Healthtronics 10Q 2004 Q2 Quarterly report

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 June 30, 2004

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR

15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 000-30406

HealthTronics Surgical Services, Inc.

(Exact name of registrant as specified in its charter)

Georgia

58-2210668

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

1841 West Oak Parkway, Suite A

Marietta, Georgia

30062

(Address of principal executive offices)

(Zip Code)

(770) 419-0691

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yesx] No¨

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

Yesx No¨

Indicate the number of shares outstanding of each of the issuer’s classes of common stock.

12,397,000 Shares of No Par Value Common Stock as of July 31, 2004

HEALTHTRONICS SURGICAL SERVICES, INC.

INDEX TO FORM 10-Q

PART I. FINANCIAL INFORMATION


		Page

Item 1.	Financial Statements

	Condensed Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003	3

	Condensed Consolidated Statements of Income for the three-month and the six-month periods ended June 30, 2004 and 2003	5

	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2003	6

	Notes to Condensed Consolidated Financial Statements	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	20

Item 3.	Quantitative and Qualitative Disclosure of Market Risk	31

Item 4.	Controls and Procedures	31

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	31

Item 4.	Submission of Matters to a Vote of Security Holders	32

Item 6.	Exhibits and Reports on Form 8-K	32

	Signatures	33

Part 1.Financial Information

Item 1.Financial Statements

HealthTronics Surgical Services, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(000’s omitted)


	June 30, 2004			December 31, 2003
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	8,746		$	9,040
Trade accounts receivable, less allowance for doubtful accounts of $1,685 and $1,669 at June 30, 2004 and December 31, 2003, respectively		17,075			14,484
Other receivables		1,310			—
Inventory		11,828			7,819
Prepaid expenses and other current assets		2,618			1,224
Deferred income taxes		800			774

Total current assets		42,377			33,341
Property and equipment, at cost:
Land		349			349
Building and leasehold improvements		2,368			1,182
Medical devices placed in service		25,246			24,420
Office equipment, furniture and fixtures		1,806			1,646
Vehicles and accessories		3,809			3,604

		33,578			31,201
Less accumulated depreciation		(12,495	)		(11,768	)

Net property and equipment		21,083			19,433
Investments in unconsolidated entities		936			2,207
Goodwill		67,323			48,317
Other assets		3,462			3,585

Total assets	$	135,181		$	106,883


	June 30, 2004		December 31, 2003
	(Unaudited)
Liabilities and shareholders’ equity
Current liabilities:
Trade accounts payable	$	7,376	$	5,035
Income taxes payable		1,960		1,605
Other accrued expenses		13,517		5,507
Deferred profit on medical devices and service contracts		1,618		375
Short-term borrowings		22,273		11,714
Current portion of capital lease obligations		278		281
Current portion of long-term debt		1,889		5,906

Total current liabilities		48,911		30,423
Deferred profit on medical device sales to related parties (subject to debt guarantees)		256		248
Noncurrent deferred income taxes		623		669
Capital lease obligations, less current portion		316		409
Long-term debt, less current portion		8,264		4,718
Minority interest in consolidated subsidiaries		27,849		28,085
Other liabilities		2,824		1,953

Total liabilities		89,043		66,505
Shareholders’ equity:
Common stock - no par value, voting:
Authorized - 30,000 shares at June 30, 2004 and December 31, 2003; Issued - 12,396 and 11,639 shares at June 30, 2004 and December 31, 2003, respectively; Outstanding - 12,394 and 11,584 at June 30, 2004 and December 31, 2003, respectively		24,187		19,034
Accumulated other comprehensive expense		—		(32	)
Retained earnings		21,951		21,376

Total shareholders’ equity		46,138		40,378

Total liabilities and shareholders’ equity	$	135,181	$	106,883

See accompanying notes.

HealthTronics Surgical Services, Inc. and Subsidiaries

Condensed Consolidated Statements of Income

(Unaudited)

(000’s omitted except per share information)


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Net revenue	$	25,334		$	21,455		$	49,074		$	42,343
Cost of devices, service parts and consumables		4,933			4,553			9,906			8,813
Salaries, general and administrative expenses		13,066			9,792			24,417			19,372
Depreciation and amortization		1,498			1,424			3,060			2,804

		5,837			5,686			11,691			11,354
Equity in earnings of unconsolidated partnerships		160			221			489			479
Partnership distributions from cost based investments		174			160			376			278
Gain on sale of investment interest		10			142			255			2,216
Gain on sale of property and equipment		94			9			240			15
Interest expense		(518	)		(511	)		(1,106	)		(1,044	)
Interest income		94			40			109			75

Income before minority interest and income taxes		5,851			5,747			12,054			13,373
Minority interest		(4,999	)		(4,600	)		(10,549	)		(8,729	)

Income before income taxes		852			1,147			1,505			4,644
Provision for income taxes		(626	)		(449	)		(930	)		(1,817	)

Net income	$	226		$	698		$	575		$	2,827

Income per common share:
Basic	$	0.02		$	0.06		$	0.05		$	0.25

Diluted	$	0.02		$	0.06		$	0.05		$	0.24

Weighted average common shares outstanding:
Basic		12,386			11,539			12,100			11,434

Diluted		12,470			11,842			12,143			11,715

See accompanying notes.

HealthTronics Surgical Services, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(000’s omitted)


	Six months ended June 30,
	2004			2003
Operating activities
Net income	$	575		$	2,827
Adjustments to reconcile net income to cash provided by operating activities:
Net change in fair value of interest rate swap		32			121
Depreciation and amortization		3,060			2,804
Amortization of loan costs		436			142
Provision for doubtful accounts		33			44
Deferred income taxes		131			(268	)
Deferred profit on medical device sales and service contracts		663			518
Equity in earnings of unconsolidated partnerships, net of distributions		638			479
Minority interest in subsidiaries, net of distributions to minority interests		(1,149	)		(606	)
Gain on sale of investment interest		(255	)		(2,216	)
Gain on sale of property and equipment		(240	)		(15	)
Changes in operating assets and liabilities, net of businesses acquired:
Trade accounts receivable		812			1,147
Other receivables		(300	)		411
Inventory		(183	)		(1,025	)
Prepaid expenses and other assets		(1,361	)		(50	)
Trade accounts payable		(1,811	)		(40	)
Income taxes payable		355			(1,871	)
Accrued expenses and other liabilities		(1,345	)		(1,207	)

Net cash provided by operating activities	$	91		$	1,195

HealthTronics Surgical Services, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows (continued)

(Unaudited)

(000’s omitted)


	Six months ended June 30,
	2004			2003
Investing activities
Purchases of property and equipment, net of businesses acquired	$	(2,901	)	$	(3,479	)
Proceeds from sale of property and equipment		830			636
Proceeds from sale of investment interest		888			3,958
Acquisition of partnership interest, net of distributions		—			(764	)
Acquisition of businesses, net of cash acquired		(1,478	)		(3,923	)

Net cash used in investing activities		(2,661	)		(3,572	)

Financing activities
Proceeds from issuance of common stock		67			769
Proceeds from issuance of long-term debt		4,654			524
Principal payments on long-term debt and capital leases		(11,214	)		(9,845	)
Proceeds from issuance of short-term borrowings		27,146			4,300
Principal payments on short-term borrowings		(18,377	)		(1,300	)

Net cash provided by (used in) financing activities		2,276			(5,552	)

Net decrease in cash and cash equivalents		(294	)		(7,929	)
Cash and cash equivalents at beginning of period		9,040			16,808

Cash and cash equivalents at end of period	$	8,746		$	8,879

See accompanying notes.

HealthTronics Surgical Services, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

1. Basis of Presentation

The accompanying condensed consolidated financial statements include the accounts of HealthTronics Surgical Services, Inc. (“HealthTronics” or the “Company”) and its subsidiaries. All significant intercompany transactions have been eliminated.

