MEDICOR LTD.
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (unaudited)
September 30, 2006
(thousands, except per share data)
Note A – Description of Business
MediCor Ltd. (the “Company”) is a global health care company that acquires, develops, manufactures and markets products primarily for the aesthetic, plastic, and reconstructive surgery and dermatology markets. Current products include breast implant products and scar management products. The Company’s breast implant products are currently sold in approximately 85 countries, but are not sold in the United States or Canada. The Company’s products are sold primarily in foreign (non-U.S.) countries and foreign sales are currently approximately 95% of total sales, with Brazil accounting for approximately 11% of sales. Breast implant and other implant products account for approximately 95% of total sales for the three months ended September 30, 2006, with sales in approximately 85 countries but not the U.S. or Canada; scar management products contributed approximately 5% of total sales. The Company sells its products to hospitals, surgical centers and physicians through a combination of distributors and direct sales personnel.
MediCor was founded in 1999 by chairman of the board Donald K. McGhan, the founder and former chairman and chief executive officer of Inamed Corporation, McGhan Medical and McGhan Limited. MediCor’s objective is to be a leading supplier of selected international medical devices and technologies. To achieve this strategy, MediCor intends to build upon and expand its business lines, primarily in the aesthetic, plastic and reconstructive surgery and dermatology markets. MediCor intends to both expand existing product lines and offerings and acquire companies and other assets, including intellectual property rights and distribution rights.
Note B – Basis of Presentation
Interim Reporting
The accompanying unaudited consolidated financial statements for the three-month period ended September 30, 2006 and September 30, 2005, have been prepared in accordance with accounting principles generally accepted in the United States and with the Securities and Exchange Commission (the “SEC”) rules for interim financial information reporting. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. These statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-KSB for the fiscal year ended June 30, 2006. In the opinion of management, all adjustments (consisting only of normal recurring accruals, unless otherwise indicated) considered necessary for a fair presentation of the results of operations for the indicated periods have been included. Certain amounts recorded in previous periods have been reclassified to conform to the current period presentation. Operating results for the three months ended September 30, 2006 are not necessarily indicative of the results for the full fiscal year.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and all of its subsidiaries in which a controlling interest is maintained. All inter-company accounts and transactions have been eliminated. Certain prior year amounts in previously issued financial statements have been reclassified to conform to the current year presentation. The consolidated financial statements have been prepared in United States dollars.
Critical Accounting Policies and Use of Estimates
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates and judgments, including those related to revenue recognition, inventories, adequacy of allowances for doubtful accounts, valuation of long-lived assets and goodwill, income taxes, litigation and warranties. The Company bases its estimates on historical and anticipated results and trends and on various other assumptions that the Company believes are reasonable under the circumstances, including assumptions as to future events. The policies discussed below are considered by management to be critical to an understanding of the Company’s financial statements. These estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results may differ from those estimates.
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Share-Based Payments
On July 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised), Share-Based Payment (“SFAS No. 123R”), which requires measurement and recognition of compensation expense for all share-based payment awards made to employees, non-employees and directors. Under SFAS No. 123R the fair value of share-based payment awards is estimated at grant date using an option pricing model and the portion that is ultimately expected to vest is recognized as compensation cost over the requisite service period. Prior to the adoption of SFAS No. 123R, the Company accounted for share-based awards using the intrinsic value method prescribed by Accounting Principles Board Opinion (“APBO”) No. 25, Accounting for Stock Issued to Employees (“APBO No. 25”), as allowed under SFAS No. 123, Accounting for Stock-Based Compensation. Under the intrinsic value method no share-based compensation cost was recognized for awards to employees or directors if the exercise price of the award was equal to the fair market value of the underlying stock on the date of grant.
The Company adopted SFAS No. 123R using the modified prospective application method. Under the modified prospective application method prior periods are not revised for comparative purposes. The valuation provisions of SFAS No. 123R apply to new awards and awards that are outstanding on the adoption effective date that are subsequently modified or cancelled. Estimated compensation expense for awards outstanding and unvested on the adoption effective date will be recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under SFAS No. 123.
Pre-tax share-based compensation expense recognized under SFAS No. 123R for the three months ended September 30, 2006 was $616, which consisted of compensation related to employee, non-employee and director stock options. Pre-tax share-based compensation expense recognized under APBO No. 25 for the three months ended September 30, 2005 was $54, which consisted of compensation related to non-employee stock options and director restricted share awards. There was no share-based compensation expense recognized during the three months ended September 30, 2005 related to employee or director stock options. The company did not recognize an income tax benefit related to the recognized share-based for the three months ended September 30, 2006 and 2005, respectively.
The Company uses the Black-Scholes option-pricing model to estimate the fair value of share-based awards. The determination of fair value using the Black-Scholes model is affected by the Company’s common stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s expected common stock price volatility over the term of the awards and projected employee stock option exercise behavior.
The Company recognizes share-based compensation cost over the requisite service period using the straight-line single option method. Since share-based compensation under SFAS No. 123R is recognized only for those awards that are ultimately expected to vest, an estimated forfeiture rate has been applied to unvested awards for the purpose of calculating compensation cost. SFAS No. 123R requires these estimates to be revised, if necessary, in future periods if actual forfeitures differ from the estimates. Changes in forfeiture estimates impact compensation cost in the period in which the change in estimate occurs. In the Company’s pro forma information required under SFAS No. 123 prior to July 1, 2006, the Company accounted for forfeitures as they occurred.
On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued Staff Position No. FAS 123(R)-3, Transitional Election Related to Accounting for Tax Effects of Share-Based Payment Awards. The Company has elected to adopt the alternative transition method provided in this FASB Staff Position for calculating the tax effects of share-based compensation pursuant to SFAS No. 123R. The alternative transition method includes a simplified method to establish the beginning balance additional paid-in capital pool (“APIC Pool”) related to tax effects of employee share-based compensation, which is available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123R.
Effects of Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. We plan to adopt SFAS No. 157 on July 1, 2008. We are evaluating the impact, if any, that SFAS No. 157 will have on our financial statements.
In July 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109, which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on de-recognition, classification, accounting in interim periods, and disclosure requirements for uncertain tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently assessing the impact of FIN 48 on its consolidated financial position and results of operations.
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In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140. This statement amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and resolves issues addressed in SFAS No. 133 Implementation Issue No. D1, Application of Statement 133 to Beneficial Interest in Securitized Financial Assets. SFAS No. 155 (a) permits fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; (b) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; (c) establishes a requirement to evaluate beneficial interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; (d) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and (e) eliminates restrictions on a qualifying special-purpose entity’s ability to hold passive derivative financial instruments that pertain to beneficial interests that are or contain a derivative financial instrument. The standard also requires presentation within the financial statements that identifies those hybrid financial instruments for which the fair value election has been applied and information on the income statement impact of the changes in fair value of those instruments. The Company is required to apply SFAS No. 155 to all financial instruments acquired, issued or subject to a re-measurement event beginning July 1, 2007, although early adoption is permitted as of the beginning of an entity’s fiscal year. The Company is evaluating the provisions of SFAS No. 155. The effects of adopting of SFAS No. 155 on the Company’s financial statements are not known at this time.
