |
|
|
Average |
|
|
Term |
|
|
Intrinsic Value |
|
|
|
(in thousands) |
|
|
Exercise Price |
|
|
(in years) |
|
|
(in thousands) |
|
Options
outstanding at
December 31, 2005 |
|
|
6,006 |
|
|
$ |
4.27 |
|
|
|
|
|
|
|
|
|
Granted |
|
|
612 |
|
|
|
3.25 |
|
|
|
|
|
|
|
|
|
Exercised |
|
|
(66 |
) |
|
|
0.79 |
|
|
|
|
|
|
|
|
|
Canceled |
|
|
(121 |
) |
|
|
4.09 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options outstanding
at March 31, 2006 |
|
|
6,431 |
|
|
|
4.21 |
|
|
|
|
|
|
|
|
|
Granted |
|
|
66 |
|
|
|
3.31 |
|
|
|
|
|
|
|
|
|
Exercised |
|
|
(20 |
) |
|
|
2.81 |
|
|
|
|
|
|
|
|
|
Canceled |
|
|
(176 |
) |
|
|
4.38 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options outstanding
at June 30, 2006 |
|
|
6,301 |
|
|
|
4.20 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Granted |
|
|
429 |
|
|
|
2.20 |
|
|
|
|
|
|
|
|
|
Exercised |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Canceled |
|
|
(391 |
) |
|
|
3.32 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options outstanding
at September 30,
2006 |
|
|
6,339 |
|
|
$ |
4.12 |
|
|
|
7.47 |
|
|
$ |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options
exercisable at
September 30, 2006 |
|
|
3,502 |
|
|
$ |
4.96 |
|
|
|
6.50 |
|
|
$ |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The following table summarizes information regarding options outstanding and options
exercisable at September 30, 2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Number |
|
Average |
|
|
|
|
|
Number |
|
|
|
|
|
|
|
|
|
|
Outstanding As |
|
Remaining |
|
Weighted |
|
Exercisable As of |
|
Weighted |
|
|
|
|
|
|
|
|
of September |
|
Contractual |
|
Average |
|
September 30, |
|
Average |
Range of Exercise Prices |
|
30, 2006 |
|
Life(Years) |
|
Exercise Price |
|
2006 |
|
Exercise Price |
$ 2.00 |
|
|
|
$ |
2.22 |
|
|
|
754,000 |
|
|
|
8.44 |
|
|
$ |
2.15 |
|
|
|
215,729 |
|
|
$ |
2.11 |
|
$ 2.25 |
|
|
|
$ |
2.36 |
|
|
|
705,000 |
|
|
|
6.63 |
|
|
$ |
2.26 |
|
|
|
626,875 |
|
|
$ |
2.26 |
|
$ 2.50 |
|
|
|
$ |
2.80 |
|
|
|
888,000 |
|
|
|
8.16 |
|
|
$ |
2.75 |
|
|
|
282,000 |
|
|
$ |
2.72 |
|
$ 2.83 |
|
|
|
$ |
3.29 |
|
|
|
639,445 |
|
|
|
8.52 |
|
|
$ |
3.04 |
|
|
|
174,435 |
|
|
$ |
3.05 |
|
$ 3.30 |
|
|
|
$ |
3.45 |
|
|
|
687,140 |
|
|
|
9.05 |
|
|
$ |
3.36 |
|
|
|
88,984 |
|
|
$ |
3.44 |
|
$ 3.69 |
|
|
|
$ |
4.20 |
|
|
|
450,250 |
|
|
|
7.34 |
|
|
$ |
4.07 |
|
|
|
308,270 |
|
|
$ |
4.08 |
|
$ 4.27 |
|
|
|
$ |
4.27 |
|
|
|
1,000,000 |
|
|
|
7.20 |
|
|
$ |
4.27 |
|
|
|
618,750 |
|
|
$ |
4.27 |
|
$ 4.50 |
|
|
|
$ |
5.13 |
|
|
|
688,459 |
|
|
|
6.17 |
|
|
$ |
4.75 |
|
|
|
660,126 |
|
|
$ |
4.75 |
|
$ 6.19 |
|
|
|
$ |
18.84 |
|
|
|
525,923 |
|
|
|
4.98 |
|
|
$ |
12.98 |
|
|
|
525,923 |
|
|
$ |
12.98 |
|
$21.23 |
|
|
|
$ |
21.23 |
|
|
|
1,000 |
|
|
|
5.09 |
|
|
$ |
21.23 |
|
|
|
1,000 |
|
|
$ |
21.23 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ 2.00 |
|
|
|
$ |
21.23 |
|
|
|
6,339,217 |
|
|
|
7.47 |
|
|
$ |
4.12 |
|
|
|
3,502,092 |
|
|
$ |
4.96 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
13
The aggregate intrinsic value is calculated as the difference between the exercise price of
the underlying awards and the quoted price of our common stock for those awards that have an
exercise price currently below the quoted price. During the three months ended September 30, 2006
and September 30, 2005, the aggregate intrinsic value of options exercised under the stock option
plans was zero and $27,000 respectively. The aggregate intrinsic value of options exercised under
the stock option plans for the nine months ended September 30, 2006 and 2005 was $0.1 million and
$0.2 million, respectively.
Cash received from option exercises under all stock-based payment arrangements for the
quarters ended September 30, 2006 and 2005 was zero and $30,000 respectively. Cash received from
option exercises for the nine months ended September 30, 2006 and 2005 was $0.1 million and
$81,000, respectively.
8. Inventories
Inventories, consisting of raw materials, work-in-process and finished goods, are stated at
the lower of cost or market, with cost determined by the first-in, first-out method. Reserves for
slow-moving and obsolete inventories are provided based on historical experience and product
demand. We evaluate the adequacy of these reserves periodically.
The following is a summary of inventories (excluding assets of discontinued operations):
|
|
|
|
|
|
|
|
|
|
|
September 30, |
|
|
December 31, |
|
|
|
2006 |
|
|
2005 |
|
Raw materials |
|
$ |
1,794 |
|
|
$ |
1,646 |
|
Work in process |
|
|
350 |
|
|
|
275 |
|
Finished goods |
|
|
878 |
|
|
|
911 |
|
|
|
|
|
|
|
|
Total inventories |
|
|
3,022 |
|
|
|
2,832 |
|
Less: inventory reserve |
|
|
(565 |
) |
|
|
(370 |
) |
|
|
|
|
|
|
|
Inventories, net |
|
$ |
2,457 |
|
|
$ |
2,462 |
|
|
|
|
|
|
|
|
9. Commitments and Contingencies
Litigation and Regulatory Investigations
As discussed in Note 3, in July 2006 we reached a settlement concerning Endocare with the SEC
and the DOJ regarding investigations commenced in January 2003 related to allegations that we and
certain of our former officers and directors and one current employee issued, or caused to be
issued, false and misleading financial statements in prior periods. Under the terms of the
settlement with the SEC (i) we paid a total of $750,000 in civil penalties and disgorgement; and
(ii) we agreed to a stipulated judgment enjoining future violations of securities laws.
On April 7, 2006, we entered into an escrow agreement with Morrison & Foerster LLP, our
outside counsel, pursuant to which we placed the $750,000 anticipated settlement in escrow with
Morrison & Foerster LLP at the request of the SEC staff. The funds were released from escrow to the
SEC in August 2006. A liability for the monetary penalty was accrued in prior years.
The investigations conducted by the SEC and the DOJ relative to certain former officers and
directors of the Company are ongoing, and are not affected by our settlements with the SEC and the
DOJ. We have obligations to indemnify and advance the legal fees for the former officers and
directors who remain under investigation. Our
14
directors and officers liability and other
insurance may fund certain losses, including defense costs, related to these matters. Recoveries
will be recorded when the amounts are determined to be recoverable from the insurance carriers.
