UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(x) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2002March 31, 2003
Commission File Number 1-13165
CRYOLIFE, INC.
(Exact name of registrant as specified in its charter)
----------------------------
Florida 59-2417093
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
1655 Roberts Boulevard, NW
Kennesaw, Georgia 30144
(Address of principal executive offices)
(zip code)
(770) 419-3355
(Registrant's telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year,
if changed since last report)
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.
YES X__X__ NO ----- -----____
The number of shares of common stock, par value $0.01 per share, outstanding on
October 28, 2002April 30, 2003 was 19,573,970.19,663,833.
Part I - FINANCIAL INFORMATION
Item 1. Financial statements
CRYOLIFE, INC. AND SUBSIDIARIES
SUMMARY CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Three Months Ended
Nine Months Ended
September 30, September 30,
------------------------------- ------------------------------March 31,
-------------------------------------
2003 2002
2001 2002 2001
------------------------------- ------------------------------
(Unaudited)-------------------------------------
(Unaudited)
Revenues:
Human tissue preservation services net $ 11,3009,130 $ 19,737 $ 49,074 $ 57,06920,238
Products 5,354 2,600 15,892 8,0296,599 5,065
Distribution and grant 235 230 658 598
------------------------------- ------------------------------
16,889 22,567 65,624 65,696191 168
-------------------------------------
15,920 25,471
Costs and expenses:
Human tissue preservation services (including2,443 8,063
(Includes lower of cost or market
write-down of $22,691
and $32,715$297 in the three and nine
months ended September 30, 2002) 27,978 8,188 53,244 23,5582003)
Products 4,739 1,196 8,817 4,0511,641 2,235
General, administrative, and marketing 11,193 8,290 32,118 24,56911,592 9,478
Research and development 1,347 1,232 3,696 3,604
Goodwill impairment 1,399 -- 1,399 --917 1,153
Interest expense 155 37 543 53132 192
Interest income (188) (449) (725) (1,587)(131) (298)
Other expense (income),income, net 35 114 (37) 856
------------------------------- ------------------------------
46,658 18,608 99,055 55,104
------------------------------- ------------------------------(26) (56)
--------------------------------------
16,568 20,767
-------------------------------------
(Loss) income before income taxes (29,769) 3,959 (33,431) 10,592(648) 4,704
Income tax (benefit) expense (10,123) 1,267 (11,367) 3,390
------------------------------- ------------------------------(214) 1,600
-------------------------------------
Net (loss) income $ (19,646)(434) $ 2,692 $ (22,064) $ 7,202
=============================== ==============================
Net (loss)3,104
=====================================
(Loss) earnings per share:
Basic $ (1.01)(0.02) $ 0.14 $ (1.14) $ 0.38
=============================== ==============================0.16
=====================================
Diluted $ (1.01)(0.02) $ 0.14 $ (1.14) $ 0.37
=============================== ==============================0.16
=====================================
Weighted average shares outstanding:
Basic 19,526 18,832 19,388 18,785
=============================== ==============================19,634 19,096
=====================================
Diluted 19,526 19,771 19,388 19,635
=============================== ==============================19,634 19,796
=====================================
See accompanying notes to summary consolidated financial statements.
2
Item 1. Financial Statements
CRYOLIFE, INC.
SUMMARY CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
September 30,March 31, December 31,
2003 2002 2001
-----------------------------------
ASSETS (Unaudited)
Current Assets:
Cash and cash equivalents $ 12,2276,898 $ 7,20410,277
Marketable securities, at market 15,926 26,48313,327 14,583
Trade receivables, net 5,851 13,3057,769 6,930
Other receivables, net 5,095 2,820
Note receivable, net -- 1,1699,090 11,824
Deferred preservation costs, net 1,662 24,1997,564 4,332
Inventories 4,659 6,2594,703 4,585
Prepaid expenses and other assets 3,650 2,3411,457 2,182
Deferred income taxes 12,292 6885,365 6,734
-----------------------------------
Total current assets 61,362 84,46856,173 61,447
-----------------------------------
Property and equipment, net 39,448 39,246
Goodwill -- 1,39936,879 38,130
Patents, net 5,500 2,9195,321 5,324
Deferred income taxes 736 --
Other, net 1,128 1,2781,439 1,513
-----------------------------------
TOTAL ASSETS $ 107,438100,548 $ 129,310106,414
===================================
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities:
Accounts payable $ 1,7822,358 $ 5553,874
Accrued expenses and other current liabilities 2,739 1,4916,017 6,823
Accrued compensation 762 2,5601,271 1,627
Accrued procurement fees 6,153 6,5922,557 3,769
Current maturities of capital lease obligations 640 6092,064 2,169
Current maturities of long-term debt 6,000 1,600
Convertible debenture -- 4,3935,200 5,600
-----------------------------------
Total current liabilities 18,076 17,80019,467 23,862
-----------------------------------
Capital lease obligations, less current maturities 2,655 3,140
Bank loan, less current maturities -- 5,600917 971
Deferred income taxes 433 449986
Other long-term liabilities 1,049 882838 795
-----------------------------------
Total liabilities 22,213 27,87121,222 26,614
-----------------------------------
Shareholders' equity:
Preferred stock -- -----
Common stock (issued 20,879(20,996 issued shares in 20022003 and
20,17220,935 shares in 2001) 208 2022002) 210 209
Additional paid-in capital 73,550 66,82873,765 73,630
Retained earnings 18,483 40,54712,352 12,786
Deferred compensation (24) (33)(18) (21)
Accumulated other comprehensive income (loss) 172 (145)103 282
Less: Treasury stock at cost (1,377(1,361 shares in 20022003 and
1,2861,361 shares in 2001) (7,164) (5,960)2002) (7,086) (7,086)
-----------------------------------
Total shareholders' equity 85,225 101,43979,326 79,800
-----------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 107,438100,548 $ 129,310106,414
===================================
See accompanying notes to summary consolidated financial statements.
3
Item 1. Financial Statements
CRYOLIFE, INC.
SUMMARY CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
NineThree Months Ended
September 30,March 31,
-----------------------------------
2003 2002 2001
-----------------------------------
(Unaudited)
Net cash from operating activities:
Net (loss) income $ (22,064)(434) $ 7,2023,104
Adjustments to reconcile net (loss) income to net cash
provided by operating activities:
LossGain on sale of marketable equity securities 240 -- (10)
Depreciation and amortization 3,926 3,2941,401 1,230
Provision for doubtful accounts 72 7224 24
Write-down of deferred preservation costs and inventories 35,816297 --
Other non-cash adjustments to income 1,399 74819 --
Deferred income taxes (11,674) (85)(342) 365
Tax effect of nonqualified option exercises 481 179-- 306
Changes in operating assets and liabilities:
Receivables 8,190 (2,821)
Income taxes (3,083) (97)1,871 (2,919)
Deferred preservation costs and inventories (11,679) (3,746)(3,647) (2,854)
Prepaid expenses and other assets (1,309) (800)725 185
Accounts payable, accrued expenses, and other liabilities 321 671(3,847) 380
-----------------------------------
Net cash flows provided byused in operating activities 636 4,617
-----------------------------------(3,933) (189)
------------------------------------
Net cash flows from investing activities:
Capital expenditures (3,877) (9,531)(79) (1,398)
Other assets (2,575) (1,281)(2) (412)
Purchases of marketable securities (10,025) (20,254)-- (11,725)
Sales and maturities of marketable securities 20,496 16,4891,205 13,036
Proceeds from note receivable 1,169 1,846-- 284
-----------------------------------
Net cash flows provided by (used in) investing activities 5,188 (12,731)1,124 (215)
-----------------------------------
Net cash flows from financing activities:
Principal payments of debt (1,200) (650)
Proceeds from debt issuance -- 1,165(400) (400)
Payment of obligations under capital leases (454) (128)(159) (149)
Proceeds from exercise of stock options and
issuance of common stock 1,313 1,166
Purchase of treasury stock (663) --136 348
-----------------------------------
Net cash (used in) provided byused in financing activities (1,004) 1,553
-----------------------------------
Increase (decrease)(423) (201)
------------------------------------
Decrease in cash 4,820 (6,561)and cash equivalents (3,232) (605)
Effect of exchange rate changes on cash 203 52(147) (33)
Cash and cash equivalents, beginning of period 10,277 7,204 17,480
-----------------------------------
Cash and cash equivalents, end of period $ 12,2276,898 $ 10,9716,566
===================================
See accompanying notes to summary consolidated financial statements.
4
CRYOLIFE, INC. AND SUBSIDIARIES
NOTES TO SUMMARY CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1 - BASIS OF PRESENTATION
The accompanying unaudited condensedsummary consolidated financial statements have been
prepared in accordance with (i) accounting principles generally accepted in the
United States for interim financial information and (ii) the instructions to
Form 10-Q and Rule 10-01 of Regulation S-X of the Securities and Exchange
Commission ("SEC"). Accordingly, the statements do not include all of the
information and disclosures required by accounting principles generally accepted
in the United States for a complete presentation of financial statements. In the
opinion of management, all adjustments (consisting of normal recurring accruals
and estimated write-downs and accruals resulting from an order and the
supplement to the order received from the United States Food and Drug
Administration ("FDA"))accruals)
considered necessary for a fair presentation have been included. Certain prior
year balances have been reclassified to conform to the 20022003 presentation. CryoLife, Inc.'s ("CryoLife" or the "Company") unaudited
September 30, 2001 year to date results of operations have been revised from the
amounts previously reported in the Form 10-Q for the quarter ended September 30,
2001, as indicated in Note 20 to the consolidated financial statements included
in the CryoLife Form 10-K for the year ended December 31, 2001.
Operating results for the three and nine months ended September 30, 2002March 31, 2003 are not necessarily
indicative of the results that may be expected for the year ending December 31,
2002.2003. For further information, refer to the consolidated financial statements
and notes thereto included in the CryoLife Form 10-K for the year ended December
31, 2001.
In addition to the current effects of the FDA Order, defined in Note 2, the
Company anticipates that the FDA Order will have significant adverse effects on
its future financial position, results of operations, and cash flows2002, as compared
to prior year periods. The Company expects its liquidity to decrease
significantly over the remainder of this year and next year due to the
anticipated significant decrease in revenues as compared to prior year as a
result of the FDA Order and an expected use of cash due to the increased legal
and professional costs relating to the defense of lawsuits and to addressing the
FDA Order. As a result, the Company reduced its employee force by approximately
105 employees on September 3, 2002. Severance and related costs are
approximately $690,000 and were recorded in the third quarter of 2002 in general
and administrative expenses. As a result of the employee reduction, management
anticipates personnel costs will be reduced by approximately $385,000 per month.
The Company believes that anticipated revenue generation, expense management,
savings resulting from the reduction in the number of employees to reflect the
reduction in revenues, tax refunds expected to be in excess of $10 million, and
the Company's existing cash and marketable securities will enable the Company to
meet its liquidity needs through September 30, 2003. Even if the Company is able
to satisfactorily address the observations detailed in the FDA's Warning Letter
dated June 17, 2002 (the "Warning Letter"), as noted in Note 2, there is no
assurance that the Company will experience a return to the level of demand for
its tissue services that existed prior to the FDA Order because of the adverse
publicity or as a result of customers and tissue recovery organizations
switching to competitors.
The Company's long term liquidity and capital requirements will depend upon
numerous factors, including the Company's ability to address the observations
detailed in the FDA's Warning Letter, the extent of any future revenue
decreases, the costs associated with becoming compliant with the FDA
requirements as outlined in the FDA Warning Letter and Order, the outcome of
litigation against the Company as described in Note 11, the level of demand for
tissue based on adverse publicity in the event the FDA Order is resolved in a
manner favorable to the Company, the default on the Term Loan as described in
Note 6 and whether or not the Company can find suitable funding sources to
replace the funds no longer available due to the Company's inability to borrow
on its line of credit as described in Note 6. The Company may require additional
financing or seek to raise additional funds through bank facilities, debt or
equity offerings, or other sources of capital to meet liquidity and capital
requirements beyond September 30, 2003. Additional funds may not be available
when needed or on terms acceptable to the Company, which could have a material
adverse effect on the Company's business, financial condition, results of
operations, and cash flows. These are factors that indicate that the Company may
be unable to continue operations.
5
amended.
NOTE 2 - FDA ORDER ON HUMAN TISSUE PRESERVATION AND OTHER FDA CORRESPONDENCE
On August 13, 2002 the Company received an order from the Atlanta district
office of the FDA regarding the non-valved cardiac, vascular, and orthopaedic
tissue processed by the Company since October 3, 2001 (the "FDA Order"). The FDA
Order followed an April 2002 FDA Form 483 Notice of Observations ("April 2002
483") and an FDA Warning Letter dated June 17, 2002, ("Warning Letter").
Subsequently, the Company responded to the Warning Letter. Revenue from human
tissue preservation services accounted for 78% of the Company's revenues for the
six months ended June 30, 2002, (the last period ending prior to the issuance of
the FDA Order) and of those revenues 67% or $26.9 million were derived from
preservation of tissues subject to the FDA Order. The Company announced the receipt of the FDA Order in a press release
dated August 14, 2002. The FDA Order follows an FDA Warning Letter dated June
17, 2002, which the Company announced in a press release dated June 24, 2002.
Subsequently, the Company responded to the Warning Letter and requested a
meeting with the FDA. The FDA Order contains the
following principal provisions:
o The FDA alleges that, based on its inspection of the Company's
facility on March 25 through April 12, 2002, certain human tissue
processed and distributed by the Company may be in violation of 21
Code of Federal Regulations ("CFR") Part 1270. (Part 1270 requires
persons or entities engaged in the recovery, screening, testing,
processing, storage, or distribution of human tissue to perform
certain medical screening and testing on human tissue intended for
transplantation. The rule also imposes requirements regarding
procedures for the prevention of contamination or cross-contamination
of tissues during processing and the maintenance of certain records
related to these activities.)
o The FDA alleges that the Company has not validated procedures for the
prevention of infectious disease contamination or cross-contamination
of tissue during processing at least since October 3, 2001.
o Non-valved cardiac, vascular, and orthopaedic tissue processed by the
Company sincefrom October 3, 2001 to September 5, 2002 must be retained
until it is recalled, destroyed, the safety is confirmed, or an
agreement is reached with the FDA for its proper disposition under the
supervision of an authorized official of the FDA.
o The FDA strongly recommends that the Company perform a retrospective
review of all tissue in inventory (i.e. currently in storage at the
Company) that is not referenced in the FDA Order to assure that it was
recovered, processed, stored, and distributed in conformance with 21
CFR 1270.
o The Center for Devices and Radiological Health ("CDRH"), a division of
the FDA, is evaluating whether there are similar risks that may be
posed by the Company's allograft heart valves, and will take further
regulatory action if appropriate.
Pursuant to the FDA Order, the Company placed all non-valved cardiac, vascular, and
orthopaedic tissue subject to the FDA Order on quality assurance quarantine and
is recalling allrecalled the non-valved cardiac, vascular, and orthopaedic tissues subject to
5
the FDA Order (i.e. processed since October 3, 2001) that havehad been distributed
but not implanted. TheIn addition, the Company appealed the FDA Order on August 14,
2002ceased processing non-valved
cardiac, vascular, and requested a hearing with the FDA, which has been set for December 12,
2002. After the FDA issued its order regarding the recall, Health Canada also
issued a recall on the same types of tissue and other countries have inquired
about the circumstances surrounding the FDA Order.orthopaedic tissues. On September 5, 2002 the Company
reached an agreement with the FDA (the "Agreement") that supplements the FDA
Order and permits the Company to resume
processing and limited distribution of its life-saving and limb-saving
non-valved cardiac and vascular tissues. The Agreement allows the tissuetissues subject to recall (processed between October 3,
2001 and September 5, 2002) to be released for distribution after the Company
completes steps to assure that the tissue is used for approved purposes and that
patients will beare notified of risks associated with tissue use. Specifically, the
Company must obtain physician prescriptions, and tissue packaging must contain
appropriatespecified warning labels. The Agreement also calls for the Company to undertake to
identify third-party records of donor tissue testing and to destroy tissue from
donors in whom microorganisms associated with an infection are found. In addition,The
Agreement had a 45-business day term and was renewed on November 8, 2002, on
January 8, 2003, and on March 17, 2003. This most recent renewal expires on June
13, 2003. The Company is unable to predict whether or not the Agreement, which has a forty-five working-day term ending November 7, 2002,
specifies interim operating procedures to permit the Company to distribute
6
tissues processed during the termFDA will grant
further renewals of the Agreement. In addition, pursuant to the Agreement, the
Company agreed to perform additional procedures in the processing of non-valved
cardiac and vascular tissues and subsequently resumed processing these tissues.
The Agreement contained the requirement that tissues subject to the FDA Order be
replaced with tissues processed under validated methods. The Company also agreed
to establish a corrective action plan within 30 days from September 5, 2002 with
steps to validate processing procedures. The corrective action plan was
submitted on October 5, 2002.
TheOn December 31, 2002 the FDA will review records and other relevant information related to the
Company's release of tissue underclarified the Agreement as well as the status of the
Company's corrective action plan, before determining whether this Agreement
should be renewed or modified to provide for any further release of tissuenoting that non-valved
cardiac and vascular tissues processed since September 5, 2002 are not subject
to the FDA Order. Specifically, for non-valved cardiac and vascular tissue
processed since September 5, 2002, the Company is not required to obtain
physician prescriptions, label the tissue as subject to a recall, or require
special steps regarding procurement agency records of donor screening and
testing beyond those required for all processors of human tissue. A renewal of
the Agreement that expires on June 13, 2003 is therefore not needed in order for
the Company to continue to distribute non-valved cardiovascular and vascular
tissues processed since September 5, 2002, including orthopaedic tissue.
The Company resumed limited processing of orthopaedic tissues in late February
2003 following an FDA inspection of the Company's processing operations. The
Company's first quarter 2003 procurement of orthopaedic tissues was
approximately 5% of orthopaedic procurement levels in the first quarter of 2002.
The Company plans to resume distribution of orthopaedic tissues.
A new FDA 483 Notice of Observations ("February 2003 483") was issued in
connection with the FDA inspection in February 2003, but corrective action was
implemented on most of its observations during the inspection. The Company
believes the observations, most of which focus on the Company's systems for
handling complaints and validation of test methods, will not materially affect
the Company's operations. The Company responded to the February 2003 483 in
March 2003. The Company is currently communicating with the FDA to determine the
adequacy of its response to close out the February 2003 483.
After receiving the FDA Order the Company met with representatives of the FDA's
CDRH division regarding CDRH's review of the Company's processed allograft heart
valves, which are not required to be recalled pursuantsubject to the FDA Order. On August 21, 2002 the FDA
publicly stated that allograft heart valves have not been included in the FDA
recall orderOrder as these devices are essential for the correction of congenital cardiac
lesions in neonate and pediatric patients and no satisfactory alternative device
exists. However, the FDA also publicly stated that it then still hashad serious
concerns regarding the Company's processing and handling of allograft heart
valves. The FDA also recommended that surgeons carefully consider using
processed allografts from alternative sources, that surgeons inform prospective
patients of the FDA's concerns withregarding the Company's allograft heart valves,
and that patients be carefully monitored for both fungal and bacterial
infections.
As a result of the adverse publicity surrounding the FDA Warning Letter, FDA
Order, and reported tissue infections, the Company's procurement of cardiac
tissues, from which heart valves and non-valved cardiac tissues are processed,
decreased 29% in the first quarter of 2003 as compared to the first quarter of
2002. The Company's first quarter 2003 procurement of cardiac tissues decreased
4% from fourth quarter of 2002. The Company has continued to process and
distribute heart valves since the receipt of the FDA Order, as these tissues are
not subject to the FDA Order.
During the first quarter of 2003 the Company limited its vascular procurement
until it addressed the observations detailed in the April 2002 483, and the
Company continues to limit its vascular procurement until it can fully evaluate
the demand for its vascular tissues. The Company's procurement of vascular
6
tissue decreased 65% in the first quarter of 2003 as compared to the first
quarter of 2002. The Company's first quarter 2003 procurement of vascular
tissues increased 25% from fourth quarter of 2002. The Company expects that
vascular procurement will continue to increase during 2003.
As a result of the FDA Order the Company recorded a reduction to pretax income
of $12.6 million in the quarter ended June 30, 2002. The reduction was comprised
of a net $8.9 million increase to cost of human tissue preservation services, a
$2.4 million reduction to revenues (and accounts receivable) for the estimated
return of the tissues subject to recall by the FDA Order, and a $1.3 million
accrual recorded in general, administrative, and marketing expenses for
retention levels under the Company's product liability and directors' and
officers' insurance policies of $1.2 million (see Note 11)12), and for estimated
expenses of $75,000 for packaging and handling for the return of affected
tissues under the FDA Order. The net increase of $8.9 million to cost of
preservation services iswas comprised of a $10.0 million write-down of deferred
preservation costs for tissues subject to the FDA Order, offset by a $1.1
million decrease in cost of preservation services due to the estimated tissue
returns resulting from the FDA Order (the costs of such recalled tissue are
included in the $10.0 million write-down). The Company evaluated many factors in
determining the magnitude of impairment to deferred preservation costs as of
June 30, 2002, including the impact of the FDA Order, the possibility of
continuing action by the FDA or other United States and foreign government
agencies, and the possibility of unfavorable actions by physicians, customers,
procurement organizations, and others. As a result of this evaluation,
management believed that since all non-valved cardiac, vascular, and orthopaedic
allograft tissues processed since October 3, 2001 arewere under recall pursuant to
the FDA Order, and since the Company did not know if it would obtain a favorable
resolution of its appeal and request for modification of the FDA Order, the
deferred preservation costs for tissues subject to the FDA Order had been
significantly impaired. The Company estimated that this impairment approximated
the full balance of the deferred preservation costs of the tissues subject to
the FDA Order, which included the tissues stored by the Company and the tissues
to be returned to the Company, and therefore recorded a write-down of $10.0
million for these assets.
In the quarter ended September 30, 2002 the Company recorded a reduction to
pretax income of $24.6 million as a result of the FDA Order. The reduction was
comprised of a net $22.2 million increase to cost of human tissue preservation
services, a $1.4 million write-down of goodwill, and a $1.0 million reduction to
revenues (and accounts receivable) for the estimated return of the tissues
shipped during the third quarter subject to recall by the FDA Order. The net
$22.2 million increase to cost of preservation services iswas comprised of a $22.7
million write-down of deferred preservation costs, offset by a $0.5 million
decrease in cost of preservation services due to the estimated and actual tissue
returns resulting from the FDA Order (the costs of such recalled tissue are
included in the $22.7 million write-down).