In the opinion of HealthTronics management, the accompanying consolidated financial statements include all the necessary adjustments (consisting of normal recurring adjustments) for a fair presentation of its consolidated financial position and results of operations for the interim periods presented. The information presented in these financial statements was prepared in conformity with accounting principles generally accepted in the United States for interim financial information and instructions for Form 10-Q and Rule 10-01 of Regulation S-X. Although management believes that the disclosures in these financial statements are adequate to make the information presented not misleading, certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. These financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 filed with the Securities and Exchange Commission.

Preparation of these interim condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States requires management to make certain estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. The interim results may not be indicative of the results that may be expected for the year.

Certain prior year balances have been reclassified to conform to the 2004 presentation.

2. Summary of Significant Accounting Policies

Cash Equivalents

The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.

Revenue Recognition, Gain Recognition and Allowance for Doubtful Accounts

Net revenue includes treatment fees for medical procedures in the clinical setting. Treatment revenue is primarily “wholesale” or “retail”. Wholesale revenue is generated primarily from fixed fee contracts with various medical facilities and is recorded in the month the related treatments are performed. Retail revenue, when third party payors are billed directly for medical facility and technical fees, is recorded at the time services are rendered. These third party billings may or may not be contractual. In determining net revenue, adjustments that

reduce retail treatment revenue from established contractual or estimated non-contractual billing rates to amounts estimated to be reimbursable are recognized in the period the services are rendered. Differences in estimates recorded and final settlements are reported during the period final settlements are made. The Company has certain negotiated agreements with third party payors that provide for payments to the Company or its subsidiaries. These payment arrangements may be based upon negotiated rates or per diem payments. Revenues are reported at the estimated net realizable amounts from medical facilities, contracted and non-contracted third party payors and individual patients for services rendered.

For sales of medical devices to unaffiliated entities, revenue is recognized upon delivery at the customer’s destination and customer acceptance.

We may sell medical devices to certain entities in which we have an interest and may have guaranteed a portion of the long-term obligations related to such purchases. We eliminate profits on such transactions where the purchaser is a consolidated subsidiary of ours. A pro rata portion of the profit representing our percentage of ownership will be deferred on sales to unconsolidated subsidiaries where we have accounted for our investment interest using the equity or cost basis methods of accounting (depending on our ability to exercise significant influence over the operating and financial policies of the joint venture.)

Revenue generated from service contracts is recognized ratably over the life of the related contract.

Accounts receivable consist primarily of amounts due from the medical facilities or partnerships, managed care health plans, commercial insurance companies and individual patients. The Company does not charge interest on its accounts receivable. Estimated provisions for doubtful accounts are recorded to the extent it is probable that a portion or all of a particular account will not be collected. In evaluating the collectibility of accounts receivable, the Company considers a number of factors, including the age of the accounts, changes in collection patterns, the composition of accounts by payor type, the status of ongoing negotiations with third party payors and general industry conditions. Changes in these estimates are charged or credited to the results of operations in the period of the change. The Company writes off accounts receivable when all collection efforts have been exhausted.

Inventory

Inventory is carried at the lower of historical cost (first-in, first-out) or market and consists of medical devices, spare parts, assemblies and consumables.

Consolidation and Partnership Investments

Historically, the Company has made a number of investments in various entities including general and limited partnerships. The majority of these investments are consolidated based upon the Company’s ability to exercise control. The remaining investments are recorded using the cost or equity method of accounting, depending upon the Company’s ability to exercise significant influence over the operating and financial policies of the partnership.

Variable Interest Entities

In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation 46,Consolidation of Variable Interest Entities, an Interpretation of ARB

No. 51 (“FIN 46”). In December 2003, the FASB modified FIN 46 to make certain technical corrections and address certain implementation issues that had arisen. FIN 46 provides a new framework for identifying variable interest entities (“VIEs”) and determining when a company should include the assets, liabilities, noncontrolling interests and results of activities of a VIE in its consolidated financial statements.

In general, a VIE is a corporation, partnership, limited-liability corporation, trust, or any other legal structure used to conduct activities or hold assets that either (1) has an insufficient amount of equity to carry out its principal activities without additional subordinated financial support, (2) has a group of equity owners that are unable to make significant decisions about its activities, or (3) has a group of equity owners that do not have the obligation to absorb losses or the right to receive returns generated by its operations.

FIN 46 requires a VIE to be consolidated if a party with an ownership, contractual or other financial interest in the VIE (a variable interest holder) is obligated to absorb a majority of the risk of loss from the VIE’s activities, is entitled to receive a majority of the VIE’s residual returns (if no party absorbs a majority of the VIE’s losses), or both. A variable interest holder that consolidates the VIE is called the primary beneficiary. Upon consolidation, the primary beneficiary generally must initially record all of the VIE’s assets, liabilities and noncontrolling interests at fair value and subsequently account for the VIE as if it were consolidated based on majority voting interest. FIN 46 also requires disclosures about VIEs that the variable interest holder is not required to consolidate but in which it has a significant variable interest. The Company does not have any significant variable interests in a VIE and the Company does not consolidate any VIEs.

Impairment of Long-Lived Assets

In accordance with Statement of Financial Accounting Standards No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets, management reviews long-lived assets used in operations for impairment when there is an event or change in circumstances that indicates the carrying amount of the asset may not be recoverable and the future undiscounted cash flows expected to be generated by the asset are less than its carrying amount. If such assets are considered to be impaired, the Company records impairment losses and reduces the carrying amount of impaired assets to an amount that reflects the fair value of the assets at the time impairment is evident. The Company’s impairment review process relies on management’s judgment regarding the indicators of impairment, the remaining lives of assets used to generate assets’ undiscounted cash flows, and the fair value of assets at a particular point in time. Management uses historical experience, current market appraisals and various other assumptions to form the basis for making judgments about the impairment of real estate assets. Under different assumptions or conditions, the asset impairment analysis may yield a different outcome, which would alter the gain or loss on the eventual disposition of the asset.

Property and Equipment

Property and equipment is stated at cost. Depreciation (which includes amortization of assets under capital leases) is computed based on the straight-line method over three to seven years based on the estimated useful lives of the related equipment or over the term of the related lease or over 39 years for buildings.

Income Taxes

The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that are expected to be in effect when the differences are expected to be recovered or settled.

The Company recognizes deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. The Company regularly reviews its deferred tax assets for recoverability and establishes a valuation allowance based upon projected future taxable income and the expected timing of the reversals of existing temporary differences.

The Company is unable to realize the benefit of net losses of foreign subsidiaries resulting in a tax rate in excess of the statutory rate.

Stock Based Compensation

The Company has elected to follow Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, and related Interpretations in accounting for employee stock options and adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123,Accounting for Stock Based Compensation (“SFAS 123”) as amended by Statements of Financial Accounting Standards No. 148,Accounting for Stock-Based Compensation – Transitional Disclosure, an Amendment to SFAS No. 123, (“SFAS 148”) for option grants to employees. The Company generally grants stock options for a fixed number of shares to employees with an exercise price equal to the fair value of the shares at the date of grant and, accordingly, recognizes no compensation expense for the employee stock option grants.

The following table illustrates the effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS 123 as amended by SFAS 148.


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
	(000’s omitted except per share information)
Net income — as reported	$	226		$	698		$	575		$	2,827
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(377	)		(194	)		(743	)		(359	)

Net income — pro forma	$	(151	)	$	504		$	(168	)	$	2,468

Earnings per share — as reported:
Basic	$	0.02		$	0.06		$	0.05		$	0.25
Diluted	$	0.02		$	0.06		$	0.05		$	0.24
Earnings (loss) per share — pro forma:
Basic	$	(0.01	)	$	0.04		$	(0.01	)	$	0.22
Diluted	$	(0.01	)	$	0.04		$	(0.01	)	$	0.21

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates and such differences may be material.

Related Party Transactions

Transactions between related parties and between different subsidiaries of the Company occur in the normal course of business. The Company eliminates transactions with its consolidated subsidiaries and appropriately discloses significant related party transactions.