On October 26, 2006, we filed a lawsuit with the Superior Court of the State of California for
the County of Orange against our former independent auditor, KPMG LLP, for professional negligence
and breach of contract, seeking damages in an amount to be determined at trial. Previously, we had
entered into a Mediation and Tolling Agreement with KPMG pursuant to which KPMG agreed that the
statute of limitations would be tolled to provide an opportunity for mediation between the parties.
We engaged in mediation with KPMG on September 27, 2006 but the parties were unable to reach
settlement. Accordingly, we proceeded with the filing of the lawsuit. We are not able to predict
the outcome of this lawsuit.
In January 2006, we entered into a settlement and release agreement with certain parties
against whom we had a claim from a judgment awarded to us in prior years. We received $162,500 in
the settlement of this claim, which was recorded as a reduction of general and administrative
expenses in the first quarter of 2006.
In addition, in the normal course of business, we are subject to various other legal matters,
which we believe will not individually or collectively have a material adverse effect on our
consolidated financial condition, results of operations or cash flows. However, the results of
litigation and claims cannot be predicted with certainty, and we cannot provide assurance that the
outcome of various legal matters will not have a material adverse effect on our consolidated
financial condition, results of operations or cash flows. As of September 30, 2006, we have not
established a liability for contingencies in the consolidated balance sheets since the likelihood
of loss and potential liability cannot be reliably estimated at this time. However, our evaluation
of the likelihood of an unfavorable outcome with respect to these actions could change in the
future.
From time to time, we have received correspondence alleging infringement of proprietary rights
of third parties. No assurance can be given that any relevant claims of third parties would not be
upheld as valid and enforceable, and therefore we could be prevented from practicing the subject
matter claimed or would be required to obtain licenses from the owners of any such proprietary
rights to avoid infringement. We do not expect any material adverse effect on our consolidated
financial condition, results of operations or cash flows because of such claims.
Other
We have tax obligations pertaining to employee loans forgiven and stock option exercises that
occurred in 2002 and prior. In the second quarter we reduced the tax liabilities by $0.9 million
(or $0.03 per basic or diluted share) because they were no longer statutorily due. This adjustment
is reflected in the nine months ended September 30, 2006 as a reduction of general and
administrative expenses.
10. Income Taxes
We reported no net income tax expense from continuing and discontinued operations during the
three months ended September 30, 2006 and 2005 due to our operating losses. The 2006 tax benefit on
continuing operations of $0.2 million is the result of the 2006 first quarter pre-tax book losses
being utilized against pre-tax book income from discontinued operations. There is an offsetting tax
provision within discontinued operations. The operating losses resulted in an increase in the
valuation allowance of $2.9 million and $3.9 million during the nine months ended September 30,
2006 and 2005, respectively. Due to our history of operating losses, management has determined that
it is more likely than not that our deferred tax assets will not be realized through future
earnings. Accordingly, valuation allowances were recorded to fully reserve the deferred tax assets
as of September 30, 2006 and December 31, 2005.
15
11. Results of Operations
Revenues and cost of revenues from continuing operations related to the following products and
services for the periods ended September 30, 2006 and 2005 are as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cryocare Surgical Systems |
|
$ |
423 |
|
|
$ |
132 |
|
|
$ |
814 |
|
|
$ |
404 |
|
Cryoablation disposable products and procedure fees |
|
|
5,952 |
|
|
|
6,653 |
|
|
|
19,024 |
|
|
|
19,690 |
|
Cardiac royalties (CryoCath) and other revenues |
|
|
325 |
|
|
|
223 |
|
|
|
1,032 |
|
|
|
700 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
6,700 |
|
|
$ |
7,008 |
|
|
$ |
20,870 |
|
|
$ |
20,794 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost of Revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cryocare Surgical Systems |
|
$ |
41 |
|
|
$ |
107 |
|
|
$ |
639 |
|
|
$ |
405 |
|
Cryoablation disposable products and procedure fees |
|
|
2,636 |
|
|
|
3,702 |
|
|
|
9,060 |
|
|
|
11,514 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
2,677 |
|
|
$ |
3,809 |
|
|
$ |
9,699 |
|
|
$ |
11,919 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues from the sales of cryoablation disposable products and cryoablation procedure fees
are comprised of the following for the periods ended September 30, 2006 and 2005:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Disposable products |
|
$ |
3,460 |
|
|
$ |
1,927 |
|
|
$ |
9,061 |
|
|
$ |
4,727 |
|
Procedure fees |
|
|
2,492 |
|
|
|
4,726 |
|
|
|
9,963 |
|
|
|
14,963 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
5,952 |
|
|
$ |
6,653 |
|
|
$ |
19,024 |
|
|
$ |
19,690 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost of revenues for cryoablation disposable product sales and procedure fees are combined for
reporting purposes. Sales of cryoablation disposable products and procedure fees both incorporate
similar inventory when sold and we do not separately track the cost of disposals sold directly to
customers and those consumed in cryoablation procedures. Cryoablation procedure services are
provided to medical facilities upon request to facilitate the overall delivery of our technology
into the marketplace.
12. Subsequent Events
On October 25, 2006, we entered into an agreement with Fusion Capital Fund II, LLC (Fusion
Capital) pursuant to which we have the right to sell to Fusion Capital up to $16.0 million of
common stock over a two year period at prices determined based upon the market price of our common
stock at the time of each sale without any fixed discount (in $100,000 increments every third
business day, over a two year period). We can sell additional $150,000 increments to Fusion
Capital every second business if the trading price of our common stock is at least $1.50 per share.
This $150,000 increment can be further increased at graduation levels up to $1.0 million if the
market price of our common stock increases from $1.50 to $6.00. We can commence these sales after
we complete the registration process with the SEC. If the price of our stock is below $1.00 per
share the obligation for Fusion Capital to buy shares of stock is automatically suspended. Under
the terms of the agreement we issued 473,957 shares of common stock to Fusion Capital as a
commitment fee.
Under the registration rights agreement, before Fusion Capital is obligated to purchase our
shares, we are required to file a registration statement covering the sale of up to 8,473,957
common shares within 20 business days of signing the agreement. We are required to maintain effectiveness of
the registration statement until the earlier of the date that Fusion Capital may sell the shares
without restriction pursuant to Rule 144(k) or the date that Fusion Capital has sold all purchased
shares and no available unpurchased shares remain under the agreement. Upon occurrence of certain
events of default as defined, including lapse of effectiveness of the registration statement for 10
or more consecutive business days or for 30 or more business days within a 365-day period,
suspension of trading for 3 business days, delisting of the shares from the principal market on
which they are traded, failure by our stock transfer agent to issue shares within 5 business days,
or other material breaches, Fusion Capital may terminate the stock purchase agreement. Fusion
Capital may also terminate the agreement if purchase of shares has not commenced on or before
January 31, 2007 due to our inability to satisfy certain conditions precedent to funding. We have
the right to terminate the agreement at any time.
13. Recent Accounting Pronouncements
In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48,
Accounting for Uncertainty in Income Taxes, an interpretation of SFAS No. 109, Accounting for
Income Taxes (FIN 48) to create a single model to address accounting for uncertainty in tax
positions. FIN 48 clarifies the accounting for income taxes, by prescribing a minimum recognition
threshold a tax position is required to meet before being recognized in the
16
financial statements.
FIN 48 also provides guidance on derecognition, measurement, classification, interest and
penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal
years beginning after December 15, 2006. The Company will adopt FIN 48 as of January 1, 2007, as
required. The cumulative effect of adopting FIN 48 will be recorded in retained earnings. The
Company has not determined the effect, if any, the adoption of FIN 48 will have on the Companys
financial position and results of operations.