The Company evaluated multiple factors in determining the magnitude of
impairment to deferred preservation costs at September 30, 2002, including the
impact of the current FDA Order, the possibility of continuing action by the FDA or
other United States and foreign government agencies, the possibility of
unfavorable actions
7
by physicians, customers, procurement organizations, and
others, the progress made to date on the corrective action plan, and the
requirement in the Agreement that tissues subject to the FDA Order be replaced
with tissues processed under validated methods. As a result of this evaluation
management believesbelieved that all tissues subject to the FDA Order, as well as the
majority of tissues processed prior to October 3, 2001, including heart valves,
which arewere not subject to the FDA Order, arewere fully impaired. Management
believesbelieved that most of the Company's customers willwould only order tissues processed
underafter the interim operating
procedures established under theSeptember 5, 2002 Agreement or tissues processed under future
procedures approved by the FDA once thesethose tissues arewere available. The Company
anticipatesanticipated that the tissues processed under the interim operating procedures
established under the Agreement willwould be available
early to mid-November. Thus, the Company has recorded a write-down of deferred
preservation costs for processed tissues in excess of the supply required to
meet demand prior to the release of these interim processed tissues. In the
quarter ended March 31, 2003 the Company recorded a $297,000 increase to cost of
preservation services to write-down the value of certain deferred tissue
preservation costs that exceeded market value. As of September 30, 2002March 31, 2003 the balance
of the deferred preservation costs after the write-down was $545,000 of$3.8 million for allograft heart valves, $176,000 ofvalve
tissues, $379,000 for non-valved cardiac tissues, $931,000 of$3.1 million for vascular
tissues, and $10,000 of$344,000 for orthopaedic tissues.
As a result of the write-down of deferred preservation costs, the Company
has
recorded a$6.3 million in income tax receivables and $4.5 million in deferred tax
assetassets as of $12.2 million.December 31, 2002. Upon destruction or shipment of the remaining
tissues associated with the deferred preservation costs write-down, the deferred
tax asset will be
reclassed as an incomebecome deductible in the Company's tax receivable.return. An expected refund
of approximately $8.9 million related to 2002 federal income taxes will be
7
generated through a carry back of operating losses resulting from theand write-downs of deferred
preservation cost
write-downs.costs. The Company filed its 2002 federal income tax returns in
April of 2003 and expects to receive its tax refund during the second quarter of
2003. In addition, the Company has recorded $4.2$2.5 million in income tax receivables
as of December 31, 2002 related to $1.7 millionestimated tax payments for 2002. The Company
received payment of tax overpayments for 2001 and an
estimatedthe $2.5 million in January of tax overpayments2003.
On September 3, 2002 the Company announced a reduction in employee force of
approximately 105 employees. In the third quarter of 2002 the Company recorded
accrued restructuring costs of approximately $690,000, for 2002.
Statement of Financial Accounting Standards No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), requires the
write-down of a long-lived asset to be heldseverance and used if the carrying valuerelated
costs of the asset oremployee force reduction. The expense was recorded in general,
administrative, and marketing expenses and was included as a component of
accrued expenses and other current liabilities on the asset group to whichSummary Consolidated
Balance Sheet. During the asset belongs, is not recoverable and
exceeds its fair value. The asset or asset group is not recoverable if its
carrying value exceedsyear ended December 31, 2002 the sumCompany utilized
$580,000 of the undiscounted future cash flows expected to
result fromaccrued restructuring costs, including $505,000 for salary and
severance payments, $64,000 for placement services for affected employees, and
$11,000 in other related costs. During the use and eventual dispositionquarter ended March 31, 2003 the
Company utilized $64,000 of the asset or asset group.accrued restructuring costs, including $57,000
for salary and severance payments and $7,000 in other related costs. In applying SFAS 144,March
2003 the Company determined thatreversed the asset groups consistedremaining accrual of $46,000 in unused
restructuring costs, which was primarily due to lower than anticipated medical
claims costs for affected employees. The Company does not expect to incur any
additional restructuring costs associated with the long-lived assets relatedemployee force reduction.
In the quarter ended March 31, 2003 the Company recorded a favorable adjustment
of $848,000 to the Company's two reporting segments, as these
representestimated tissue recall returns due to lower actual tissue
returns under the lowest levelFDA Order than were originally estimated in the second and
third quarters of 2002. The adjustment increased cardiac tissue revenues by
$92,000, vascular tissue revenues by $711,000, and orthopaedic tissue revenues
by $45,000 in the first quarter of 2003. As of March 31, 2003 approximately
$100,000 remains in the accrual for which identifiable cash flows are largely
independentestimated return of tissues subject to
recall by the cash flows of other assets and liabilities.FDA Order.
The Company used
a fourteen-year period forexpects its liquidity to continue to decrease significantly over the
undiscounted future cash flows. This period of
time was selected based upon the remaining life of the primary assets of the
asset groups, which are leasehold improvements. Based on its analysis,
management does not believe an impairment of the Company's intangible and
tangible assets relatednext year due to the anticipated significant decrease in revenues throughout at
least the first half of 2003 as compared to the prior year period, as a result
of reported tissue preservation business or medical device
business had occurred as of September 30, 2002. However, depending on the
Company's ability to address the observations detailed in the Warning Letter and
the future effects of adverse publicity surroundinginfections, the FDA Order and reported
infections on preservation revenues, these assets may become impaired.
Management will continueassociated adverse publicity,
and an expected decrease in cash due to evaluate the recoverabilityanticipated increased legal and
professional costs relating to the defense of these assets.
Goodwilllawsuits (discussed in Note 12)
and ongoing FDA compliance. The Company believes that anticipated revenue
generation, expense management, savings resulting from business acquisitionsthe reduction in the
number of employees to reflect the reduction in revenues, tax refunds expected
to be approximately $8.9 million from loss carrybacks generated from operating
losses and write-downs of deferred preservation costs, and the Company's
existing cash and marketable securities will enable the Company to meet its
liquidity needs through at least March 31, 2004, even if the Term Loan (as
discussed in Note 5) is not amortized, butcalled in its entirety. There is instead
subjectno assurance that the
Company will be able to periodic impairment testing in accordance with SFAS No. 142,
"Goodwill and Other Intangible Assets" ("SFAS 142"). As a resultreturn to the level of demand for its tissue services
that existed prior to the FDA Order due to the Company determined that an evaluation of the possible impairment of
intangible assets under SFAS 142 was necessary. The Company engaged an
independent valuation expert to perform the valuation using a discounted cash
flow methodology, andadverse publicity or as a result
of this analysis,customers and tissue banks switching to competitors. Failure of the Company
determined that
goodwill related to maintain sufficient demand for its tissue processing reportable unit was fully impaired asservices would have a material adverse
effect on the Company's business, financial condition, results of September 30, 2002. Therefore,operations,
and cash flows.
On February 20, 2003 the Company recordedreceived a write-downletter from the FDA stating that a
510(k) premarket notification should be filed for the Company's CryoValve SG and
that premarket approval marketing authorization should be obtained for the
Company's CryoVein SG when used for arteriovenous ("A-V") access. The agency's
position is that use of $1.4
millionthe SynerGraft technology in goodwill during the quarter ended September 30, 2002. Management does
not believe an impairment exists relatedprocessing of allograft
heart valves represents a modification to the other intangible assets.
ManagementCompany's legally marketed
CryoValve allograft, and that femoral veins used for A-V access are medical
devices that require premarket approval. The FDA letter did not question the
safety or efficacy of the SynerGraft process or the CryoVein A-V access implant.
The FDA has advised the Company that its CryoValve SG and CryoVein SG used for
AV access will continuebe regulated as medical devices. The Company is in discussions
with the FDA about the type of clearances necessary for these products. The
Company advised the FDA that it has voluntarily suspended use of the SynerGraft
technology in the processing of allograft heart valves and vascular tissue until
the regulatory status of the CryoValve SG and CryoVein SG is resolved. The FDA
has not suggested that these tissues be recalled. Until such time as the issues
surrounding the SynerGraft tissue are resolved, the Company will employ its
traditional processing methods on these tissues. Distribution of allograft heart
valves and vascular tissue processed using the Company's traditional processing
protocols will continue. The outcome of the discussions with the FDA regarding
8
the use of the SynerGraft process on human tissue could result in a reduction in
SynerGraft processed cardiovascular and vascular tissue which would reduce the
revenues and gross margins with respect to evaluate the recoverability of these intangible
assets.cardiovascular and vascular tissues.
NOTE 3 - CASH EQUIVALENTS AND MARKETABLE SECURITIES
The Company maintains cash equivalents, which consist primarily of highly liquid
investments with maturity dates of 90 days or less at the time of acquisition,
and marketable securities in several large, well-capitalized financial
institutions, and the Company's policy disallows investment in any securities
rated less than "investment-grade" by national rating services.
8
Management determines the appropriate classification of debt securities at the
time of purchase and reevaluates such designations as of each balance sheet
date. Debt securities are classified as held-to-maturity when the Company has
the positive intent and ability to hold the securities to maturity.
Held-to-maturity securities are stated at amortized cost. Debt securities not
classified as held-to-maturity or trading and marketable equity securities not
classified as trading are classified as available-for-sale. At September 30,
2002March 31, 2003
and December 31, 2001,2002 all marketable equity securities and debt securities were
designated as available-for-sale.
Available-for-sale securities are stated at their fair values, with the
unrealized gains and losses, net of tax, reported in a separate component of
shareholders' equity. Interest income, dividends, realized gains and losses, and
declines in value judged to be other than temporary are included in investment
income. The cost of securities sold is based on the specific identification
method.
The following is a summary of cash equivalents and marketable securities (in
thousands):
Unrealized Estimated
Adjustments Adjusted Holding Market
September 30, 2002 Cost Basis to Cost Basis Cost Basis Gains/(Losses) Value
-----------------------------------------------------------------------------------
Cash equivalents:
Money market funds $ 47 $ -- $ 47 $ -- $ 47
Municipal obligations 5,636 -- 5,636 -- 5,636
-----------------------------------------------------------------------------------
$ 5,683 $ -- $ 5,683 $ -- $ 5,683
===================================================================================
Marketable securities:
Municipal obligations $ 15,615 $ -- $ 15,615 $ 311 $ 15,926
===================================================================================
Unrealized Estimated
Adjustments Adjusted Holding Market
December 31, 2001 Cost Basis to Cost Basis Cost Basis Gains/(Losses) Value
-----------------------------------------------------------------------------------
Cash equivalents:
Money market funds $ 1,301 $ -- $ 1,301 $ -- $ 1,301
Municipal obligations 500 -- 500 -- 500
-----------------------------------------------------------------------------------
$ 1,801 $ -- $ 1,801 $ -- $ 1,801
===================================================================================
Marketable securities:
Municipal obligations $ 17,696 $ -- $ 17,696 $ 147 $ 17,843
Debt securities 6,227 (1,217) 5,010 -- 5,010
Equity securities 3,900 (343) 3,557 10 3,567
Certificates of deposit 63 -- 63 -- 63
-----------------------------------------------------------------------------------
$ 27,886 $ (1,560) $ 26,326 $ 157 $ 26,483
===================================================================================
The Adjustments toUnrealized Estimated
Holding Market
March 31, 2003 Cost Basis column includes a $1.6 million loss as ofGains/(Losses) Value
------------------------------------------------
Cash equivalents:
Money market funds $ 103 -- $ 103
Municipal obligations 2,200 -- 2,200
------------------------------------------------
$ 2,303 $ -- $ 2,303
================================================
Marketable securities:
Municipal obligations $ 13,071 $ 256 $ 13,327
================================================
Unrealized Estimated
Holding Market
December 31, 2001 recorded for an other than temporary decline in the2002 Cost Basis Gains/(Losses) Value
------------------------------------------------
Cash equivalents:
Money market value of
debt and equity securities.funds $ 52 $ -- $ 52
Municipal obligations 7,175 -- 7,175
------------------------------------------------
$ 7,227 $ -- $ 7,227
================================================
Marketable securities:
Municipal obligations $ 14,276 $ 307 $ 14,583
================================================
Differences between cost and market listed above, consisting of a net unrealized
holding gain less deferred taxes of $106,000$87,000 at September 30, 2002March 31, 2003 and $50,000$104,000 as of
December 31, 2001,2002, are included in the accumulated other comprehensive income
account of shareholders' equity.
The marketable securities of $15.9$13.3 million on September 30, 2002March 31, 2003 and $26.5$14.6 million
on December 31, 20012002 had maturity dates as follows: approximately $1.3$2.0 million
and zero,$1.2 million, respectively, had a maturity date of less than 90 days,
approximately $3.2$8.0 million and $3.4$8.0 million, respectively, had a maturity date
between 90 days and 1 year, and approximately $11.4$3.3 million and $14.5$5.4 million,
respectively, had a maturity date between 1 and 5 years, and approximately zero
and $8.6 million matured in more than 5 years or did not have a maturity date.years.
9
NOTE 4 - INVENTORIES
Inventories are comprised of the following (in thousands):
September 30,March 31, December 31,
2003 2002
2001
----------------------------------------------------------------
(Unaudited)
Raw materials $ 2,5982,542 $ 1,9872,341
Work-in-process 264 1,183388 306
Finished goods 1,797 3,089
---------------------------------1,773 1,938
-------------------------------
$ 4,6594,703 $ 6,259
=================================
In the third quarter of 2002, the Company recorded a $3.1 million write-down of
bioprosthetic valves, including SynerGraft(R) and non-SynerGraft treated porcine
heart valves, due to the Company's decision to stop future expenditures on the
development and marketing of these valves and to maintain its focus on its
preservation services business, and its BioGlue(R) and SynerGraft vascular graft
product lines.4,585
===============================
NOTE 5 - EARNINGS/(LOSS) PER SHARE
The following table sets forth the computation of basic and diluted
earnings/(loss) per share (in thousands, except per share data):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------
Numerator for basic and diluted earnings
per share:
Net (loss) income available to common
shareholders $ (19,646) $ 2,692 $ (22,064) $ 7,202
=============================== ==============================
Denominator for basic earnings per share:
Weighted-average basis 19,526 18,832 19,388 18,785
Effect of dilutive stock options -- 939 -- 850
------------------------------- ------------------------------
Denominator for diluted earnings per share:
Adjusted weighted-average shares 19,526 19,771 19,388 19,635
=============================== ==============================
Net (loss) earnings per share:
Basic $ (1.01) $ 0.14 $ (1.14) $ 0.38
=============================== ==============================
Diluted $ (1.01) $ 0.14 $ (1.14) $ 0.37
=============================== ==============================
The effects of stock options of 791,000 and 975,000 shares for the three and
nine months ended September 30, 2002, respectively, were excluded from the
calculation because the amounts are antidilutive for the periods presented.
On July 23, 2002 the Company's Board of Directors authorized the purchase of up
to $10 million of its common stock. As of August 13, 2002 the Company had
repurchased 68,000 shares of its common stock for $663,000. No further purchases
are anticipated in the near term.
NOTE 6 - DEBT
On April 25, 2000 the Company entered into a loan agreement permitting the
Company to borrow up to $8 million under a line of credit during the expansion
of the Company's corporate headquarters and manufacturing facilities. Borrowings
under the line of credit accrued interest equal to Adjusted LIBOR plus 2%
adjusted monthly. On June 1, 2001 the line of credit was converted to a term
loan (the "Term Loan") to be paid in 60 equal monthly installments of principal
10
plus interest computed at Adjusted LIBOR plus 1.5% (3.32%(2.84% at September 30,
2002)March 31, 2003). At
September 30, 2002March 31, 2003 the principal balance of the Term Loan was $6.0$5.2 million. The Term
Loan is secured by substantially all of the Company's assets. The Term Loan
contains certain restrictive covenants including, but not limited to,
maintenance of certain financial ratios, a minimum tangible net worth
requirement, and the requirement that no materially adverse event has occurred.
The lender has notified the Company that the FDA Order, as described in Note 2,
and the inquiries of the SEC, as described in Note 11,the Company's Form 10-K for the
year ended December 31, 2002, as amended, have had a material adverse effect on
the Company that constitutes an event of default. Additionally, as of September 30, 2002,March 31,
2003, the Company is in violation of the debt coverage ratio and net worth
financial covenants. As of October 28, 2002April 30, 2003 the lender has elected not to declare
an event of default, but reserves the right to exercise any such right under the
terms of the Term Loan. Therefore, all amounts due under the Term Loan as of
September 30, 2002March 31, 2003 are reflected as a current liability on the Summary Consolidated
Balance Sheets.
In March 1997 the Company issued a $5.0 million convertible debenture in
connection with the Ideas for Medicine, Inc. acquisition. The debenture accrued
interest at 7% and was convertible into common stock of the Company at any time
prior to the due date of March 5, 2002 at $8.05 per common share. On March 30,
1998 $607,000 of the convertible debenture was converted into 75,000 shares of
the Company's common stock, and on March 4, 2002 the remaining $4.4 million was
converted into 546,000 shares of the Company's common stock.
On July 30, 2002 the Company entered into a line of credit agreement with the
same lender as for the Term Loan, permitting the Company to borrow up to $10
million. Borrowings under the line of credit agreement accrue interest equal to
Adjusted LIBOR plus 1.25% adjusted monthly. This loan is secured by
substantially all of the Company's assets. As of September 30, 2002 no amounts
were drawn on the line of credit. As a result of the FDA Order, as discussed in
Note 2, the Company is not in compliance with the lender's requirements for
advances of funds under the line of credit. On August 21, 2002 the lender
notified the Company that it was not entitled to any further advances under the
line of credit.
NOTE 76 - DERIVATIVES
The Company's Term Loan, which accrues interest computed at Adjusted LIBOR plus
1.5%, exposes the Company to changes in interest rates going forward. On March
16, 2000 the Company entered into a $4.0 million notional amount
forward-starting interest swap agreement, which took effect on June 1, 2001 and
expires in 2006. This swap agreement was designated as a cash flow hedge to
effectively convert a portion of the Term Loan balance to a fixed rate basis,
thus reducing the impact of interest rate changes on future income. This
agreement involves the receipt of floating rate amounts in exchange for fixed
rate interest payments over the life of the agreement, without an exchange of
the underlying principal amounts. The differential to be paid or received is
recognized in the period in which it accrues as an adjustment to interest
expense on the Term Loan.
On January 1, 2001 the Company adopted SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133") as amended. SFAS 133 requires
the Company to recognize all derivative instruments on the balance sheet at fair
value, and changes in the derivative's fair value must be recognized currently
in earnings or other comprehensive income, as applicable. The adoption of SFAS
133 impacts the accounting for the Company's forward-starting interest rate swap
agreement. Upon adoption of SFAS 133, the Company recorded an unrealized loss of
approximately $175,000 related to the interest rate swap, which was recorded as
part of long-term liabilities and accumulated other comprehensive income as the
cumulative effect of adopting SFAS 133 within the Statement of Shareholders'
Equity.
In August 2002 the Company determined that changes in the derivative's fair
value could no longer be recorded in other comprehensive income, as a result of
the uncertainty of future cash payments on the Term Loan caused by the lender's
ability to declare an event of default as discussed in Note 6.5. Beginning in
August 2002 the Company is recordingrecords all changes in the fair value of the derivative
10
currently in other expense/income on the Summary Consolidated 11
Statements of
Operation,Operations, and is amortizing the amounts previously recorded in other
comprehensive income into other expense/income over the remaining life of the
agreement. If the lender accelerates the payments due under the Term Loan by
declaring an event of default, any remaining balance in other comprehensive
income will be reclassed into other expense/income during that period.
At September 30, 2002March 31, 2003 the notional amount of this swap agreement was $3.0$2.6 million,
and the fair value of the interest rate swap agreement, as estimated by the bank
based on its internal valuation models, was a liability of $305,000.$252,000. The fair
value of the swap agreement is recorded as part of long-termshort-term liabilities. For
the three and nine months ended September 30, 2002March 31, 2003 the Company recorded a loss of $26,000$19,000 on
the interest rate swap. The unamortized value of the swap agreement, recorded in
the accumulated other comprehensive income account of shareholders' equity, was
$279,000$241,000 at September 30, 2002.March 31, 2003.
NOTE 87 - COMPREHENSIVE INCOME/(LOSS) ComponentsINCOME
The following is a summary of comprehensive income/(loss) consist of the following, net of taxincome (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------
Net (loss) income $ (19,646) $ 2,692 $ (22,064) $ 7,202
Unrealized gain/(loss) on investments 56 (45) 98 772
Change in fair value of interest rate swap
(including cumulative effect of adopting
SFAS 133 in 2001) (6) (67) 17 (225)
Translation adjustment (12) 176 205 52
------------------------------- ------------------------------
Comprehensive income $ (19,608) $ 2,756 $ (21,744) $ 7,801
===============================March 31,
------------------------------
2003 2002
------------------------------
(Unaudited)
Net (loss) income $ (434) $ 3,104
Unrealized loss on investments (34) (86)
Change in fair value of interest rate swap
(including cumulative effect of adopting
SFAS 133 in 2001) 13 8
Translation adjustment (158) (33)
------------------------------
Comprehensive (loss) income $ (613) $ 2,993
==============================
The tax effect on the change in unrealized gain/loss on investments is $29,000$17,000
and zero$39,000 for the three months ended September 30,March 31, 2003 and 2002, and 2001, respectively.
The tax effect for the nine months ended September 30, 2002 and 2001 is $56,000
and $398,000, respectively.
The tax effect on the change in fair value of the interest rate swap is $4,000an
expense of $6,000 and $34,000a benefit of $5,000 for the three months ended September
30,March 31,
2003 and 2002, and 2001, respectively. The tax effect foron the nine months ended
September 30, 2002 and 2001 is $2,000 and $115,000, respectively. The translation adjustment is
not currently$110,000 and zero for the three months ended March 31, 2003 and 2002,
respectively.
11
NOTE 8 - (LOSS) EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted (loss)
earnings per share (in thousands, except per share data):
Three Months Ended
March 31,
-------------------------------
2003 2002
-------------------------------
(Unaudited)
Numerator for basic and diluted earnings
per share - (loss) income available to
common shareholders $ (434) $ 3,104
===============================
Denominator for basic earnings per share -
weighted-average basis 19,634 19,096
Effect of dilutive stock options -- 700
-------------------------------
Denominator for diluted earnings per share -
adjusted weighted-average shares 19,634 19,796
===============================
(Loss) earnings per share:
Basic $ (0.02) $ 0.16
===============================
Diluted $ (0.02) $ 0.16
===============================
The effect of stock options of 364,000 shares for income taxes, as it relatesthe three months ended March
31, 2003, was excluded from the calculation because this amount is antidilutive
for the period presented.
On July 23, 2002 the Company's Board of Directors authorized the purchase of up
to a permanent investment$10 million of its common stock. As of August 13, 2002 the Company had
repurchased 68,000 shares of its common stock for $663,000. No further purchases
are anticipated in a foreign subsidiary.the near term.
NOTE 9 - ACCOUNTING PRONOUNCEMENTSSTOCK-BASED COMPENSATION
On January 1,December 31, 2002 the Company was required to adopt SFAS 142No. 148, "Accounting
for Stock-Based Compensation - Transition and Disclosure" ("SFAS 144.148"). SFAS 142 specifies148
amends SFAS No. 123, "Accounting for Stock-Based Compensation" to provide
alternative methods of transition for companies that goodwillvoluntarily elect to adopt
the fair value recognition and certain other intangible assets willmeasurement methodology prescribed by SFAS 123.
In addition, regardless of the method a company elects to account for
stock-based compensation arrangements, SFAS 148 requires additional disclosures
in the footnotes of both interim and annual financial statements regarding the
method the company uses to account for stock-based compensation and the effect
of such method on the Company's reported results. The adoption of SFAS 148 did
not have a material effect on the financial position, results of operations, and
cash flows of the Company.