In May 2005, FASB issued SFAS No. 154, Accounting Changes and Error Corrections, which replaces APBO No. 20, Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. This pronouncement applies to all voluntary changes in accounting principle, and revises the requirements for accounting for and reporting a change in accounting principle. SFAS No. 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle, unless it is impracticable to do so. This pronouncement also requires that a change in the method of depreciation, amortization, or depletion for long-lived, non-financial assets be accounted for as a change in accounting estimate that is effected by a change in accounting principle. SFAS No. 154 retains many provisions of APBO No. 20 without change, including those related to reporting a change in accounting estimate, a change in the reporting entity, and correction of an error. The pronouncement also carries forward the provisions of SFAS No. 3 which govern reporting accounting changes in interim financial statements. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Statement does not change the transition provisions of any existing accounting pronouncements, including those that are in a transition phase as of the effective date of SFAS No. 154. The Company has applied the provisions of this statement effective July 1, 2006.
In December 2004, FASB issued SFAS No. 123(R), Share-Based Payment, which establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. A key provision of this statement is the requirement of a public entity to measure the cost of employee services received in exchange for an award of equity instruments (including stock options) based on the grant date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award (i.e., the requisite service period or vesting period). On April 14, 2005, the SEC approved a new rule that delays the effective date for SFAS 123(R) to fiscal years beginning after June 15, 2005, thereby rendering it effective as to the Company on July 1, 2006. The adoption of SFAS 123(R) had an impact of $616 on the Company’s consolidated net income and a loss per share of $0.02.
No other new accounting pronouncement issued or effective during this fiscal year has had or is expected to have a material impact on our consolidated financial statements.
Note C – Inventories
Inventories consisted of:
| | September 30, 2006 | | June 30, 2006 | |
| | | | | |
Raw Materials | | $ | 2,058 | | $ | 1,611 | |
Work in Process | | 756 | | 646 | |
Finished Goods | | 6,967 | | 6,902 | |
| | | | | |
Total | | $ | 9,781 | | $ | 9,160 | |
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Note D – Accrued Expenses
Accrued expenses and other current liabilities at September 30, 2006 consisted of:
| | September 30, 2006 | | June 30, 2006 | |
| | | | | |
Subsequent acquisition payment for Biosil Ltd. and Nagor Ltd. | | $ | 5,838 | | $ | 5,838 | |
Wages, paid leave and payroll related taxes | | 2,687 | | 3,200 | |
Product replacement allowance | | 1,847 | | 2,287 | |
Accrued purchases | | 520 | | 1,256 | |
Legal settlement | | 150 | | 350 | |
Other | | 250 | | 416 | |
| | | | | |
| | $ | 11,291 | | $ | 13,347 | |
The Company entered into a settlement with its previous Mexican distributor, Europlex, S.A. de C.V., pursuant to which Europlex agreed to extinguish and release all claims against the Company, in exchange for future payments totaling $1,000 of which $850 has been paid. Other accrued expenses included interest and other legal expenses.
Note E - Product Replacement Programs
Most of the Company’s subsidiaries provide a product replacement program to surgeons for deflations of breast implant products for a period of ten years from the date of implantation. For Nagor products sold in the U.K., the Company also provides a free replacement implant in cases of capsular contracture within one year of the original implantation. For certain surgeons outside of the U.S., Eurosilicone provides a product replacement program for the life of the patient, including replacements for competitive implants, aesthetic dissatisfaction and for deflation. In follow-on clinical studies, the Company may extend the period in which free replacement implants can be claimed for capsular contracture or deflation. In addition to a free replacement, certain of the programs also pay limited financial assistance to the surgeon to help reduce the cost of the replacement surgical procedure. Management has estimated the amount of potential future product replacement claims based on a detailed analysis. Expected future obligations are determined based on the history of product shipments and claims and are discounted to a current value, and this amount is set aside as an allowance. Changes to the volume or pattern of expected claims and changes in interest rates would affect the calculation and could materially impact the Company’s allowance and results of operations. Although breast implant products are not currently being sold in the U.S. (because the Company is in the process of seeking clearance from the U.S. Food and Drug Administration, or “FDA”, to market them in the U.S., as more fully described below), they were sold under a distribution agreement prior to May 2000 and an allowance for product replacements is maintained for the products sold in prior years.
For the three months ended September, 2006, III Acquisition Corporation, which does business under the name PIP.America, paid $167 with respect to settlements under its product replacement program for products previously sold under its distribution agreement with Poly Implants Prothèses S.A. (“PIP”), a third-party manufacturer of breast implants. For the three months ended September 30, 2006, MediCor Aesthetics paid $195 with respect to settlements under its product replacement program for the products previously sold under its distribution agreement between Hutchison International, Inc. and Biosil Limited.
As of September 30, 2006, the Eurosilicone, PIP.America and MediCor Aesthetics product replacement program allowance consisted of:
Balance at July 1, 2005 | | $ | 1,004 | |
Provision for product replacement program expansion during the period | | 2,460 | |
Settlements incurred during the period | | (1,177 | ) |
Balance at June 30, 2006 | | 2,287 | |
| | | |
Provision for product replacement program expansion during the period | | 50 | |
Settlements incurred during the period | | (490 | ) |
Balance at September 30, 2006 | | $ | 1,847 | |
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Note F – Debt
Long-term debt consisted of the following amounts:
| | September 30, 2006 | | June 30, 2006 | |
| | | | | |
Senior secured convertible note - variable 3-month LIBOR plus 6%, with maturity in March 2011 | | $ | 50,000 | | $ | 50,000 | |
Variable 6-month EURIBOR plus 2.25% euro-denominated note, with maturity in September 2011 | | 9,848 | | 11,695 | |
Subordinated secured convertible note to related party - variable 3- month LIBOR plus 6%, with maturity in March 2011 | | 37,500 | | 37,500 | |
Subordinated note to related party - 10%, with maturity in September 2011 | | 32,388 | | 31,592 | |
Convertible debentures | | 100 | | 150 | |
Obligations under capital leases | | 2,348 | | 2,265 | |
Subsequent acquisition payment for Biosil Ltd. and Nagor Ltd. | | 5,255 | | 5,255 | |
Other notes | | 321 | | 406 | |
| | | | | |
| | 137,760 | | 138,863 | |
Less: current maturities | | (2,832 | ) | (2,834 | ) |
Less: note discounts | | (70,290 | ) | (76,690 | ) |
| | | | | |
Long-term debt | | $ | 64,639 | | $ | 59,339 | |
On April 26, 2006, the Company raised $50,000 in a private placement that included the sale of senior secured convertible notes (the “Notes”). $25,000 of this was utilized in the acquisition of Biosil and Nagor, with the remaining balance made available for the Company’s general working capital needs. The Notes carry an interest rate of three-month LIBOR, plus 6%, and a one-time balloon payment at maturity on March 2011. As part of this financing transaction, the Company also issued warrants (the “Warrants”) to purchase shares of our common stock. The Notes and Warrants are subject to a Registration Rights Agreement that requires that the Company register the underlying shares with the SEC and maintain the effectiveness of the registration statement. The Registration Rights Agreement also provides for liquidated damages on the occurrence of several events. As of September 30, 2006, no liquidating damages have been incurred by the Company.
In September 2004, MediCor’s ES Holdings subsidiary entered into an arrangement with a financial institution to borrow up to €16,400, at an interest rate of six-month EURIBOR plus 2.25%, to fund payments due to the sellers of Eurosilicone, a company acquired by MediCor in July 2004. The last borrowing is scheduled for 2007 and scheduled repayments complete in September 2011. As of September 30, 2006, the outstanding principal was €7,762.
Convertible debentures at September 30, 2006 were $100. These are convertible, at the holder’s discretion, after one year and at the 18-month, 24-month, 30-month and 36-month anniversary of the issuance date to shares of the Company’s common stock at a price equal to the greater of $5.00 or seventy-five percent (75%) of the daily weighted average trading price per share of the Company’s common stock over a period of twenty (20) trading days prior to the conversion date. They are all reported within the current portion of long-term debt. During the three months ended September 30, 2006, the Company did not incur any costs relating to these convertible debentures.