Concentrations of Credit Risk

The Company sells its products primarily in the United States. Credit is extended based on an evaluation of the customer’s financial condition and collateral is generally not required. Accounts receivable are generally receivable from medical facilities, insurance companies or patients.

Fair Value of Financial Instruments

The Company’s financial instruments are comprised principally of cash and cash equivalents, trade accounts receivable, amounts due from affiliated partnerships, trade accounts payable, customer deposits, short-term borrowings and long-term debt. The carrying amounts of these financial instruments approximate their fair values.

Long-Lived Assets

The Company has recorded property, plant and equipment and intangible assets at cost less accumulated depreciation and amortization. The determination of useful lives and whether or not these assets are impaired involves significant judgment. The Company reviews long-lived assets, including identifiable intangible assets whenever events or changes in circumstances indicate the carrying amounts of such assets may not be recoverable. Goodwill is the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations accounted for as purchases. Goodwill is subject to annual testing for impairment at the reporting unit level unless events or circumstances indicate the carrying amount is impaired.

Other Comprehensive Income or Expense

Effective February 12, 2002, the Company entered into two two-year interest rate swap agreements which qualified as cash flow hedges and matured on February 12, 2004. These hedges were highly effective and, thus, the change in fair values for the three and six months ended June 30, 2004 are reported as other comprehensive income of $0 and $32,000, respectively, and for the three and six months ended June 30, 2003 are reported as other comprehensive income of $68,000 and $121,000, respectively.

3. Description of Business

HealthTronics Surgical Services, Inc. (the “Company”) was incorporated in the state of Georgia in 1995. On July 21, 1997, the Company received FDA approval to market the LithoTron^{^®}, a kidney lithotripsy device manufactured by HMT High Medical Technologies AG (“HMT”). On October 12, 2000, the Company received FDA approval to market the OssaTron^{^®}, an HMT manufactured orthopaedic shock wave medical device, for treatment of chronic plantar fasciitis. On March 13, 2003, HealthTronics also received FDA approval to market the OssaTron^{^®} for treatment of chronic lateral epicondylitis. The Company is currently establishing additional test sites for OssaTron FDA clinical trials for additional applications.

In October 2000, with the FDA approval of the OssaTron the Company began establishing orthopaedic partnerships for the purpose of purchasing, owning and operating OssaTron devices. HealthTronics contributed certain capital to partnerships and offered equity interests to third parties. As sole general partner, through its subsidiary, HT Orthotripsy Management Company, LLC, the Company maintains control and, therefore, consolidates the second tier orthopaedic partnerships. The Company has equity interests in these partnerships ranging from 5% to 100%.

The Company operates under the terms of distribution agreements with HMT that grant the Company the exclusive right to use, sell and lease the OssaTron and related devices and parts in the United States, Canada and Mexico. On March 5, 2004, the Company purchased the outstanding capital stock of HMT Holding AG (“HMT Holding”) which holds a 72.4% voting interest and a 39.7% financial interest in HMT.

It is the Company’s intent to generate revenues from four sources: 1) fees for clinical services provided by consolidated subsidiaries; 2) recurring revenues from sales of consumable products and maintenance of equipment; 3) sales of medical devices including related accessories; and 4) management, leasing and licensing fees. The Company also generates gains from sales of partnership investment interests.

In December 2001, the Company purchased 100% of the outstanding stock of Litho Group, Inc. (“LGI”) for $42,500,000 in cash. Through its various 100% subsidiaries, LGI is the sole general partner of several separate second and third tier lithotripsy partnerships with equity interests ranging from 15% to 100%, operating in the northern, eastern and southern United States. As sole general partner, LGI consolidates the second and third tier partnerships. The Company is also general partner or managing partner in various separate lithotripsy partnerships, which it controls and, therefore, consolidates.

The accompanying consolidated financial statements include the accounts of each of the Company’s subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

4. Business Acquisitions and Dispositions

On April 1, 2004, the Company increased its ownership interest in Tenn-Ga Stone Group Three (“Tenn-Ga III”), a Tennessee general partnership, from 30% to 97% for $967,800. Prior to this acquisition, Tenn-Ga III was included in the Company’s consolidated operations based on the Company’s ability to exercise control. In conjunction with this acquisition, Tenn-Ga III purchased all of the outstanding capital stock in NGST, Inc. (“NGST”), a Tennessee corporation, for $1,116,000. In connection with this transaction, the Company purchased approximately 9% of NGST from the Company’s chief executive officer. Tenn-Ga III and NGST collectively own a 75% interest in Tenn-Ga Stone Group Two (“Tenn-Ga II”), a Tennessee general partnership. The Company’s purchase of an additional 67% of Tenn-Ga III and indirect purchase of 100% of NGST increased the Company’s indirect ownership of Tenn-Ga II from 11% to 73%. As a result of the above transactions, the Company has consolidated the operations of NGST and Tenn-Ga II since April 1, 2004 as part of the Company’s Lithotripsy reporting and business segment.

The purchase price was determined and negotiated by the parties based on the expected annual cash flow to be generated by the company purchased. The Board of Directors of HealthTronics, independent of the Company’s CEO, approved the final purchase price of NGST. The Company financed the acquisitions under its current bank financing arrangement.

On March 5, 2004, the Company, through a wholly owned subsidiary, purchased all of the issued and outstanding capital shares of HMT Holding, a Swiss company, from its five individual shareholders for $1,000 and 800,000 of the Company’s shares valued at $5,091,000. The purchase price was determined and negotiated by the parties based on the expected annual cash flow to be generated by HMT Holding and upon the value of certain licenses, patents and manufacturing rights to medical devices. The fair value of the Company’s common stock issued to acquire all of HMT Holding’s outstanding common stock was determined based on the average market price of the Company’s common stock just prior to and following the date of the acquisition agreement, in accordance with Emerging Issues Task Force (“EITF”) Issue No. 99-12. HMT Holding owns 72.4% of the voting shares and 39.7% of the financial interest shares of HMT, the primary supplier of the medical devices sold by the Company. HMT consolidates its Swiss manufacturing operations and its wholly owned distributorships in Japan, Germany and the United States of America. The Company, through its voting

share interest, has the ability to exercise control over the operating and financial policies of HMT and its subsidiaries and therefore, the Company has consolidated the financial position and results of operations of HMT. The Company has consolidated the operations of HMT Holding and its subsidiaries since the date of acquisition as part of the Company’s manufacturing sales and service reporting unit and business segment. The Company also contributed approximately $1,550,000 to HMT Holding which HMT Holding used to repay its bank debt.

The estimated purchase prices of the above acquisitions, have been allocated on a preliminary basis to assets and liabilities based on management’s estimate of their fair values. These allocations are subject to change pending the completion of the final analyses of the fair value of certain of its acquired assets including, but not limited to evaluating licenses, patents, contracts and manufacturing rights to medical devices in order to finalize its purchase price allocations. Based on the results of these evaluations, the preliminary purchase price allocations may be subject to change.

The table below represents pro forma financial information for the six months ended June 30, 2004 and 2003 as if the above acquisitions had occurred on January 1, 2004 and 2003, respectively.

HealthTronics Surgical Services, Inc. and Subsidiaries

Pro Forma Combined Condensed Statements of Income

FOR THE SIX MONTHS ENDED JUNE 30, 2004

(UNAUDITED)


	AS REPORTED		PRO FORMA COMBINED
	(000’s omitted except per share amounts)
Net revenues	$	49,074	$	54,448

Income before income taxes	$	1,505	$	1,670

Net income	$	575	$	680

Income per common share:
Basic	$	0.05	$	0.06

Diluted	$	0.05	$	0.06

HealthTronics Surgical Services, Inc. and Subsidiaries

Pro Forma Combined Condensed Statements of Income

FOR THE SIX MONTHS ENDED JUNE 30, 2003

(UNAUDITED)


	AS REPORTED		PRO FORMA COMBINED
	(000’s omitted except per share amounts)
Net revenues	$	42,343	$	57,535

Income before income taxes	$	4,644	$	4,739

Net income	$	2,827	$	2,890

Income per common share:
Basic	$	0.25	$	0.25

Diluted	$	0.24	$	0.25

As a result of the March 5, 2004 business combination with HMT Holding, the Company has established a restructuring plan whereby it will consolidate certain of its administrative, sales and distribution activities. The plan requires the closing or relocation of certain facilities and the relocation or termination of certain employees employed in such activities acquired at March 5, 2004. The Company has accrued approximately $8,192,000 as a liability assumed in purchase of HMT Holding representing its best estimate to date of these costs. The Company is in the process of finalizing its estimates of the related costs which are expected to impact the final aggregate purchase price.