The Company has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" and related interpretations ("APB
25") in accounting for its employee stock options because, as discussed below,
the alternative fair value accounting provided for under SFAS 123 requires use
of option valuation models that were not developed for use in valuing employee
stock options. Under APB 25, because the exercise price of the Company's
employee stock options equals the market price of the underlying stock on the
date of the grant, no longercompensation expense is recognized.
Pro forma information regarding net income and earnings per share is required by
SFAS 123, which requires that the information be amortized but instead will be subject to periodic impairment testing. SFAS
144 clarifies accounting and reportingdetermined as if the Company
has accounted for assets heldits employee stock options granted under the fair value method
of that statement. The fair values for sale, scheduledthese options were estimated at the dates
of grant using a Black-Scholes option pricing model with the following
weighted-average assumptions:
12
Three Months Ended
March 31,
-------------------------------
2003 2002
-------------------------------
(Unaudited)
Expected dividend yield 0% 0%
Expected stock price volatility .617 .630
Risk-free interest rate 2.49% 3.67%
Expected life of options 4.0 Years 5.3 Years
The Black-Scholes option valuation model was developed for abandonment or other disposal, and recognition of impairment loss related touse in estimating the
carryingfair value of long-lived assets. See Note 2 fortraded options which have no vesting restrictions and are fully
transferable. In addition option valuation models require the input of highly
subjective assumptions, including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different from those of traded options and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a discussionreliable single
measure of the impactfair value of these two statements onits employee stock options.
For purposes of pro forma disclosures, the current quarter results.estimated fair values of the options
are amortized to expense over the options' vesting periods. The Company's pro
forma information follows (in thousands, except per share data):
Three Months Ended
March 31,
-------------------------------
2003 2002
-------------------------------
(Unaudited)
Net (loss) income--as reported $ (434) $ 3,104
Deduct: Total stock-based employee
compensation expense determined under
the fair value based method for all awards,
net of tax 128 160
-------------------------------
Net (loss) income--pro forma $ (562) $ 2,944
==============================
(Loss) earnings per share--as reported:
Basic $ (0.02) $ 0.16
===============================
Diluted $ (0.02) $ 0.16
===============================
(Loss) earnings per share--proforma:
Basic $ (0.03) $ 0.15
===============================
Diluted $ (0.03) $ 0.15
===============================
NOTE 10 - ACCOUNTING PRONOUNCEMENTS
The Company will bewas required to adopt SFAS No. 143, "Accounting for Asset Retirement
Obligations" ("SFAS 143") on January 1, 2003. SFAS 143 addresses accounting and
reporting for retirement costs of long-lived assets resulting from legal
obligations associated with acquisition, construction, or development
transactions. The Company has determined that the adoption of SFAS 143 willdid not have a material effect on the
results of operations or financial position of the Company.
The Company will bewas required to adopt SFAS No. 145, "Rescission of FASB Statements
4, 44 and 64, Amendment to FASB Statement 13, and Technical Corrections" ("SFAS
145"), on January 1, 2003. SFAS 145 rescinds SFAS No. 4, 44 and 64, which
required gains and losses from extinguishments of debt to be 12
classified as
extraordinary items. SFAS 145 also amends SFAS No. 13 eliminating
inconsistencies in certain sale-leaseback transactions. The provisions of SFAS
145 are effective for fiscal years beginning after May 15, 2002. The Company is
currently evaluatingadoption of
SFAS 145 did not have a material effect on the impactresults of this Statement.operations or
financial position of the Company.
13
The Company will bewas required to adopt SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities" ("SFAS 146") on January 1, 2003. SFAS 146
requires that costs associated with exit or disposal activities be recorded at
their fair values when a liability has been incurred. Under previous guidance,
certain exit costs were accrued upon management's commitment to an exit plan,
which is generally before an actual liability has been incurred. The Company is currently evaluatingadoption of
SFAS 146 did not have a material effect on the impactresults of this Statement.operations or
financial position of the Company.
NOTE 1011 - SEGMENT INFORMATION
The Company has two reportable segments: Human Tissue Preservation Services and
Implantable Medical Devices. The Company's segments are organized according to
services and products.
The HUMAN TISSUE PRESERVATION SERVICES segment includes external revenue from
cryopreservation services of cardiac, vascular, and orthopaedic allograft
tissues. The IMPLANTABLE MEDICAL DEVICES segment includes external revenue from
product sales of BioGlue Surgical Adhesive, and bioprosthetic devices, including
stentless porcine heart valves, SynerGraft treated porcine heart valves, and
SynerGraft treated bovine vascular grafts.grafts, and Cerasorb(R) Ortho bone graft
substitute. There are no intersegment revenues.
The primary measure of segment performance, as viewed by the Company's
management, is segment gross margin, or net external revenues less cost of
preservation services and products. The Company does not segregate assets by
segment, therefore asset information is excluded from the segment disclosures
below.
The following table summarizes revenues, cost of preservation services and
products, and gross margins for the Company's operating segments (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------Three Months Ended
March 31
-------------------------------
2003 2002
-------------------------------
(Unaudited)
Revenue:
Human tissue preservation services, net a 11,300 19,737 49,074 57,069
Implantable medical devices 5,354 2,600 15,892 8,029
All other b 235 230 658 598
------------------------------- ------------------------------
$ 16,889 $ 22,567 $ 65,624 $ 65,696
------------------------------- ------------------------------
Cost of Preservation Services and Products:
Human tissue preservation services c 27,978 8,188 53,244 23,558
Implantable medical devices 4,739 1,196 8,817 4,051
All other b -- -- -- --
------------------------------- ------------------------------
32,717 9,384 62,061 27,609
------------------------------- ------------------------------
Gross Margin (Loss):
Human tissue preservation services (16,678) 11,549 (4,170) 33,511
Implantable medical devices 615 1,404 7,075 3,978
All other b 235 230 658 598
------------------------------- ------------------------------
$ (15,828) $ 13,183 $ 3,563 $ 38,087
------------------------------- ------------------------------
a Revenue from human tissue preservation services includes the estimated
effect9,130 20,238
Implantable medical devices 6,599 5,065
All other(a) 191 168
-------------------------------
$ 15,920 $ 25,471
-------------------------------
Cost of the return of tissues subject to recall by the FDA Order of $1.0
millionPreservation Services and $3.5 million, respectively, in the three and nine months ended
September 30, 2002.
bProducts:
Human tissue preservation services 2,443 8,063
Implantable medical devices 1,641 2,235
All other(a) -- --
-------------------------------
4,084 10,298
-------------------------------
Gross Margin (Loss):
Human tissue preservation services 6,687 12,175
Implantable medical devices 4,958 2,830
All other(a) 191 168
-------------------------------
$ 11,836 $ 15,173
-------------------------------
- ----------
(a) The "All other" designation includes 1) grant revenue and 2) distribution
revenue.
1314
c Cost of human tissue preservation services includes the write-down of
deferred preservation costs for tissues subject to the FDA Order of $22.7
and $32.7 million, respectively, in the three and nine months ended
September 30, 2002.
The following table summarizes net revenues by product (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------Three Months Ended
March 31
-------------------------------
2003 2002
-------------------------------
(Unaudited)
Revenue:
Human tissue preservation services, net a:
Cardiovascular tissue $ 5,487 $ 8,209 $ 20,131 $ 22,307
Vascular tissue 3,260 6,192 14,918 18,617
Orthopaedic tissue 2,553 5,336 14,025 16,145
------------------------------- ------------------------------
Total preservation services 11,300 19,737 49,074 57,069
------------------------------- ------------------------------
BioGlue surgical adhesive 5,183 2,431 15,308 7,505
Bioprosthetic devices 171 169 584 524
Distribution and grant 235 230 658 598
------------------------------- ------------------------------
$ 16,889 $ 22,567 $ 65,624 $ 65,696
=============================== ==============================
a Revenue from tissue preservation services:
Cardiovascular tissue $ 4,725 $ 7,307
Vascular tissue 4,255 7,017
Orthopaedic tissue 150 5,914
-------------------------------
Total preservation services includes the estimated effect of
the return of tissues subject to recall by the FDA Order of $170,0009,130 20,238
-------------------------------
BioGlue surgical adhesive 6,494 4,873
Other implantable medical devices 105 192
Distribution and $510,000, respectively, in cardiovascular tissue, $833,000 and $2.5 million,
respectively, in vascular tissue, and $28,000 and $408,000, respectively, in
orthopaedic tissue, totaling $1.0 and $3.5 million, respectively, for the
three and nine months ended September 30, 2002.grant 191 168
-------------------------------
$ 15,920 $ 25,471
===============================
NOTE 1112 - COMMITMENTS AND CONTINGENCIES
In the normal course of business as a medical device and services company, the
Company has product liability complaints filed against it. As of OctoberApril 28, 2002 fifteen2003
twenty-three cases had beenwere open that were filed against the Company between May 18,
2000 and October 8, 2002.April 14, 2003. The cases are currently in the pre-discovery or
discovery stages. Of these cases, nine15 allege product liability claims arising out
of the Company's orthopaedic tissue fourservices, seven allege product liability
claims arising out of the Company's allograft heart valve tissue one alleges product liability
claims arising out of the Company's allograft vascular tissue,services, and
one alleges product liability claims arising out of the non-tissue products made
by Ideas for Medicine, when it was a subsidiary of the Company.
IncludedOn March 31, 2003 the Company announced that a settlement has been reached in
these cases is the lawsuit brought against the Company by the estate of Brian Lykins. The
complaint filed against the Company in the Superior Court of Cobb County,
Georgia, on July 12, 2002 by Steve Lykins, as Trustee for the benefit of next of
kin of Brian Lykins. This complaint allegesLykins alleged strict liability, negligence, professional negligence, and breach of
warranties related to tissue implanted in November 2001. In addition to this
lawsuit, three other lawsuits have been dismissed or were settled during the
first quarter of 2001.2003. The plaintiff seeks unspecified
compensatorytotal settlements involved in these cases including
amounts paid by the Company and punitive damages.its insurer were less than 10% of total current
assets at March 31, 2003.
The Company maintains claims-made insurance policies, which the Company believes
to be adequate to defend against these suits. The Company's insurance company
has been notified of these actions. The Company intends to vigorously defend
against these claims. Nonetheless, an adverse judgment or judgments imposing
aggregate liabilities in excess of the Company's insurance coverage could have a
material adverse effect on the Company's financial position, results of
operations, and cash flows.
Claims-made insurance policies cover only those asserted claims and incidents
that are reported to the insurance carrier while the policy is in effect. Thus,
a claims-made policy does not represent a transfer of risk for claims and
incidents that have been incurred but not reported to the insurance carrier. The
Company periodically evaluates its exposure to unreported product liability
claims, and records accruals as necessary for the estimated cost of unreported
claims related to services performed and products sold. As of December 31, 2002
the Company accrued $3.6 million in estimated costs for unreported product
liability claims related to services performed and products sold prior to
December 31, 2002. The expense was recorded in 2002 in general, administrative,
and marketing expenses and was included as a component of accrued expenses and
other current liabilities on the Summary Consolidated Balance Sheets. As of
March 31, 2003 the accrual for unreported product liability claims remained
unchanged for services performed and products sold prior to March 31, 2003.
The Company has concluded that it is probable that it will incur losses relating
to asserted claims and pending litigation of at least $1.2 million, which
represents the aggregate amount of the Company's retention under its product
15
liability and directors' and officers' insurance policies. Therefore, the
Company recorded an accrual of $1.2 million during 2002. As of March 31, 2003
the remaining accrual for the retention levels decreased to $750,000 due to
required insurance retention payments made related to legal settlements reached
during the first quarter of 2003.
Several putative class action lawsuits were filed in July through September 2002
against the Company and certain officers of the Company, alleging that the
defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of
1934 and Rule 10b-5 promulgated there under,thereunder by issuing a series of purportedly
materially false and misleading statements to the market throughoutmarket. During the Class Period of
August of 2000 through Augustthird
quarter of 2002 which statements had the effectCourt consolidated the suits, and on November 14, 2002 lead
plaintiffs and lead counsel were named. A consolidated complaint was filed on
January 15, 2003, seeking the Court's certification of artificially inflating the market pricelitigation as a class
action on behalf of all purchasers of the Company's securities.stock between April 2, 2001
and August 14, 2002. The
14
principal allegations of the complaintsconsolidated complaint are
that the Company failed to disclose its alleged lack of compliance with certain
FDA regulations regarding the handling and processing of certain tissues and
other product safety matters. TheIn the consolidated complaint, plaintiffs seek unspecifiedto
recover compensatory damages in an amount to be proven at
trial.and various fees and expenses of litigation,
including attorneys' fees. The Company believes these cases will beand the other defendants filed a motion
to dismiss the consolidated into one putative
class action lawsuit. The Company believescomplaint on February 28, 2003 which remains pending
before the claims made in the lawsuits are
without merit and intends to vigorously defend against these claims. Management
has retained the services of the Atlanta based law firm of King & Spalding to
defend the Company.Court. The Company carries director'sdirectors' and officer'sofficers' liability
insurance policies, which the Company believes to be adequate to defend against
these
suits.this action. Nonetheless, an adverse judgment in excess of the Company's
insurance coverage could have a material adverse effect on the Company's
financial position, results of operations, and cash flows.
The Company received notice in October thatOn August 30, 2002 a complaint had been filed
instituting apurported shareholder derivative action was filed by
Rosemary Lichtenberger against the Company and Company
officers and directors Steven G. Anderson, Albert E. Heacox, John W.
Cook, Ronald C. Elkins, Virginia C. Lacy, Ronald D. McCall, Alexander C.
Schwartz, and Bruce J. Van Dyne. The suit was filedDyne in the Superior Court of Gwinnett County,
Georgia, by Rosemary Lichtenberger but has not been served on the defendants.Georgia. The suit, which names the Company as a nominal defendant, alleges that
the individual defendants breached their fiduciary duties to the Company by
causing or allowing the Company to engage in certain inappropriate practices
that caused the Company to suffer damagesdamages. The complaint was preceded by being outone day
by a letter written on behalf of compliance with FDA
guidelines, andMs. Lichtenberger demanding that the Company's
Board of Directors take certain actions in response to her allegations. On
January 16, 2003 another purported derivative suit alleging claims similar to
those of the Lichtenberger suit was filed in the Superior Court of Fulton County
by causingcomplainant Robert F. Frailey. As in the CompanyLichtenberger suit, the filing of
the complaint in the Frailey action was preceded by a purported demand letter
sent on Frailey's behalf to issue press releases that erroneously
portrayed CryoLife's products, operations, financial results and future
prospects. The complainant seeksthe Company's Board of Directors. Both complaints
seek undisclosed damages, costs and attorney's fees, punitive damages and
prejudgment interest against the individual defendants derivatively on behalf of
the Company as a nominal defendant. Filing of the
complaint was preceded by a demand letter on behalf of the complainant dated one
day prior to the filing of the suit. Another derivative demand letter of similar
import was received on behalf of complainant Robert F. Fraley; however, to the
Company's knowledge, no suit has yet been filed by Mr. Fraley.Company. The Company's Board of Directors has established an independent
committee to investigate the claims asserted in theallegations of Ms. Lichtenberger complaint and the demands made in the
Fraley letter and report back to the Board with its recommendations for action
in response to the shareholders' demands.Mr. Frailey.
The independent committee has engaged independent legal counsel to assist in the
investigation.investigation and that investigation is currently proceeding.
NOTE 13 - SUBSEQUENT EVENTS
On August 7, 2002April 11, 2003 the Company announcedentered into an agreement to finance $1.4 million
in insurance premiums associated with the settlementyearly renewal of its ongoing litigation
with Colorado State University Research Foundation ("CSURF") over the ownershipcertain of the
Company's SynerGraft technology. The settlement resolves all disputes
between the parties and extinguishes all CSURF ownership claims to any aspect of
the Company's SynerGraft technology. The settlement includes an unconditional
assignment to the Company of CSURF tissue engineering patents, trade secrets and
know-how relating to tissue decellularization and recellularization. The
technology assignment supercedes the 1996 technology license, which was
terminated by the terms of the settlement. Payment terms include a nonrefundable
advance of $400,000 paid by the Company to CSURF that will be applied to earned
royalties as they accrue through March 2011. The Company recorded these amounts
as prepaid royalties and will expense the amounts as the royalties accrue. The
earned royalty rate is a maximum of 0.75% of net revenues from products or
tissue services utilizing the SynerGraft technology. Royalties earned under the
agreement for revenues through September 30, 2002 were approximately $33,000.
On August 17, 2002 the Company received a letter from the United States
Securities and Exchange Commission (the "SEC Letter") that stated that the
Company was subject to an investigation related to the Company's August 14, 2002
announcement of the FDA Order and requesting information from the Company from
the period between September 1, 2001 through the date of the Company's response
to the SEC Letter. The SEC Letter stated, in part, that "We are trying to
determine whether there have been any violations of the federal securities laws.
The investigation and the subpoena do not mean that we have concluded that
anyone has broken the law. Also, the investigation does not mean that we have a
negative opinion of any person, entity or security." The staff of the SEC
subsequently confirmed that its investigation is informal in nature, and that it
does not have subpoena power at this time. At the present time, the Company is
unable to predict the outcome of this matter.
15
The Company has concluded that it is probable that it will incur losses relating
to claims and litigation of at least $1.2 million; which represents the
aggregate amount of the Company's deductibles under its product liability and
directors' and officers' insurance policies. Therefore the Company has recorded
an accrual of $1.2 million as of June 30, 2002.The amount financed accrues interest at a 3.75%
rate and is payable in equal monthly payments over a nine month period.
16
PART I - FINANCIAL INFORMATION
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
RECENT EVENTS
On August 13,February 5, 2003 the Company announced that it had signed an exclusive
agreement with curasan AG, located in Germany, for United States distribution of
Cerasorb(R) Ortho, curasan's resorbable bone graft substitute. The five-year
agreement gives CryoLife exclusive rights to market Cerasorb Ortho for all
non-spine, non-dental orthopaedic indications such as trauma, general, and
sports medicine. Cerasorb, a resorbable, beta-tricalcium phosphate bone
regeneration material, was first introduced in Germany in 1998 for dental use.
The product captured approximately 60% of the synthetic dental bone regeneration
market in Germany within four years. In 2001 curasan received CE Mark
certification for Cerasorb's use in general orthopaedics, and in 2002 received
FDA 510(k) approval for orthopaedic use. The Company anticipates that the United
States market for bone grafts and substitutes for which it can distribute
Cerasorb is approximately $140 million annually.
A new FDA 483 Notice of Observations was issued in connection with the FDA
inspection in February of 2003, but corrective action was implemented on most of
its observations during the inspection. The Company believes the observations,
most of which focus on the Company's systems for handling complaints and
validation of test methods, will not materially affect the Company's operations.
If the Company is unable to satisfactorily respond to the FDA's observations
contained in this notice, the FDA could take further action, which could have a
material adverse effect on the Company's business, results of operations,
financial position, or cash flows. The Company resumed limited processing of
orthopaedic tissues in late February 2003 following the FDA inspection. The
Company plans to resume distribution of orthopaedic tissues.
On February 20, 2003 the Company received an ordera letter from the Atlanta district
officeFDA stating that a
510(k) premarket notification should be filed for the Company's CryoValve SG and
that premarket approval marketing authorization should be obtained for the
Company's CryoVein SG when used for arteriovenous ("A-V") access. The agency's
position is that use of the SynerGraft technology in the processing of allograft
heart valves represents a modification to the Company's legally marketed
CryoValve allograft, and that femoral veins used for A-V access are medical
devices that require premarket approval. The FDA letter did not question the
safety or efficacy of the SynerGraft process or the CryoVein A-V access implant.
The FDA has advised the Company that its CryoValve SG and CryoVein SG used for
AV access will be regulated as medical devices. The Company is in discussions
with the FDA about the type of clearances necessary for these products. The
Company has voluntarily suspended use of the SynerGraft technology in the
processing of allograft heart valves and vascular tissue until the regulatory
status of the CryoValve SG and CryoVein SG is resolved. The FDA has not
suggested that these tissues be recalled. Until such time as the issues
surrounding the SynerGraft tissue are resolved, the Company will employ its
traditional processing methods on these tissues. Distribution of allograft heart
valves and vascular tissue processed using the Company's traditional processing
protocols will continue. The outcome of the discussions with the FDA regarding
the non-valved cardiac, vascular, and orthopaedic
tissue processed byuse of the Company since October 3, 2001 (the "FDA Order"). Revenue
fromSynerGraft process on human tissue preservation services accounted for 78%could result in a reduction in
SynerGraft processed cardiovascular and vascular tissue which would reduce the
revenues and gross margins with respect to cardiovascular and vascular tissues.
Considering additional costs associated with processing SynerGraft cardiac and
vascular tissues, the potential net financial impact from not utilizing the
SynerGraft technology in cardiac and vascular tissue processing is estimated to
be approximately 10% of the Company'scardiac and vascular revenues for the six months ended June 30, 2002, and of those revenues 67% or
$26.9 million were derived from
preservation of tissues subject to the FDA
Order. The Company announced the receipt of the FDA Order in a press release
dated August 14, 2002. The FDA Order follows an FDA Warning Letter dated June
17, 2002, whichSynerGraft processing.
On March 31, 2003 the Company announced that a settlement has been reached in
a press release dated June 24, 2002.
Subsequently,the lawsuit brought against the Company responded to the Warning Letter and requested a
meeting with the FDA. The FDA Order contains the following principal provisions:
o The FDA alleges that, based on its inspection of the Company's facility
on March 25 through April 12, 2002, certain human tissue processed and
distributed by the Company may be in violationestate of 21 Code of Federal
Regulations ("CFR") Part 1270. (Part 1270 requires persons or entities
engaged in the recovery, screening, testing, processing, storage, or
distribution of human tissue to perform certain medical screening and
testing on human tissue intended for transplantation. The rule also
imposes requirements regarding procedures for the prevention of
contamination or cross-contamination of tissues during processing and
the maintenance of certain records related to these activities.)
o The FDA alleges that the Company has not validated procedures for the
prevention of infectious disease contamination or cross-contamination
of tissue during processing at least since October 3, 2001.
o Non-valved cardiac, vascular, and orthopaedic tissue processed by the
Company since October 3, 2001 must be retained until it is recalled,
destroyed, the safety is confirmed, or an agreement is reached with the
FDA for its proper disposition under the supervision of an authorized
official of the FDA.
o The FDA strongly recommends that the Company perform a retrospective
review of all tissue in inventory (i.e. currently in storage at the
Company) that is not referenced in the FDA Order to assure that it was
recovered, processed, stored, and distributed in conformance with 21
CFR 1270.
o The Center for Devices and Radiological Health ("CDRH"), a division of
the FDA, is evaluating whether there are similar risks that may be
posed by the Company's allograft heart valves, and will take further
regulatory action if appropriate.