MediCor has several capital leases. Substantially all of these lease obligations reside with the Company’s Eurosilicone subsidiary and are leases of facilities and vehicles. In addition, MediCor has several other notes, with outstanding principal balances ranging from $50 to $197 and annual interest rates ranging from 3.39% to 8.0%. As of September 30, 2006, MediCor had $3,447 of unamortized financing costs recorded in other assets. These costs are being amortized straight-line over the life of the related note. These notes mature in March and September 2011.
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Payments due on capital lease obligations as of September 30, 2006 are as follows:
October 2006 - September 2007 | | $ | 575 | |
October 2007 - September 2008 | | 407 | |
October 2008 - September 2009 | | 371 | |
October 2009 - September 2010 | | 323 | |
October 2010 - September 2011 | | 262 | |
Later years | | 1,036 | |
| | | |
Total minimum payments required | | 2,974 | |
Less: Amount representing interest | | (626 | ) |
| | | |
Present value (principal) of capital lease obligations | | 2,348 | |
| | | |
Less: Current portion of capital lease obligations | | (532 | ) |
| | | |
Long term portion of capital lease obligations | | $ | 1,816 | |
Principal payments due on long-term debt as of September 30, 2006, other than capital lease obligations, are as follows:
September 2006 - October 2007 | | $ | 2,200 | |
September 2007 - October 2008 | | 8,732 | |
September 2008 - October 2009 | | 1,970 | |
September 2009 - October 2010 | | 1,970 | |
September 2010 - October 2011 | | 51,970 | |
Later years | | 70,918 | |
| | | |
Total minimum payments required | | 137,760 | |
| | | |
Less: Amount representing current portion | | (2,200 | ) |
| | | |
Non-current portion of long-term debt | | $ | 135,560 | |
The current portion of long-term debt is as follows:
Current portion of capital lease obligations | | $ | 532 | |
Convertible debentures | | 100 | |
Current portion of other long-term debt | | 2,200 | |
| | | |
| | $ | 2,832 | |
Short-term note payable was $120 at September 30, 2006.
Senior Secured Convertible Debt and Related Instruments
Pursuant to accounting guidance in EITF 00-19 and SFAS 133, the Company completed a thorough analysis and review of the terms of the Notes, their respective covenants, and the Warrants and determined that the appropriate accounting treatment for the Warrants and for the conversion feature of the Notes was as derivative liabilities. At June 30, 2006, the Company ascribed values of $6,375 and $27,750 to these Warrants and the conversion feature, respectively. At September 30, 2006, the values ascribed to them were $5,969 and $26,000, respectively. The decline in the value of each liability gave rise to gains of $406 and $1,750, respectively, which have been reflected in the Company’s Consolidated Statement of Operations. The fair value of these derivative liabilities had decreased due largely to a decrease in the market value of the Company’s common stock from $3.00 at June 30 to $2.85 at September 30. The estimated fair values of the Warrants and the conversion feature were determined using the Black-Scholes option pricing model. The model uses several assumptions, including the Company’s common stock price volatility, risk-free interest rate, remaining time to maturity, and the closing price of the Company’s common stock to determine the estimated fair value of the derivative liabilities. In valuing the derivative liabilities at September 30, 2006, the Company used its common stock closing price, the respective exercise prices, the remaining term on each Warrant and conversion right, and a common stock volatility of 98.23%. The recorded value of such derivative liabilities can fluctuate significantly based on fluctuations in the market value of the underlying securities of the issuer of the Warrants and of the Notes as well as in the volatility of the common stock price during the term used for
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observation to serve as a basis to estimate future volatility and in the term remaining for the Warrants and the conversion rights.
The value of the discount on the Notes is being accreted over the term of the Notes (4.9 years). For the three months ended September 30, 2006, the Company accreted $3,699 of debt discount related to these Notes
The following table reflects the carrying value of the senior secured convertible Notes at September 30, 2006:
Principal | | $ | 50,000 | |
(Less): Note discount | | (37,939 | ) |
| | $ | 12,061 | |
For the Notes, the $50,000 total principal amount is due in the year ending June 30, 2011.
Interest Expense
The following table summarizes interest expense—including that relating to the Notes, the Sirius Capital LLC (“Sirius”) subordinated note (“Subordinated Note”) and International Integrated, LLC (“LLC”) notes, and amortization of note discount and deferred financing fees—net, for the three months ended September 30, 2006:
Interest expense on the Notes, at stated rate | | $ | 1,419 | |
Amortization of note discount on the Notes | | 3,699 | |
Amortization of deferred financing fees from issuance of the Notes | | 290 | |
Interest expense on Sirius and LLC Notes (to related party), at stated rates | | 1,861 | |
Amortization of note discount on Sirius and LLC Notes | | 2,700 | |
Other interest expense (income), net | | 229 | |
| | $ | 10,198 | |
Note G – Federal Income Taxes
The Company follows SFAS 109, Accounting for Income Taxes, for reporting income taxes. The expense (benefit) for income taxes reflected in the Consolidated Statements of Operations for the Company for the periods noted consist of:
| | September 30, 2006 | | September 30, 2005 | |
| | | | | |
Current | | | | | |
| | | | | |
Net loss | | $ | (3,955 | ) | $ | (1,351 | ) |
Foreign income tax expense (benefit) on unconsolidated subsidiaries | | 185 | | (128 | ) |
| | (3,770 | ) | (1,480 | ) |
Deferred | | | | | |
| | | | | |
Allowance for bad debts | | 168 | | 103 | |
Allowance for product replacement | | (27 | ) | 96 | |
Depreciation and amortization | | 295 | | 20 | |
Unrealized foreign currency gain/(loss) | | 355 | | — | |
| | 791 | | 220 | |
| | | | | |
Total benefit | | (2,979 | ) | (1,260 | ) |
Valuation provision for realization of deferred tax asset | | 3,164 | | 1,131 | |
| | | | | |
Total tax expense (benefit) | | $ | 185 | | $ | (128 | ) |
The current tax expense for the three months ended September 30, 2006 was income tax paid by foreign subsidiaries. As of September 30, 2006, the Company recorded an allowance of $44,946 against certain future tax benefits, the realization of which is currently uncertain. The deferred differences related to certain accounts receivable, accrued warranties, and depreciation/amortization not currently deductible as expenses under Internal Revenue Service provisions. Although the Company recorded this allowance to the deferred tax assets, the Company may still utilize the future tax benefits from net operating losses for 20 years from the year of the loss to the extent of future taxable income. The estimated net operating losses for tax purposes of approximately $64,000 will expire over several years ending in 2027.
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Primary components of the deferred tax asset as of September 30, 2006 were approximately as follows:
| | September 30, 2006 | | June 30, 2006 | |
| | | | | |
Computed expected income tax benefit at 34% | | $ | 3,955 | | $ | 5,496 | |
Adjustments | | | | | |
Net operating loss | | 36,114 | | 30,618 | |
Provision for bad debts | | 1,816 | | 1,648 | |
Provision for product replacement | | 617 | | 644 | |
Depreciation and amortization expense | | 1,388 | | 1,093 | |
Unrealized foreign currency gain | | 1,056 | | 701 | |
| | | | | |
Income tax benefit | | $ | 44,946 | | $ | 40,200 | |
Valuation allowance for realization of deferred tax asset | | (44,946 | ) | (40,200 | ) |
| | | | | |
Deferred tax asset, net | | $ | — | | $ | — | |
Note H – Net Loss per Common Share Reconciliation
Basic loss per share is computed by dividing the net loss applicable to common shares after preferred dividend requirements by the weighted average of common shares outstanding during the period. Diluted loss per share adjusts basic loss per share for the effects of convertible securities, stock options and other potentially dilutive financial instruments, only in the periods in which such effect is dilutive.