On June 11, 2004, the Company executed a definitive Agreement and Plan of Merger with Prime Medical Services, Inc. (“Prime”). Under the terms of that agreement, Prime stockholders will receive one share of the Company common stock for each share of Prime common stock. If the merger is approved, Prime’s stockholders will own approximately 62% of the shares of HealthTronics common stock, and Prime’s directors and senior management will represent a majority of the combined company’s directors and senior management; therefore Prime will be deemed to be the acquiring company for accounting purposes and the merger will be accounted for as a reverse acquisition under the purchase method of accounting for business combinations in accordance with accounting principles generally accepted in the United States.

5. Inventory

Inventory is carried at the lower of cost (first-in, first-out) or market and consists of the following:


	June 30, 2004		December 31, 2003
	(000’s omitted)
Medical devices / other equipment	$	6,579	$	5,994
Spare parts and assemblies		3,859		738
Consumables		1,390		1,087

	$	11,828	$	7,819

6. Gain on Sale of Subsidiary and Investment Interest

The Company sold a portion of the partnership interests of certain limited partnerships and recognized gains of $10,000 and $255,000 for the three and six months ended June 30, 2004, respectively and $142,000 and $2,216,000 for the three and six months ended June 30, 2003, respectively. The gains represent the excess of the sales price over the Company’s investment basis in the partnership interest.

7. Interest Rate Swaps

In order to protect the Company from interest rate volatility, effective February 12, 2002, the Company entered into two two-year interest rate swap agreements (“the swaps”) that matured on February 12, 2004. The total notional amount of swap

agreements was $0 and $12,600,000 at June 30, 2004 and December 31, 2003. The swaps effectively converted a portion of the Company’s floating-rate debt to a fixed-rate basis through February 12, 2004, thus reducing the impact of interest-rate changes on interest expense. This fixed rate was 3.2525% plus the applicable percentage (2.0% during the second quarter of 2003). The swaps qualified as cash flow hedges under Statement of Financial Accounting Standards No. 133,Accounting for Derivative Instruments and Hedging Activities, and expired on February 12, 2004. The Company believes that its hedges were effective with changes in fair value to be reported in other comprehensive income. As of June 30, 2004 and December 31, 2003, the market value of the derivatives was a liability of approximately $0 and $32,000, respectively, which is included on the accompanying balance sheet. The change in fair values for the three and six months ended June 30, 2004 are reported as other comprehensive income of $0 and $32,000, respectively, and for the three and six months ended June 30, 2003 are reported as other comprehensive income of $68,000 and $121,000, respectively.

The counterparty to the interest rate swap agreements was a major commercial bank. The Company was exposed to counterparty credit risk for nonperformance and, in the event of nonperformance, to market risk for changes in interest rates.

8. Comprehensive Income

The components of comprehensive income are as follows for the three and six months ended June 30, 2004 and 2003:


	Three months ended June 30,				Six months ended June 30,
	2004		2003		2004		2003
	(000’s omitted)
Net income	$	226	$	698	$	575	$	2,827
Net change in fair value of interest rate swap		—		68		32		121

Comprehensive income	$	226	$	766	$	607	$	2,948

9. Earnings Per Share Information

The following table sets forth the computation of earnings per share:


	Three Months Ended June 30,				Six Months Ended June 30,
	2004		2003		2004		2003
	(000’s omitted except per share amounts)
Numerator: Net income	$	226	$	698	$	575	$	2,827

Weighted average shares outstanding		12,386		11,539		12,100		11,434
Effect of dilutive securities:
Stock options		84		303		43		281

Denominator for diluted earnings per share		12,470		11,842		12,143		11,715

Basic earnings per share	$	0.02	$	0.06	$	0.05	$	0.25

Diluted earnings per share	$	0.02	$	0.06	$	0.05	$	0.24

10. Segment Information

The Company applies the disclosure provisions of SFAS No. 131,Disclosures About Segments of an Enterprise and Related Information. Effective April 1, 2003, the Company internally reorganized its operating structure and as a result the Company’s business units have been aggregated into three reportable operating segments: Lithotripsy; Orthopaedics; and Manufacturing, Sales and Service. The factors for determining the reportable segments were based on the distinct nature of their operations. They are disclosed as separate operating segments because these business units each have different marketing strategies due to differences in types of consumers, different market conditions and different capital requirements. Asset information by segment, including capital expenditures, and net income beyond operating margins are not provided to the Company’s chief operating decision maker. In fiscal 2003, the Company changed from one reportable segment to three reportable segments. For all periods presented, the corresponding items of segment information have been reclassified to conform to the current presentation.

The Lithotripsy segment provides lithotripsy services to physicians and medical facilities. The Orthopaedics segment provides non-invasive surgical solutions for a variety of orthopaedic conditions. The Manufacturing, Sales and Service segment represents manufacturing, sales and service of medical devices and related products. The “Other” category includes the Company’s non-reportable segments.

The Company primarily evaluates segment performance based on the income or loss before income taxes from its operating segments, which do not include unallocated corporate overhead and intersegment eliminations.


	For the Three Months Ended June 30, 2004
	(Unaudited)
	(000’s omitted)
	Lithotripsy		Orthopaedics			Manufacturing, Sales and Service			Other		Total
Net revenue from segment	$	15,054	$	4,559		$	7,754		$	1,836	$	29,203
Less intersegment revenue		386		—			3,483			—		3,869

Total consolidated net revenues by segment	$	14,668	$	4,559		$	4,271		$	1,836	$	25,334

Segment depreciation and amortization	$	816	$	460		$	32		$	164	$	1,472

Plus unallocated depreciation and amortization												26

Total consolidated depreciation and amortization											$	1,498

Equity in earnings of unconsolidated entities	$	160	$	—		$	—		$	—	$	160

Segment income (loss) before income taxes	$	2,672	$	(99	)	$	(350	)	$	3	$	2,226

Less unallocated corporate expenses and intersegment eliminations												(1,374	)

Total consolidated income before income taxes											$	852


		For the Three Months Ended June 30, 2003

		(Unaudited)
		(000’s omitted)

	Lithotripsy		Orthopaedics			Manufacturing, Sales and Service			Other		Total
Net revenue from segment	$	14,002	$	4,463		$	3,018		$	1,099	$	22,582
Less intersegment revenue		301		–			826			–		1,127

Total consolidated net revenues by segment	$	13,701	$	4,463		$	2,192		$	1,099	$	21,455


Segment depreciation and amortization	$	854	$	437		$	4		$	37	$	1,332

Plus unallocated depreciation and amortization												92

Total consolidated depreciation and amortization											$	1,424


Equity in earnings of unconsolidated entities	$	221	$	—		$	—		$	—	$	221


Segment income (loss) before income taxes	$	2,654	$	(130	)	$	47		$	31	$	2,602

Less unallocated corporate expenses and intersegment eliminations												(1,455	)


Total consolidated income before income taxes											$	1,147


		For the Six Months Ended June 30, 2004

		(Unaudited)
		(000’s omitted)

	Lithotripsy		Orthopaedics			Manufacturing, Sales and Service			Other		Total
Net revenue from segment	$	29,492	$	8,743		$	12,813		$	3,733	$	54,781
Less intersegment revenue		739		–			4,968			–		5,707

Total consolidated net revenues by segment	$	28,753	$	8,743		$	7,845		$	3,733	$	49,074