In May 2005, the Financial Accounting Standards Board (FASB) issued Statement No. 154 (SFAS
No. 154), Accounting Changes and Error Corrections, which replaced APB Opinion No. 20, Accounting
Changes, and SFAS No. 3, Reporting Changes in Interim Financial Statements. SFAS No. 154 requires
retrospective application to prior periods financial statements of voluntary changes in accounting
principles and changes required by a new accounting standard when the standard does not include
specific transition provisions. Previous guidance required most voluntary changes in accounting
principle to be recognized by including the cumulative effect of changing to the new accounting
principle in net income of the period in which the change was made. SFAS No. 154 carries forward
existing guidance regarding the reporting of the correction of an error and a change in accounting
estimate. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal
years beginning after December 15, 2005. We adopted SFAS No. 154 as of January 1, 2006. The
adoption did not have a material effect on our consolidated financial position or results of
operations.
Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task
Force), the American Institute of Certified Public Accountants, and the SEC did not, or are not
believed by management to, have a material impact on our present or future consolidated financial
statements.
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the unaudited
condensed consolidated financial statements and notes thereto included in Part I Item 1 of this
report, and the audited consolidated financial statements and notes thereto, and Managements
Discussion and Analysis of Financial Condition and Results of Operations contained in the Annual
Report on Form 10-K for the fiscal year ended December 31, 2005.
This discussion contains forward-looking statements based on our current expectations. There
are various factors many beyond our control that could cause our actual results or the
occurrence or timing of expected events to differ materially from those anticipated in these
forward-looking statements. Some of these factors are described below and other factors are
described elsewhere in this Quarterly Report on Form 10-Q or under Risk Factors in our Annual
Report on Form 10-K referred to above. In addition, there are factors not described in this
Quarterly Report on Form 10-Q or in our Annual Report on Form 10-K that could cause our actual
results or the occurrence or timing of expected events to differ materially from those anticipated
in these forward-looking statements. All forward-looking statements included in this Quarterly
Report on Form 10-Q are based on information available to us as of the date hereof, and we assume
no obligation to update any such forward-looking statements.
Overview
We are an innovative medical device company focused on the development of minimally invasive
technologies for tissue and tumor ablation through cryoablation, which is the use of lethal ice to
destroy tissue, such as tumors, for therapeutic purposes. We develop and manufacture devices for
the treatment of prostate and renal cancers and we believe that our proprietary technologies have
broad applications across a number of markets, including the ablation of tumors in the lung and
liver and pain resulting from bone metastases.
Today, our FDA-cleared Cryocare Surgical System occupies a growing position in the urological
market for treatment of prostate and renal cancers. Because of our initial concentration on
prostate and renal cancers, the majority of our sales and marketing resources are directed toward
the promotion of our technology to urologists. In addition to selling our cryosurgical disposable
products to hospitals and mobile service companies, we contract directly with hospitals for the use
of our Cryocare Surgical System and disposable products on a fee-for-service basis. Since 2003, we
also maintain a dedicated sales team focused on selling percutaneous cryoablation procedures
related to liver, kidney and lung cancer and pain resulting from bone metastases to interventional
radiology physicians throughout the United States. We intend to continue to identify and develop
new markets for our cryosurgical products and technologies, particularly in the area of tumor
ablation.
17
We previously owned Timm Medical Technologies, Inc. (Timm Medical), a company focused on
erectile dysfunction products. We sold Timm Medical to United Kingdom-based Plethora Solutions
Holdings plc effective on February 10, 2006.
Strategy, Key Metrics and Developments
Our primary objective is to grow market share, currently measured in terms of the number of
procedures performed with our Cryocare Surgical System, which we calculate using two primary
components. The first component is that we include the actual number of cryoablation cases for
which we are responsible for performing the service element on behalf of the healthcare facility.
In the second, we compute a procedure case equivalent based on sales of our cryoablation disposable
products by using the expected disposable product usage for those sales. Procedure growth has been
an important metric to which we have referred during the past several years in order to measure the
success of our strategy.
In addition to being a key business metric, procedure growth has been an important driver of
revenue growth, because a significant percentage of our revenues consist of sales of the disposable
products used in procedures performed with the Cryocare Surgical System, as shown below under
Results of Operations. In 2003 we redirected our strategy for our cryoablation business away from
emphasizing sales of Cryocare Surgical Systems and instead toward seeking to increase sales of
cryoablation disposable products.
We have focused on measuring our success by referring to procedure growth because of the
disparity in per-procedure revenue between cases for which we are responsible for providing the
service element and cases for which we merely sell disposable products. This disparity results
from the fact that the revenue from a case for which we merely sell disposable products is less
than the revenue from a case for which we are responsible for providing the service element
(referred to as procedure fees below). As the percentage of cases for which we merely sell
disposable products increases relative to cases for which we are responsible for providing the
service element, our incremental revenues grow at a slower rate than our overall procedure growth.
However, the gross profit realized is generally equivalent since we do not incur fees to third
party service providers for cases for which we merely sell disposable products. In contrast, in
cases for which we are responsible for providing the service element, we typically subcontract with
a third party service provider to provide the service element on our behalf and thereby incur
service fees. As a result, our gross margin (gross profit as a percent of revenues) increases as we
shift from procedure fees to sale of disposable products.
In the past several years, we have been successful in increasing the number of procedures on a
year-over-year basis. In 2005 total procedures increased 35.9 percent to 6,407 from 4,713 in 2004.
During the three months ended September 30, 2006, total procedures increased 17.3 percent to 1,883
from 1,605 in the quarter ended September 30, 2005. Year to date in 2006 our procedures have
increased 18.3 percent to 5,582 from 4,717 in the same period last year.
The factors driving interest in and utilization of cryoablation by urologists include
increased awareness and acceptance of cryoablation by physicians and industry thought leaders,
continued publication of clinical follow up data on the effectiveness of cryoablation, including
10-year data presented in 2005, increased awareness among patients of cryoablation and its
preferred outcomes as compared to other modalities, the efforts of our dedicated cryoablation sales
force and our continued expenditure of funds on patient education and advocacy.
We believe that one of the factors that adversely impact procedure growth and revenues is that
certain urologists decide from time to time to try new techniques for the treatment of prostate
cancer. We cannot predict the extent to which this factor may continue to affect us. However, the
prostate cancer treatment market is very competitive and there are many different treatment options
that have been developed and that are continuing to be developed.
Historically, we were responsible for performing the service element of the procedure on
behalf of the healthcare facility for the majority of our reported procedures. In 2004, we decided
to change our business model to emphasize our strength as a medical device manufacturer and
strategically reduce the amount of revenue attributable to the service model, with the goal of
eventually having the substantial
majority of our procedures comprised of the sale of cryoablation disposable products instead
of performing the service element of the procedure. During 2005, we succeeded in causing the
percentage of procedures for which we perform the service element to decline from 72.4
18
percent of
total reported procedures for the three months ended March 31, 2005, to 59.3 percent of total
reported procedures for the three months ended December 31, 2005.
During the nine months ended September 30, 2006, we experienced a faster than anticipated
shift from procedure fees to sales of cryoablation disposable products. For the three months ended
September 30, 2006, the percent of total procedures for which we are responsible for the service
element of the procedure decreased to 27.0 percent. As a result of this shift, over time, we
expect the number of procedures performed to become a less important measure of our business and
our revenues to become a more important metric.