A reconciliation of weighted average shares outstanding, used to calculate basic loss per share, to weighted average shares outstanding assuming dilution, used to calculate diluted loss per share, follows:
| | Three Months Ended | | Three Months Ended | |
| | September 30, 2006 | | September 30, 2005 | |
| | | | | | Per-Share | | | | | | Per-Share | |
| | Income | | Shares | | Amount | | Income | | Shares | | Amount | |
| | (Numerator) | | (Denominator) | | | | (Numerator) | | (Denominator) | | | |
| | | | | | | | | | | | | |
Net Income (Loss) before preferred stock dividends | | (12,712 | ) | | | | | (3,827 | ) | | | | |
Less: Preferred stock dividends | | 135 | | | | | | 124 | | | | | |
| | | | | | | | | | | | | |
Basic EPS | | (12,847 | ) | 23,746 | | (0.54 | ) | (3,951 | ) | 20,336 | | (0.19 | ) |
| | | | | | | | | | | | | |
Effect of dilutive securities | | — | | | | | | — | | | | | |
| | | | | | | | | | | | | |
Diluted EPS | | $ | (12,847 | ) | 23,746 | | (0.54 | ) | $ | (3,951 | ) | 20,336 | | (0.19 | ) |
| | | | | | | | | | | | | | | |
Common equivalent shares of 32,367 have been excluded from the computation of diluted earnings per share because their effect would be anti-dilutive.
Note I – Stock Options and Warrants
The Company has a stock option plan for key employees and consultants. There were 4,243 shares reserved for issuance pursuant to the Company’s stock option plan and up to 4 shares were reserved for issuance pursuant to stand-alone options granted in connection with employment agreements. The Company’s employee share option activity for and related information is summarized below:
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The Company’s share option activity and related information is summarized below:
| | | | Weighted Average | |
| | Options | | Exercise Price | |
| | | | | |
Options outstanding at June 30, 2005 | | 4,316 | | $ | 3.28 | |
| | | | | |
Granted | | 168 | | 3.52 | |
Exercised | | (235 | ) | 1.92 | |
Cancelled | | (210 | ) | 4.16 | |
Options outstanding at June 30, 2006 | | 4,039 | | $ | 3.31 | |
| | | | | |
Granted | | 1,117 | | 2.50 | |
Exercised | | — | | — | |
Cancelled | | — | | — | |
Options outstanding at September 30, 2006 | | 5,156 | | $ | 3.14 | |
| | | | | |
Options exercisable at end of period | | 2,329 | | $ | 3.34 | |
The following table summarizes information about stock options outstanding at September 30, 2006:
Outstanding | | Exercisable | |
| | | | Weighted | | | | | | | |
| | | | Average | | | | | | | |
| | | | Remaining | | Weighted | | | | Weighted | |
| | | | Years of | | Average | | | | Average | |
Range of | | Number of | | Contractual | | Exercise | | Number of | | Exercise | |
Exercise Prices | | Options | | Life | | Price | | Options | | Price | |
| | | | | | | | | | | |
$1.00 - $2.50 | | 1,901 | | 5.4 | | $ | 2.18 | | 477 | | $ | 1.67 | |
$3.00 - $3.80 | | 2,280 | | 4.6 | | $ | 3.48 | | 1,125 | | $ | 3.48 | |
$4.00 - $4.30 | | 958 | | 4.9 | | $ | 4.22 | | 727 | | $ | 4.22 | |
Note J – Commitments and Contingencies
In October 1999, Case No. 99-25227-CA-01, June 2000, Case No. 00-14665-CA-01, June 2003, Case No. 03-15006-CA-09, and September 2003, Case Nos. 0322537-CA-27 and 03-22399-CA-15, separate litigations were filed by Saul Kwartin, Ruth Kwartin, Steven M. Kwartin, Robert Kwartin and Nina Kwartin against PIP.America (our subsidiary), PIP/USA, Inc., (“PIP/USA”) Poly Implants Protheses, S.A. (“PIP”), Jean Claude Mas, Jyll Farren-Martin and Donald K. McGhan in the Circuit Court of Miami-Dade County, Florida. The Kwartin family members variously allege that they are shareholders of PIP/USA or have statutory and common law rights of shareholders of PIP/USA as a result of loans or investments allegedly made to or into PIP/USA or a third party or under an alleged employment agreement. Plaintiffs assert that they have certain derivative or other rights to an alleged distribution agreement between PIP and PIP/USA. Plaintiffs further allege, among other things, that PIP.America and its chairman tortiously interfered with that agreement and plaintiffs’ other alleged rights. In addition to monetary damages and injunctive relief, plaintiffs seek to reinstate the alleged distribution agreement between PIP/USA and PIP and invalidate PIP.America’s distributor relationship with PIP. These cases are consolidated for pretrial purposes but not for trial. Defendants have filed a motion to dismiss the consolidated cases, which will be heard in March, 2007.
Peggy Williams v. PIP/USA, Inc., Case No. 03 CH 9654, Jessica Fischer Schnebel, et al. v. PIP/USA, Inc., Case No. 03CH07239, Dawn Marie Cooper, et al. v. PIP/USA, Inc., Case No. 03CH11316, Miriam Furman, et al. v. PIP/USA, Inc., Case No. 03CH10832 and Karen S. Witt, et al. v. PIP/USA, Inc., Case No. 03CH12928 were filed in the Circuit Court of Cook County, Chancery Division, in or around July 2003. Counsel for Jessica Fischer Schnebel, et al. v. PIP/USA, Inc., Case No. 03CH07239 amended her class action complaint to include plaintiffs from the other four cases, and each of the others was voluntarily dismissed. The consolidated second amended complaint contained counts alleging product liability, breach of the implied warranties of merchantability and fitness for a particular purpose, violation of the Illinois Consumer Fraud Act
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and third-party beneficiary status. Unspecified monetary damages, exemplary damages and attorneys fees and costs had been sought. On January 26, 2006, PIP.America, which was a defendant in the action, won dismissal of all counts in these cases but the third-party beneficiary claims. Plaintiffs have amended and refiled their complaint against PIP.America (seeking the same damages), and PIP.America has filed another motion to dismiss plaintiffs’ latest complaint (the Third Amended Complaint). PIP.America’s motion to dismiss has been fully briefed and will be heard on November 1, 2006. PIP, a defendant in the Schnebel litigation, has agreed to indemnify PIP.America for any losses PIP.America may suffer as a result of the Illinois litigation.
With respect to cases involving PIP, PIP.America is indemnified by PIP/USA, PIP, and PIP’s President, Jean Claude Mas, personally, from, among other things, claims arising from products manufactured by PIP-France. PIP.America either already has, or is in the process of, asserting its indemnification claims and, in the event of an adverse judgment in any of the cases, PIP.America intends to seek the benefits of this indemnity. As a result, we believe the costs associated with these matters will not have a material adverse impact on our business, results of operations or financial position.