Segment depreciation and amortization	$	1,672	$	908		$	120		$	306	$	3,006

Plus unallocated depreciation and amortization												54

Total consolidated depreciation and amortization											$	3,060


Equity in earnings of unconsolidated entities	$	489	$	—		$	—		$	—	$	489


Segment income (loss) before income taxes	$	4,659	$	(633	)	$	(288	)	$	288	$	4,026

Less unallocated corporate expenses and intersegment eliminations												(2,521	)

Total consolidated income before income taxes											$	1,505


		For the Six Months Ended June 30, 2003

		(Unaudited)
		(000’s omitted)

	Lithotripsy		Orthopaedics			Manufacturing, Sales and Service		Other		Total
Net revenue from segment	$	27,541	$	8,599		$	6,042	$	2,285	$	44,467
Less intersegment revenue		550		–			1,574		–		2,124

Total consolidated net revenues by segment	$	26,991	$	8,599		$	4,468	$	2,285	$	42,343


Segment depreciation and amortization	$	1,689	$	843		$	8	$	87	$	2,627

Plus unallocated depreciation and amortization											177

Total consolidated depreciation and amortization										$	2,804


Equity in earnings of unconsolidated entities	$	479	$	—		$	—	$	—	$	479


Segment income (loss) before income taxes	$	7,382	$	(243	)	$	140	$	95	$	7,374

Less unallocated corporate expenses and intersegment eliminations											(2,730	)

Total consolidated income before income taxes										$	4,644

11. Line of Credit

On March 5, 2004 the Company amended and restated its primary bank term loan and line of credit facility (“New Facility”). The revised agreement provides for a $25,000,000 line of credit, which is renewable every 90 days and matures on March 5, 2007. The Company typically pays interest on a monthly basis on all outstanding balances on the New Facility. The New Facility is secured by certain accounts receivable, inventory and equipment and the Company’s equity interest in its subsidiaries and bears interest at the stated bank rate (3.59% at June 30, 2004). At June 30, 2004 there was $18,500,000 outstanding under the New Facility.

Item 2.

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

market for the Company’s products; difficulty integrating HMT and realizing projected cost savings; unanticipated regulatory and clinical costs related to FDA clinical trials and application for approval of High-Intensity Focused Ultrasound (“HIFU”); difficulty integrating Prime Medical Services, Inc. into the Company on an efficient basis; and difficulty in managing the Company’s growth. Additional factors that might cause such a difference, include, but are not limited to the items identified under the caption “Risk Factors” in Item 1 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, and in subsequent documents filed by HealthTronics Surgical Services with the Securities and Exchange Commission

Overview

We provide equipment as well as technical and administrative services to physicians, hospitals, and surgery centers performing minimally invasive surgical procedures in the urologic and orthopaedic markets, including lithotripsy and orthopaedic extracorporeal shock wave surgery (“ESWS”). We were formed in December 1995 and began offering lithotripsy services in mid-1997. In October 2000, we received FDA approval to market an orthopaedic ESWS device, the OssaTron, and since then we have invested significant resources in developing our orthopaedic services network while expanding our lithotripsy operations. As a result of our recent acquisition of controlling interest of HMT High Medical Technologies AG, we also develop and manufacture minimally invasive medical devices.

Our services are provided principally through limited partnerships or other entities that we manage which use lithotripsy devices or OssaTron orthopaedic shock wave devices. Many of these partnerships were formed by us, and we have retained equity interests in such partnerships ranging from 5% to 100% while selling any remaining interests primarily to physicians. We generally retain the sole managing interest in the entities and manage their daily operations. We also provide equipment maintenance services to some of the partnerships and supply them with various consumables used in lithotripsy and orthopaedic ESWS procedures. To date we have expanded our operations by securing additional facility contracts in our existing partnerships, forming partnerships in new geographic markets and acquiring interests in partnerships from third parties, and we expect to continue to do so in the future.

As a result of the control we exert over certain entities by virtue of our sole managing interest, management contract and otherwise, for financial reporting purposes we consolidate the results of operations of certain partnerships with our own even though we own less than all (and in many cases less than 50%) of their outstanding equity interests. We reflect the equity of third party partners in the partnerships’ results of operations in our consolidated statements of income and on our consolidated balance sheet as minority interest.

In other instances, we do not control partnerships or other entities in which we have ownership interests. We account for our interests in these entities either on the equity or cost basis, depending on the degree of influence we exert over the entity.

We recognize revenue in our consolidated statements of income from the following four principal sources:

•

Fees for clinical services provided by the Company or partnerships. A substantial majority of our consolidated revenues is derived from technical fees relating to treatments performed using our equipment and related services. We bill for these fees under two different models. Under the “wholesale” billing model, we charge a fee to the hospital or surgery center at which the treatment is performed. Our fee might be a set fee per procedure, a set fee per month based on a specified number of days of service at the facility per month, or a set percentage of revenue derived. Under the “retail” billing model, we charge the patient’s insurer, HMO or other responsible party, and we pay a fee to the health care facility for access to its premises. Under either model, the professional fee payable to the physician performing the procedure is generally billed and collected by the physician. The billing and collection cycle for wholesale fees is typically significantly shorter than for retail fees, although the gross margin for retail billing is moderately higher than for wholesale billing.

•

Technical services, equipment maintenance and sale of consumables to affiliated and unaffiliated third parties. We charge fees to third parties who own or operate lithotripsy and orthopaedic shock wave surgical devices for equipment maintenance, technical support and related services. We also sell a variety of consumables used in lithotripsy, orthopaedic ESWS, transurethral microwave therapy and cryosurgery procedures to unaffiliated third parties.

•

Equipment and parts sales to third parties. We generate revenue from the sale of shock wave devices and parts to third parties.

•

Providing partnership management, leasing and licensing services. We generate revenue from managing lithotripsy, orthopaedic shock wave surgery and cryosurgical partnerships and by entering into leasing or licensing arrangements with third parties.

We measure results in each of our areas in part based upon the number of procedures performed. The number of total kidney stone procedures in the United States should grow slightly with the aging population. Growth for the Company in lithotripsy procedures will come from new facility contracts in existing partnerships and the acquisition or affiliation of partners or partnerships. Procedures performed with the OssaTron for orthopaedic conditions have significant potential for growth as many patients currently are treated with invasive surgery or continue to suffer pain without receiving treatment. The Company believes procedures for chronic plantar fasciitis and chronic lateral epicondylitis will continue to grow as the modality is accepted by patients, physicians and third party payors. Procedures for treatment of benign prostatic hyperplasia (a benign enlargement of the prostate causing difficulty in urination) have potential for growth due to the aging population and the fact that many patients currently are treated with drugs or other alternative treatments. The number of procedures for cryosurgical treatment of prostate and other cancers should increase during the year, but such growth will be tempered by the slow process of educating and training physicians on the treatment.

We are dependent, both directly in the case of “retail” billing and indirectly in the case of “wholesale” billing, on the reimbursement policies of governmental and private third party payors. While the reimbursement status of lithotripsy is well established, orthopaedic

ESWS is a relatively new procedure in the U.S., and the reimbursement policies of third party payors for this treatment are still developing. Reimbursement for transurethral microwave therapy (“TUMT”) of benign prostatic hyperplasia (a benign enlargement of the prostate causing difficulty in urination) (“BPH”) is currently established and favorable for in-office treatments. Cryosurgery for prostate cancer is a hospital-based procedure and reimbursement is established but was recently adjusted by Medicare to exclude certain pass-through charges. Our results of operations could be significantly affected by changes in reimbursement policies regarding lithotripsy, TUMT, cryosurgery of the prostate or by decisions made regarding the reimbursement status of orthopaedic ESWS.

Recent Developments

On June 11, 2004, we executed a definitive Agreement and Plan of Merger with Prime Medical Services, Inc. (“Prime”). Under the terms of that agreement, Prime stockholders will receive one share of HealthTronics common stock for each share of Prime common stock. If the merger is approved, Prime’s stockholders will own approximately 62% of the shares of our common stock, and Prime’s directors and senior management will represent a majority of the combined company’s directors and senior management; therefore Prime will be deemed to be the acquiring company for accounting purposes and the merger will be accounted for as a reverse acquisition under the purchase method of accounting for business combinations in accordance with accounting principles generally accepted in the United States.