Pursuant to the FDA Order, the Company placed all non-valved cardiac, vascular,
and orthopaedic tissue subject to the FDA Order on quality assurance quarantine
and is recalling all non-valved cardiac, vascular, and orthopaedic tissues
subject to the FDA Order (i.e. processed since October 3, 2001) that have been
distributed but not implanted. The Company appealed the FDA Order on August 14,
2002 and requested a hearing with the FDA, which has been set for December 12,
2002. After the FDA issued its order regarding the recall, Health Canada also
issued a recall on the same types of tissue and other countries have inquired
about the circumstances surrounding the FDA Order.
On September 5, 2002, the Company reached an agreement with the FDA (the
"Agreement") that supplements the FDA Order and permits the Company to resume
processing and limited distribution of its life-saving and limb-saving
non-valved cardiac and vascular tissues. The Agreement allows the tissue to be
released for distribution after the Company completes steps to assure that the
tissue is used for approved purposes and that patients will be notified of risks
associated with tissue use. Specifically, the Company must obtain physician
prescriptions and tissue packaging must contain appropriate warning labels. The
Agreement also calls for the Company to undertake to identify third-party
records of donor tissue testing, and to destroy tissue from donors in whom
microorganisms associated with an infection are found. In addition, the
Agreement, which has a forty-five working-day term ending November 7, 2002,
17
specifies interim operating procedures to permit the Company to distribute
tissues processed during the term of the Agreement. The Company also agreed to
establish a corrective action plan within 30 days with steps to validate
processing procedures. The corrective action plan was submitted on October 5,
2002. The FDA will review records and other relevant information related to the
Company's release of tissue under the Agreement, as well as the status of the
Company's corrective action plan, before determining whether this Agreement
should be renewed or modified to provide for any further release of tissue
subject to the FDA Order.
After receiving the FDA Order, the Company met with representatives of the FDA's
CDRH division regarding CDRH's review of the Company's processed allograft heart
valves, which are not required to be recalled pursuant to the FDA Order. On
August 21, 2002 the FDA publicly stated that allograft heart valves have not
been included in the FDA recall order as these devices are essential for the
correction of congenital cardiac lesions in neonate and pediatric patients and
no satisfactory alternative device exists. However, the FDA also publicly stated
that it still has serious concerns regarding the processing and handling of
allograft heart valves. The FDA also recommended that surgeons carefully
consider using processed allografts from alternative sources, that surgeons
inform prospective patients of the FDA's concerns with the Company's allograft
heart valves, and that patients be carefully monitored for both fungal and
bacterial infections.
As a result of the adverse publicity surrounding the FDA Warning Letter, the
Company's procurement of cardiac tissues, from which heart valves and non-valved
cardiac tissues are processed, decreased 15% in September 2002 as compared to
September 2001. Although, the Company expects to be able to maintain the current
level of cardiac tissue procurement if it continues to make progress in
addressing the observations detailed in the Warning Letter, there is no
guarantee that sufficient tissue will be available. The Company has continued to
process and distribute heart valves since the receipt of the FDA Order, as these
tissues are not subject to the FDA Order. The Company reduced the level of
processing for non-valved cardiac tissue to minimum levels after the receipt of
the FDA Order. After the Agreement, the Company resumed processing of non-valved
cardiac tissues under the interim operating procedures.
Upon receipt of the FDA Order, the Company ceased the procurement and processing
of vascular tissues until it entered into the Agreement allowing for interim
processing and distribution of vascular tissues. On September 17, 2002 the
Company resumed the procurement and processing of vascular tissues under the
interim operating procedures. The Company anticipates it will procure and
process vascular tissues at reduced levels as compared to prior year periods at
least until it addresses the observations detailed in the Warning Letter and
evaluates the demand for the vascular tissues.
Upon receipt of the FDA Order, the Company ceased the procurement and processing
of orthopaedic tissues. The Company does not anticipate procuring and processing
additional orthopaedic tissues until after it has satisfied the observations
detailed in the Warning Letter.
As a result of the FDA Order, the Company recorded a reduction to pretax income
of $12.6 million in the quarter ended June 30, 2002. The reduction was comprised
of a net $8.9 million increase to cost of human tissue preservation services, a
$2.4 million reduction to revenues (and accounts receivable) for the estimated
return of the tissues subject to recall by the FDA Order, and a $1.3 million
accrual recorded in general, administrative, and marketing expenses for
retention levels under the Company's product liability and directors' and
officers' insurance policies of $1.2 million (see Note 11), and for estimated
expenses of $75,000 for packaging and handling for the return of affected
tissues under the FDA Order. The net increase of $8.9 million to cost of
preservation services is comprised of a $10.0 million write-down of deferred
preservation costs for tissues subject to the FDA Order, offset by a $1.1
million decrease in cost of preservation services due to the estimated tissue
returns resulting from the FDA Order (the costs of such recalled tissue are
included in the $10.0 million write-down). The Company evaluated many factors in
determining the magnitude of impairment to deferred preservation costs as of
June 30, 2002, including the impact of the FDA Order, the possibility of
continuing action by the FDA or other United States and foreign government
agencies, and the possibility of unfavorable actions by physicians, customers,
procurement organizations, and others. As a result of this evaluation,
management believed that since all non-valved cardiac, vascular, and orthopaedic
allograft tissues processed since October 3, 2001 are under recall pursuant to
18
the FDA Order, and the Company did not know if it would obtain a favorable
resolution of its appeal and request for modification of the FDA Order, the
deferred preservation costs for tissues subject to the FDA Order had been
significantly impaired. The Company estimated that this impairment approximated
the full balance of the deferred preservation costs of the tissues subject to
the FDA Order, which included the tissues stored by the Company and the tissues
to be returned to the Company, and therefore recorded a write-down of $10.0
million for these assets.
In the quarter ended September 30, 2002, the Company recorded a reduction to
pretax income of $24.6 million as a result of the FDA Order. The reduction was
comprised of a net $22.2 million increase to cost of human tissue preservation
services, a $1.4 million write-down of goodwill, and a $1.0 million reduction to
revenues (and accounts receivable) for the estimated return of the tissues
shipped during the third quarter subject to recall by the FDA Order. The net
$22.2 million increase to cost of preservation services is comprised of a $22.7
million write-down of deferred preservation costs, offset by a $0.5 million
decrease in cost of preservation services due to the estimated and actual tissue
returns resulting from the FDA Order (the costs of such recalled tissue are
included in the $22.7 million write-down).
The Company evaluated multiple factors in determining the magnitude of
impairment to deferred preservation costs, including the impact of the current
FDA Order, the possibility of continuing action by the FDA or other United
States and foreign government agencies, the possibility of unfavorable actions
by physicians, customers, procurement organizations, and others, the progress
made to date on the corrective action plan, and the requirement in the Agreement
that tissues subject to the FDA Order be replaced with tissues processed under
validated methods. As a result of this evaluation, management believes that all
tissues subject to the FDA Order as well as the majority of tissues processed
prior to October 3, 2001, including heart valves which are not subject to the
FDA Order, are fully impaired. Management believes that most of the Company's
customers will only order tissues processed under the interim operating
procedures established under the Agreement or tissues processed under future
procedures approved by the FDA once these tissues are available. The Company
anticipates the tissues processed under the interim operating procedures
established under the Agreement will be available early to mid-November. Thus,
the Company has recorded a write-down of deferred preservation costs for
processed tissues in excess of the supply required to meet demand prior to the
release of these interim processed tissues. As of September 30, 2002 the balance
of the deferred preservation costs after the write-down was $545,000 of
allograft heart valves, $176,000 of non-valved cardiac tissues, $931,000 of
vascular tissues, and $10,000 of orthopaedic tissues.
As a result of the write-down of deferred preservation costs, the Company has
recorded a deferred tax asset of $12.2 million. Upon destruction of the tissues
associated with the deferred preservation costs, the deferred tax asset will be
reclassed as an income tax receivable. An expected refund will be generated
through a carry back of losses resulting from the deferred preservation cost
write-downs. In addition, the Company has recorded $4.2 million in income tax
receivables related to $1.7 million of tax overpayments for 2001 and an
estimated $2.5 million of tax overpayments for 2002.
Statement of Financial Accounting Standards No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), requires the
write-down of a long-lived asset to be held and used if the carrying value of
the asset or the asset group to which the asset belongs, is not recoverable and
exceeds its fair value. The asset or asset group is not recoverable if its
carrying value exceeds the sum of the undiscounted future cash flows expected to
result from the use and eventual disposition of the asset or asset group. In
applying SFAS 144, the Company determined that the asset groups consisted of the
long-lived assets related to the Company's two reporting segments, as these
represent the lowest level for which identifiable cash flows are largely
independent of the cash flows of other assets and liabilities. The Company used
a fourteen-year period for the undiscounted future cash flows. This period of
time was selected based upon the remaining life of the primary assets of the
asset groups, which are leasehold improvements. Based on its analysis,
management does not believe an impairment of the Company's intangible and
tangible assets related to the tissue preservation business or medical device
business had occurred as of September 30, 2002. However, depending on the
Company's ability to address the observations detailed in the Warning Letter and
the future effects of adverse publicity surrounding the FDA Order and reported
infections on preservation revenues, these assets may become impaired.
Management will continue to evaluate the recoverability of these assets.
19
Goodwill resulting from business acquisitions is not amortized, but is instead
subject to periodic impairment testing in accordance with SFAS No. 142,
"Goodwill and Other Intangible Assets" ("SFAS 142"). As a result of the FDA
Order, the Company determined that an evaluation of the possible impairment of
intangible assets under SFAS 142 was necessary. The Company engaged an
independent valuation expert to perform the valuation using a discounted cash
flow methodology, and as a result of this analysis, the Company determined that
goodwill related to its tissue processing reportable unit was fully impaired as
of September 30, 2002. Therefore, the Company recorded a write-down of $1.4
million in goodwill during the quarter ended September 30, 2002. Management does
not believe an impairment exists related to the other intangible assets.
Management will continue to evaluate the recoverability of these intangible
assets.
On September 3, 2002 the Company announced a reduction in employee force of
approximately 105 employees. The Company anticipates that severance and related
costs will be approximately $690,000, which was recorded in the third quarter of
2002. As a result of the employee reduction, management anticipates personnel
costs will be reduced by approximately $385,000 per month.Brian Lykins. See Part
II, Item 1 "Legal Proceedings" for a discussion of certain material
legal proceedings.further discussion.
CRITICAL ACCOUNTING POLICIES
A summary of the Company's significant accounting policies is included in Note 1
to the consolidated financial statements, as filed in the Form 10-K for the
fiscal year ended December 31, 2001.2002, as amended. Management believes that the
consistent application of these policies enables the Company to provide users of
17
the financial statements with useful and reliable information about the
Company's operating results and financial condition. The consolidated financial
statements are prepared in accordance with accounting principles generally
accepted in the United States, which require the Company to make estimates and
assumptions. The following are accounting policies that management believes are
most important to the portrayal of the Company's financial condition and results
and may involve a higher degree of judgment and complexity.
REVENUE RECOGNITION: The Company recognizes revenue in accordance with SEC Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB
101"), which provides guidance on applying generally accepted accounting
principles to revenue recognition issues. Revenues for human tissue preservation
services are recognized when services are completed and tissue is delivered to
the customer. The Company accepts returned human tissue within 72 hours of
original shipment if certain quality criteria are maintained. The Company has
recorded the estimated revenues of tissues to be recalled pursuant to the FDA
Order as a service revenue return. Revenues for products are recognized at the
time the product is shipped, at which time title passes to the customer. There
are no further performance obligations and delivery occurs upon shipment.
Revenues from research grants are recognized in the period the associated costs
are incurred. The Company assesses the likelihood of collection based on a
number of factors, including past transaction history with the customer and the
credit-worthiness of the customer.
DEFERRED PRESERVATION COSTS: Tissue is procured from deceased human donors by
organ and tissue procurement agencies, which consign the tissue to the Company
for processing and preservation. Preservation costs related to tissue held by
the Company are deferred until revenue is recognized upon shipment of the tissue
to the implanting hospital.facilities. Deferred preservation costs consist primarily of
laboratory and personnel expenses, tissue procurement fees, fringe andbenefits,
facility allocations, and freight-in charges, and are stated at the lower of
cost or market, net of reserve, on a first-in, first-out basis.
As of September 30, 2002March 31, 2003 the balance of deferred preservation costs were $545,000was $3.8 million
for allograft heart valve tissues, $176,000$379,000 for non-valved cardiac tissues, $931,000$3.1
million for vascular tissues, and $10,000$344,000 for orthopaedic tissues. For the three and
20
nine months ended September 30,During 2002 respectively,
the Company recorded a write-down of deferred preservation costs of $8.7 million
and $8.7 million for valved cardiac tissues, $1.3 million and $2.9 million for non-valved cardiac tissues, $6.9 million and $11.9
million for vascular tissues, and $5.8 million and $9.2 million for orthopaedic tissue totaling $22.7 and
$32.7 million. These write-downs were recorded as a result of the FDA Order as
discussed at Note 2 to the Summary Consolidated Financial Statements in the
Recent Events section.this
Form 10-Q. The amount of these write-downs reflects management's
estimatemanagements' estimates based
on information currently available to it.it at the time the estimates were made. These
estimates may prove inaccurate, as the scope and impact of the FDA Order are
determined. Management will continuecontinues to evaluate the recoverability of these
deferred preservation costs based on the factors discussed in the Recent Events sectionNote 2 to Summary
Consolidated Financial Statements and will record additional write-downs if it
becomes clear that additional impairments have occurred. The write-down created
a new cost basis which cannot be written back up if these tissues become
shippable. The cost of human tissue preservation services may be favorably
impacted depending on the future level of tissue shipments related to previously
written-down deferred preservation costs. The shipment levels of these
written-down tissues will be affected by the amount and timing of the release of
tissues processed after September 5, 2002, as a result of the Agreement with the
FDA, since, under the Agreement, written-down tissues may be shipped if tissues
processed after September 5, 2002 are not available for shipment.
VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL: The Company assesses
the impairment of its long-lived, identifiable intangible assets and related
goodwill annually and whenever events or changes in circumstances indicate that
the carrying value may not be recoverable. Factors that management considers
important that could trigger an impairment review include the following:
o significantSignificant underperformance relative to expected historical or
projected future operating results;
o significantSignificant negative industry or economic trends;
o significantSignificant decline in the Company's stock price for a sustained
period; and
o Significant decline in the Company's market capitalization relative to
net book value.
Statement of Financial Accounting Standards No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), requires the
write-down of a long-lived asset to be held and used if the carrying value of
the asset or the asset group to which the asset belongs is not recoverable and
exceeds its fair value.recoverable. The
carrying value of the asset or asset group is not recoverable if its
carrying valueit exceeds the
sum of the undiscounted future cash flows expected to result from the use and
eventual disposition of the asset or asset group. In applying SFAS 144, the
Company defined the specific asset groups used to perform the cash flow
analysis. The Company defined the asset groups at the lowest level possible, by
identifying the cash flows from groups of assets that could be segregated from
the cash flows of other assets and liabilities. Using this methodology, the
Company determined that theits asset groups consisted of the long-lived assets
related to the Company's two reporting segments, as these
represent the lowest level for which identifiable cash flows are largely
independent of the cash flows of other assets and liabilities.segments. The Company used a
fourteen-year period for the undiscounted future cash flows. This period of time
was selected based upon the remaining life of the primary assets of the asset
groups, which are leasehold improvements. Based on its analysis,The undiscounted future cash flows
related to these asset groups exceeded their carrying values as of March 31,
2003 and therefore management doeshas concluded that there is not believe an impairment of
the Company's long-lived intangible assets and tangible assets related to the
18
tissue preservation business or medical device business had occurred as of September 30, 2002.business. However, depending on
the Company's ability to addressrebuild demand for its tissue preservation services,
the observations detailed inoutcome of discussions with the Warning LetterFDA regarding the shipping of orthopaedic
tissues, and the future effects of adverse publicity surrounding the FDA Order
and reported infections on preservation revenues, these assets may become
impaired. Management will continue to evaluate the recoverability of these
assets.
Goodwillassets in accordance with SFAS 144.
Beginning with the Company's adoption of Statement of Financial Accounting
Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142")
on January 1, 2002 the goodwill resulting from business acquisitions is not
amortized, but is instead subject to periodic impairment testing in accordance
with SFAS No. 142,
"Goodwill and Other Intangible Assets" ("SFAS 142").142. Patent costs are amortized over the expected useful lives of the
patents (primarily 17 years) using the straight-line method. Other intangibles,
which consist primarily of manufacturing rights and agreements, are amortized
over the expected useful lives of the related assets (primarily five years). As
a result of the FDA Order, the Company determined that an evaluation of the
possible impairment of intangible assets under SFAS 142 was necessary. The
Company engaged an independent valuation expert to perform the valuation using a
discounted cash flow methodology, and as a result of this analysis, the Company
determined that goodwill related to its tissue processing reportablereporting unit was
fully impaired as of September 30, 2002. Therefore, the Company recorded a
write-down of $1.4 million in goodwill during the quarter ended September 30,
2002. Management does not believe an impairment exists related to the other
intangible assets.
Management will continueassets that were assessed in accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144").
PRODUCT LIABILITY CLAIMS: In the normal course of business as a medical device
and services company, the Company has product liability complaints filed against
it. The Company maintains claims-made insurance policies to evaluatemitigate its
financial exposure to product liability claims. Claims-made insurance policies
cover only those asserted claims and incidents that are reported to the
recoverabilityinsurance carrier while the policy is in effect. Thus, a claims-made policy does
not represent a transfer of these intangible
assets.
21
risk for claims and incidents that have been
incurred but not reported to the insurance carrier. The Company periodically
evaluates its exposure to unreported product liability claims, and records
accruals as necessary for the estimated cost of unreported claims related to
services performed and products sold. As of December 31, 2002 the Company had
accrued $3.6 million in estimated costs for unreported product liability claims
related to services performed and products sold prior to December 31, 2002. The
Company engaged an independent actuarial firm to perform an analysis of the
unreported product claims as of December 31, 2002. The independent firm
estimated the unreported product loss liability using a frequency-severity
approach, whereas, projected losses were calculated by multiplying the estimated
number of claims by the estimated average cost per claim. The estimated claims
were calculated based on the reported claim development method and the
Bornhuetter-Ferguson method using a blend of the Company's historical claim
emergence and industry data. The estimated cost per claim was calculated using a
lognormal claims model blending the Company's historical average cost per claim
with industry claims data. The expense was recorded in 2002 in general,
administrative, and marketing expenses and was included as a component of
accrued expenses and other current liabilities on the Summary Consolidated
Balance Sheet. As of March 31, 2003 the accrual for unreported product liability
claims remained unchanged for services performed and products sold prior to
March 31, 2003. The Company believes that the accrual for unreported product
liability claims in addition to the product liability insurance renewal
effective as of April 1, 2003 is adequate to cover product liability complaints
filed against it. The Company's product liability insurance coverage may have a
favorable impact on future accruals for unreported product liability claims.
NEW ACCOUNTING PRONOUNCEMENTS
On January 1, 2002 theThe Company was required to adopt SFAS 142 and SFAS 144. See
Critical Accounting policies for a discussion of the impact of these
pronouncements on current financial results.
The Company will be required to adopt SFAS No. 143, "Accounting for Asset Retirement
Obligations" ("SFAS 143") on January 1, 2003. SFAS 143 addresses accounting and
reporting for retirement costs of long-lived assets resulting from legal
obligations associated with acquisition, construction, or development
transactions. The Company has determined that the adoption of SFAS 143 willdid not have a material effect on the
financial position, results of operations and
cash flowsor financial position of the Company.
The Company will bewas required to adopt SFAS No. 145, "Rescission of FASB Statements
4, 44 and 64, Amendment to FASB Statement 13, and Technical Corrections" ("SFAS
145"), on January 1, 2003. SFAS 145 rescinds SFAS No. 4, 44 and 64, which
required gains and losses from extinguishments of debt to be classified as
extraordinary items. SFAS 145 also amends SFAS No. 13 eliminating
19
inconsistencies in certain sale-leaseback transactions. The provisions of SFAS
145 are effective for fiscal years beginning after May 15, 2002. The Company is
currently evaluatingadoption of
SFAS 145 did not have a material effect on the impactresults of this Statement.operations or
financial position of the Company.
The Company will bewas required to adopt SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities" ("SFAS 146") on January 1, 2003. SFAS 146
requires that costs associated with exit or disposal activities be recorded at
their fair values when a liability has been incurred. Under previous guidance,
certain exit costs were accrued upon management's commitment to an exit plan,
which is generally before an actual liability has been incurred. The Company is currently evaluatingadoption of
SFAS 146 did not have a material effect on the impactresults of this Statement.operations or
financial position of the Company.
RESULTS OF OPERATIONS
(IN THOUSANDS)
REVENUES
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------
Revenues as reported $ 16,889 $ 22,567 $ 65,624 $ 65,696
Reduction in revenues due to
estimated tissue returns 1,031 -- 3,464 --
-------------- ------------- ------------- ------------
Revenues prior to reduction for
estimated tissue returns $ 17,920 $ 22,567 $ 69,088 $ 65,696
============== ============= ============= =============
One Month Ended
September 30,
-------------------------------
2002 2001
-------------------------------
Revenues prior to reduction
for estimated tissue returns $ 3,632 $ 7,394
Three Months Ended
March 31,
-------------------------------
2003 2002
-------------------------------
Revenues as reported $ 15,920 $ 25,471
Adjustment to estimated tissue recall returns 848 --
-------------------------------
Revenues prior to adjustment to estimated
tissue recall returns (a) $ 15,072 $ 25,471
===============================
Revenues as reported decreased 37% for the three months ended March 31, 2003 as
compared to the three months ended March 31, 2002. Revenues as reported include
$848,000 in favorable adjustments to the estimated tissue recall returns due to
lower actual tissue returns under the FDA Order than were originally estimated.
As of March 31, 2003 approximately $100,000 remains in the accrual for estimated
return of tissues subject to recall by the FDA Order. Revenues prior to the
reductionadjustment to estimated tissue recall returns decreased 41% for the estimated effect of tissue returns as a
result of the FDA Order decreased 51% and 21% and increased 5%, respectively,
for the one, three and nine months
ended September 30,March 31, 2003 as compared to the three months ended March 31, 2002. This
decrease in revenues for the one and three months ended September 30, 2002, respectively,
was primarily due to a 72% and 38%59% decrease in human tissue
preservation service revenues as a result of the FDA Order's restriction on
shipments of certain tissues, the Company's cessation of orthopaedic processing,
and decreased demand as a result of the adverse publicity surrounding the FDA
Order, FDA Warning Letter, and reported tissue infections, partially offset by a
82% and 113%33% increase in BioGlue(R) Surgical Adhesive revenues due to increased demand
for the one and three months ended September 30,
2002. The increase in revenues for the nine month period ended September 30,
2002 was primarily due to a 104% increase in sales of BioGlue Surgical Adhesive,
22
partially offset by a 14% decrease in human tissue preservation service revenues
as a result of the FDA Order's restriction on shipments of certain tissues and
decreased demand as a result of the adverse publicity surrounding the FDA Order
and reported incidents of infection. The BioGlue increases are primarily
attributable to the receipt of FDA approval for BioGlue in December 2001.