Results of Operations
Revenues and costs of revenues from continuing operations related to the following products
and services for the three and nine months ended September 30, 2006 and 2005 are as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cryocare Surgical Systems |
|
$ |
423 |
|
|
$ |
132 |
|
|
$ |
814 |
|
|
$ |
404 |
|
Cryoablation disposable products and procedure fees |
|
|
5,952 |
|
|
|
6,653 |
|
|
|
19,024 |
|
|
|
19,690 |
|
Cardiac royalties (CryoCath) and other revenues |
|
|
325 |
|
|
|
223 |
|
|
|
1,032 |
|
|
|
700 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
6,700 |
|
|
$ |
7,008 |
|
|
$ |
20,870 |
|
|
$ |
20,794 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Costs of Revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cryocare Surgical Systems |
|
$ |
41 |
|
|
$ |
107 |
|
|
$ |
639 |
|
|
$ |
405 |
|
Cryoablation disposable products and procedure fees |
|
|
2,636 |
|
|
|
3,702 |
|
|
|
9,060 |
|
|
|
11,514 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
2,677 |
|
|
$ |
3,809 |
|
|
$ |
9,699 |
|
|
$ |
11,919 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues from the sales of cryoablation disposable products and cryoablation procedure fees
are comprised of the following for the periods ended September 30, 2006 and 2005:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Disposable products |
|
$ |
3,460 |
|
|
$ |
1,927 |
|
|
$ |
9,061 |
|
|
$ |
4,727 |
|
Procedure fees |
|
|
2,492 |
|
|
|
4,726 |
|
|
|
9,963 |
|
|
|
14,963 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
5,952 |
|
|
$ |
6,653 |
|
|
$ |
19,024 |
|
|
$ |
19,690 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Costs of revenues for cryoablation disposable products and procedure fees are combined for
reporting purposes. Sales of cryoablation disposable products and procedure fees incorporate
similar inventory when sold and we do not separately track the cost of disposable products sold
directly to customers and those consumed in cryoablation procedures. Procedure fees relate to
services which are provided to medical facilities upon request to facilitate the overall delivery
of our technology into the marketplace.
We recognize revenues from sales of Cryocare Surgical Systems and disposable cryoprobes when
persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed and
determinable, and collectibility is reasonably assured. We also contract with medical facilities
for the use of the Cryocare Surgical Systems in cryoablation treatments for which we charge a
per-procedure fee. Cryoablation services generally consist of rental and transport of a Cryocare
Surgical System as well as the services of a technician to assist the physician with the setup and
monitoring of the equipment.
Costs of revenues consist of fixed and variable costs incurred in the manufacture of our
products in addition to depreciation of Cryocare Surgical Systems placed in the field with
customers under our placement program or with our sales and service personnel. We incur an
additional cost of revenues in the form of a fee for equipment usage and other services when a
procedure is performed on a system owned by an unrelated service provider. The fee paid to the
third-party service provider is charged to costs of revenues when the procedure is performed and
billed.
19
Research and development expenses include expenses associated with the design and
development of new products as well as enhancements to existing products. We expense research and
development costs when incurred. Our research and development efforts are occasionally subject to
significant non-recurring expenses and fees that can cause some variability in our quarterly
research and development expenses.
Selling and marketing expenses primarily consist of salaries, commissions and related benefits
and overhead costs for employees and activities in the areas of selling, marketing and customer
service. Expenses associated with advertising, trade shows, promotional and training costs related
to marketing our products are also classified as selling and marketing expenses.
General and administrative expenses primarily consist of salaries and related benefits and
overhead costs for employees and activities in the areas of legal affairs, finance, information
technology, human resources and administration. Fees for attorneys, independent auditors and
certain other outside consultants are also included where their services are related to general and
administrative activities. This category also includes reserves for bad debt, and litigation losses
less amounts recoverable under our insurance policies. Litigation reserves and insurance recoveries
are recorded when such amounts are probable and can be reasonably estimated.
Effective January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123
(revised 2004), Share Based Payment (SFAS No. 123R) using the modified-prospective transition
method. Under that transition method, compensation cost recognized in the nine months ended
September 30, 2006 includes (a) compensation cost for all share-based payments granted prior to,
but not yet vested as of January 1, 2006 based on the grant-date fair value estimated in accordance
with the original provisions of SFAS 123 and (b) compensation cost for all share-based payments
granted subsequent to January 1, 2006, based on the grant-date fair value estimate in accordance
with the provisions of SFAS 123R. Results for prior periods have not been restated. As a result
of adopting SFAS No. 123R, our net loss for the three and nine months ended September 30, 2006 was
$65,000 and $1.8 million, respectively, greater than if we had continued to account for stock-based
compensation under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees, and its related interpretations. The $65,000 expense recorded for the three months ended
September 30, 2006 and the $1.8 million expense for the nine months ended September 30, 2006
includes a $0.4 million ($0.01 per basic and diluted share) reduction in stock compensation expense
as calculated through June 30, 2006 due to changes in our estimated forfeiture rate in conjunction
with the provisions of SFAS No. 123R, Share Based Payment as further discussed in Note 7 -
Stock-Based Compensation. As of September 30, 2006, there was $3.4 million of total unrecognized
compensation costs related to unvested stock-based compensation arrangements granted under the
stock option plans. That cost is expected to be amortized on a straight-line basis over a weighted
average period of 1.3 years less any stock options forfeited prior to vesting.
Three Months Ended September 30, 2006 Compared to Three Months Ended September 30, 2005
Revenues. Revenues for the three months ended September 30, 2006 decreased 4.4 percent to
$6.7 million compared to $7.0 million for the same period in 2005. Although our total procedures
increased 17.3 percent over the same period last year, our rapid shift in revenue mix has caused a
decrease in our average selling price per case and case equivalents. Generally, we earn less
revenue per case for sales of cryoablation disposable products than for procedure fees; however the
related gross margin as a percent of revenues for sales of cryoablation disposable products is
greater.
The total number of cryoablation procedures performed increased 17.3 percent to 1,883 in the
third quarter of 2006 from 1,605 in the comparable period of 2005, while the related revenues
decreased 10.5 percent to $6.0 million in the third quarter of 2006 from $6.7 million for the
comparable period in 2005. Of the total procedures performed during the three months ended
September 30, 2006, 27.0 percent were those in which we provided cryoablation services and
73.0 percent were from the sale of cryoablation disposable products. This compares to 59.5 percent
of cryoablation procedures and 40.5 percent for sales of disposable cryoablation products during
the three months ended September 30, 2005. Contributing to growth in sales of cryoablation products
was an increase in sales to a market served by interventional radiologists, treating tumors in the
kidney, lung and liver and pain resulting from metastases of cancer in the bone. Direct sales of
disposable products and interventional radiology procedures generally have a lower average selling
price than procedures performed by urologists on prostate and renal cancer, although costs of
revenues are also lower. Therefore, as the percentage of cases derived from sale of cryosurgical
disposable products increases relative to cases derived from cryoablation procedure fees (where we
are responsible for providing the service element of the procedure), our incremental revenues grow
at a slower rate than our overall procedure growth and our gross margin as a percent of revenues
increases. However, gross profit realized is generally equivalent since we do not incur fees to third party service providers for sale
of cryoablation disposable products.
20
Cardiac royalty revenues decreased slightly for the three months ended September 30, 2006 over
the same period in 2005. The contractual rate of royalties CryoCath is obligated to pay us as a
percentage of related revenues decreased from 9.0 percent in 2005 to 5.0 percent in 2006. Revenues
from Cryocare Surgical Systems increased 220.0 percent to $0.4 million from $0.1 million during the
three months ended September 30, 2006 compared to the same period in 2005. This increase is
primarily due to increased international sales of our systems.