In July, 2005, IP Resources Limited, a UK-based company filed an action against our subsidiary, Eurosilicone SAS in the Marseille Civil Court (Tribunal de Grande Instance), Marseille, France. The complaint alleges that Eurosilicone infringed upon a certain European Patent licensed by IP Resources, Inc. known as “Implantable prosthesis device” Patent #0174141B1, and seeks damages of €3 million, plus legal costs. The case is in the preliminary stages and we believe we do not infringe on the 0174141B1 patent and are prepared to wage a vigorous defense based on both the validity of the patent and upon the merits of the claims.
Though it is not yet possible to predict the outcome of the cases described above, MediCor and its subsidiaries, as applicable, have denied plaintiffs’ allegations and are vigorously defending themselves in each lawsuit. MediCor and its subsidiaries have been and will continue to be periodically named as defendants in other lawsuits in the normal course of business, including product liability and product replacement claims. In the majority of such cases, the claims are dismissed, or settled for immaterial amounts. Litigation, particularly product liability litigation, can be expensive and disruptive to our normal business operations and the results of complex proceedings can be very difficult to predict. Claims against MediCor or its subsidiaries have been and are periodically reviewed with counsel in the ordinary course of business. We presently believe that we or our subsidiaries have meritorious defenses in all lawsuits in which we or our subsidiaries are defendants, subject to the subsidiaries’ continuing product replacement obligations, which the subsidiaries intend to continue to satisfy. While it is not possible to predict the outcome of these matters, we believe that the costs associated with these proceedings will not have a material adverse impact on our business, results of operations or financial position.
The Company leases offices, manufacturing and warehouse facilities and office equipment under various terms. Lease expenses amounted to $125 and $88 for the three months ended September 30, 2006 and 2005, respectively. Future minimum lease payments are as follows:
Year ended September 30, | | | |
2008 | | $ | 713 | |
2009 | | 530 | |
2010 | | 388 | |
2011 | | 229 | |
2012 | | 133 | |
Later years | | 594 | |
| | | |
Total minimum payments required | | $ | 2,586 | |
Note K – Acquisitions
On April 28, 2006, the Company, through its wholly-owned subsidiary, Biosil UK Ltd., completed its acquisition of Biosil Limited. and Nagor Limited., both privately held Isle of Man (British Isles) companies, from their shareholders (the “Sellers”) pursuant to the Agreement for the Sale and Purchase of the Shares of Biosil Limited and Nagor Limited (the “Biosil/Nagor SPA”) dated September 13, 2005. The combined purchase price for both companies was £20,000 plus 2,640 shares of MediCor common stock. The Company paid £13,000 in cash at closing from funds available as part of a separate, earlier $50,000 senior secured convertible note private placement. The remaining £7,000 is due in two equal payments in fiscal 2008. In conjunction with the transaction, the Company and each of the Sellers entered into Put and Call Option Agreements and a Registration Rights Agreement. Copies of these agreements and the Biosil/Nagor SPA were provided with the Company’s Current Report on Form 8-K filed with the SEC on May 4, 2006. The terms of the acquisition were determined on the basis of arm’s-length negotiations and at values that the Company believes are below the values associated
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with comparable medical device companies. The Company has included the operations of Biosil Limited and Nagor Limited in its Consolidated Statement of Operations since the date of acquisition, April 28, 2006, through September 30, 2006.
In accordance with SFAS No. 141, the total purchase price was allocated to the tangible and intangible assets of Biosil and Nagor based upon their estimated fair values at the acquisition date with the excess purchase price allocated to goodwill. The estimates are preliminary and are prior to completion of independent valuations. Consequently, the values below are subject to change as the valuations become final.
The following table summarizes the preliminary, estimated fair values of the assets acquired and liabilities assumed at the date of acquisition, April 28, 2006.
Cash (£13,000 at $1.78726 per £ bank settlement rate at April 28, 2006) | | $ | 23,234 | |
Cash (£7,000, discounted to £6,200 at 11.1% annual interest, translated at $1.7893 per £ exchange rate at April 28, 2006) | | 11,093 | |
Shares of MediCor common stock
(2,640 shares at $3.60 per share, the median market price for 20 business days on either side of the acquisition date, less registration costs) | | 9,498 | |
Direct acquisition costs | | 1,130 | |
Total purchase price | | $ | 44,955 | |
| | | |
Allocation of purchase price | | | |
| | | |
Cash and cash equivalents | | $ | 1,376 | |
Accounts receivable | | 1,804 | |
Inventories | | 4,124 | |
Other current assets | | 304 | |
Property and equipment | | 2,841 | |
Investments | | 43 | |
Intangible assets | | 36,219 | |
Other non-current assets | | 96 | |
Accounts payable | | (144 | ) |
Deferred tax liability, current | | (273 | ) |
Other current liabilities | | (687 | ) |
Deferred tax liability, non-current | | (748 | ) |
Total purchase price | | $ | 44,955 | |
The Company is awaiting independent valuation of the intangible assets listed above. The values assigned to these intangible assets as of the acquisition date were preliminary and estimated as follows:
| | Amount | | Life | |
Customer list | | $ | 2,871 | | 3.1 years | |
Goodwill | | 33,348 | | Indefinite | |
Total intangible assets | | $ | 36,219 | | | |
In addition, the Company is awaiting independent valuation of other possible intangibles; therefore no value has yet been assigned for patents, trade names, non-compete agreements, etc.
In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, goodwill and certain other intangible assets are deemed to have indefinite lives and, accordingly, are not amortized but instead are subject to periodic impairment testing at future periods. Customer relationships are amortized over 3.1 years using the straight-line method.
The following unaudited pro-forma financial information reflects the condensed consolidated results of operations of the Company as if the acquisition had taken place on July 1, 2005. The pro-forma financial information is not necessarily indicative of the results of operations had the transaction been effected on July 1, 2005.
| | September 30, 2005 | |
Net sales | | $ | 8,408 | |
Net loss | | $ | (3,619 | ) |
| | | |
Net loss per share of common stock, basic and diluted | | $ | (0.18 | ) |
The information presented above is for illustrative purposes only and is not necessarily indicative of the operating results or financial position that would have occurred had the acquisition been completed as of the dates indicated, nor are they
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necessarily indicative of future operating results or financial position. The purchase accounting adjustments made in connection with the unaudited pro forma condensed consolidated financial statements are based on a preliminary valuation that has been made solely for the purpose of developing the pro forma financial information and are based upon currently available information. Such a valuation is subject to final adjustments. Accordingly, the actual adjustments to be recorded in connection with the final purchase price allocation may differ from the pro forma adjustments reflected in the unaudited pro forma condensed consolidated financial statements, and any such differences may be material. The purchase price valuations are expected to be completed by March 31, 2007.
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ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
| | For the Three Months Ended | |
| | September 30, | | September 30, | |
Major items as a percentage of sales | | 2006 | | 2005 | |
| | | | | |
Cost of Sales | | 67 | % | 70 | % |
Selling, general and administrative | | 73 | % | 63 | % |
Research and development | | 9 | % | 16 | % |
Interest expense | | 107 | % | 26 | % |
Reduction in value of derivative liabilities | | (23 | )% | — | |
Net loss | | (133 | )% | (68 | )% |
Sales
Sales for the three months ended September 30, 2006 were $9,493,549, an increase of $3,831,534 or 68% versus the same period a year ago. Of this, approximately $2,963,318 reflects the inclusion in our financial statements of three months of the results of operations of Biosil Limited and Nagor Limited. At Eurosilicone, positive unit growth—particularly in Latin America—was partially offset by a decrease in unit prices and a decline in the dollar relative to the euro. This decline in the dollar negatively impacted overall MediCor sales by approximately 4%.