Revenues as reported decreased 25% and less than 1%, respectively, for the three
and nine months ended September 30, 2002. Revenues were adversely impacted by
the estimated effect of the return of tissues subject to recall by the FDA
Order, which resulted in an estimated decrease of $1.0 million and $3.5 million,
respectively, in preservation service revenues during the three and nine months
ended September 30, 2002. As discussed herein, the estimated effect of the
return of tissues subject to recall includes credits for tissues actually
returned to the Company to date and the expected credits for future tissues to
be returned to the Company as a result of the FDA Order.
Although the Company has not yet determined the full impact of the FDA Order on
future revenues, the September revenues for 2002 as compared to 2001 decreased
51% primarily as a result of the FDA Order and adverse publicity.March 31, 2003.
Management believes that a decrease in revenues as compared to prior year
periods will continue.continue at least through the first half of 2003, although the
ongoing corrective actions taken by the Company regarding the FDA issues and the
anticipated resolution of the FDA issues should assist the Company in rebuilding
demand for its preservation services. In the event the Company is not successful
in addressing the issues detailed in
the Warning Letter as described in the recent events section or is unable to
reach a satisfactory agreement with the FDA,rebuilding demand for its preservation services, future revenues can be
expected to decrease significantly as compared to historical levels. As
discussed in Note 2 to the Summary Consolidated Financial Statements, the
outcome of the discussions with the FDA regarding the use of the SynerGraft
process on human tissue could result in a reduction in SynerGraft processed
cardiovascular and vascular tissue which would reduce revenue and the gross
margins with respect to cardiovascular and vascular tissues.
- --------
(a) The measurement "revenues prior yearto adjustment to estimated tissue recall
returns" may be deemed to be a "non-GAAP" financial measure as that term is
defined in Regulation G and Item 10(e) of Regulation S-K and is included for
informational purposes to provide information comparable to revenues in prior
periods. Presentation of revenues excluding such adjustment might mislead
investors with respect to the magnitude of the Company's revenues, since the
"adjustment to estimated tissue recall returns" included in "revenues as
reported" does not represent revenues earned from actual tissues shipped during
the period.
20
BIOGLUE SURGICAL ADHESIVE
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------
Revenues as reported $ 5,183 $ 2,431 $ 15,308 $ 7,505
Percentage of total revenue as reported 31% 11% 23% 11%
Percentage of total revenue prior to
reduction for estimated tissue returns 29% 11% 22% 11%
One Month Ended
September 30,
-------------------------------
2002 2001
-------------------------------
Revenues $ 1,786 $ 981
Percentage of total revenue 49% 13%
Three Months Ended
March 31,
-------------------------------
2003 2002
-------------------------------
Revenues as reported $ 6,494 $ 4,873
BioGlue revenues as reported as a
percentage of total revenue as reported 41% 19%
BioGlue revenues as reported as a
percentage of total revenue prior to adjustment
to estimated tissue recall returns(a) 43% 19%
Revenues from the sale of BioGlue Surgical Adhesive increased 82%, 113% and
104%, respectively,33% for the one, three
and nine month periodsmonths ended September
30,March 31, 2003 as compared to the three months ended March 31,
2002. The increase in revenues for the one, three months ended March 31, 2003 was due
to a 23% increase in the amount of BioGlue cartridges and nine month periods
ended September 30, 2002 wasdelivery devices
shipped due to an increase in the milliliters of BioGlue
shipped of 56%, 89%demand and 82%, respectively, and ana 10% increase in the average selling
price of the BioGlue cartridges and delivery devices shipped. The increase in shipments was primarily
due to the receipt of FDA approval in December 2001 for the use of BioGlue in
the United States as an adjunct in open surgical repair of large vessels for
adult patients. Domestic revenues
accounted for 78%79% and 69%80% of total BioGlue revenues for the three months ended
September 30,March 31, 2003 and 2002, and 2001, respectively.
Domestic revenues accounted for 78% and 67% of total BioGlue revenues for the
nine months ended September 30, 2002 and 2001, respectively.
Although BioGlue revenue increased as compared to the prior year and BioGlue was
not included in the FDA Order, future sales of BioGlue could be adversely
affected due to the adverse publicity surrounding the FDA's review of and
correspondence with the Company. Additionally, there is a possibility that the
Company's BioGlue manufacturing operations could come under increased scrutiny
from the FDA as a result of their review of the Company's tissue processing
laboratories.
23
CARDIOVASCULAR PRESERVATION SERVICES
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------
Revenues as reported $ 5,487 $ 8,209 $ 20,131 $ 22,307
Percentage of total revenue as reported 32% 36% 31% 34%
Revenues prior to reduction for
estimated tissue returns $ 5,657 $ 8,209 $ 20,643 $ 22,307
Percentage of total revenue prior to
reduction for estimated tissue returns 32% 36% 30% 34%
One Month Ended
September 30,
-------------------------------
2002 2001
-------------------------------
Revenues prior to reduction
for estimated tissue returns $ 1,196 $ 2,487
Percentage of total revenue 33% 34%
Three Months Ended
March 31,
-------------------------------
2003 2002
-------------------------------
Revenues as reported $ 4,725 $ 7,307
Adjustment to estimated tissue recall returns 92 --
-------------------------------
Revenues prior to adjustment to estimated
tissue recall returns(a) $ 4,633 $ 7,307
===============================
Cardiovascular revenues as reported as a
percentage of total revenue as reported 30% 29%
Cardiovascular revenues prior to adjustment
to estimated tissue recall returns as a
percentage of total revenue prior to adjustment
to estimated tissue recall returns(a) 31% 29%
Revenues from cardiovascular preservation services as reported decreased 35% for
the three months ended March 31, 2003 as compared to the three months ended
March 31, 2002. Revenues as reported include $92,000 in favorable adjustments to
the estimated tissue recall returns due to lower actual tissue returns under the
FDA Order than were originally estimated. Revenues from cardiovascular
preservation services prior to the reductionadjustment to estimated tissue recall returns
decreased 37% for estimated returns of tissue subjectthe three months ended March 31, 2003 as compared to the FDA Order, decreased 52%, 31% and 7%,
respectively, for the one, three and nine
months ended September 30,March 31, 2002. This decrease in revenues for the one, three and nine month periodsmonths
ended September
30, 2002March 31, 2003 was primarily due to a 43% decrease in cardiovascular
shipments due to a decline in customer demand duerelated to the adverse publicity
surrounding the FDA Order certainand FDA Warning Letter, the FDA Letter posted on its
website, reported tissue infections and the related adverse publicity, and the
restrictions on shipments of certain non-valved cardiac tissues subject to the
FDA Order. Revenues as reported from cardiovascular preservation services decreased 33% and
10%, respectively, forThis decrease in shipments was partially offset by a 6% increase in
21
average service fees due to a higher percentage of shipments in the three and nine months ended September 30, 2002. The
revenues from cardiovascular preservation services were adversely impacted by
the estimated effectfirst
quarter of the2003 consisting of heart valves rather than non-valved cardiac tissues returned subjecttissue
as compared to recall by the FDA Order, which resulted in an estimated decreasefirst quarter of $170,000 and
$510,000 in service revenues during the three and nine months ended September
30, 2002.
The Company anticipates a future decrease in cardiovascular preservation
revenues as compared to prior year periods for at least the first half of 2003
as a result of the FDA Warning Letter, the FDA Order, the FDA letter posted on
its website, certain reported tissue infections, and the related adverse
publicity. If the Company is unable to rebuild demand for its preservation
services for these tissues, future cardiac preservation revenue could continue
to decrease.
VASCULAR PRESERVATION SERVICES
Three Months Ended
March 31,
-------------------------------
2003 2002
-------------------------------
Revenues as reported $ 4,255 $ 7,017
Adjustment to estimated tissue recall returns 711 --
-------------------------------
Revenues prior to adjustment to estimated
tissue recall returns(a) $ 3,544 $ 7,017
===============================
Vascular revenues as reported as a
percentage of total revenue as reported 27% 28%
Vascular revenues prior to adjustment
to estimated tissue recall returns as a
percentage of total revenue prior to adjustment
to estimated tissue recall returns(a) 24% 28%
Revenues from vascular preservation services as reported decreased 39% for the
three months ended March 31, 2003 as compared to the three months ended March
31, 2002. Revenues as reported include $711,000 in favorable adjustments to the
estimated tissue recall returns due to lower actual tissue returns under the FDA
Order than were originally estimated. Revenues from vascular preservation
services prior to the adjustment to estimated tissue recall returns decreased
49% for the three months ended March 31, 2003 as compared to the three months
ended March 31, 2002. This decrease in revenues for the three months ended March
31, 2003 was primarily due to a 42% decrease in vascular shipments due to a
decline in demand related to the adverse publicity surrounding the FDA Order and
FDA Warning Letter, reported tissue infections and the related adverse
publicity, and the restrictions on shipments of certain vascular tissues subject
to the FDA Order. Additional decreases in revenues were due to a 7% decrease in
average service fees due to an increase in shorter multiple grafts, used as
composite grafts, shipped per case relative to longer, singular vascular grafts,
which have higher service fees, shipped per case in the first quarter of 2002.
The Company anticipates a future decrease in vascular preservation revenues as
compared to prior year periods for at least the first half of 2003 as a result
of the adverse publicity surrounding the FDA Warning Letter, FDA Order, and
certain reported tissue infections. If the Company is unable to address the observations detailed in the
Warning Letter,rebuild demand
for its preservation services for these tissues, future non-valved cardiacvascular preservation
revenue if any, may be
immaterial.
VASCULARcould continue to decrease.
22
ORTHOPAEDIC PRESERVATION SERVICES
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------
Revenues as reported $ 3,260 $ 6,192 $ 14,918 $ 18,617
Percentage of total revenue as reported 19% 27%Three Months Ended
March 31,
-------------------------------
2003 2002
-------------------------------
Revenues as reported $ 150 $ 5,914
Adjustment to estimated tissue recall returns 45 --
-------------------------------
Revenues prior to adjustment to estimated
tissue recall returns(a) $ 105 $ 5,914
===============================
Orthopaedic revenues as reported as a
percentage of total revenue as reported 1% 23%
Orthopaedic revenues prior to adjustment
to estimated tissue recall returns as a
percentage of total revenue prior to adjustment
to estimated tissue recall returns(a) 1% 23% 28%
Revenues prior to reduction for
estimated tissue returns $ 4,093 $ 6,192 $ 17,464 $ 18,617
Percentage of total revenue prior to
reduction for estimated tissue returns 23% 27% 25% 28%
24
One Month Ended
September 30,
-------------------------------
2002 2001
-------------------------------
Revenues prior to reduction
for estimated tissue returns $ 573 $ 1,942
Percentage of total revenue 16% 26%
Revenues from human vascularorthopaedic preservation services as reported decreased 97% for
the three months ended March 31, 2003 as compared to the three months ended
March 31, 2002. Revenues as reported include $45,000 in favorable adjustments to
the estimated tissue recall returns due to lower actual tissue returns under the
FDA Order than were originally estimated. Revenues from orthopaedic preservation
services prior to reductionthe adjustment to estimated tissue recall returns decreased
98% for estimated returns of tissue subjectthe three months ended March 31, 2003 as compared to the FDA Order, decreased 70%, 34% and
6%, respectively, for the one, three and nine months
ended September 30,March 31, 2002. This decrease in revenues for the one, three and nine month periodsmonths ended September 30, 2002March
31, 2003 was primarily due to a 97% decrease in orthopaedic shipments due to a
decline in customer demand duerelated to the adverse publicity surrounding the FDA Order,
certainFDA Warning Letter, and reported tissue infections, cessation of processing of
orthopaedic tissue until late February 2003, and the restrictions on shipments
of certain orthopaedic tissues subject to the FDA Order. Revenues as reportedsince August
14, 2002 have been from human vascular tissue preservation services decreased
47% and 20%, respectively, for the three and nine months ended September 30,
2002. The revenues from vascular tissue preservation servicesshipments of orthopaedic tissues that were adversely
impacted by the estimated effect of the return of tissues subject to recall by
the FDA Order, which resulted in an estimated decrease of $833,000 and $2.5
million, respectively, in vascular preservation service revenues during the
three and nine months ended September 30, 2002.
The Company anticipates a future decrease in vascular preservation revenues as
compared to prior year periods as a result of the adverse publicity surrounding
the FDA Warning Letter, FDA Order, and certain reported tissue infections. If
the Company is unable to address the observations detailed in the Warning
Letter, future vascular preservation revenues, if any, may be immaterial.
ORTHOPAEDIC PRESERVATION SERVICES
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------- ------------------------------
2002 2001 2002 2001
------------------------------- ------------------------------
Revenues as reported $ 2,553 $ 5,336 $ 14,025 $ 16,145
Percentage of total revenue as reported 15% 24% 21% 25%
Revenues prior to reduction for
estimated tissue returns $ 2,581 $ 5,336 $ 14,433 $ 16,145
Percentage of total revenue prior to
reduction for estimated tissue returns 14% 24% 21% 25%
One Month Ended
September 30,
-------------------------------
2002 2001
-------------------------------
(Credits) revenues prior to
reduction for estimated tissue returns $ (22) $ 1,870
Percentage of total revenue (1%) 25%
Revenues from human orthopaedic tissue preservation services,processed
prior to reduction
for estimated returns of tissue subject to the FDA Order, decreased 101%, 52%
and 11% for the one, three, and nine months ended September 30, 2002. This
decrease in revenues for the one, three, and nine month periods ended September
30, 2002 was primarily due to a decline in customer demand due to the adverse
publicity surrounding the FDA Order, certain reported tissue infections, and the
restrictions on shipments of certain tissues subject to the FDA Order.
25
Revenues as reported from human orthopaedic tissue preservation services
decreased 52% and 13% for the three and nine months ended September 30, 2002.
The revenues from orthopaedic tissue preservation services were adversely
impacted by the estimated effect of the return of tissues subject to recall by
the FDA Order, which resulted in an estimated decrease of $28,000 and $408,000,
respectively, in orthopaedic preservation service revenues during the three and
nine months ended September 30, 2002.October 3, 2001.
The Company anticipates a substantial decrease in the orthopaedic preservation
revenues as compared to prior year periods for at least the first half of 2003
due to the Company's inability to ship orthopaedic grafts processed sincebetween
October 3, 2001 and September 5, 2002 pursuant to the FDA Order, the adverse
publicity resulting from the FDA Warning Letter and FDA Order, and the reported
infections in some orthopaedic allograft recipients. The Company resumed
processing orthopaedic tissues in late February 2003 following the FDA
inspection of the Company's operations as discussed in Note 2 to the Summary
Consolidated Financial Statements. The Company's first quarter 2003 procurement
of orthopaedic tissues was approximately 5% of orthopaedic procurement levels in
the first quarter of 2002. The Company plans to resume distribution of
orthopaedic tissues. If the Company is unable to address the observations detailed in the Warning Letter
to enable the Company to process and ship orthopaedic tissue, or ifrebuild demand for theseits
preservation services for orthopaedic tissues, does not return after the observations are addressed, future orthopaedic preservation
revenue, if any, may be immaterial.
BIOPROSTHETICminimal.
IMPLANTABLE MEDICAL DEVICES
Revenues from bioprosthetic cardiovascularimplantable medical devices increased 1%decreased 45% to $171,000$105,000 for the
three months ended September 30, 2002March 31, 2003 from $169,000$192,000 for the three months ended September 30, 2001,March
31, 2002, representing 1% of total revenues during each such period. Revenues from bioprosthetic cardiovascular devices increased 11% to
$584,000 for the nine months ended September 30, 2002 from $524,000 for the nine
months ended September 30, 2001, representing 1% of total revenues during each
such period.periods.
DISTRIBUTION AND GRANT REVENUES
Distribution and grantGrant revenues increased to $235,000$191,000 for the three months ended September 30, 2002March 31, 2003
from $230,000$27,000 for the three months ended September 30, 2001.
Distribution and grant revenues increased to $658,000 for the nine months ended
September 30, 2002 from $598,000 for the nine months ended September 30, 2001.March 31, 2002. Grant revenues of $77,000 and $230,000, for the three months ended September 30,
2002 and 2001, respectively, and $208,000 and $598,000, for the nine months
ended September 30, 2002 and 2001, respectively, arein both
years were primarily attributable to the SynerGraft(R)SynerGraft research and development
programs. Distribution revenues of
$158,000decreased to zero for the three months ended
September 30, 2002 and $450,000March 31, 2003 from $141,000 for the ninethree months ended September 30, 2002 are forMarch 31, 2002.
Distribution revenues consisted of commissions received for the distribution of
orthopaedic tissues for another processor. DistributionThe Company does not currently
anticipate receiving distribution revenues for 2001 were zero.from any third party processors in
2003.
23
COSTS AND EXPENSES
Cost of human tissue preservation services aggregated $28.0$2.4 million for the three
months ended September 30, 2002 asMarch 31, 2003 compared to $8.2$8.1 million for the three months ended
September 30, 2001,March 31, 2002, representing 248%27% and 41%40%, respectively, of total human tissue
preservation service revenues foras reported during each such period. Cost of human
tissue preservation services aggregated $53.2 millionwas 29% and 40% for the ninethree months ended September 30,March
31, 2003 and 2002, as compared to $23.6 million for the nine months ended
September 30, 2001, representing 108% and 41%, respectively, of total human tissue preservation service
revenues forprior to the adjustment to estimated tissue recall returns during each
period. The decrease in the first quarter 2003 cost of humanpreservation was due to
decreased shipments resulting from decreased demand and shipments of tissue preservation services for the three and nine months ended September 30, 2002,
respectively, includeswith
a $22.7 million and $32.7 million write-downzero cost basis due to write-downs of deferred preservation costs relatedin the
second and third quarter of 2002. The reduction in cost of preservation services
for tissues shipped in the first quarter of 2003 due to prior period write-downs
was estimated to be $2.3 million. This decrease was partially offset by a
$297,000 increase to cost of preservation services to adjust the FDA Order as discussed in Recent Events.value of
certain deferred tissue preservation costs that exceeded market value. The
Company anticipates a reduction in the cost of human tissue preservation
services for at least the first half of 2003 as compared to prior periods due to
a reduction in shipments of tissues as a result of the FDA Order; howeverOrder and FDA Warning
Letter, reported tissue infections, and the currentrelated adverse publicity. The cost
of human tissue preservation services as a percent of revenue is likely to
increase as a result of lower tissue processing volumes, especially if the
decline in demand continues. However, the demandcost of human tissue preservation
services may be favorably impacted, depending on the future level of tissue
shipments related to previously written-down deferred preservation costs,
because the write-down creates a new cost basis which cannot be written back up
if these tissues are shipped or become available for shipment. The shipment
levels of these written-down tissues will be affected by the amount and timing
of the release of tissues continues.processed after September 5, 2002, pursuant to the
Agreement with the FDA, since written-down tissues may only be shipped if
tissues processed after the Agreement are not available for shipment.
Cost of products aggregated $4.7$1.6 million for the three months ended September
30, 2002 asMarch 31,
2003 compared to $1.2$2.2 million for the three months ended September 30,
2001,March 31, 2002,
representing 89%25% and 46%, respectively, of product revenues for each such
period. Cost of products aggregated $8.8 million for the nine months ended
September 30, 2002 as compared to $4.1 million for the nine months ended
September 30, 2001, representing 55% and 50%44%, respectively, of total product revenues during such
periods. The decrease in cost of products is primarily due to a decrease in the
costs related to bioprosthetic products due to lower sales and production levels
for each period. Thethese products, partially offset by an increase in BioGlue sales. The
decrease in the 2002first quarter 2003 cost of products as a percentage of total
product revenues is primarily due to a $3.1 million
write-down of bioprosthetic valves, including SynerGraft and non-SynerGraft
treated porcine valves, in the third quarter of 2002 due to the Company's
26
decision to stop future expenditures on the development and marketing of these
valves and to maintain its focus on its preservation services business, and its
BioGlue and SynerGraft vascular graft product lines. The decrease in the 2002
cost of products as a percentage of total product revenues was partially offset
by a favorable product mix that was impacted by anthe
increase in revenues from BioGlue Surgical Adhesive, which carries higher gross
margins than bioprosthetic devices.
General, administrative, and marketing expenses increased 35%22% to $11.2$11.6 million
forin the three months ended September 30, 2002,first quarter of 2003, compared to $8.3$9.5 million forin the three months ended September 30, 2001,first quarter of
2002, representing 66%73% and 37%, respectively, of total revenues during each such
period. General, administrative, and
marketing expenses increased 31% to $32.1 million for the nine months ended
September 30, 2002, compared to $24.6 million for the nine months ended
September 30, 2001, representing 49% and 37%, respectively, of total revenues
during each such period.periods. The increase in expenditures for the three and nine
months ended September 30, 2002March 31, 2003
was primarily due to increased overhead costs in
connection with the expansion of the corporate headquarters and manufacturing
facility, which was substantially completed in the first quarter of 2002, an increase of approximately $2.0 million in professional
fees (legal, consulting, and accounting) due to increased litigation, litigation
settlement costs, and issues surrounding the FDA Order and an increase of
approximately $300,000 in insurance premiums, an increase in legal and accounting costs, a
$1.2 million accrual for retention levels under the Company's liability and
directors' and officers' insurance policies (see Legal Proceedings at Part II,
Item 1), and additional professional fees required to address the observations
detailed in the Warning Letter.premiums. The Company expects to continue to
incur significant
increases in legal costs and professional fees over the remainder of the year to defend the lawsuits filed
against the Company and to address the observations
detailed in the Warning Letter and to appeal the FDA Order.compliance requirements. Additional
marketing expenses may also be incurred to address the effects of the adverse
publicity surrounding the FDA Order.
Research and development expenses increased 9%decreased 20% to $1.3 million$917,000 for the three months
ended September 30, 2002,March 31, 2003, compared to $1.2 million for the three months ended September 30, 2001, representing 8% and 5%, respectively, of total
revenues for each such period. Research and development expenses increased 3% to
$3.7 million for the nine months ended September 30,March
31, 2002, compared to $3.6
million for the nine months ended September 30, 2001, representing 6% and 5%, respectively, of total revenues for eachduring such
period.periods. Research and development spending for the threein 2003 and nine months ended September 30, 2002 was primarily
focused on the Company's SynerGraft and Protein Hydrogel Technologies.
As discussed in New Accounting Pronouncements, the Company has recorded a $1.4
million write-downInterest expense, net of its goodwill, which is shown as a separate line on the
Summary Consolidated Statements of Operationinterest income, was $1,000 for the three and nine months ended
September 30, 2002.
InterestMarch 31, 2003 as compared to $106,000 of interest income, net of interest
expense, was $33,000 and $412,000 for the three months ended September 30, 2002 and 2001, respectively. Interest income, net of
interest expense, was $182,000 and $1.5 million for the nine months ended
September 30, 2002 and 2001, respectively.March 31, 2002. The 20022003 decrease in net
interest income iswas due to reduced investments earning interest in 2003 as
compared to 2002 and lower interest rates in 20022003, partially offset by a
reduction in the principal debt amount outstanding due to scheduled principal
payments and the conversion of the convertible debenture in March of 2002.