Cost of Revenues. Costs of revenues for the three months ended September 30, 2006 decreased
29.7 percent to $2.7 million compared to $3.8 million for the same period in 2005. The decrease in
cost of revenues resulted primarily from the change in the mix of our revenues from those where we
are responsible for providing cryoablation procedure services to solely selling cryoablation
disposable products. This mix shift led to a decrease in the number of cases for which we paid
fees to third party service providers. In addition, costs of revenues declined due to decreases in
materials, labor and overhead costs per cryoablation case as well as a decrease in the average
service fee per case paid to third party service providers. Costs of revenues related to our
cryoablation disposable products and procedure fees decreased 28.8 percent to $2.6 million for the
third quarter of 2006 from $3.7 million for the same period in 2005 as a result of the revenue mix
shift. During the three months ended September 30, 2006 and 2005, substantially all of our
cryoablation procedures for which we were responsible for the service element were performed by
third party service providers at an additional cost to us.
Gross Margins. Gross margins on revenues increased to 60.0 percent for the three months ended
September 30, 2006 compared to 45.6 percent for the same period in 2005. The positive trend in
gross margins was primarily related to our shift from procedures where we bear responsibility for
the service element of the procedure to those where we solely sell our cryoablation disposable
products. Sales of cryoablation disposable products yield a higher gross margin as a percent of
revenues than procedures performed by third party subcontractors. Additional factors include
continued reductions in manufacturing costs for our cryoablation disposable products as well as a
decline in the average service fee we paid to third parties to provide cryoablation procedures on
our behalf.
Research and Development Expenses. Research and development expenses for the three months
ended September 30, 2006 increased to $0.6 million compared to $0.5 million during the three months
ended September 30, 2005. As a percentage of revenues, research and development expenses increased
to 8.7 percent for the three months ended September 30, 2006 from 7.7 percent during the comparable
period in 2005. This increase is attributable to the investment in development projects we have
undertaken to reduce manufacturing costs as well as efforts to broaden the application of
cryoablation outside of our current markets in urology and interventional radiology.
Selling and Marketing Expenses. Selling and marketing expenses for the three months ended
September 30, 2006 increased 14.5 percent to $3.7 million as compared to $3.3 million for the same
period in 2005. The increase is primarily due to continued investments in additional sales and
marketing professionals to address current and targeted growth and increased expenditures for
physician training and trade show expenses, consistent with our objective of increasing the
utilization of cryoablation systems and our cryoablation disposable products by urologists for
prostate and renal cancers.
General and Administrative Expenses. General and administrative expenses for the three months
ended September 30, 2006 decreased 5.8 percent to $3.2 million as compared to $3.4 million for the
same period in 2005. This decrease is primarily due to payment of liquidated damages in the third
quarter of 2005 in the amount of $0.5 million relating to the delay in the registration of our
common stock issued in our March 2005 private placement, which did not recur in 2006. Professional
services expenses also declined $0.3 million as the result of a continued effort to reduce
operating expenses. These reductions were partially offset by an aggregate of $0.3 million in
severance costs related to a former executive officer.
Interest Expense, Net. Interest expense, net, for the three months ended September 30, 2006
was a negative expense of $(1.3) million compared to a $(0.6) million negative expense for the same
period in 2005. Interest expense, net for the three months ended September 30, 2006 and 2005
includes a reduction of interest expense of $(1.2) million and $(0.5) million, respectively, which
represents the decrease in the fair value of common stock warrants issued in connection with our
private placement in March 2005. Interest expense, net in the 2006 and 2005
periods also includes interest income on a note receivable for the 2003 sale of our urinary
incontinence product line and interest income earned from the investment of our cash balances.
21
Loss from Continuing Operations. Loss from continuing operations for the three months ended
September 30, 2006 was $2.1 million or $0.07 per basic and diluted share on 30.2 million weighted
average shares outstanding compared to a net loss of $3.4 million or $0.11 per basic and diluted
share on 30.1 million weighted shares outstanding for the same period in 2005. Included in the
third quarter 2006 loss is an aggregate of $65,000 of non-cash stock-based compensation expense in
accordance with SFAS No. 123R and the reduction in interest expense of $1.2 million from the change
in the fair value of common stock warrants.
Income from Discontinued Operations. There was no income from discontinued operations for the
three months ended September 30, 2006 due to the fact that our disposition of Timm Medical was
completed during the three months ended March 31, 2006. Income from discontinued operations for
the three months ended September 30, 2005 was $0.5 million or $0.01 per basic and diluted share on
30.1 million weighted average shares outstanding.
Net Loss. Net loss for the three months ended September 30, 2006 was $2.1 million or $0.07 per
basic and diluted share on 30.2 million weighted average shares outstanding, compared to a net loss
of $2.9 million, or $0.10 per basic and diluted share on 30.1 million weighted average shares
outstanding during the same period in 2005.
Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005
Revenues. Revenues for the nine months ended September 30, 2006 increased to $20.9 million
compared to $20.8 million in 2005. The revenue increase resulted from the increase in cryoablation
procedures performed during the nine months ended September 30, 2006 compared to the same period in
2005, partially offset by the rapid shift in mix from procedures for which we are responsible for
providing the service element to those for which we solely sell our cryoablation disposable
products. Total procedures increased 18.3 percent to 5,582 for the nine months ended September 30,
2006 from 4,717 in the comparable period of 2005, while the related revenues decreased at 3.5
percent to $19.0 million from $19.7 million for the comparable period in 2005. Of the total
procedures performed during the nine months ended September 30, 2006, 36.5 percent were those for
which we provided cryoablation services and 63.5 percent were from the sale of cryoablation
disposable products. This compares to 63.9 percent for cryoablation services and 36.1 percent for
sales of cryoablation disposable products during the nine months ended September 30, 2005. Cardiac
royalty revenue decreased to $0.5 million for the nine months ended September 2006 from $0.7
million for the same period in 2005. Revenue from the sale of Cryocare Surgical Systems increased
for the nine months ended September 30, 2006 from the comparable period in 2005 to $0.8 million
from $0.4 million primarily due to increased sales of our systems internationally.
Costs of Revenues. Costs of revenues for the nine months ended September 30, 2006 decreased
18.6 percent to $9.7 million compared to $11.9 million for the same period in 2005. The decrease
was driven mainly by the rapid shift in revenue mix resulting in a decrease in the number of
cryoablation procedures for which we bear responsibility for providing the service element of the
procedure as opposed to solely selling our cryoablation disposable products, as well as a continued
decrease in the average amount per procedure we pay to the third party service providers and
decreased costs for materials, labor and overhead per cryoablation case. Costs of revenues related
to cryoablation revenues decreased 21.3 percent to $9.1 million for 2006 from $11.5 million, for
the same period in the 2005. During the nine months ended September 30, 2006 and 2005,
substantially all of our cryoablation procedures for which we were responsible for the service
element were performed by third party service providers at an additional cost to us.
Gross Margins. Gross margins on revenues increased to 53.5 percent for the nine months ended
September 30, 2006 compared to 42.7 percent for the same period in 2005. The positive trend in our
gross margins relates primarily to the shift in our business model to a much larger percentage of
total procedures for which we solely sell our cryoablation disposable products as opposed to
bearing responsibility for providing the service element of the procedure, which generates a lower
gross margin as a percent of revenues. Also contributing to the increase in gross margin were
continued reductions in manufacturing costs for our cryoablation disposable products and a
reduction in the average fees we paid to third parties to provide cryoablation procedures on our
behalf. Gross margins were negatively affected during the nine months ended September 30, 2006 by
transactions where we allowed certain customers to upgrade to our Cryocare CS System from a
previous generation of our Cryocare Surgical System with nominal additional payment, resulting in a
negative gross profit.