Cost of Sales
Cost of sales as a percentage of net sales for the three months ended September 30, 2006 was approximately 67% compared to approximately 70% during the same period in 2005. This decrease was primarily attributable to the implementation of the programs to improve manufacturing efficiencies implemented during fiscal 2006 which have enabled us to increase production and lower unit cost of sales. Based on our historical review of costs, we expect that cost of sales in the future will remain in line on a percentage basis with our historic level of approximately 66%. As sales volumes and prices increase, costs should then reduce as a percentage of sales.
Selling, General and Administrative Expenses
Selling, general and administrative (“SG&A”) expenses increased to $6,897,680 for the three months ended September 30, 2006, as compared to $3,579,066 during the same period in 2005. Of this, approximately, $1,034,890 are SG&A expenses of Biosil Limited and Nagor Limited. The remaining increase was attributable to $576,838 for share-based payments; payroll related expenses of $482,558; consulting fees of $216,261; product replacement related fees of $204,724; commission expense of $168,705; accounting fees of $155,958; additional amortization and deprecation of $143,791; advertising fees of $82,637; and other various increases of $252,252. Of all SG&A expenses the Company incurred during the three months ended September 30, 2006, the majority were charges that are expected to be recurring.
Research and Development Expenses
Research and development expenses for the three months ended September 30, 2006 were $854,860 as compared to $912,565 for the comparable period in 2005. While we recognized an increase of costs associated with the PIP product of $82,256 and increased expenses of $66,722 from Biosil Limited and Nagor Limited, we recognized a decrease in costs relating to the development of other product lines of $206,683. We expect that research and development expenses will continue to remain substantial and grow as we aggressively move to bring products to market. However, we expect that research and development expenses will decrease with respect to a particular product once we receive required government approvals for it, but these expenses will continue to increase overall as we bring new products to market or existing products to new markets.
Interest Expense
Interest expense increased to $10,198,446 for the three months ended September 30, 2006 as compared to $1,454,303 at September, 30, 2005. Interest expense consists primarily of interest related to borrowings.
Interest expense for the three months ended September 30, 2006, primarily included $3,570,464 for the interest at stated rates on the senior secured convertible notes (the “Notes”) and subordinated debt (the “Subordinated Note”) and $6,399,298
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for amortization of related note discounts. We expect interest expense to continue at a high level, due both to maintaining a high level of debt and to the amortization of the note discounts and deferred financing fees.
Reduction in Value of Derivative Liabilities
The value of derivative liabilities at September 30, 2006 was $2,156,250 less than at June 30, 2006, which resulted in a gain. There were no derivative liabilities in the same quarter a year ago. The gain was on the revaluation of the warrant liability and convertible feature liability of the Notes and the Subordinated Note from June 30, 2006 until September 30, 2006. This resulted from a decline in our stock price, which reduced the carrying value of these liabilities.
Net Loss
Net loss attributable to common stockholders for the three months ended September 30, 2006 increased to $12,846,129 from $3,951,126 for the previous period. Basic and diluted loss attributable to common stockholders per share of common stock for the three months ended September 30, 2006 was $0.54 as compared to $0.19 for the three months ended September 30, 2005.
Liquidity and Capital Resources
Cash used in operations during the three months ended September 30, 2006 was $7,681,075. This was primarily driven by selling, general and administrative expenses, including continued startup costs, increased regulatory and quality assurance expenses, increased engineering expenses, research and development expenses and interest expense. Our investing activities of $158,719 were principally due to the acquisition of additional fixed assets. Our ability to make payments to refinance our debt and to fund operations and planned capital expenditures will depend on our ability to secure additional significant financing and generate sufficient cash in the future. Currently, we have only limited product sales in the United States and will not be in a position to materially increase United States sales unless and until the FDA issues a pre-market approval relating to one or more of the products sought to be sold by us. Product entry into the United States market is a significant business priority. Our business strategy depends in significant part on the success of bringing our products to the United States market. We are currently funding substantial activities for two pre-market approval applications which are operating expenses. There can be no assurance that either application will be approved.
Historically we have raised funds to support our operating expenses and capital requirements through sales of equity or debt securities or through other credit arrangements, including borrowing from our affiliates. Most recently, we raised $46.5 million ($50 million less fees) in a private placement that included the sale of Notes and Warrants. Of this, approximately $25 million was utilized in our acquisition of Biosil and Nagor and the balance was made available for general working capital needs. In addition, our ES Holdings subsidiary is party to a bank loan agreement under which it had an outstanding indebtedness of approximately $9,847,658 at September 30, 2006. In fiscal 2006, ES Holdings notified the banks under the loan agreement that inconsistencies existed in the loan covenant formulations which prevented consistent calculation of certain covenants. ES Holdings and the banks are currently negotiating an amendment to the loan agreement to clarify and correct these formulations. We anticipate that an amendment will be completed in the second quarter of fiscal 2007. To satisfy our liquidity requirements, we will need to raise additional funds. To the extent additional sales of equity or debt securities are insufficient to satisfy our liquidity requirements, we plan on being able to obtain any necessary additional funds through the incurrence of additional indebtedness to our affiliates. We have received a written commitment from International Integrated Industries, LLC, an affiliate of our chairman, to fund any operating expenses and capital expenditures through July 1, 2007. The same entity has provided to us over $77 million in funding through September 30, 2006. This historic funding has been a combination of equity and debt. However, our ability to incur additional indebtedness is restricted by our outstanding Notes. These Notes only permit the incurrence of a maximum of $10 million of indebtedness that is both expressly subordinate to them and unsecured. We are also restricted by these Notes from issuing convertible securities or options, and our Note holders have a right of first refusal with respect to new security issuances other than the issuance of common stock in an underwritten public offering of $75 million or more in which the net price per share (after deduction of underwriting discounts and commissions) is at or above $8.00. To the extent our future liquidity requirements are greater than these capital resources or limitations; we may have to seek to negotiate to obtain any necessary additional funds through the incurrence of additional indebtedness or issuance of equity securities. Continued delays in or failure to successfully bring planned products to the United States market adversely affects our liquidity and need for additional capital resources to a significant extent.
We expect our operating losses to continue and increase as long as we do not have breast implant products approved for sale in the United States. We anticipate that we will need additional liquidity to cover negative cash flow during fiscal 2007. In addition, to the extent we want to pursue additional product introductions or acquisitions, we expect that we will need additional financing. We do not presently have any commitments for such financing and it may not be available when we need it, on terms acceptable to us or at all. The lack of adequate financing could adversely affect our ability to effect
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acquisitions. In particular, there is an exception to the Note holders’ right of first refusal with respect to new security issuances for securities issued in connection with acquisitions in which we acquire at least a majority of the voting power of the entity being acquired. However, we may or may not be able to exclusively use common stock in any proposed transaction.
Our ES Holdings subsidiary may be required to make a performance payment of up to €3 million to the sellers in fiscal 2008 under the Eurosilicone acquisition agreement and our Biosil U.K. Holdings Ltd. subsidiary will be required to make two subsequent payments of £3.5 million each in fiscal 2008 under the Biosil/Nagor acquisition agreement. If a payment is required and ES Holdings does not otherwise have sufficient funds from dividends or distributions from Eurosilicone, we may seek third-party financing to make this payment. We intend to pay the two required Biosil/Nagor £3.5 million payments out of current funding resources—operating cash flows plus our recent debt financing.