Results of Consolidated Operations

Three Months Ended June 30, 2004 Compared to Three Months Ended June 30, 2003

Revenues for the second quarter of 2004 totaled $25.3 million, up 17.7% from $21.5 million for the same period of 2003. Lithotripsy revenue for the second quarter of 2004 was $14.7 million compared to $13.7 million in the second quarter of 2003, a 7.3% increase. Consolidated lithotripsy procedures for the second quarter of 2004 increased 10.8% over the second quarter of 2003. We anticipate that our lithotripsy business will remain strong and continue to generate good cash flow for the Company. Lithotripsy procedures increased more than revenues for the second quarter of 2004 compared to the second quarter of 2003 due to a change in the payor mix. For the second quarter of 2004, approximately 79% of the lithotripsy procedures were wholesale while 21% were retail. For the second quarter of 2003, approximately 71% of the lithotripsy procedures were wholesale while only 29% were retail. Since wholesale procedures generally carry a lower reimbursement per procedure, the shifting payor mix caused revenues to grow less quickly than procedure volume.

Our orthopaedic business demonstrated moderate growth in revenues year over year. In what remains a challenging reimbursement climate, we performed 1,978 orthopaedic procedures during the second three months of 2004 compared to 1,967 procedures performed in the second three months of 2003, and revenues for the orthopaedic business in the second quarter of 2004 increased 2.2% to $4.6 million from $4.5 million in the same period of 2003. We continue to make progress in training physicians and educating insurance companies.

Our prostate treatment business showed solid growth year over year. Revenues for the second quarter of 2004 rose 63.6% to $1.8 million from the $1.1 million in the second quarter of 2003. We performed 1,030 procedures on either benign or cancerous prostate conditions during the second quarter of 2004, an increase of 27.8% over the 806 procedures performed during the comparable quarter of 2003. The revenue growth can be attributed to two main factors: an increase in Medicare reimbursement for BPH treatments and the larger growth of our cryosurgery procedures, which have a higher average reimbursement.

Revenue from the equipment sales and service division was $4.3 million for the second quarter of 2004 compared to $2.2 million for the second quarter of 2003, an increase of 95.5%. The growth was primarily due to our acquisition of HMT.

As our Company has grown, our salaries, general and administrative expenses have increased year over year from $9.8 million for the second quarter of 2003 to $13.1 million for the second quarter of 2004. The acquisition of HMT Holding is primarily responsible for the 33.7% increase.

Our depreciation and amortization expense increased 7.1% from $1.4 million during the second quarter of 2003 to $1.5 million during the second quarter of 2004 primarily as a result of the addition of equipment by certain cryosurgical partnerships.

Our business strategy is to partner with physicians and healthcare providers in each of our local markets. Often we will sell equity interest in our partnerships to these strategic partners. In 2003, we commenced planned sales of portions of equity in certain lithotripsy partnerships in LGI. As a result, gains on sale of subsidiary and investment interest in 2003 were $4.5 million, of which $0.1 million was in the second quarter. We anticipate that equity sales will continue throughout 2004, although not at the levels of previous years. In the second quarter of 2004, gains on sale decreased to $10,000.

Our subsidiary partners’ equity in the current year net income is represented by the minority interest in consolidated subsidiaries. Our partners’ minority interest in consolidated subsidiaries grew from $4.6 million in the second quarter of 2003 to $5.0 million in the second quarter of 2004, an increase of 8.7%. This increase was due to new acquisitions and sales of portions of equity in certain lithotripsy partnerships.

Six Months Ended June 30, 2004 Compared to Six Months Ended June 30, 2003

Revenues for the first six months of 2004 totaled $49.1 million, up 16.1% from $42.3 million for the same period of 2003. Lithotripsy revenue for the first six months of 2004 was $28.8 million compared to $27.0 million in the first six months of 2003, a 6.7% increase. Consolidated lithotripsy procedures for the first half of 2004 increased 9.8% over the first half of 2003. We anticipate that our lithotripsy business will remain strong and continue to generate good cash flow for the Company. Lithotripsy procedures increased more than revenues for the first half of 2004 compared to the first half of 2003 due to a change in the payor mix. For the first six months of 2004, approximately 77% of the lithotripsy procedures were wholesale while 23% were retail. For the first six months of 2003, approximately 71% of the lithotripsy procedures were wholesale while only 29% were retail. Since wholesale procedures generally carry a lower reimbursement per procedure, the shifting payor mix caused revenues to grow less quickly than procedure volume.

Our orthopaedic business demonstrated moderate growth in revenues year over year. In what remains a challenging reimbursement climate, we performed 3,868 orthopaedic procedures during the first half of 2004 compared to 3,730 procedures performed in the same period of 2003, and revenues for the orthopaedic business in the first six months of 2004 increased 1.2% to $8.7 million from $8.6 million in the first six months of 2003. We continue to make progress in training physicians and educating insurance companies.

Our prostate treatment business showed solid growth year over year. Revenues for the first six months of 2004 rose 60.9%, to $3.7 million from $2.3 million for the first six months of 2003. We performed 2,151 procedures on either benign or cancerous prostate conditions during the first half of 2004, an increase of 28.6% over the 1,672 procedures performed during the same period of 2003. The revenue growth can be attributed to two main factors: an increase in Medicare reimbursement for BPH treatments and the larger growth of our cryosurgery procedures, which have a higher average reimbursement.

Revenue from the equipment sales and service division was $7.8 million for the first six months of 2004 compared to $4.5 million for the first six months of 2003, an increase of 73.3%. The growth was primarily due to our acquisition of HMT.

As our Company has grown, our salaries, general and administrative expenses have increased year over year from $19.4 million for the first half of 2003 to $24.4 million for the first half of 2004. The expansion of our orthopaedic business and the acquisition of HMT Holding are primarily responsible for the 25.8% increase.

Our depreciation and amortization expense increased 10.7% from $2.8 million during the first six months of 2003 to $3.1 million during the first six months of 2004 primarily as a result of the addition of equipment by certain cryosurgical partnerships.

Our business strategy is to partner with physicians and healthcare providers in each of our local markets. Often we will sell equity interest in our partnerships to these strategic partners. In 2003, we commenced planned sales of portions of equity in certain lithotripsy partnerships in LGI. As a result, gains on sale of subsidiary and investment interest in 2003 were $4.5 million, of which $2.2 million was in the first six months. We anticipate that equity sales will continue throughout 2004, although not at the levels of previous years. In the first six months of 2004, gains on sale decreased to $255,000.

Our subsidiary partners’ equity in the current year net income is represented by the minority interest in consolidated subsidiaries. This minority interest will grow in total as we continue to sell interest in our subsidiaries. Our partners’ minority interest in consolidated subsidiaries grew from $8.7 million in the first half of 2003 to $10.5 million in the first half of 2004, an increase of 20.7%. This increase was due to new acquisitions and sales of portions of equity in certain lithotripsy partnerships.

Critical Accounting Policies

Our consolidated financial statements are based on the application of accounting principles generally accepted in the United States of America, which require us to make estimates and assumptions about future events that affect the amounts reported in our financial statements and the accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Estimates and assumptions are reviewed periodically and the effects of the revisions are reflected in the consolidated financial statements in the period they are determined to be necessary. Actual results could differ from those estimates, and any such differences may be material to the financial statements. If different assumptions or conditions were to prevail, the results could be materially different from our reported results.

Consolidation

Our consolidated financial statements include the accounts of those significant subsidiaries that we control. They also include our undivided interests in these subsidiaries’ assets and liabilities. Amounts representing our percentage interest in the underlying net assets of other significant affiliates that we do not control, but over which we exercise significant influence, are included in “Investments in unconsolidated entities”; our share of the net income of these companies is included in the consolidated statement of income caption “Equity in earnings of unconsolidated partnerships”. The accounting for these non-consolidated companies is based upon the equity method of accounting. Our investments in other companies that we do not control and for which we do not have the ability to exercise significant influence as discussed above are carried at the lower of cost or fair value, as appropriate.