22
Research and Development Expenses. Research and development expenses for the nine months ended
September 30, 2006 increased 25.0 percent to $2.1 million compared to $1.7 million for the
comparable period in 2005. The increase was primarily attributable to increased compensation costs
of $0.2 million and costs associated with several new development projects we have undertaken in
our efforts to reduce manufacturing costs of the disposable components used in cryoablation
surgical procedures as well as efforts to broaden the application of cryoablation outside of our
current markets in urology and interventional radiology. Included in research and development
expenses for the nine months ended September 30, 2006 is $92,000 in non-cash stock-based
compensation expense. As a percentage of revenues, research and development expenses increased to
9.9 percent during the nine months ended September 30, 2006, from 7.9 percent during the nine
months ended September 30, 2005.
Selling and Marketing Expenses. Selling and marketing expenses for the nine months ended
September 30, 2006 increased 16.4 percent or $1.6 million to $11.4 million as compared to $9.8
million for the same period in 2005. Driving the increases were proctor fees and related cost
increases of $0.5 million, non-cash stock-based compensation expenses relating to the
implementation of SFAS No. 123R in the amount of $0.4 million and increased compensation related
expenses in our sales organization of $0.5 million.
General and Administrative Expenses. General and administrative expenses for the nine months
ended September 30, 2006 declined 9.0 percent or $0.9 million to $9.3 million as compared to $10.2
million for the same period in 2005. The decline resulted from decreases in legal and accounting
costs of $1.4 million, a $0.9 million reduction in accrued payroll taxes pertaining to employee
loans forgiven and stock option exercises that occurred in 2002 and prior, as well as the
non-recurrence of liquidated damages from 2005 in the amount of $0.6 million. These reductions
were partially offset by $1.2 million non-cash stock-based compensation expenses relating to the
implementation of SFAS No. 123R. These decreases were further offset by an aggregate of $0.6
million in increases relating primarily to compensation and related personnel costs resulting from
establishing an in-house legal department to reduce overall legal fees, severance expense related
to a former executive officer and changing the classification of certain regulatory and compliance
employees from selling and marketing expenses.
Interest Expense, Net. Interest expense, net, for the nine months ended September 30, 2006 was
a negative expense of $(3.4) million compared to $0.4 million in expense for the same period in
2005. Interest expense, net for the nine months ended September 30, 2006 and 2005 includes a
reduction of interest expense of $(2.9) million and interest expense of $0.6 million, respectively,
which represents the change in the fair value of common stock warrants issued in connection with
our private placement in March 2005. Interest expense, net, in the 2006 and 2005 periods also
includes interest income on a note receivable for the 2003 sale of our urinary incontinence product
line and interest income earned from the investment of our cash balances.
Loss from Continuing Operations. Loss from continuing operations for the nine months ended
September 30, 2006 was $8.0 million or $0.27 per basic and diluted share on 30.2 million weighted
average shares outstanding compared to a net loss of $13.2 million or $0.45 per basic and diluted
share on 29.0 million weighted average shares outstanding for the same period in 2005. Included in
the loss from continuing operations during the nine months ended September 30, 2006 is an aggregate
of $1.8 million of non-cash stock-based compensation expense in accordance with SFAS No. 123R, a
reduction in accrued payroll taxes of $0.9 million which were no longer statutorily due and the
reduction in interest expense of $2.9 million from the change in the fair value of common stock
warrants.
Income from Discontinued Operations. Income from discontinued operations for the nine months
ended September 30, 2006 represents the operating results of Timm Medical through the date of sale
on February 10, 2006. Income for the 2006 period was $0.2 million or $0.01 per basic and diluted
share on 30.2 million weighted average shares outstanding. The 2006 income included $0.4 million
gain on sale of Timm Medical and a tax provision of $0.2 million. Income from discontinued
operations for the nine months ended September 30, 2005 was $1.6 million or $0.05 per basic and
diluted share on 29.0 million weighted average shares outstanding. The 2005 period includes income
of $0.6 million as a result of the elimination of the estimated costs to sell, which was previously
reported as a component of a 2004 impairment charge when Timm Medical was initially marketed for
sale.
Net Loss. Net loss for the nine months ended September 30, 2006 was $7.8 million or $0.26 per
basic and diluted share on 30.2 million weighted average shares outstanding, compared to a net loss
of $11.6 million, or $0.40 per basic and diluted share on 29.0 million weighted average shares
outstanding for the same period in 2005.
23
Liquidity and Capital Resources
Since inception, we have incurred losses from operations and have reported negative cash
flows. As of September 30, 2006, we had an accumulated deficit of $173.5 million and cash and cash
equivalents of $5.5 million.
We do not expect to reach break-even or cash flow positive operations in 2006, and we expect
to continue to generate losses from operations for the foreseeable future. These losses have
resulted in part from our continued investment to gain acceptance of our technology and investment
in cost reduction initiatives. In addition to these continued investments, although we
recently resolved the investigations by the SEC and DOJ of our historical accounting and financial
reporting (see below under Part II, Item 1 Legal Proceedings), we still have obligations to
indemnify and advance the legal fees for our former officers and former directors in connection
with the ongoing investigations related to those individuals. The amount of those legal fees may
exceed the reimbursement due to us from our directors and officers liability insurance, and the
excess may have a material adverse effect on our financial condition, results of operations and
liquidity. We also face large cash expenditures in the future related to past due sales and use tax
obligations, which we estimate to be approximately $2.8 million and which was accrued as of
September 30, 2006. We are in the process of negotiating resolutions of the past due state and
local tax obligations with the applicable tax authorities.
We intend to continue investing in our sales and marketing efforts to physicians in order to
raise awareness and gain further acceptance of our technology. This investment is required in order
to increase physicians usage of our technology in the treatment of prostate and renal cancers,
lung and liver cancers and in the management of pain from bone metastases. Such costs will be
reported as current period charges under generally accepted accounting principles.
On October 25, 2006, we entered into an agreement with Fusion Capital Fund II, LLC (Fusion
Capital) pursuant to which we have the right to sell to Fusion Capital up to $16.0 million of
common stock over a two year period at prices determined based upon the market price of our common
stock at the time of each sale without any fixed discount (in $100,000 increments every third
business day, with additional $150,000 increments available every second business day if the market
price of our common stock is $1.50 or higher), subject to our ability to comply with certain
on-going requirements. These requirements include maintaining effectiveness of the registration
statement covering the sale of the shares purchased by Fusion Capital, listing of the shares on the
principal market on which they are traded and maintenance of trading prices at or above $1.00. The
$150,000 increment can be increased if the market price of our common stock increases. We can
commence these sales after we complete the registration process with the SEC.
We will use existing cash reserves, as well as future proceeds from sales, if any, of common
stock to Fusion Capital, to finance our projected operating and cash flow needs, along with
continued expense management efforts. In addition, we may borrow funds under our line of credit
with our bank as long as we remain in compliance with the representations, warranties, covenants
and borrowing conditions set forth in the agreements governing the line of credit. This line of
credit permits us to borrow up to the lesser of $4.0 million or amounts available under the
Borrowing Base. The Borrowing Base is (i) 80 percent of our eligible accounts receivable, plus
(ii) the lesser of 30 percent of the value of our eligible inventory or $500,000. The credit
facility includes a subjective acceleration clause and a requirement to maintain a lockbox with the
lender to which all collections are deposited. At September 30, 2006, we were not in compliance
with the minimum tangible net worth requirement under the credit facility. We are currently in
negotiations with the bank to obtain a waiver and update the financial covenants. While we expect
a favorable outcome, there is no assurance that a waiver will be issued. We have no amounts
outstanding under this line of credit at September 30, 2006.
We believe that the financing with Fusion Capital and our line of credit with our bank should
provide us with the capital resources that we need to reach the point where our operations will
generate positive cash flows. However, our cash needs are not entirely predictable and the
availability of funds from Fusion Capital and our bank are subject to many conditions, including
certain subjective acceleration clauses and other provisions, some of which are predicated on
events that are not within our control. Accordingly, we cannot guarantee the availability of these
capital resources or that they will be sufficient to fund our ongoing operations to the point where
our operations will generate positive cash flows.