We have also entered into put and call option agreements with each of the former shareholders of Biosil and Nagor. These agreements were required by the sellers in connection with their agreeing to take a portion of the acquisition consideration in shares of our common stock. Under those agreements we may be obligated to purchase the 2,640,000 shares of common stock issued to those shareholders in the acquisition if they are put to us by the holders. We may also call the same shares. The shares may be put to us starting 18 months after the saline-filled breast implant manufactured by Biosil is approved for commercialization in the United States by the FDA. The put options expire if our common stock ever trades at or above $10.00 per share for 30 out of 45 consecutive trading days (whether before or after the puts are exercisable) and each put option is only exercisable to the extent the individual selling shareholder still holds the common stock we issued to him or her in the acquisition. The purchase price associated with the puts varies depending on when the FDA approves silicone-filled breast implants for commercialization in the United States. If FDA silicone approval occurs on or before the date that is nine months after the Biosil product’s approval, the price is $5.50 per share. If FDA silicone approval occurs after the date that is nine months after the Biosil product’s approval and on or before the date that is 18 months after the Biosil product’s approval, the price is $6.50 per share. If FDA silicone approval occurs after the date that is 18 months after the Biosil product’s approval, the price is $7.50 per share. Under each of these circumstances, the maximum number of shares that may be put to us in any three-month period by all of the selling shareholders is 660,000, less any shares of common stock otherwise sold by any of those holders during that period. The puts are also exercisable if there is a public offer by any person to acquire all of our outstanding shares of common stock. In such event, the price will be $5.50 per share if both Biosil’s saline-filled breast implant and any third party’s silicone-filled breast implant have both been approved for commercialization in the United States by the FDA by the time the person becomes entitled to compulsorily acquire our common stock. Otherwise the price will be $6.50 per share. Any exercise of the puts will put additional demands on our capital resources, and we presently have no specific contingency plan for this possible future event. We may also call the shares of common stock issued to the selling shareholders at any time after FDA commercialization approval of the Biosil saline-filled breast implant and until our common stock trades at or above $20.00 per share for 30 out of 45 consecutive trading days at prices of $7.50, $10.00 and $15.00 per share, based on the same FDA silicone approval events that apply to the puts. Each holder also terminates the call with respect to his or her shares if he or she elects in his or her discretion to terminate the put.
Both Eurosilicone and the combined operations of Biosil and Nagor have positive operating cash flows that may or may not be sufficient to fund all of their respective projected operational, working capital, financial and other obligations. We expect that, from time to time, one or more of these operating subsidiaries may have additional liquidity needs which may require financing by MediCor, a third-party, such as a bank, or our affiliates. In addition, we have a written commitment from an affiliate of our chairman to fund any operating expenses and capital expenditures through July 1, 2007. However, the ability to access that commitment will be limited by the restrictions of the Notes described above.
Our revenues are primarily denominated in U.S. dollars, in euros and British pounds, with U.S. dollars accounting for approximately 40% of total revenues. Our expenses are denominated in U.S. dollars; euros and British pounds. We do not currently hedge against foreign exchange risk and do not have any plan to do so.
ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In the normal course of business, our operations are exposed to fluctuations in interest rates and foreign currency exchange rates. Our experience and expectation is that these fluctuations are not so great as to pose a significant risk to our business, even if they may be material to valuations on our balance sheet and to the results of our operations. We do not enter into financial instruments to hedge such exposures except where required by loan agreements, nor do we enter into financial instruments for either trading or speculative purposes.
The value of two derivative liabilities on our balance sheet—warrants and senior note conversion feature—is affected both by interest rates and by the market value of our common stock. Our stock price is thinly traded and its price is volatile, and thus changes in valuations of these instruments can be significant. However, changes in the valuation of these derivatives have no impact on our cash obligations.
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Interest Rate Risk
At September 30, 2006, we have $97,347,658 of variable rate debt—$87,500,000 of U.S. dollar-denominated debt that varies with the three-month LIBOR rate and $9,847,658 (€7,761,701) of euro-denominated debt that varies with the six-month EURIBOR rate. If the interest rates on our variable rate debt were higher or lower by 1%, 2% or 3% for the next year, interest expense would increase or decrease for that year by $973,477, $1,946,953 or $2,920,430, respectively.
The two derivative liabilities on our balance sheet are revalued quarterly using the Black-Scholes option pricing model, in which one factor is the risk-free interest rate as of the valuation date. If this rate had been higher by 1%, 2% or 3% at September 30, 2006, an additional loss of $312,500, $593,750, or $906,250, respectively, would have been recorded. If this rate had been lower by 1%, 2% or 3% at September 30, 2006, an additional gain of $187,500, $500,000, or $843,750, respectively, would have been recorded.
Foreign Currency Exchange Risk
Our subsidiaries do not sell products only in their local currencies nor do they buy materials or services only in their local currencies, and many of our subsidiaries operate in a local currency other than the U.S. dollar. The gains and losses from settling trade accounts receivable and payable in other than functional currencies is minimized by prompt collections and payments, so that our operations are not significantly impacted.
We also have transactions between our subsidiaries—principally inter-company loans and the receivables and payables that result from inter-company supply of product—which can result in both foreign currency transactions settlement and translation effects. However, these have no net cash impact on our operations.
Because $9,847,658 (€7,761,701) of our debt is euro-denominated at September 30, 2006, we do have foreign currency exchange risk on it. If the U.S. dollar were stronger or weaker by 10% relative to the euro for the next year, interest expense would decrease or increase for that year by $984,766.
Common Stock Market Value Risk
The two derivative liabilities on our balance sheet are revalued quarterly using the Black-Scholes option pricing model, in which one factor is the market price of our common stock as of the valuation date. Our stock has varied between $2.25 and $4.40 over the past year (varying less than 40% around its median of $3.20), with the market price having been $2.85 at September 30, 2006. If this market price had been higher by 25% or 50% at September 30, 2006, an additional loss of $9,718,750 or $19,781,250, respectively, would have been recorded. If this market price had been lower by 25% or 50% at September 30, 2006, an additional gain of $9,312,500 or $18,375,000, respectively, would have been recorded.
ITEM 4 - CONTROLS AND PROCEDURES
As of the quarter ended September 30, 2006, management, with the participation of the chief executive and financial officers, carried out an evaluation of the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the chief executive officer and the chief financial officer believe that, as of end of the fiscal quarter covered by this report, our disclosure controls and procedures were effective in making known to them material information relating to MediCor (including its consolidated subsidiaries) required to be included in this report. There were no significant changes in our internal control over financial reporting during the three months ended September 30, 2006 that have materially affected or are likely to materially affect our internal control over financial reporting.
Management of MediCor is responsible for establishing and maintaining effective internal control over financial reporting as is defined in Exchange Act Rule 13a-15(f). The consolidated financial statements and other information presented in this quarterly report have been prepared in accordance with accounting principles generally accepted in the United States. MediCor’s internal control system was designed to provide reasonable assurance to our management and board of directors regarding the preparation and fair presentation of published financial statements. Disclosure controls and procedures, no matter how well designed and implemented, can provide only reasonable assurance of achieving an entity’s disclosure objectives. The likelihood of achieving such objectives is affected by limitations inherent in disclosure controls and procedures. These include the fact that human judgment in decision-making can be faulty and that breakdowns in internal control can occur because of human failures such as simple errors or mistakes or intentional circumvention of the established process. Management will continue to review our disclosure controls and procedures periodically to determine their effectiveness and to consider modifications or additions to them.
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PART II
ITEM 1 - LEGAL PROCEEDINGS
A description of material pending legal proceedings, other than ordinary routine litigation incidental to the Company’s business, to which MediCor or any of its subsidiaries is a party or of which their property is subject is included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2006. There were no material developments in such litigation during the quarter ended September 30, 2006.