Other income decreased to $26,000 for the three months ended March 31, 2003 as
compared to 2001 and$56,000 for the lack
of interest expense capitalized in 2002 in connection with the expansion of the
corporate headquarters and manufacturing facility, which was substantially
completed in the first quarter ofthree months ended March 31, 2002.
The effective income tax rate was 33% and 34% for quarters ended March 31, 2003
and 32% for the three and nine months
ended September 30, 2002, and 2001, respectively.
24
SEASONALITY
The demand for the Company's cardiovascular tissue preservation services is
seasonal, with peak demand generally occurring in the second and third quarters.
Management believes this trend for cardiovascular tissue preservation services
is primarily due to the high number of surgeries scheduled during the summer
months. However, the demand for the Company's human vascular and orthopaedic
tissue preservation services, BioGlue Surgical Adhesive, and bioprosthetic
cardiovascular and vascular devices does not appear to experience seasonal
trends.
27
LIQUIDITY AND CAPITAL RESOURCES
NET WORKING CAPITAL
At September 30, 2002March 31, 2003 net working capital (current assets of $56.2 million less
current liabilities of $19.5 million) was $43.3$36.7 million, with a current ratio
(current assets divided by current liabilities) of 3 to 1, compared to net
working capital of $37.6 million, with a current ratio of 3 to 1 compared to $66.7 million at December 31,
2001.2002. The Company's primary capital requirements historically arose out ofarise from general working
capital needs, capital expenditures for facilities and equipment, and funding of
research and development projects. The Company has historically funded these
requirements through bank credit facilities, cash generated by operations, and
equity offerings. Based on the anticipated decrease in revenues resulting from the FDA
Order, FDA Warning Letter, reported tissue infections, and associated adverse
publicity, the Company expects that its cash generated by
operationsused in operating activities will
decreaseincrease significantly over the near term, and that net working capital will
decrease. The Company believes that anticipated revenue generation, expense
management, savings resulting from the reduction in the number of employees to
reflect the reduction in revenues, federal tax refunds expectedof approximately $8.9
million due to be in
excessloss carrybacks generated from operating losses and write-downs
of $10 million,deferred preservation costs and inventory, and the Company's existing cash
and cash equivalents and marketable securities will enable the Company to meet
its liquidity needs, including repayment of the Term Loan if required, through
September 30, 2003.at least March 31, 2004. It is possible that the Company will not have
sufficient funds to meet its primary capital requirements over the long term.
NET CASH FROM OPERATING ACTIVITIES
Net cash provided byused in operating activities was $636,000$3.9 million and $189,000 for the
ninethree months ended September 30,March 31, 2003 and 2002, respectively. The difference is
primarily attributable to the net loss in 2003 compared to net income in 2002
and changes in accounts receivable, accounts payable, and deferred preservation
costs. These changes in working capital reflect the decrease in revenues and
increased expenses as compared to $4.6the first quarter of 2002. The $3.9 million for the nine months ended
September 30, 2001. The $636,000 in
current year net cash providedused was primarily due
to $8.2 million in net income before depreciation, taxes, and excluding non-cash
items, partially offset by a decrease in cash of $7.6 million due to an increase in working capital
requirements from planned revenue growth, expansiondue to a $4.9 million net change in operating assets and
liabilities, partially offset by non-cash items, including depreciation and
amortization of product lines, and an increase in tissue procurement. Non-cash adjustments to
net income$1.4 million, provision for the nine months ended September 30, 2002 include a $32.7 milliondoubtful accounts of $24,000,
write-down for the impairment of deferred preservation costs resulting fromof $297,000, and other non-cash
adjustments to income of $19,000 The net loss of $434,000 includes a $2.0
million increase in professional fees due to increased litigation, litigation
settlement costs, and issues surrounding the FDA Ordercompliance requirements, as
discussed in Recent Events, a $3.1 million write-down for the impairmentResults of inventory as discussed in Costs and Expenses, and a $1.4 million
write-down of goodwill as discussed in New Accounting Pronouncements.Operations section above.
NET CASH FROM INVESTING ACTIVITIES
Net cash provided by investing activities was $5.2$1.1 million forin the ninethree months
ended September 30, 2002,March 31, 2003, as compared to cash used of $12.7 million for$215,000 in the ninethree months
ended September 30, 2001.March 31, 2002. The $5.2$1.1 million in current year net cash provided was
primarily due to a net $10.5$1.2 million increase in cash from maturities of marketable
securities, primarily due to the maturity of
debt securities, and $1.2 million
in proceeds from notes receivable, partially offset by a $3.9 million decrease
due to capital expenditures in 2002, as the expansion and renovation of the
Company's corporate headquarters and manufacturing facilities approached
completion, and a decrease due to spending on patents of $2.6 million, primarily
relating to costs incurred to defend the SynerGraft technology patents, as
discussed in Legal Proceedings.expenditures.
NET CASH FROM FINANCING ACTIVITIES
Net cash used byin financing activities was $1.0 million for$423,000 and $201,000 in the ninethree
months ended September 30,March 31, 2003 and 2002, as compared to cash provided of $1.6 million for the nine
months ended September 30, 2001.respectively. The $1.0 million$423,000 in current year
net cash used was primarily due to $1.2 million$400,000 in principal payments on the Term
25
Loan $663,000
for the purchase of treasury stock, and $454,000$159,000 in principal payments on capital leases, partially offset by a $1.3 million$136,000
increase in cash due to proceeds from stock
option exercises.the issuance of stock.
SCHEDULED CONTRACTUAL OBLIGATIONS AND FUTURE PAYMENTS
Scheduled contractual obligations and the related future payments subsequent to
March 31, 2003 are as follows (in thousands):
Remainder of
Total 2003 2004 2005 Thereafter
----------- ----------- ----------- ----------- -----------
Debt $ 5,200 $ 1,200 $ 1,600 $ 1,600 $ 800
Capital Lease Obligations 3,426 632 843 843 1,108
Operating Leases 26,706 1,721 2,115 2,091 20,779
Purchase Commitments 700 322 378 -- --
----------- ----------- ----------- ----------- -----------
Total Contractual Obligations $ 36,032 $ 3,875 $ 4,936 $ 4,534 $ 22,687
=========== =========== =========== =========== ===========
The Company's Term Loan, of which the principal balance was $5.9$5.1 million as of
October 28, 2002,April 30, 2003, contains certain restrictive covenants including, but not
limited to, maintenance of certain financial ratios and a minimum tangible net
worth requirement, and the requirement that no materially adverse event has
occurred. The lender has determinednotified the Company that the FDA Order, as described
in Note 2, to the Summary Consolidated Financial Statements, and the inquiries of the Securities and Exchange Commission,SEC, as described in Note 11 to the Summary
Consolidated Financial Statements,12, have had a
material adverse effect on the Company that constitutes an event of default.
Additionally, as of September 30, 2002,March 31, 2003 the Company is in violation of the debt
coverage ratio and net worth financial covenants. As of October 28, 2002April 30, 2003 the
lender has elected not to declare an event of default, but reserves the right to
exercise any such right under the terms of the Term Loan. Therefore, all amounts
due under the Term Loan as of September
30, 2002March 31, 2003 are reflected as a current
liability on the Summary Consolidated Balance Sheet.Sheets. In the event the lender
calls the Term Loan, the Company at present has adequate funds to pay the
principal amount outstanding. The Term Loan is secured by substantially all of
the Company's assets. 28
Due to cross default provisions included in the Company's
debt agreements, as of March 31, 2003 the Company was in default of certain
capital lease agreements maintained with the lender of the Term Loan. Therefore,
all amounts due under these capital leases are reflected as a current liability
on the Summary Consolidated Balance Sheets as of March 31, 2003. Since the
lender has not elected to exercise its rights to declare an event of default,
the above chart shows the payments according to their scheduled payment dates.
The Company's Term Loan, which accrues interest computed at Adjusted LIBOR plus
1.5%, exposes the Company to changes in interest rates going forward. On March
16, 2000, the Company entered into a $4 million notional amount forward-starting
interest swap agreement, which took effect on June 1, 2001 and expires in 2006.
This swap agreement was designated as a cash flow hedge to effectively convert a
portion of the Term Loan balance to a fixed rate basis, thus reducing the impact
of interest rate changes on future income. This agreement involves the receipt
of floating rate amounts in exchange for fixed rate interest payments over the
life of the agreement, without an exchange of the underlying principal amounts.
The differential to be paid or received is recognized in the period in which it
accrues as an adjustment to interest expense on the Term Loan.
INTEREST RATE SWAP AGREEMENT
On January 1, 2001 the Company adopted SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133") as amended. SFAS 133 requires
the Company to recognize all derivative instruments on the balance sheet at fair
value, and changes in the derivative's fair value must be recognized currently
in earnings or other comprehensive income, as applicable. The adoption of SFAS
133 impacts the accounting for the Company's forward-starting interest rate swap
agreement. Upon adoption of SFAS 133, the Company recorded an unrealized loss of
approximately $175,000 related to the interest rate swap, which was recorded as
part of long-term liabilities and accumulated other comprehensive income within
the Statement of Shareholders' Equity.
In August 2002 the Company determined that changes in the derivative's fair
value could no longer be recorded in other comprehensive income, as a result of
the uncertainty of future cash payments on the Term Loan caused by the lender's
ability to declare an event of default as discussed in Note 6.5. Beginning in
August 2002 the Company is recording all changes in the fair value of the
derivative currently in other expense/income on the Summary Consolidated
26
Statements of Operation, and is amortizing the amounts previously recorded in
other comprehensive income into other expense/income over the remaining life of
the agreement. If the lender accelerates the payments due under the term loadTerm Loan by
declaring an event of default, any remaining balance in other comprehensive
income will be reclassed into other expense/income during that period.
At September 30, 2002March 31, 2003 the notional amount of this swap agreement was $3.0$2.6 million,
and the fair value of the interest rate swap agreement, as estimated by the bank
based on its internal valuation models, was a liability of $305,000.$252,000. The fair
value of the swap agreement is recorded as part of long-termshort-term liabilities. For
the three and nine months ended September 30, 2002March 31, 2003 the Company recorded a loss of $26,000$19,000 on
the interest rate swap. The unamortized value of the swap agreement, recorded in
the accumulated other comprehensive income account of shareholders' equity, was
$279,000$241,000 at September 30, 2002.March 31, 2003.
STOCK REPURCHASE
On July 23, 2002 the Company's Board of Directors authorized the purchase of up
to $10 million of its common stock. As of August 13, 2002 the Company had
repurchased 68,000 shares of its common stock for $663,000. No further purchases
are anticipated in the near term.
On July 30,CAPITAL EXPENDITURES
The Company expects that its full year capital expenditures in 2003 will be less
than its expenditures in 2002, which were approximately $4.1 million. The
Company expects to have the flexibility to increase or decrease the majority of
its planned capital expenditures depending on its ability to resume normal
operating levels once it has fully evaluated the demand for its tissues and
resumed distribution of orthopaedic tissues. The Company entered into a linedoes not currently
anticipate any major purchase of credit agreement with the
lender that made the Term Loan, permitting the Company to borrow up to $10
million. Borrowings under the line of credit agreement accrue interest equal to
Adjusted LIBOR plus 1.25% adjusted monthly. This loan is secured by
substantially all of the Company's assets. As of October 28, 2002 no amounts
were drawn on the line of credit. Asequipment as a result of the April 2002 and
February 2003 FDA Order, as discussed in
Note 2inspections.
OVERALL TREND IN LIQUIDITY AND CAPITAL RESOURCES
Century Medical, Inc. has completed the Japanese BioGlue clinical trial and is
performing a post clinical trial follow up of patients who have received the
product. The Company does not know when to expect a final decision on the
Summary Consolidated Financial Statements,approval of the BioGlue application from the Japanese Ministry of Health and
Welfare. If approval is received, the Company is not in
compliance with the lender's requirements for advances of funds under the line
of credit. On August 21, 2002 the lender notified the Company thatbelieves it was not
entitled to any further advances under the line of credit.
Since October 1998 management has been seeking to enter intocould have a corporate
collaboration or to complete a potential private placement of equity or
equity-oriented securities to fund the commercial development ofpositive
impact on its Activation
Control Technology ("ACT"). This technology is now held by the Company's wholly
owned subsidiary AuraZyme Pharmaceutical, Inc.(R), ("AuraZyme") which was formed
on February 26, 2001. This strategy, if successful, will allow an affiliated
entity to fund the ACT and should expedite the commercial development of its
oncology, fibrin olysis (blood clot dissolving), and surgical sealant product
applications without additional research and development expenditures by the
Company (other than through the affiliated company). This strategy, if
successful, will favorably impact the Company's liquidity going forward.
29
However, if the Company is unable to obtain funds for the commercial development
of the ACT and/or if the Company decides to fund the technology itself, the
expenses required to fund the ACT could adversely impact the Company's liquidity
going forward. The Company expects that it will reduce its efforts to fund the
commercial development of ACT in the near term until it has evaluated the
financial impact of the recent FDA Order.BioGlue business.
The Company expects its liquidity to decrease significantly over the next year
due to the anticipated significant decrease in revenues through at least the
first half of 2003 as compared to the prior year period, as a result of the FDA
Order and associated adverse publicity, and an expected decrease in cash due to
the anticipated increased legal and professional costs relating to the defense
of lawsuits and the FDA Order. On September 3, 2002 the Company announced a
reduction in employee force of approximately 105 employees. Severance and
related costs are approximately $690,000 and were recorded in the third quarter
of 2002. As a result of the employee reduction, management anticipates personnel
costs will be reduced by approximately $385,000 per month. The Company believes that anticipated revenue
generation, expense management, including the cessation
of the development of the bioprosthetic valves, savings resulting from the reduction in the
number of employees to reflect the reduction in revenues, tax refunds expectedof
approximately $8.9 million due to be in excess of $10 million (consisting of $1.7 million of
overpayments from 2001 received in October of 2002, $2.5 million of expected
overpayments for the 2002 tax year which is expected to be received in the first
quarter of 2003, and at least $5.8 million of loss carrybacks generated from operating
losses and write-downs of deferred preservation cost write-downs the receipt of which will be based upon
the timing of the destruction of the related tissues),costs and inventory, and the
Company's existing cash and cash equivalents and marketable securities will
enable the Company to meet its liquidity needs through September 30, 2003. Evenat least March 31, 2004,
even if the CompanyTerm Loan is able to
address the observations detailedcalled in the FDA's Warning Letter, thereits entirety. There is no assurance that the
Company will be able to return to the level of demand for its tissue services
that existed prior to the FDA Order as a result of the adverse publicity or as a
result of customers and tissue banks switching to competitors. Failure of the
Company to maintain sufficient demand for its services would have a material
adverse effect on the Company's business, financial condition, results of
operations, and cash flows.
The Company's long term liquidity and capital requirements will depend upon
numerous factors, including the abilitycontinued acceptance of the Company to address the
observations detailed in the Warning Letter,BioGlue, the ability to
haveextend the Agreement with the FDA, extended, the extent and duration of the anticipated
revenue decreases, the costs associated with becoming compliantcompliance with the FDA requirements, as outlined
in the FDA Order,
the outcome of litigation pending against the Company as described in Part II
Item 1 of this Form 10-Q, the level of demand for cardiovascular and vascular
tissue, based onthe continuing effect of adverse publicity, in the eventCompany's ability to
resolve the February 2003 FDA Order is resolved in a manner favorable483 and the informal February FDA letter regarding
tissues processed with SynerGraft technology, the ability to regain orthopaedic
demand, the Company,actual outcomes of product liability claims that have been incurred
but not reported as of March 31, 2003 for which $3.6 million has been accrued,
the timing of the Company's receipt of FDA approvals to begin clinical trials
for its products currently in development, the availability of resources
27
required to further develop its marketing and sales capabilities if and when
those products gain approval, and the extent to which the Company's products
generate market acceptance and demand and the resolution of the "Risk
Factors" discussed below. The ultimate impact of many of these factors will be
affected by the outcome of others.demand. There can be no assurance the Company
will not require additional financing or will not be required to seek to raise
additional funds through bank facilities, debt or equity offerings, or other
sources of capital to meet future requirements. Additional funds may not be
available when needed or on terms acceptable to the Company, which could have a
material adverse effect on the Company's business, financial condition, results
of operations, and cash flows.
30
RISK FACTORS
FDA ORDER ON HUMAN TISSUE-DEPENDENCE ON PRESERVATION OF HUMAN TISSUE
On August 13, 2002 the Company received an order from the FDA calling for the
retention, recall, and/or destruction of all non-valved cardiac, vascular, and
orthopaedic tissue processed by the Company at its headquarters since at least
October 3, 2001 based upon allegations of FDA violations by the Company of its
handling of such tissue and alleged contamination through the Company's
processing of such tissue that resulted in 14 post-transplant infections
including one death. A significant portion of the Company's current revenues is
derived from the preservation of human tissues. Revenues of human tissue
preservation services for the six months ended June 30, 2002, the last period
ending prior to the issuance of FDA Order, were 78% of the Company's revenues.
Of those revenues, 67% were derived from preservation of tissues subject to the
FDA Order representing $26.9 million. Revenues for human tissue preservation
services for the year ended 2001 were 86% of the Company's revenues. Of those
revenues, 68% were derived from preservation of tissues subject to the FDA
Order. On September 30, 2002, the first full month in which the Company was
subject to the FDA Order as supplemented by the Agreement, revenues derived from
the preservation of tissues for the Company were $1.7 million, a 72% decrease in
revenues from September 2001.
The FDA Order has had a material adverse effect on the Company's business,
financial condition, results of operations and cash flows. As a result of the
FDA Order, the Company has experienced, and continues to expect to experience,
decreases in revenues and profits and there is a possibility that the Company
may not generate sufficient cash from operations to fund its operations.
Although the Agreement that supplements the FDA Order has allowed the Company to
process vascular and non-valve cardiac patch tissues subject to the FDA Order
with certain restrictions, the Company has continued to experience a reduced
demand for such tissues due to the adverse publicity generated from the recall
and from implanting physicians' or risk managers at implanting institutions
decisions to use human tissue from the Company's competitors. Even if the
Company is able to address the observations detailed in the FDA's Warning
Letter, demand for such tissue has been, and may continue to be, reduced by the
adverse publicity generated from the recall or from implanting physicians' and
risk managers' decisions to use human tissue from the Company's competitors.
Therefore, even if the Company is able to address the observations detailed in
the FDA's Warning Letter, the Company could still experience significant
decreases in revenues and profits and there is a possibility that the Company
would not generate sufficient cash from operations to fund its operations. Even
if the Company is able to address the observations detailed in the FDA's Warning
Letter, the Company currently believes that the time for processing human tissue
and the costs of such processing are likely to increase, which could have a
material adverse affect on the Company's business, results of operations and
financial position.
In the event that the Company is able to address the observations detailed in
the FDA's Warning Letter, the success of the Company depends upon, among other
factors, the availability of sufficient quantities of tissue from human donors.
Any material reduction in the supply of donated human tissue could restrict the
Company's growth. The Company relies primarily upon the efforts of third party
procurement agencies and tissue banks (most of which are not-for-profit) and
others to educate the public and foster a willingness to donate tissue. Because
of the adverse publicity associated with the recall and uncertainty regarding
future tissue processing, some procurement agencies have ceased sending tissue
to the Company for processing. If the Company's relationships with procurement
agencies continue to be adversely affected or the Company is unable to obtain
tissues from procurement agencies that have ceased sending tissue to the Company
for processing, the Company may be unable to obtain adequate supplies of donated
tissues to operate profitably.
EFFECTS OF FDA ORDER ON LIQUIDITY AND CAPITAL RESOURCES
Based upon the FDA Order, the Company anticipates a continued decrease in
liquidity. Based upon the anticipated decrease in revenues and profits from the
FDA Order and associated adverse publicity, the Company expects that cash
generated by operations will continue to decrease over the near term and working
capital could decrease. Although the Company has reduced its level of operation
and the number of personnel employed in response to the FDA Order, there is a
possibility that the Company may not have sufficient funds to fund its primary
capital requirements or to meet its operating and development needs.
31
CURRENT DEMAND FOR OUR ORTHOPAEDIC TISSUE PRESERVATION SERVICES IS MINIMAL AND
MAY NOT RETURN
As a result of the FDA Order and related adverse publicity the Company has
received only nominal revenue from the cryopreservation of orthopaedic tissues
since August 14, 2002. For the year ended December 2001, human tissue
preservation services revenues for orthopaedic tissues were $22.5 million, which
represented 26% of the Company's revenues. For the six months ended June 30,
2002, revenues for preservation services for orthopaedic tissues were $11.9
million, which represented 23% of the Company's revenues. Even if the Company is
able to address the observations in the FDA's Warning Letter and the Company is
allowed to resume processing and shipping of orthopaedic tissues, because
orthopaedic tissue is generally not involved in life-saving or limb-saving
procedures and due to the adverse publicity, the demand for orthopaedic tissue
from the Company may be minimal and may never return to the levels in existence
before the FDA Order. As a result, this portion of the Company's business may
have to be permanently discontinued or may only continue at an extremely reduced
level. Any of these occurrences would result in a significant decrease in the
Company's revenues and profitability in the future as compared to historical
results.
PHYSICIANS MAY BE RELUCTANT TO IMPLANT THE COMPANY'S PRESERVED TISSUES
Even if the Company is able to address the observations detailed in the FDA's
Warning Letter, and the Company is allowed to resume shipping all of the tissues
subject to the FDA Order without the restrictions set forth in the Agreement,
there is a risk that physicians or implanting institutions will be reluctant to
choose the Company's preserved tissues for use in implantation, due to a
perception that they may not be safe or to a belief that the implanting
physician or hospital may be subject to a heightened liability risk if the
Company's tissues are used. In addition, for similar reasons, hospital risk
managers may forbid implanting surgeons to utilize the Company's tissues where
alternatives are available. If a significant number of implanting hospitals or
physicians refused to use tissues preserved by the Company, the Company's
revenues and profits would be materially adversely affected.
HEART VALVES PROCESSED BY THE COMPANY MAY ALSO BE RECALLED
On August 21, 2002 the FDA publicly stated that allograft heart valves have not
been included in the FDA recall order as these devices are essential for the
correction of congenital cardiac lesions in neonate and pediatric patients and
no satisfactory alternative device exists. However, the FDA also publicly stated
that it still has serious concerns regarding the processing and handling of
allograft heart valves. The FDA also recommended that surgeons carefully
consider using processed allografts from alternative sources, that surgeons
should inform prospective patients of the FDA's concerns with the Company's
allograft heart valves, and that patients should be carefully monitored for both
fungal and bacterial infections. The FDA could institute a recall or other
corrective measures if it felt that the Company was not making progress in
complying with the FDA Order. Any adverse finding by the FDA regarding allograft
heart valves, including a recall, would cause further decreases in the Company's
revenue base and profits and significantly reduce the Company's potential for
growth. If such a recall occurs, the Company may also be required to write-down
all or a portion of the deferred preservation costs for allograft heart valves,
which could have a material adverse effect on the results of operations and
financial condition of the Company.