24
Despite the availability of funds from Fusion Capital and our bank, our independent auditors
may issue a qualified opinion, to the effect that there is substantial doubt about our ability to
continue as a going concern due to subjective acceleration provisions and conditions that must be
met in order to access the funds. A qualified opinion could itself have a material adverse effect
on our business, financial condition, results of operations and cash flows.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The primary objective of our investment activities is to preserve principal while at the same
time maximizing the income we receive from our invested cash without significantly increasing risk
of loss. Our financial instruments include cash, cash equivalents, accounts receivable, accounts
payable and accrued liabilities. As of September 30, 2006, the carrying values of our financial
instruments approximated their fair values. Our policy is not to enter into derivative financial
instruments. In addition, we do not enter into any futures or forward contracts and therefore we do
not have significant market risk exposure with respect to commodity prices.
Although we transact our business in U.S. dollars, future fluctuations in the value of the
U.S. dollar may affect the price competitiveness of our products. However, we do not believe that
we currently have any significant direct foreign currency exchange rate risk and have not hedged
exposures denominated in foreign currencies or any other derivative financial instruments.
Item 4. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures. We maintain disclosure controls and
procedures that are designed to ensure that information required to be disclosed in our reports
pursuant to the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and
reported within the time periods specified in the Securities and Exchange Commissions rules and
forms and that such information is accumulated and communicated to our management, including our
chief executive officer and chief financial officer, as appropriate, to allow for timely decisions
regarding required disclosure. In designing and evaluating the disclosure controls and procedures,
management recognizes that any controls and procedures, no matter how well designed and operated,
can provide only reasonable assurance of achieving the desired control objectives, and management
is required to apply its judgment in evaluating the cost-benefit relationship of possible controls
and procedures.
As required by Rule 13a-15(b) of the Securities Exchange Act of 1934, as amended, we carried
out an evaluation, under the supervision and with the participation of our management, including
our chief executive officer and chief financial officer, of the effectiveness of the design and
operation of our disclosure controls and procedures as of the end of the quarter covered by this
report. Based on the foregoing, our chief executive officer and chief financial officer concluded
that our disclosure controls and procedures were effective at the reasonable assurance level.
(b) Changes in Internal Controls. There was no change in our internal control over financial
reporting during our third fiscal quarter for 2006 that has materially affected, or is reasonably
likely to materially affect, our internal control over financial reporting.
25
PART II OTHER INFORMATION
Item 1. Legal Proceedings
We are a party to lawsuits in the normal course of our business. Litigation and governmental
investigation can be expensive and disruptive to normal business operations. Moreover, the results
of complex legal proceedings are difficult to predict. Significant judgments or settlements in
connection with the legal proceedings described below may have a material adverse effect on our
business, financial condition, results of operations and cash flows. Other than as described below,
we are not a party to any legal proceedings that we believe to be material.
Governmental Investigations
As reported in the Form 8-K that we filed on July 20, 2006, we executed a consent to entry of
judgment in favor of the Securities and Exchange Commission (the SEC) on July 14, 2006 and
entered into a non-prosecution agreement with the Department of Justice (the DOJ) on July 18,
2006. These two agreements effectively resolve with respect to the Company the investigations
begun by the SEC and by the DOJ in January 2003. The investigations related to certain former
officers and directors remain ongoing.
Under the terms of the consent judgment with the SEC, the Company, without admitting or
denying any wrongdoing, agreed to pay a total of $750,000 in civil penalties and is enjoined from
future violations of securities laws. In April 2006, we had placed this amount in escrow at the
request of the SEC staff.
Under the terms of the non-prosecution agreement with the DOJ, the United States Attorneys
Office for the Central District of California has agreed not to prosecute the Company for any
crimes committed by the Companys employees relating to the DOJs investigation. The agreement
becomes final and irrevocable on January 1, 2007.
Given the recent announcements by numerous companies and the SECs current focus on stock
option plan administration, our Audit Committee requested that management conduct an internal
review of our historical stock option practices, the timing of stock option grants and related
accounting and documentation. Based on this review, management identified several stock option
grants made between 1997 and 2002 for which the actual measurement dates appeared to differ from
the recorded grant dates. Management analyzed the potential accounting impact, assuming that the
measurement dates for these option grants differ from the recorded grant dates, and concluded that
the financial impact did not necessitate adjustment to or restatement of our previously-issued
financial reports. Management reported the results of its review to our Audit Committee and Board
of Directors at their regularly scheduled meetings on July 26, 2006. Following these meetings, we
contacted the SEC and the DOJ and reported our findings. On August 1, 2006, we met with the SEC
staff to discuss our findings and later received a subpoena from the SEC requesting additional
option-related information. We have responded to this subpoena and will continue to fully
cooperate with the SEC and DOJ and with their ongoing investigations related to certain of our
former officers and directors.
After receiving the subpoena from the SEC, management identified certain stock option grants
made in 2003 for which the actual measurement dates may differ from the recorded grant dates.
However, similar to the grants between 1997 and 2002 previously identified, management concluded
that the financial impact of the 2003 grants did not necessitate adjustment to or restatement of
our previously-issued financial reports.
Lawsuit Against KPMG LLP
On October 26, 2006, we filed a lawsuit with the Superior Court of the State of California for
the County of Orange against our former independent auditor, KPMG LLP, for professional negligence
and breach of contract, seeking damages in an amount to be determined at trial. Previously, we had
entered into a Mediation and Tolling Agreement with KPMG pursuant to which KPMG agreed that the
statute of limitations would be tolled to provide an opportunity for mediation between the parties.
We engaged in mediation with KPMG on September 27, 2006 but the parties were unable to reach
settlement. Accordingly, we proceeded with the filing of the lawsuit. We are not able to predict
the outcome of this lawsuit.
26
Item 1A. Risk Factors
Please see our 2005 Annual Report on Form 10-K filed with the SEC on March 16, 2006 and our
second quarter 2006 Quarterly Report on Form 10-Q filed with the SEC on August 8, 2006, which
include a detailed discussion of our risk factors. We do not believe that there have been any
material changes in our risk factors from those disclosed in the Form 10-K and the second quarter
Form 10-Q, except for the addition of the following risk factors:
We may require additional financing to sustain our operations and without it we may not be able to
continue operations.
We had an operating cash flow deficit of $9.9 million for the nine months ended September 30,
2006 and $14.7 million for the year ended December 31, 2005. We do not currently have sufficient
financial resources to fund our operations beyond March 31, 2007. Therefore, we need additional
funds to continue these operations.
The availability of funds under our common stock purchase agreement with Fusion Capital and
our credit agreement with Silicon Valley Bank is subject to many conditions, some of which are
predicated on events that are not within our control. Accordingly, we cannot guarantee that these
capital resources will be sufficient to fund our ongoing operations.
We only have the right to receive $100,000 every three business days under the agreement with
Fusion Capital unless our stock price equals or exceeds $1.50, in which case we can sell greater
amounts to Fusion Capital as the price of our common stock increases. Fusion Capital does not have
the right or the obligation to purchase any shares of our common stock on any business day that the
market price of our common stock is less than $1.00. Since we have authorized 8,000,000 shares for
sale to Fusion Capital under the common stock purchase agreement, the selling price of our common
stock to Fusion Capital will have to average at least $2.00 per share for us to receive the maximum
proceeds of $16.0 million. Assuming a purchase price of $1.74 per share (the closing sale price of
the common stock on October 31, 2006) and the purchase by Fusion Capital of the full 8,000,000
shares under the common stock purchase agreement, gross proceeds to us would be $13.9 million.