Revenue Recognition, Gain Recognition and Allowance for Doubtful Accounts

Net revenue includes treatment fees for medical devices in the clinical setting. Treatment revenue is primarily “wholesale” or “retail”. Wholesale revenue is generated primarily from fixed fee contracts with various medical facilities and is recorded in the month the related treatments are performed. Retail revenue, generated when we bill third party payors for medical facility and technical fees, is recorded at the time services are rendered. These third party billings may or may not be contractual. In determining net revenue adjustments which reduce retail treatment revenue from established contractual or estimated non-contractual billing rates to amounts estimated to be reimbursable are recognized in the period the services are rendered. Differences in estimates recorded and final settlements are reported during the period final settlements are made.

Revenue is recognized upon delivery at the customer’s destination and customer acceptance for sales of medical devices to unaffiliated entities.

Revenue generated from service contracts is recognized ratably over the life of the related contract.

We form wholly owned limited partnerships in which we are the general partner and then contribute a medical device to the partnership. We may sell interests in these partnerships to other investors. We generally recognize a gain on the interest sold as non-operating income at the time the subscription agreement is signed. Certain gains on the sale of partnership interests are deferred when payment terms exceed one year.

In order to record our accounts receivable at their net realizable value, we must assess their collectibility. A considerable amount of judgment is required in order to make this assessment including the analysis of historical bad debts and other adjustments, a review of the aging of our receivables and the current creditworthiness of our customers. We have recorded allowances for receivables which we believe are uncollectible. However, depending upon how such potential issues are resolved, or if the financial condition of any of our customers was to deteriorate and their ability to make required payments became impaired, increases in these allowances may be required.

Inventory

We are required to state our inventories at the lower of cost or market. Our inventories include medical devices, parts for servicing the medical equipment, assemblies and consumables for the medical equipment. We continually evaluate the inventory for excess and obsolescence. At this time we believe that no inventory reserve is required to reduce the carrying value of our inventory to its net realizable value. However, if the demand for our products were to decline we might be required to establish such reserves.

Long-Lived Assets

We have recorded property, plant and equipment and intangible assets at cost less accumulated depreciation and amortization. The determination of useful lives and whether or not these assets are impaired involves significant judgment. We review long-lived assets, including identifiable intangible assets whenever events or changes in circumstances indicate the carrying amounts of such assets may not be recoverable. Goodwill is the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations accounted for as purchases. Goodwill is subject to annual testing for impairment at the reporting unit level unless events or circumstances indicate the carrying amount is impaired. Intangible assets determined to have definite lives are amortized over their remaining useful lives. Goodwill of a reporting unit is tested for impairment on an annual basis or between annual tests if an event occurs or circumstances change that would reduce the fair value of a reporting unit below its carrying amount.

Income Taxes

We account for income taxes in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities. They are measured using the enacted tax rates and laws that are expected to be in effect when the differences are expected to be recovered or settled.

We regularly review our deferred tax assets for recoverability and establish a valuation allowance based upon projected future taxable income and the expected timing of the reversals of existing temporary differences. A valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized. We have established a valuation allowance for that portion of the deferred tax asset for which it is more likely than not that it will not be realized.

We are unable to realize the benefit of net losses of our foreign subsidiaries resulting in a tax rate in excess of the statutory rate.

Derivative Instruments and Hedging

We manage risks associated with interest rates and we may use derivative instruments to hedge these risks. As a matter of policy, we do not use derivative instruments unless there is an underlying exposure and, therefore, we do not use derivative instruments for trading or speculative purposes. The evaluation of hedge effectiveness is subject to assumptions based on the terms and timing of the underlying exposures. All derivative instruments are recognized in our consolidated balance sheet at fair value. The fair value of our derivative instruments is generally based on quoted market prices.

Related Party Transactions

Transactions between related parties occur in the normal course of business. We provide services and products to our subsidiaries; our subsidiaries provide services and products to other subsidiaries. We eliminate transactions with our consolidated subsidiaries and appropriately disclose other significant related party transactions.

Recently Issued Accounting Standards

In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation 46,Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 (“FIN 46”). In December 2003, the FASB modified FIN 46 to make certain technical corrections and address certain implementation issues that had arisen. FIN 46 provides a new framework for identifying variable interest entities (“VIEs”) and determining when a company should include the assets, liabilities, noncontrolling interests and results of activities of a VIE in its consolidated financial statements.

FIN 46 requires a VIE to be consolidated if a party with an ownership, contractual or other financial interest in the VIE (a variable interest holder) is obligated to absorb a majority of the risk of loss from the VIE’s activities, is entitled to receive a majority of the VIE’s residual returns (if no party absorbs a majority of the VIE’s losses), or both. A variable interest holder that consolidates the VIE is called the primary beneficiary. Upon consolidation, the primary beneficiary generally must initially record all of the VIE’s assets, liabilities and noncontrolling interests at fair value and subsequently account for the VIE as if it were consolidated based on majority voting interest. FIN 46 also requires disclosures about VIEs that the variable interest holder is not required to consolidate but in which it has a significant variable interest. We do not have any significant variable interests in a VIE and we do not consolidate any VIEs.

Liquidity and Capital Resources

We have funded our working capital requirements and capital expenditures from net cash provided by operating activities and borrowings under bank credit facilities. In conjunction with the purchase of Litho Group, we obtained a $50,000,000 credit facility. Concurrent with the acquisition of the controlling interest in HMT AG, we amended and restated the $50,000,000 credit facility to a $25,000,000 credit facility (“New Facility”). The revised credit agreement provides for a $25,000,000 line of credit, which is renewable every 90 days and matures on March 5, 2007. The Company typically pays interest on a monthly basis on all balances on the New Facility. At June 30, 2004 and December 31, 2003, we had approximately $18,500,000 and $17,737,000, respectively, outstanding under the credit facility plus additional debt of approximately $14,520,000 and $5,291,000, respectively, primarily at the subsidiary level. Under the new $25,000,000 credit facility, $6,500,000 was available at June 30, 2004. Debt at the subsidiary level is typically related to 1) financing needs of our foreign operations and 2) equipment purchased and operated by our U.S. subsidiaries and is secured by that equipment. Cash and cash equivalents decreased from $9,040,000 at December 31, 2003 to $8,746,000 at June 30, 2004.

Net cash provided by operating activities for the six months ended June 30, 2004 was $91,000 compared to $1,195,000 provided by operating activities for the six months ended June 30, 2003. This overall decrease is due to a decrease in after-tax net income driven largely by the smaller gain on sale of investment in 2004 as compared to 2003. In 2003, we resyndicated certain lithotripsy partnerships by selling some of our investment interest to other parties. In 2004, we used cash for additional loan costs and deferred compensation, which increased cash used for other assets. The decrease in cash used for accounts payable in 2004 was a direct result of the timing of inventory purchases from third parties. Net cash used in investing activities was $2,661,000 for the six months ended June 30, 2004 compared to $3,572,000 for the six months ended June 30, 2003. The change is due primarily to the decrease in proceeds from the Company’s resyndication efforts in several lithotripsy partnerships from 2003 and due to less cash used in the acquisition of businesses. Net cash provided by financing activities aggregated $2,276,000 in the six months ended June 30, 2004 as compared to net cash used in financing activities of $5,552,000 for the six months ended June 30, 2003 and consisted primarily of an increase in borrowings and a decrease in payments made.

Our capital expenditures, primarily for the purchase of medical devices, aggregated $2,901,000 in the six months ended June 30, 2004. We currently estimate that our capital expenditures will aggregate approximately $4,000,000 to $5,000,000 for the year ended December 31, 2004 and will be used to purchase additional medical devices for partnerships. We continuously review new investment opportunities and believe that our financial position can support higher levels of capital expenditures, if justified by opportunities to increase revenue or decrease recurring costs. Accordingly, it is possible that our capital expenditures in 2004 could be higher than anticipated. We plan to use our cash generated from operations and borrowings under our revolving credit facility to fund these expenditures.