DEMAND FOR HEART VALVES PROCESSED BY THE COMPANY HAS DECREASED AND MAY CONTINUE
TO DECREASE
Possibly as a result of the FDA's public statement on August 21, 2002 regarding
allograft heart valves, and due to the adverse publicity associated with the FDA
Order, some physicians and implanting institutions have been reluctant to choose
the Company's allograft heart valves for use in implantation, due to a
perception that they may not be safe or to a belief that the implanting
institutions or hospitals may be subject to a heightened liability risk if the
Company's preserved tissues are used, especially if alternatives are available.
If adverse publicity continues, and if the Company is unable to address the
observations in the FDA's Warning Letter and the FDA's public statement is not
retracted, the demand for Company's allograft heart valves could continue to
decrease and may never return to the levels exhibited before the FDA Order. In
such an event, the Company's revenues and profits would be materially adversely
affected as compared to historical results.
32
ESTIMATED COSTS OF RECALL AND RELATED WRITE-DOWNS
The Company's financial statements reflect the estimated cost of recalling
tissue pursuant to the FDA Order. The Company has recorded a write-down of $32.7
million of deferred preservation costs for tissues subject to the FDA Order.
While these estimates are based on the Company's best estimate of the costs
associated with the recall and the impairment of deferred preservation costs
subject to the FDA Order, there can be no assurance that these costs and
write-downs will in fact be limited to the amount estimated.
RISKS RELATED TO PRODUCTS NOT AFFECTED BY THE FDA RECALL
Even though the Company's BioGlue products and its porcine heart valve products
(which are not sold in the United States) are not included in the FDA Order,
there is a possibility that surgeons or risk managers at institutions that use
such products may be reluctant to use such products because of the adverse
publicity associated with the FDA Order. Decreased demand for such products,
particularly BioGlue, could have a material adverse effect on the Company's
business, results of operations and financial position.
REGULATORY ACTION OUTSIDE OF THE UNITED STATES
After the FDA issued its order regarding the recall, Health Canada also issued a
recall on the same types of tissue. In addition, other countries have inquired
as to the tissues exported by the Company, although their inquiries are now, to
the Company's knowledge, complete. In addition, the Company has not shipped
tissue out of the United States without following the restrictions set forth in
the FDA Order as supplemented by the Agreement. In the event that the Company is
unable address the observations detailed in the FDA's Warning Letter or
additional regulatory concerns raised by other countries, the Company may be
unable to export tissues subject to the FDA Order.
THE COMPANY MAY BE FORCED TO CEASE TISSUE PRESERVATION
If the Company is not able to address the observations detailed in the Warning
Letter, or if the allograft heart valves processed by the Company are also
recalled, or if the Agreement expires and is not extended, the Company may not
be able to profitably continue its tissue processing business. In such an event,
the Company would attempt to continue as a smaller adhesives and valve
manufacturing company; however, in order to do so the Company would be required
to divest itself of a number of assets related to its tissue processing business
and would have to institute large-scale workforce reductions. There is no
guarantee that the resulting entity would be able to generate sufficient
revenues to operate profitably, and in any event, the Company would be much
smaller and would likely be valued at a reduced level by the marketplace.
THE COMPANY'S COMMON STOCK IS POTENTIALLY AT RISK OF BEING DELISTED FROM THE NEW
YORK STOCK EXCHANGE
Because of the FDA Order and the current trading price of the Company's common
stock, there is a possibility that the Company's common stock could be delisted
from the New York Stock Exchange. If the stock is delisted, there is no
guarantee that there will be a liquid market for the stock and the trading price
of the stock would likely be adversely affected.
THE COMPANY IS THE SUBJECT OF AN ONGOING SEC INVESTIGATION
The Company received notice from the Securities and Exchange Commission on
August 17, 2002 that it is the subject of an investigation with respect to
accounting issues and trades in the Company's stock related to the FDA Order.
The Company does not know any details of what the SEC is specifically
investigating, but believes that an adverse finding by the SEC could have a
material adverse effect on its business financial position, results of
operations, and cash flows. The staff of the SEC subsequently confirmed that its
investigation is informal in nature, and that it does not have subpoena power at
this time. At the present time, the Company is unable to predict the outcome of
this matter.
33
EFFECTS OF THE FDA RECALL ON CREDIT FACILITY
The Term Loan contains certain restrictive covenants including, but not limited
to, maintenance of certain financial ratios, a minimum tangible net worth
requirement, and the requirement that no materially adverse event has occurred.
The lender has determined that the FDA Order, as described in Note 2 to the
Summary Consolidated Financial Statements, and the inquiries of the Securities
and Exchange Commission, as described in Note 12 to the Summary Consolidated
Financial Statements, have a material adverse effect on the Company that
constitutes an event of default. Additionally, as of September 30, 2002, the
Company is in violation of the debt coverage ratio and net worth financial
covenants. As of October 28 2002 the lender has elected not to declare an event
of default, but reserves the right to exercise any such right under the terms of
the Term Loan. There is no assurance the lender will not exercise its rights,
which could have a material adverse effect on the Company's liquidity.
THE COMPANY'S INSURANCE COVERAGE MAY BE INSUFFICIENT TO COVER CURRENT AND FUTURE
CLAIMS AND ADDITIONAL COVERAGE MAY BE DIFFICULT OR IMPOSSIBLE TO OBTAIN IN THE
FUTURE
The Company's products are used by health care providers in connection with the
treatment of patients, who will, on occasion, sustain injury or die as a result
of their condition or medical treatment. As a result, the use of the Company's
products and human tissue processed by the Company involves the possibility of
adverse effects that could expose the Company to product liability claims,
including the lawsuits filed against the Company relating to infection of
implanted tissue described below in Part II, Item 1 "Legal Proceedings." The
recent FDA Order could adversely influence the outcome of current product
liability claims relating to infection of tissue processed by the Company. In
addition, due to the publicity surrounding the recent FDA Order more product
liability claims relating to alleged infection of tissue processed by the
Company could be filed.
In addition, a recent United States Supreme Court decision held that product
liability may exist despite FDA approval, and future court decisions may also
increase the Company's risk of product liability.
Whether or not the Company is ultimately determined to be liable for product
liability claims, the Company will incur significant legal expenses. In
addition, such litigation could damage the Company's reputation and therefore
impair its ability to market its products or obtain product liability insurance
and could cause the premiums for such insurance to increase. Although the
Company has incurred minimal losses due to product liability claims to date, the
Company may incur significant losses in the future. Management believes that the
coverage is adequate to cover any losses due to product claims if actually
incurred however, there can be no assurance that such coverage will be adequate.
In addition, there can be no assurance that such coverage will continue to be
available on terms acceptable to the Company, especially in light of the FDA
Order and the number of product liability claims the Company has had made
against it. Furthermore, if any product liability claims are successful, it
could have a material adverse effect on the Company's business, financial
condition, results of operations, and cash flows.
Because of the current litigation and the adverse publicity from the FDA Order,
the Company may be unable to obtain additional insurance coverage in the future,
causing the Company to be subject to additional future exposure from product
liability claims.
INTENSE COMPETITION
The Company faces competition from other companies that cryopreserve human
tissue, as well as companies that market mechanical valves and synthetic and
animal tissue for implantation and companies that market wound closure products.
During the time that the Company has been restricted in its processing and
distribution of human tissue due to the FDA Order as supplemented by the
Agreement, tissue preservation service customers have been forced to obtain
tissue from the Company's competitors, which could lead to permanent
substitution when, and if, the Company resumes processing tissues without the
restrictions of the FDA Order, as supplemented by the Agreement.
34
Management believes that at least four tissue banks offer preservation services
for allograft heart valves and many companies offer processed porcine heart
valves and mechanical heart valves. A few companies dominate portions of the
mechanical and porcine heart valve markets, including St. Jude Medical, Inc.,
Medtronic, Inc. and Edwards Life Sciences. The Company is aware that several
companies have surgical adhesive products under development. Competitive
products may also be under development by other large medical device,
pharmaceutical and biopharmaceutical companies. Many of the Company's
competitors have greater financial, technical, manufacturing and marketing
resources than the Company and are well established in their markets.
There can be no assurance that the Company's products and services will be able
to compete successfully with the products of these or other companies. Any
products developed by the Company that gain regulatory clearance or approval
would have to compete for market acceptance and market share. Failure of the
Company to compete effectively could have a material adverse effect on the
Company's business, financial condition, results of operations and cash flows.
The FDA Order and related adverse publicity have had an adverse effect on the
Company's competitive position, which has had a material adverse effect on the
Company's results of operations. The FDA Order and related adverse publicity may
continue to have an adverse effect on the Company's competitive position, which
may continue to have a material adverse effect on the Company's results of
operations. As a result of the FDA Order, the Company's competitors may gain
competitive advantages that may be difficult to overcome.
RAPID TECHNOLOGICAL CHANGE
The technologies underlying the Company's products and services are subject to
rapid and profound technological change. The Company expects competition to
intensify as technical advances in each field are made and become more widely
known. There can be no assurance that others will not develop products or
processes with significant advantages over the products and processes that the
Company offers or is seeking to develop. Any such occurrence could have a
material adverse effect on the Company's business, financial condition, results
of operations, and cash flows.
UNCERTAINTIES REGARDING PRODUCTS IN DEVELOPMENT
The Company's growth and profitability will depend, in part, upon its ability to
complete development of and successfully introduce new products, including
additional applications of its BioGlue and SynerGraft technologies and its ACT.
The Company may be required to undertake time consuming and costly development
activities and seek regulatory clearance or approval for new products. The
Company has had minimal reduction in its development efforts since the receipt
of the FDA Order. The Company may have to further reduce its development efforts
in the future because of the impact of the FDA Order on the Company's financial
condition or if it is unable to address the observations detailed in the Warning
Letter.
Although the Company has conducted pre-clinical studies on many of its products
under development which indicate that such products may be effective in a
particular application, there can be no assurance that the results obtained from
expanded clinical studies will be consistent with earlier trial results or be
sufficient for the Company to obtain any required regulatory approvals or
clearances. There can be no assurance that the Company will not experience
difficulties that could delay or prevent the successful development,
introduction and marketing of new products, that regulatory clearance or
approval of these or any new products will be granted on a timely basis, if
ever, or that the new products will adequately meet the requirements of the
applicable market or achieve market acceptance.
The completion of the development of any of the Company's products remains
subject to all of the risks associated with the commercialization of new
products based on innovative technologies, including unanticipated technical or
other problems, manufacturing difficulties and the possible insufficiency of the
funds allocated for the completion of such development. Consequently, the
Company's products under development may not be successfully developed or
manufactured or, if developed and manufactured, such products may not meet price
or performance objectives, be developed on a timely basis or prove to be as
effective as competing products.
35
The inability to complete successfully the development of a product or
application, or a determination by the Company, for financial, technical or
other reasons, not to complete development of any product or application,
particularly in instances in which the Company has made significant capital
expenditures, could have a material adverse effect on the Company's business,
financial condition, results of operations, and cash flows. The Company's
porcine heart valve products, including its SynerGraft treated porcine valves,
are currently only offered for sale outside of the United States. The Company's
porcine heart valves are subject to the risk that the Company may be unable to
obtain regulatory approval necessary to permit commercial distribution of these
products in the United States. The Company's research and development efforts
are time consuming and expensive and there can be no assurance that these
efforts will lead to commercially successful products or services. Even the
successful commercialization of a new service or product in the medical industry
can be characterized by slow growth and high costs associated with marketing,
under-utilized production capacity and continuing research and development and
education costs. The introduction of new human tissue products may require
significant physician training and years of clinical evidence derived from
follow-up studies on human implant recipients in order to gain acceptance in the
medical community.
UNCERTAINTIES REGARDING THE FUNDING OF THE ACT TECHNOLOGY
The ACT is a reversible linker technology that has potential uses in the areas
of cancer therapy, fibrin olysis (blood clot dissolving) and other drug delivery
applications. The Company has formed AuraZyme, a wholly owned subsidiary, in
order to seek a corporate collaboration or to complete a potential private
placement of equity or equity-oriented securities to fund the commercial
development of the ACT.
This strategy is designed to allow the Company to continue development of this
technology without incurring additional research and development expenditures,
other than through AuraZyme. There can be no guarantee that such funding can be
obtained on acceptable terms, if at all, especially in light of the recent FDA
Order. If such funding is not obtained, the Company may be unable to effectively
test and develop the ACT, and may therefore be unable to determine its
effectiveness. Even if such financing is obtained, there is no guarantee that
the ACT will in fact prove to be effective in the above applications. Failure to
obtain the desired financing, or failure of the ACT to perform as anticipated in
future tests, could have a material adverse effect on the Company's future
expansion plans and could limit future growth.
UNCERTAINTIES REGARDING THE SYNERGRAFT TECHNOLOGY
The Company processes porcine, bovine and human tissues with the SynerGraft
process. In animal studies, explanted porcine heart valves have been shown to
repopulate with the hosts' cells. However, should SynerGraft-treated tissues
implanted in humans not repopulate with the human host cells, the
SynerGraft-treated tissues may not have the improved longevity over the CryoLife
standard processing technology that the Company currently expects. This could
have a material adverse effect on future expansion plans and could limit future
growth.
EXTENSIVE GOVERNMENT REGULATION
Government regulation in the United States, the EC and other jurisdictions
represents a potentially determinative factor in the success of the Company's
efforts to market and develop its products. The allograft heart valves to which
the Company applies its preservation services are currently regulated as Class
II medical devices by the FDA and are subject to significant regulatory
requirements, including Quality System Regulations and record keeping
requirements. Changes in regulatory treatment or the adoption of new statutory
or regulatory requirements are likely to occur, which could adversely impact the
marketing or development of these products or could adversely affect market
demand for these products. Other allograft tissues processed and distributed by
the Company are currently regulated as "human tissue" under rules promulgated by
the FDA pursuant to the Public Health Services Act. These rules establish
requirements for donor testing and screening of human tissue and record keeping
36
relating to these activities and impose certain registration and product listing
requirements on establishments that process or distribute human tissue or
cellular-based products. The FDA has proposed and is refining a regulation that
will improve good tissue practices, akin to good manufacturing practices,
followed by tissue banks and processors of human tissue. It is anticipated that
these good tissue practices regulations when promulgated will enhance regulatory
oversight of the Company and other processors of human tissue.
BioGlue Surgical Adhesive is regulated as a Class III medical device and the
Company believes that its ACT may be regulated as a biologic or drug by the FDA.
The ACT has not been approved for commercial distribution in the United States.
or elsewhere. Fixed porcine heart valve products are classified as Class III
medical devices. There can be no assurance that the Company will be able to
obtain the FDA approval required to distribute its porcine heart valve products
in the United States. Distribution of these products within the EC is dependent
upon the Company maintaining its CE Mark and ISO 9001 certifications, of which
there can be no assurance.
Most of the Company's products in development, if successfully developed, will
require regulatory approvals from the FDA and perhaps other regulatory
authorities before they may be commercially distributed. The process of
obtaining required regulatory approvals from the FDA normally involves clinical
trials and the preparation of an extensive premarket approval ("PMA")
application and often takes many years. The process is expensive and can vary
significantly based on the type, complexity and novelty of the product. There
can be no assurance that any products developed by the Company, independently or
in collaboration with others, will receive the required approvals for
manufacturing and marketing.
Delays in obtaining United States or foreign approvals could result in
substantial additional cost to the Company and adversely affect the Company's
competitive position. The FDA may also place conditions on product approvals
that could restrict commercial applications of such products. Product marketing
approvals or clearances may be withdrawn if compliance with regulatory standards
is not maintained or if problems occur following initial marketing. Delays
imposed by the governmental clearance process may materially reduce the period
during which the Company has the exclusive right to commercialize patented
products.
Also, delays or rejections may be encountered during any stage of the regulatory
approval process based upon the failure of the clinical or other data to
demonstrate compliance with, or upon the failure of the product to meet, the
regulatory agency's requirements for safety, efficacy and quality, and those
requirements may become more stringent due to changes in applicable law,
regulatory agency policy or the adoption of new regulations. Clinical trials may
also be delayed due to unanticipated side effects, inability to locate, recruit
and qualify sufficient numbers of patients, lack of funding, the inability to
locate or recruit clinical investigators, the redesign of clinical trial
programs, the inability to manufacture or acquire sufficient quantities of the
particular product candidate or any other components required for clinical
trials, changes in the Company's or its collaborative partners' development
focus and disclosure of trial results by competitors.
Even if regulatory approval is obtained for any of the Company's products or
services, the scope of the approval may significantly limit the indicated usage
for which such products or services may be marketed. Products or services
marketed by the Company pursuant to FDA or foreign oversight or approvals are
subject to continuing regulation. In the United States, devices and biologics
must be manufactured in registered establishments (and, in the case of
biologics, licensed establishments) and must be produced in accordance with
Quality System Regulations. Manufacturing facilities and processes are subject
to periodic FDA inspection. Labeling and promotional activities are also subject
to scrutiny by the FDA and, in certain instances, by the Federal Trade
Commission. The export of devices and biologics is also subject to regulation
and may require FDA approval. From time to time, the FDA may modify such
regulations, imposing additional or different requirements. Failure to comply
with any applicable FDA requirements, which may be ambiguous, could result in
civil and criminal enforcement actions, warnings, citations, product recalls or
detentions and other penalties and could have a material adverse effect on the
Company's business, financial condition, results of operations, and cash flows.
As noted above, the FDA Order has had, and may continue to have such an effect.
37
In addition, The National Organ Transplant Act ("NOTA") prohibits the
acquisition or transfer of human organs for "valuable consideration" for use in
human transplantation. NOTA permits the payment of reasonable expenses
associated with the removal, transportation, processing, preservation, quality
control and storage of human organs. There can be no assurance that restrictive
interpretations of NOTA will not be adopted in the future that will challenge
one or more aspects of the Company's methods of charging for its preservation
services. The Company's laboratory operations are subject to the United States
Department of Labor, Occupational Safety and Health Administration and
Environmental Protection Agency requirements for prevention of occupational
exposure to infectious agents and hazardous chemicals and protection of the
environment. Some states have enacted statutes and regulations governing the
processing, transportation and storage of human organs and tissue.
More restrictive state laws or regulations may be adopted in the future and they
could have a material adverse effect on the Company's business, financial
condition, results of operations and cash flows.
UNCERTAINTIES RELATED TO PATENTS AND PROTECTION OF PROPRIETARY TECHNOLOGY
The Company owns several patents, patent applications and licenses relating to
its technologies, which it believes provide important competitive advantages.
There can be no assurance that the Company's pending patent applications will
issue as patents or that challenges will not be instituted concerning the
validity or enforceability of any patent owned by the Company, or, if
instituted, that such challenges will not be successful. The cost of litigation
to uphold the validity and prevent infringement of a patent could be
substantial. Furthermore, there can be no assurance that competitors will not
independently develop similar technologies or duplicate the Company's
technologies or design around the patented aspects of the Company's
technologies. There can be no assurance that the Company's proposed technologies
will not infringe patents or other rights owned by others.
In addition, under certain of the Company's license agreements, if the Company
fails to meet certain contractual obligations, including the payment of minimum
royalty amounts, such licenses may become nonexclusive or terminable by the
licensor, which could have a material adverse effect on the Company's business,
financial condition, results of operations, and cash flows. Additionally, the
Company protects its proprietary technologies and processes in part by
confidentiality agreements with its collaborative partners, employees and
consultants. There can be no assurance that these agreements will not be
breached, that the Company will have adequate remedies for any breach or that
the Company's trade secrets will not otherwise become known or independently
discovered by competitors, any of which could have a material adverse effect on
the Company's business, financial condition, results of operations, and cash
flows.
UNCERTAINTIES REGARDING FUTURE HEALTH CARE REIMBURSEMENT
Even though the Company does not receive payments directly from third-party
health care payors, their reimbursement methods and policies impact demand for
the Company's cryopreserved tissue and other services and products. The
Company's preservation services with respect to its cardiac, vascular, and
orthopaedic tissues may be particularly susceptible to third-party cost
containment measures. For example, the initial cost of a cryopreserved allograft
heart valve generally exceeds the cost of a mechanical, synthetic or
animal-derived valve. The Company is unable to predict what changes will be made
in the reimbursement methods and policies utilized by third-party health care
payors or their effect on the Company.
Changes in the reimbursement methods and policies utilized by third-party health
care payors, including Medicare, with respect to cryopreserved tissues provided
for implant by the Company and other Company services and products, could have a
material adverse effect on the Company. Significant uncertainty exists as to the
reimbursement status of newly approved health care products and services and
there can be no assurance that adequate third-party coverage will be available
for the Company to maintain price levels sufficient for realization of an
appropriate return on its investment in developing new products.
Government, hospitals, and other third-party payors are increasingly attempting
to contain health care costs by limiting both coverage and the level of
reimbursement for new products approved for marketing by the FDA and by refusing
in some cases to provide any coverage for uses of approved products for
38
indications for which the FDA has not granted marketing approval. If adequate
coverage and reimbursement levels are not provided by government and other
third-party payors for uses of the Company's new products and services, market
acceptance of these products would be adversely affected, which could have a
material adverse effect on the Company's business, financial condition, results
of operations and cash flows.
DEPENDENCE ON KEY PERSONNEL
The Company's business and future operating results depend in significant part
upon the continued contributions of its key technical personnel and senior
management, many of who would be difficult to replace. The Company's business
and future operating results also depend in significant part upon its ability to
attract and retain qualified management, processing, technical, marketing, sales
and support personnel for its operation. Competition for such personnel is
intense and there can be no assurance that the Company will be successful in
attracting and retaining such personnel. The loss of key employees, the failure
of any key employee to perform adequately or the Company's inability to attract
and retain skilled employees as needed could have a material adverse effect on
the Company's business, financial condition, results of operations and cash
flows.
VOLATILITY OF SECURITIES PRICES
The trading price of the Company's common stock has been subject to wide
fluctuations recently and may continue to be subject to such volatility in the
future. Trading price fluctuations can be caused by a variety of factors,
including regulatory actions such as the recent FDA Order, recent product
liability claims, quarter to quarter variations in operating results,
announcement of technological innovations or new products by the Company or its
competitors, governmental regulatory acts, developments with respect to patents
or proprietary rights, general conditions in the medical device or service
industries, actions taken by government regulators, changes in earnings
estimates by securities analysts or other events or factors, many of which are
beyond the Company's control. If the Company's revenues or operating results in
future quarters fall below the expectations of securities analysts and
investors, the price of the Company's common stock would likely decline further,
perhaps substantially. Changes in the trading price of the Company's common
stock may bear no relation to the Company's actual operational or financial
results. If the Company's share prices do not meet the requirements of the New
York Stock Exchange, the Company's shares may be delisted. The Company's closing
stock price since January 1, 2002 has ranged from a high of $31.31 to a low of
$1.89.
ANTI-TAKEOVER PROVISIONS
The Company's Articles of Incorporation and Bylaws contain provisions that may
discourage or make more difficult any attempt by a person or group to obtain
control of the Company, including provisions authorizing the issuance of
preferred stock without shareholder approval, restricting the persons who may
call a special meeting of the shareholders and prohibiting shareholders from
taking action by written consent. In addition, the Company is subject to certain
provisions of Florida law that may discourage or make more difficult takeover
attempts or acquisitions of substantial amounts of the Company's common stock.