The extent to which we rely on Fusion Capital as a source of funding will depend on a number
of factors including the prevailing market price of our common stock and the extent to which we are
able to secure working capital from other sources, such as through the sale of our products. If
obtaining sufficient financing from Fusion Capital were to prove unavailable or prohibitively
dilutive and if we are unable to sell enough of our products, we may need to secure another source
of funding in order to satisfy our working capital needs. Even if we are able to access the full
$16.0 million under the common stock purchase agreement with Fusion Capital, we may still need
additional capital to fully implement our business, operating and development plans. Should the
financing we require to sustain our working capital needs be unavailable or prohibitively expensive
when we require it, the consequences would be a material adverse effect on our business, financial
condition, results of operations and cash flows.
Even despite the availability of funds from Fusion Capital and Silicon Valley Bank, our independent
auditor may issue a qualified opinion, to the effect that there is substantial doubt about our
ability to continue as a going concern.
Even despite the availability of funds from Fusion Capital and Silicon Valley Bank, our
independent auditors may issue a qualified opinion, to the effect that there is substantial doubt
about our ability to continue as a going concern due to subjective acceleration provisions and
conditions that must be met in order to access the funds. A qualified opinion could itself have a
material adverse effect on our business, financial condition, results of operations and cash flows.
The sale of our common stock to Fusion Capital may cause dilution and the sale of the shares of
common stock acquired by Fusion Capital could cause the price of our common stock to decline.
In connection with entering into the common stock purchase agreement with Fusion Capital, we
authorized the sale to Fusion Capital of up to 8,000,000 shares of our common stock, in addition to
the 473,957 shares that we issued to Fusion Capital as a commitment fee. The number of shares
ultimately offered for sale by Fusion Capital is dependent upon the number of shares purchased by
Fusion Capital under the agreement. The purchase price for the
27
common stock to be sold to Fusion Capital pursuant to the common stock purchase agreement will
fluctuate based on the price of our common stock. All 8,473,957 shares that we expect to register
pursuant to our registration rights agreement with Fusion Capital are expected to be freely
tradable. It is anticipated that shares registered will be sold over a period of up to 24 months.
Depending upon market liquidity at the time, a sale of shares by Fusion Capital at any given time
could cause the trading price of our common stock to decline. Fusion Capital may ultimately
purchase all, some or none of the 8,000,000 shares of common stock authorized for sale to Fusion
Capital under the common stock purchase agreement. After it has acquired such shares, it may sell
all, some or none of such shares. Therefore, sales to Fusion Capital by us under the common stock
purchase agreement may result in substantial dilution to the interests of other holders of our
common stock. The sale of a substantial number of shares of our common stock by Fusion Capital, or
anticipation of such sales, could make it more difficult for us to sell equity or equity-related
securities in the future at a time and at a price that we might otherwise wish to effect sales.
However, we have the right to control the timing and amount of any sales of our shares to Fusion
Capital and the agreement may be terminated by us at any time at our discretion without any cost to
us.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Not applicable.
Item 3. Defaults Upon Senior Securities
Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits
A list of exhibits filed with this Form 10-Q or incorporated by reference herein is found in
the Exhibit Index immediately following the Signature Page of this Form 10-Q, which is hereby
incorporated by reference herein.
28
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized.
|
|
|
|
|
|
ENDOCARE, INC.
|
|
|
By: |
/s/ CRAIG T. DAVENPORT
|
|
|
|
Craig T. Davenport |
|
|
|
Chief Executive Officer, President and
Chairman of the Board
(Duly Authorized Officer) |
|
|
|
|
|
|
By: |
/s/ MICHAEL R. RODRIGUEZ
|
|
|
|
Michael R. Rodriguez |
|
|
|
Senior Vice President, Finance and
Chief Financial Officer
(Principal Financial and
Accounting Officer) |
|
|
Date: November 9, 2006
29
EXHIBIT INDEX
|
|
|
Exhibit |
|
|
No. |
|
Description |
2.1(1)
|
|
Partnership Interest Purchase Agreement, dated as of December 30, 2004, by and between the
Company and Advanced Medical Partners, Inc. |
|
|
|
2.2(2)
|
|
Stock Purchase Agreement, dated as of January 13, 2006, by and among the Company, Plethora
Solutions Holdings plc and Timm Medical Technologies, Inc. The schedules and other
attachments to this exhibit were omitted. The Company agrees to furnish a copy of any
omitted schedules or attachments to the Securities and Exchange Commission upon request. |
|
|
|
2.3(3)
|
|
$1,425,000 Secured Convertible Promissory Note, dated as of February 10, 2006, from
Plethora Solutions Holdings plc to the Company. |
|
|
|
3.1(4)
|
|
Certificate of Amendment of Restated Certificate of Incorporation of the Company. |
|
|
|
3.2(4)
|
|
Certificate of Designation of Series A Junior Participating Preferred Stock of the Company. |
|
|
|
3.3(4)
|
|
Restated Certificate of Incorporation. |
|
|
|
3.4(5)
|
|
Amended and Restated Bylaws of the Company. |
|
|
|
4.1(6)
|
|
Form of Stock Certificate. |
|
|
|
4.2(7)
|
|
Form of Series A Warrant. |
|
|
|
4.3(7)
|
|
Form of Series B Warrant. |
|
|
|
4.4(8)
|
|
Rights Agreement, dated as of September 30, 1999, between the Company and U.S. Stock
Transfer Corporation, which includes the form of Certificate of Designation for the Series
A Junior Participating Preferred Stock as Exhibit A, the form of Rights Certificate as
Exhibit B and the Summary of Rights to Purchase Series A Preferred Shares as Exhibit C. |
|
|
|
4.5(9)
|
|
Amendment No. 1 to Rights Agreement, dated as of September 24, 2005, between the Company
and U.S. Stock Transfer Corporation. |
|
|
|
10.1
|
|
Non-Prosecution Agreement, dated as of July 18, 2006, by and between the Company and the
United States Department of Justice. |
|
|
|
10.2
|
|
Consent to Entry of Judgment, dated as of July 14, 2006, in favor of the United States
Securities and Exchange Commission. |
|
|
|
31.1
|
|
Certification under Section 302 of the Sarbanes-Oxley Act of 2002 for Craig T. Davenport. |
|
|
|
31.2
|
|
Certification under Section 302 of the Sarbanes-Oxley Act of 2002 for Michael R. Rodriguez. |
|
|
|
32.1
|
|
Certification under Section 906 of the Sarbanes-Oxley Act of 2002 for Craig T. Davenport. |
|
|
|
32.2
|
|
Certification under Section 906 of the Sarbanes-Oxley Act of 2002 for Michael R. Rodriguez. |
|
|
|
(1) |
|
Previously filed as an exhibit to our Form 8-K filed on January 6, 2005. |
|
(2) |
|
Previously filed as an exhibit to our Form 8-K filed on January 18, 2006. |
|
(3) |
|
Previously filed as an exhibit to our Form 10-K filed on March 16, 2006. |
30
|
|
|
(4) |
|
Previously filed as an exhibit to our Registration Statement on Form S-3 filed on September 20, 2001. |
|
(5) |
|
Previously filed as an exhibit to our Form 10-K filed on March 15, 2004. |
|
(6) |
|
Previously filed as an exhibit to our Form 10-K for the year ended December 31, 1995. |
|
(7) |
|
Previously filed as an exhibit to our Form 8-K filed on March 16, 2005. |
|
(8) |
|
Previously filed as an exhibit to our Form 8-K filed on September 3, 1999. |
|
(9) |
|
Previously filed as an exhibit to our Form 8-K filed on June 28, 2005. |
31