We believe that our cash generated from operations and borrowings under our revolving credit facility will be sufficient to meet our liquidity and capital spending needs at least through the end of 2004.

Quantitative and Qualitative Disclosure of Market Risk

We are subject to market risk from exposure to changes in interest rates on our variable rate debt. Although there can be no assurances that interest rates will not change significantly, we do not expect changes in interest rates to have a material effect on income or cash flows in

2004. As of June 30, 2004 and December 31, 2003, our corporate-level fixed-rate debt was $0 and $12,600,000, respectively, and our corresponding corporate-level variable-rate debt was $18,500,000 and $5,100,000, respectively. Based on our variable-rate debt at June 30, 2004 and December 31, 2003, in the absence of the swaps discussed below, a one-percent change in interest rates would result in an annual change in interest rate expense calculated on a simple interest basis of approximately $185,000 and $51,000, respectively.

In order to protect us from interest rate volatility, effective February 12, 2002, we entered into two two-year interest rate swap agreements (“the swaps”) that matured on February 12, 2004. The total notional amount of swap agreements was $0 and $12,600,000 at June 30, 2004 and December 31, 2003, respectively. The swaps effectively converted a portion of our floating-rate debt to a fixed-rate basis through February 12, 2004, thus reducing the impact of interest-rate changes on interest expense. This fixed rate was 3.2525% plus the applicable percentage (2.0% during the second quarter of 2003). The swaps qualified as cash flow hedges under Statement of Financial Accounting Standards No. 133,Accounting for Derivative Instruments and Hedging Activities, and expired on February 12, 2004. We believe that our hedges were effective with changes in fair value to be reported in other comprehensive income. As of June 30, 2004 and December 31, 2003, the market value of the derivatives was a liability of approximately $0 and $32,000, respectively, which is included on the accompanying balance sheet. The change in fair values for the three and six months ended June 30, 2004 are reported as other comprehensive income of $0 and $32,000, respectively, and for the three and six months ended June 30, 2003 are reported as other comprehensive income of $68,000 and $121,000, respectively.

The counterparty to the interest rate swap agreements was a major commercial bank. We were exposed to counterparty credit risk for nonperformance and, in the event of nonperformance, to market risk for changes in interest rates.

Cautionary Statements

This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties or other factors which may cause actual results, performance or achievements of HealthTronics Surgical Services to be materially different from any future results, performance or achievements express or implied by such forward-looking statements. As always, these expectations and projections are based on currently available competitive, financial, and economic data, along with operating plans, and are subject to future events and uncertainties. Among the events and uncertainties which could adversely affect future periods are: inability to establish or maintain relationships with physicians and hospitals; health care regulatory developments that prevent certain transactions with health care professionals or facilities; inability of the Company or health care providers to obtain reimbursement for use of the Company’s current or future products; competition or technological change that impacts the market for the Company’s products; difficulty integrating HMT and realizing projected cost savings; unanticipated regulatory and clinical costs related to FDA clinical trials and application for approval of HIFU; difficulty integrating Prime Medical Services, Inc. into the Company on an efficient basis; and difficulty in managing the Company’s growth. Additional factors that might cause such a difference, include, but are not limited to those discussed in the Management’s Discussion and Analysis of Financial Condition and Results of Operations in this

report and the items identified under the caption “Risk Factors” in Item 1 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003.

Item 3.Quantitative and Qualitative Disclosure of Market Risk

The information called for by this item is provided under the caption “Quantitative and Qualitative Disclosure of Market Risk” under Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Item 4.Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13(a)-15(e) and 15(d)-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this Form 10-Q. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this Form 10-Q, our disclosure controls and procedures provide reasonable assurances that the information we are required to disclose in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time period required by the United States Securities and Exchange Commission’s rules and forms.

There have been no changes in our internal control over financial reporting (as such term is defined in Rules 12a-15(f) and 15(d)-15(f) under the Exchange Act) during the period covered by this Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II.OTHER INFORMATION

Item 1.Legal Proceedings

As previously disclosed, a Consolidated Amended Class Action Complaint was filed on July 3, 2004 with the United States District Court, Northern District of Georgia, Atlanta Division, amending and consolidating several previously filed shareholder class action lawsuits alleging securities fraud. The plaintiffs in the suit are three individual shareholders, and the defendants are the Company and the following current and former directors and officers: Argil J. Wheelock, M.D., Ronald Gully, Martin McGahan, Victoria W. Beck, Roy S. Brown, John House, and Russell H. Maddox. The Consolidated Amended Class Action Complaint alleges fraudulent disclosures relating to the results of the clinical trial for the Company’s orthopaedic shock wave device, treatment revenue utilizing such device, insurance company reimbursement, medical device sales, and earnings projections. The plaintiffs seek unspecified compensatory damages and reasonable costs and expenses. The Company believes the claims alleged in the lawsuit are without merit. The Company has directors and officers liability insurance that provides coverage for this lawsuit. Given the early stage of the litigation, the Company is not in a position to determine any potential liability but it currently does not believe the lawsuit will have a significant financial impact on the Company.

Item 4.Submission of Matters to a Vote of Security Holders

A. The annual meeting of shareholders was held on May 21, 2004.

B. The following directors were elected to the board of directors:

James R. Andrews

Andreas Baenziger

Scott A. Cochran

Donny R. Jackson

Timothy J. Lindgren

Russell H. Maddox

Martin J. McGahan

J. Richard Steadman

Argil J. Wheelock

C. The following matters were voted upon at the annual meeting:


		For	Against/Withheld	Abstain/Broker non-vote
1.	To elect the following directors to serve for the ensuing year:
	James R. Andrews	10,419,240	1,500	211,355
	Andreas Baenziger	10,584,353	1,500	46,242
	Scott A. Cochran	10,498,853	1,500	131,742
	Donny R. Jackson	10,498,253	1,500	132,342
	Timothy J. Lindgren	10,498,953	1,500	131,642
	Russell H. Maddox	10,419,185	1,500	211,410
	Martin J. McGahan	10,583,188	1,500	47,407
	J. Richard Steadman	10,497,028	1,500	133,567
	Argil J. Wheelock	10,471,808	1,500	158,787
2.	To ratify the appointment of Ernst & Young LLP as independent auditors for the fiscal year ending December 31, 2004.	10,597,568	25,937	8,590
3.	To approve adoption of the Company’s 2004 Equity Incentive Plan and the reservation of 500,000 shares of common stock for issuance thereunder.	5,999,889	1,000,086	26,471

Item 6.Exhibits and Reports on Form 8-K

(a) Exhibits



10.1		Employment Agreement with Ms. Beck

31.1		Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer

31.2		Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer



32.1		Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350) of Chief Executive Officer and Chief Financial Officer

(b) Reports on Form 8-K

During the second quarter of 2004, the Company filed the following current reports on Form 8-K:


Date of Report		Description

May 6, 2004		Furnished text of press release reporting the Company’s financial results for the first quarter of 2004

June 15, 2004		Furnished text of press release announcing that the Company had entered into a Definitive Agreement and Plan of Merger with Prime Medical Services, Inc.

June 15, 2004		Furnished text of Agreement and Plan of Merger between the Company and Prime Medical Services, Inc.; HealthTronics Surgical Services, Inc. Voting Agreement; and Prime Medical Services, Inc. Voting Agreement

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.


HEALTHTRONICS SURGICAL SERVICES, INC.

By:		/s/ Victoria W. Beck
		Victoria W. Beck Chief Accounting Officer

Date:		August 9, 2004

Exhibit Index


Exhibit No.		Description

10.1		Employment Agreement with Ms. Beck

31.1		Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer

31.2		Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer

32.1		Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350) of Chief Executive Officer and Chief Financial Officer

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	8th grade Avg

Healthtronics (HTRN) Inactive 10-Q2004 Q2 Quarterly report

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