Further, pursuant to the terms of a shareholder rights plan adopted in 1995,
each outstanding share of common stock has one attached right. The rights will
cause substantial dilution of the ownership of a person or group that attempts
to acquire the Company on terms not approved by the Board of Directors and may
have the effect of deterring hostile takeover attempts.
ABSENCE OF DIVIDENDS
The Company has not paid, and does not presently intend to pay, cash dividends.
The Company's major credit agreement contains, and future credit agreements may
contain, financial covenants, including covenants to maintain certain levels of
net worth and certain leverage ratios, which could have the effect of
restricting the amount of dividends that the Company may pay. It is not likely
that any cash dividends will be paid in the foreseeable future.
39
FORWARD-LOOKING STATEMENTS
This Form 10-Q includes "forward-looking statements" withincontains forward-looking statements and information made or
provided by the meaningCompany that are based on the beliefs of Section 27Aits management as well
as estimates and assumptions made by and information currently available to our
management. The words "could," "may," "might," "will," "would," "shall,"
"should," "pro forma," "potential," "pending," "intend," "believe," "expect,"
"anticipate," "estimate," "plan," "future" and other similar expressions
generally identify forward-looking statements, including, in particular,
statements regarding anticipated revenues, cost savings, insurance coverage,
regulatory activity, available funds and capital resources, and pending
litigation. These forward-looking statements are made pursuant to the safe
harbor provisions of the Securities Act of 1933, as amended (the "Securities Act"),
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange
Act") and the Private Securities Litigation Reform Act of 1995.
AllReaders are cautioned not to place undue reliance on these forward-looking
statements, other thanwhich are as of their respective dates.
Some of the forward-looking statements of historical facts, included herein which
address activities, events or developments which the Company expects or
anticipates will or may occurcontained in the future, including statements regarding thethis Form 10-Q include those
regarding:
o The impact of recent accounting pronouncements,pronouncements;
o The adequacy of product liability
insurance to defend against lawsuits, thecoverage;
o The outcome of lawsuits filed against the Company, theCompany;
o The impact of the FDA Order, related Agreements, reported tissue
infections, and the related Agreementadverse publicity on future revenues,
profits and business operations, the effect of the FDA Order on sales of
BioGlue, future tissue procurement levels, resulting from the FDA Order, the
Company's ability to address the observations detailed in the Warning Letter,
the outcome of the Company's appeal of the FDA Order,and
the estimates underlying the related charges recorded in the second
quarter dueand third quarter;
o The Company's intent to resume shipping orthopaedic tissue;
o Future costs of human tissue preservation services;
o The impact of the February 2003 FDA Order, the estimates
underlying the accrual to second quarter earnings established to account for the
cost to the Company483 and of the FDA Orderletter
regarding SynerGraft processed cardiovascular and the legal and professional fees
necessary becausevascular tissues;
o Expected future impact of the FDA Order, theBioGlue on revenues;
o The estimates of the amounts accrued for the retention levels under
itsthe Company's product liability and directors' and officers' insurance
policies, future costs of human tissue preservation services, changes
in liquidity and capital resources as a resultpolicies;
o The estimates of the FDA Order, the outcome of
any evaluation of allograft heart valves by the FDA, the possible adverse
outcome of the SEC investigation referenced in the SEC Letter, futureamounts accrued for product development plans as a result of the FDA Order, the Company's competitive
position, the successful development of its SynerGraft porcine heart valves,
funding available to continue development of the ACT, estimated dates relating
to the Company's proposed regulatory submissions, the Company's expectations
regarding theliability claims
incurred but not reported at March 31, 2003; and
o The adequacy of current financing arrangements, product demand and
market growth, the potential of the ACT for use in cancer therapies, fibrin
olysis (blood clot dissolving), and other drug delivery applications, the
outcome of litigation, the impact on the Company of adverse results of surgery
utilizing tissue processed by it, and other statements regarding future plans
and strategies, anticipated events or trends and similar expressions concerning
matters that are not historical facts are forward-looking statements.growth.
These statements are based on certain assumptions and analyses made by the
Company in light of its experience and its perception of historical trends,
current conditions, and expected future developments as well as other factors it
believes are appropriate in the circumstances. However, whether actual results
and developments will conform towith the Company's expectations and predictions is
subject to a number of risks and uncertainties, as is the Company's business.
These risks and uncertainties which could cause actual results
to differ materially from the Company's expectations, includeincluding without
limitation, in addition to those specified in the text surrounding such
statements, the risk factors discussedset forth below, the risks set forth under "Risk
Factors" in thisPart I, Item 1 of the Company's Form 10-Q10-K for the year ended
December 31, 2002 and other factors, many of which are beyond the control of the
Company. Consequently, all of the forward-looking statements made in this Form
10-Q are qualified by these cautionary statements and there can be no assurance
that the actual results or developments anticipated by the Company will be
realized or, even if substantially realized, that they will have the expected
consequences to or effects on the Company or its business or operations. The
Company assumes no obligation to update publicly any such forward-looking
statements, whether as a result of new information, future events, or otherwise.
40The risks and uncertainties which might impact the forward-looking statements
and the Company include concerns that:
o The impact of the FDA Order, the FDA Warning Letter, reported tissue
infections, and the resulting adverse publicity on CryoLife's
business, liquidity and capital resources has been and may continue to
be material;
o The Company may not be able to obtain sufficient cardiovascular,
vascular, and orthopaedic tissue to operate profitably;
o Shipments of orthopaedic tissues are now minimal and demand may not
return;
o Physicians may be reluctant to implant the Company's preserved
tissues;
o Heart valves processed by the Company may also be recalled;
29
o Products not included in the FDA Order may come under increased
scrutiny;
o Demand for heart valves processed by the Company has decreased and may
decrease further in the future;
o Adverse publicity may reduce demand for products not affected by the
FDA Order;
o We may be unable to address the concerns raised by the FDA in its
February 2003 Form 483 Notice of Observations, or the February 2003
letter regarding the use of SynerGraft technology to process human
tissue;
o Regulatory action outside of the U.S. may also affect the Company's
business;
o The Company's common stock is potentially at risk of being delisted
from the New York Stock Exchange;
o The Company is the subject of an informal SEC investigation;
o As a result of the FDA Order and resulting financial impact,
CryoLife's lender has notified it that it is in default of certain
provisions of the Company's credit facility, resulting in cross
defaults under CryoLife's lease;
o The Company's insurance coverage may be insufficient to cover
judgments under existing or future claims;
o Insurance coverage may be difficult or impossible to obtain in the
future and if obtained, the cost of insurance coverage is likely to be
much more expensive than in the past;
o Intense competition may affect the Company's ability to recover from
the FDA Order and develop its surgical adhesive business;
o Extensive government regulation may retard the Company's ability to
develop and sell products and services; and
o Uncertainties regarding future health care reimbursement may affect
the amount and timing of the Company's revenues.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
The Company's interest income and expense are most sensitive to changes in the
general level of United States interest rates. In this regard, changes in United
States interest rates affect the interest earned on the Company's cash and cash
equivalents of $12.2$6.9 million and short-term investments in municipal obligations
of $15.9$13.3 million as of September 30, 2002,March 31, 2003, as well as interest paid on its debt. A
10% adverse change in interest rates affecting the Company's cash equivalents
and short-term investments would not have a material impact on the Company's
interest income for 2002.2003.
The Company manages interest rate risk through the use of fixed debt and an
interest rate swap agreement. At September 30, 2002March 31, 2003 approximately $3.0$2.6 million of
the Company's $6.0$5.2 million in debt charged interest at a fixed rate. This fixed
rate debt includes a portion of the Company's outstanding term loan balance that
has been effectively converted to fixed rate debt through an interest rate swap
agreement. A 10% increase in interest rates affecting the Company's variable
rate debt, net of the effect of the interest rate swap agreement, would not have
a material increase in the Company's interest expense for 2002.2003. A 10% decrease
in interest rates would not have a material effect on the interest rate swap
agreement.
Item 4. Controls and Procedures.
With the participation of management, the Company's President and Chief
Executive Officer along with the Company's Vice President of Finance, Treasurer,
and Chief Financial Officer evaluated the Company's disclosure controls and
procedures within 90 days of the filing date of this quarterly report. Based
upon this evaluation, the Company's President and Chief Executive Officer along
with the Company's Vice President of Finance and Chief Financial Officer
concluded that the Company's disclosure controls and procedures are effective in
ensuring that material information required to be disclosed is included on a
timely basis in the reports that it files with the Securities and Exchange
Commission.
There were no significant changes in the Company's internal controls or, to the
knowledge of the management of the Company, in other factors that could
significantly affect these controls subsequent to the evaluation date.
4130
Part II - OTHER INFORMATION
Item 1. Legal Proceedings.
In the normal course of business as a medical device and services company the
Company has product liability complaints filed against it. As of OctoberApril 28, 2002 fifteen2003
twenty-three cases had beenwere open that were filed against the Company between May 18,
2000 and October 8, 2002.April 14, 2003. The cases are currently in the pre-discovery or
discovery stages. Of these cases, nine15 allege product liability claims arising out
of the Company's orthopaedic tissue fourservices, seven allege product liability
claims arising out of the Company's allograft heart valve tissue one alleges product liability claims arising out of
the Company's allograft vascular tissue,services, and
one alleges product liability claims arising out of the non-tissue products made
by Ideas for Medicine, when it was a subsidiary of the Company.
IncludedOn March 31, 2003 the Company announced that a settlement has been reached in
these cases is the lawsuit brought against the Company by the estate of Brian Lykins. The
complaint filed against the Company in the Superior Court of Cobb County,
Georgia, on July 12, 2002 by Steve Lykins, as Trustee for the benefit of next of
kin of Brian Lykins. This
complaint allegesLykins alleged strict liability, negligence, professional negligence, and breach of
warranties related to tissue implanted in November 2001. In addition to this
lawsuit, three other lawsuits have been dismissed or were settled during the
first quarter of 2001.2003. The plaintiff seeks unspecified compensatorytotal settlements involved in these cases including
amounts paid by the Company and punitive damages.its insurer were less than 10% of total current
assets at March 31, 2003.
The Company maintains claims-made insurance policies, which the Company believes
to be adequate to defend against these suits. The Company's insurance company
has been notified of these actions. The Company intends to vigorously defend
against these claims. Nonetheless, an adverse judgment or judgments imposing
aggregate liabilities in excess of the Company's insurance coverage could have a
material adverse effect on the Company's financial position, results of
operations, and cash flows.
Claims-made insurance policies cover only those asserted claims and incidents
that are reported to the insurance carrier while the policy is in effect. Thus,
a claims-made policy does not represent a transfer of risk for claims and
incidents that have been incurred but not reported to the insurance carrier. The
Company periodically evaluates its exposure to unreported product liability
claims, and records accruals as necessary for the estimated cost of unreported
claims related to services performed and products sold. As of December 31, 2002
the Company accrued $3.6 million in estimated costs for unreported product
liability claims related to services performed and products sold prior to
December 31, 2002. The expense was recorded in 2002 in general, administrative,
and marketing expenses and was included as a component of accrued expenses and
other current liabilities on the Summary Consolidated Balance Sheets. As of
March 31, 2003 the accrual for unreported product liability claims remained
unchanged for services performed and products sold prior to March 31, 2003.
The Company has concluded that it is probable that it will incur losses relating
to asserted claims and pending litigation of at least $1.2 million, which
represents the aggregate amount of the Company's retention under its product
liability and directors' and officers' insurance policies. Therefore, the
Company recorded an accrual of $1.2 million during 2002. As of March 31, 2003
the remaining accrual for the retention levels decreased to $750,000 due to
required insurance retention payments made related to legal settlements reached
during the first quarter of 2003.
Several putative class action lawsuits were filed in July through September 2002
against the Company and certain officers of the Company, alleging that the
defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of
1934 and Rule 10b-5 promulgated there under,thereunder by issuing a series of purportedly
materially false and misleading statements to the market throughoutmarket. During the Class Period of August of 2000 through Augustthird
quarter of 2002 which statements had the effectCourt consolidated the suits, and on November 14, 2002 lead
plaintiffs and lead counsel were named. A consolidated complaint was filed on
January 15, 2003, seeking the Court's certification of artificially inflating the market pricelitigation as a class
action on behalf of all purchasers of the Company's securities.stock between April 2, 2001
and August 14, 2002. The principal allegations of the complaintsconsolidated complaint are
that the Company failed to disclose its alleged lack of compliance with certain
FDA regulations regarding the handling and processing of certain tissues and
other product safety matters. TheIn the consolidated complaint, plaintiffs seek unspecifiedto
recover compensatory damages in an amount to be
proven at trial.and various fees and expenses of litigation,
including attorneys' fees. The Company believes these cases will beand the other defendants filed a motion
to dismiss the consolidated into one putative class action lawsuit. The Company believescomplaint on February 28, 2003 which remains pending
before the claims
made in the lawsuits are without merit and intends to vigorously defend
against these claims. Management has retained the services of the
Atlanta based law firm of King & Spalding to defend the Company.Court. The Company carries director'sdirectors' and officer'sofficers' liability
31
insurance policies, which the Company believes to be adequate to defend against
these suits.this action. Nonetheless, an adverse judgment in excess of the Company's
insurance coverage could have a material adverse effect on the Company's
financial position, results of operations, and cash flows.
The Company received notice in October thatOn August 30, 2002 a complaint had been filed
instituting apurported shareholder derivative action was filed by
Rosemary Lichtenberger against the Company and
Company officers and directors Steven G. Anderson, Albert E. Heacox, John W.
Cook, Ronald C. Elkins, Virginia C. Lacy, Ronald D. McCall, Alexander C.
Schwartz, and Bruce J. Van Dyne. The suit was filedDyne in the Superior Court of Gwinnett County,
Georgia, by Rosemary Lichtenberger
but has not been served on the defendants.Georgia. The suit, which names the Company as a nominal defendant, alleges that
the individual defendants breached their fiduciary duties to the Company by
causing or allowing the Company to engage in certain inappropriate practices
that caused the Company to suffer damagesdamages. The complaint was preceded by being outone day
by a letter written on behalf of compliance with FDA
guidelines, andMs. Lichtenberger demanding that the Company's
Board of Directors take certain actions in response to her allegations. On
January 16, 2003, another purported derivative suit alleging claims similar to
those of the Lichtenberger suit was filed in the Superior Court of Fulton County
by causingcomplainant Robert F. Frailey. As in the CompanyLichtenberger suit, the filing of
the complaint in the Frailey action was preceded by a purported demand letter
sent on Frailey's behalf to issue press releases that
erroneously portrayed CryoLife's products, operations, financial results
and future prospects. The complainant seeksthe Company's Board of Directors. Both complaints
seek undisclosed damages, costs and attorney's fees, punitive damages, and
prejudgment interest against the individual defendants derivatively on behalf of
the Company as a
nominal defendant. Filing of the complaint was preceded by a demand
letter on behalf of the complainant dated one day prior to the filing of
the suit. Another derivative demand letter of similar import was
received on behalf of complainant Robert F. Fraley; however, to the
Company's knowledge, no suit has yet been filed by Mr. Fraley.Company. The
42
Company's Board of Directors has established an independent
committee to investigate the claims asserted in theallegations of Ms. Lichtenberger complaint and the
demands made in the Fraley letter and report back to the Board with its
recommendations for action in response to the shareholders' demands.Mr. Frailey.
The independent committee has engaged independent legal counsel to assist in the
investigation.
On August 7, 2002 the Company announced the settlement of its ongoing
litigation with Colorado State University Research Foundation ("CSURF")
over the ownership of the Company's SynerGraft technology. The
settlement resolves all disputes between the parties and extinguishes
all CSURF ownership claims to any aspect of the Company's SynerGraft
technology. The settlement includes an unconditional assignment to the
Company of CSURF tissue engineering patents, trade secrets and know-how
relating to tissue decellularization and recellularization. The
technology assignment supercedes the 1996 technology license, which was
terminated by the terms of the settlement. Payment terms include a
nonrefundable advance of $400,000 paid by the Company to CSURF that will
be applied to earned royalties as they accrue through March 2011. The
Company recorded these amounts as prepaid royalties and will expense the
amounts as the royalties accrue. The earned royalty rate is a maximum of
0.75% of net revenues from products or tissue services utilizing the
SynerGraft technology. Royalties earned under the agreement for revenues
through September 30, 2002 were approximately $33,000.
On August 17, 2002 the Company received a letter from the United States
Securities and Exchange Commission (the "SEC Letter") that stated that
the Company was subject to an investigation related to the Company's
August 14, 2002 announcement of the FDA Order and requesting information
from the Company from the period between September 1, 2001 through the
date of the Company's response to the SEC Letter. The SEC Letter stated,
in part, that "We are trying to determine whether there have been any
violations of the federal securities laws. The investigation and the
subpoena do not mean that we have concluded that anyone has broken the
law. Also, the investigation does not mean that we have a negative
opinion of any person, entity or security." The staff of the SEC
subsequently confirmed that its investigation is informal in nature, and
that it does not have subpoena power at this time. At the present time,
the Company is unable to predict the outcome of this matter.
The Company has concluded that it is probable that it will incur losses
relating to claims and litigation of at least $1.2 million; which
represents the aggregate amount of the Company's deductibles under its
product liability and directors and officer's insurance policies.
Therefore the Company has recorded an accrual of $1.2 million as of June
30, 2002.currently proceeding.
Item 2. Changes in Securities.
None
Item 3. Defaults Upon Senior Securities.
See Note 65 to the Summary Consolidated Financial Statements for information
regarding a notification by the Company's lender that the FDA Order and the
inquiries of the SEC have had a material adverse effect on the Company,
which constitutes an event of default. The lender has elected not to
declare an event of default at this time.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
43
Item 5. Other information.
Alexander C. Schwartz, Jr. resigned from the Board of Directors on
October 14, 2002 due to health reasons following a lengthy illness.None.
Item 6. Exhibits and Reports on Form 8-K
(a) The exhibit index can be found below.
Exhibit
Number Description
3.1- ------- -----------
3.1* Restated Certificate of Incorporation of the Company, as amended.
(Incorporated by reference to Exhibit 3.1 to the Registrant's Annual
Report on Form 10-K for the fiscal year ended December 31, 2000.)
3.23.2* ByLaws of the Company, as amended.
(Incorporated by reference to
Exhibit 3.2 to the Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1995.)32
3.3 Articles of Amendment to the ArticlesCertificate of Incorporation of the
Company. (Incorporated by reference to Exhibit 3.3 to the Registrant's
Annual Report on Form 10-K for the fiscal year ended December 31,
2000.)
4.1 Form of Certificate for the Company's Common Stock. (Incorporated by
reference to Exhibit 4.1 to the Registrant's Registration Statement on
Form S-1 (No. 33-56388).
10.1* Second Amendment to Construction Loan and Permanent FinancingLetter Agreement dated July 30, 2002, by and between the Company and Bank of
America.FDA, dated March 17, 2003.
10.2* Promissory Note by and between the Company and Bank of America, dated
July 30, 2002.
10.3* Settlement and Release Agreement, dated August 2, 2002, by and between
Colorado State University Research Foundation, the Company and Dr. E.
Christopher Orton.
10.4* Employment Agreement, by and between the Company and D. Ashley Lee,
dated September 3, 2002.
10.5* Employment Agreement, by and between the Company and Sidney B.
Ashmore, dated September 3, 2002.
10.6* Employment Agreement, by and between the Company and Kirby S. Black,
dated September 3, 2002.
10.7* Employment Agreement, by and between the Company and Albert E. Heacox,
dated September 3, 2002.
10.8* Employment Agreement, by and between the Company and David M. Fronk,
dated September 3, 2002.
10.9* Employment Agreement, by and between the Company and James C. Vander
Wyk, dated September 3, 2002.
10.10*First Amendment to Employment Agreement, by and between the Company
and Steven G. Anderson, dated September 3, 2002.
44
10.11 Letter Agreement between the Company and FDA, dated September 5, 2002.
(Incorporated by reference to Exhibit 10.38 to the registrant's report
of Form 8-K filed on September 6, 2002).
10.12* Eighth Amendment to Lease dated February 13, 1986, by and between New
Market Partners III, Laing Properties, Inc., General Partner, as
Landlord, and the Company as tenant, dated November 18, 1998.
10.13* Ninth Amendment to Lease dated February 13, 1986, by and between New
Market Partners III, Laing Properties, Inc., General Partner, as
Landlord, and the Company as tenant, dated July 25, 2001.
10.14* Tenth Amendment to Lease dated February 13, 1986, by and between New
Market Partners III, Laing Properties, Inc., General Partner, as
Landlord, and the Company as tenant, dated June 25, 2002.
10.15* First Amendment to Lease dated July 23, 1993, by and between Newmarket
Partners I, Laing Properties, Inc. and Laing Management Company,
General Partner, as Landlord, and the Company as Tenant, dated June 9,
1994.
10.16* Second Amendment to Lease dated July 23, 1993, by and between
Newmarket Partners I, Laing Properties, Inc. and Laing Management
Company, General Partner, as Landlord, and the Company as Tenant,
dated June 6, 1998.
10.17* Third Amendment to Lease dated July 23, 1993, by and between Newmarket
Partners I, Laing Properties, Inc. and Laing Management Company,
General Partner, as Landlord, and the Company as Tenant, dated August
3, 2001.
10.18* Fourth Amendment to Lease dated July 23, 1993, by and between
Newmarket Partners I, Laing Properties, Inc. and Laing Management
Company, General Partner, as Landlord, and the Company as Tenant,
dated June 25, 2002.
99.1* Certification Pursuant To 18 U.S.C. Section 1350, As Adopted Pursuant
To Section 906 Of The Sarbanes-Oxley Act Of 2002.
(b) No Reports on Form 8-K were filed during the quarter.
- ------------------------
* Filed herewith.
(b) Current Reports on Form 8-K.
The Registrant filed a Current Report on Form 8-K with the Commission on
September 6, 2002 with respect to the Letter Agreement between the Company and
the FDA.
4533
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CRYOLIFE, INC.
(Registrant)
/s/ STEVEN G. ANDERSON /s/ DAVID ASHLEY LEE
- ------------------------------------------------------------------------ ----------------------------------
STEVEN G. ANDERSON DAVID ASHLEY LEE
Chairman, President, and Vice President, Treasurer, and Chief Financial
Chief Executive Officer Chief Financial Officer
(Principal Financial and
Accounting Officer)
October 29, 2002May 2, 2003
- ------------------------
DATE
4634
CERTIFICATIONS
I, Steven G. Anderson, Chairman, President, and Chief Executive Officer, certify
that:
1. I have reviewed this quarterly report on Form 10-Q of CryoLife, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report.
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal controls or
in other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: October 29, 2002May 5, 2003
/s/ STEVEN G. ANDERSON
------------------------------------------------------------------------
Chairman, President, and Chief
Executive Officer
4735
I, David Ashley Lee, Vice President, Treasurer, and Chief Financial Officer,
certify that:
1. I have reviewed this quarterly report on Form 10-Q of CryoLife, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report.
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal controls or
in other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: October 29, 2002May 5, 2003
/s/DAVID ASHLEY LEE
------------------------------------------------------------------
Vice President, Treasurer, and
Chief Financial Officer
48
1505366v236