ITEM 1A – RISK FACTORS
If clinical trials or pre-market approval applications for our products are unsuccessful or delayed, we will be unable to meet our anticipated development, commercialization and revenue timelines.
Before obtaining regulatory approvals for the commercial sale of any products in the United States, we must first demonstrate through pre-clinical testing and clinical trials that our products are safe and effective for use in humans. We must also prepare and submit investigational device exemption and pre-market approval applications, based on data from this testing and these trials, to appropriate regulatory authorities. Conducting pre-clinical testing and clinical trials and preparing and submitting investigational device exemption and pre-market approval applications are lengthy, time-consuming and expensive processes.
Completion of pre-clinical testing and clinical trials may take several years or more. Our commencement and rate of completion of pre-clinical testing and clinical trials and our submission of investigational device exemption and pre-market approval applications may be delayed or prevented by many factors, including:
· complex chemical and other scientific issues;
· design and implementation of detailed testing and trial protocols;
· lack of efficacy during clinical trials;
· unforeseen safety issues;
· uncertainties with or actions of our collaborative partners or suppliers;
· slower than expected patient recruitment;
· difficulties in recognizing technical or laboratory data and clinical data;
· inability to adhere to protocols during clinical trials, including collection of data;
· difficulties in patient recruitment or retention;
· issues in acceptance of clinical data by regulatory authorities;
· inability to follow patients after treatment in clinical trials;
· inconsistencies between early clinical trial results and results obtained in later clinical trials;
· varying interpretations or criticisms of data generated by clinical trials;
· changes in regulatory policy during the period of product development in the United States and abroad; and
· government or regulatory delays.
The results from pre-clinical testing and early clinical trials are often not predictive of results obtained in later clinical trials. A number of new products have shown promising results in clinical trials, but subsequently failed to establish sufficient safety and efficacy data to obtain necessary regulatory approvals. Data obtained from pre-clinical and clinical activities are susceptible to varying interpretations, or criticisms which may delay, limit or prevent regulatory approval. In addition, regulatory delays or rejections may be encountered as a result of many factors, including perceived defects in the design of the pre-clinical testing or clinical trials, questions about data integrity and changes in regulatory policy during the period of product development. We have invested and intend to continue to invest heavily in all aspects of pre-clinical testing, clinical trials, and preparing and prosecuting regulatory submissions. If these efforts are not successful, we will not recover that expense and we will not achieve targeted revenue. This will adversely affect our business. Any delays in, or termination of, our pre-clinical testing or clinical trials or the pre-clinical testing or clinical trials of our collaborative partners or suppliers will similarly adversely affect our development and commercialization timelines, which would adversely affect our future sales and profitability.
If we are unable to develop, gain regulatory approval for and market new products and technologies, we will not achieve meaningful revenue and may experience a decrease in demand for our products or our products could become obsolete.
The medical device industry is highly competitive and is subject to significant and rapid technological change. We believe that our ability to respond quickly to consumer needs or advances in medical technologies, without compromising product quality, will be crucial to our success. We are continually engaged in product development and improvement programs to establish and improve our competitive position. This includes substantial pre-clinical testing, clinical trials and regulatory submissions. We cannot, however, guarantee that we will be successful in enhancing our existing products or
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products we have in development or clinical trials. Nor can we guarantee that we will be successful in developing new products or technologies that will timely or ever achieve regulatory approval or receive market acceptance. Once developed, we must also timely obtain regulatory approval for our products including products currently in the late stages of the regulatory process. The success in gaining approval for our products is critical to our business and viability, and delays may cause our products to be obsolete once regulatory approval is granted. Two of our competitors are in the advanced stage of obtaining regulatory approval for their silicone-filled breast implants, while we have not started the formal regulatory process for those products in the United States. This could put us at a significant disadvantage in the U.S. market. The lack of U.S. regulatory approval for our products, in the face of our competitors’ approvals, may also adversely affect us in foreign markets.
If we are unable to maintain satisfactory agreements with a third-party manufacturer to distribute saline-filled breast implants in the United States, we may not be able to distribute those products in the United States.
We currently are dependent on maintaining rights to distribute in the United States pre-filled saline breast implant products manufactured by a third party. We may not be able to maintain these rights on acceptable terms or at all. If we fail to maintain these rights, we may not be able to sell these breast implant products in the United States for a number of years, if at all.
Our business may be significantly limited if we cannot obtain additional financing.
To accomplish our plans to conduct our current operations, including expensive pre-clinical testing, clinical trials and regulatory submissions, to expand our current product lines and markets and to purchase new companies, products and intellectual property, we need substantial additional capital, which we may or may not be able to obtain when and as it is needed. Critical to our financing needs are costs associated with bringing products to market and delays or risks in ever getting products to market. We currently have significant debt that must be serviced. Prior to our recent third-party financing involving the sale of the Notes and Warrants, we had been funded in substantial part by International Integrated Industries, LLC, an affiliate of our chairman. We do not anticipate this funding source will provide significant additional capital in the future, and we expect that we will need to rely on external financing sources for most future financing needs. We have in the past and will likely in the future negotiate with potential equity and debt providers to obtain additional financing, but this additional financing may not be available on terms that are acceptable to us, or at all. In addition, the terms of the Notes contain restrictions on our ability to incur indebtedness and issue convertible securities and options, and provide the Note holders with rights of first refusal with respect to most issuances of new securities. If adequate funds are not available, or are not available on acceptable terms, our ability to operate our business or implement our expansion and growth plans may be significantly impaired. In addition, the financial terms of any such financing, if obtainable, may be dilutive to existing stockholders.
We rely on our chairman for continued capital funding, management direction and strategic planning and we do not presently have any alternative funding or a management transition plan in place.
We rely on our chairman, Donald K. McGhan, for capital funding, management direction and strategic planning. Mr. McGhan, through certain of his affiliates, is a significant lender to us, and he is our principal stockholder, chairman of our board of directors and a member of our four-person executive committee. Consequently, Mr. McGhan has substantial influence over significant corporate transactions, including acquisitions that we may pursue. Although we have no written charter, our executive committee generally functions on the basis of consensus, though Mr. McGhan’s multiple roles and significant financial and stockholder stake are typically considered. To date, we have not had any event where Mr. McGhan has sought to or exercised any type of unilateral control over us, though there can be no assurance that this will not happen in the future. The loss of Mr. McGhan’s financial support or services to our company could materially and adversely affect our operations. We do not presently have a written or other well-established management or financing transition plan in the event we were to lose the services or financial support of Mr. McGhan.
Because we have only a limited operating history and our business strategy calls for significant growth through new products and acquisitions, there is significant uncertainty about our business and prospects.
MediCor and its subsidiaries have only been in existence since 1999. Although our Biodermis, Eurosilicone and Biosil/Nagor operations have been in existence for longer periods of time, Biodermis has only operated under our management since its acquisition in 2001 and Eurosilicone and Biosil/Nagor have only operated under MediCor’s management since their acquisitions in July 2004 and April 2006, respectively. Significantly, during much of our history we have also been prevented from selling our primary existing product, breast implants, in the U.S. market due to the FDA’s call for a PMA by 2000 for those products. As a result of this regulatory situation, all of our revenues prior to the Eurosilicone acquisition in 2004 were derived primarily from our scar management products, both inside and outside the United States, and with respect with the recent acquisitions of Eurosilicone and Biosil and Nagor, more than 95% of our revenues are
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sourced outside the United States. This revenue mix is expected to change if and when products are approved for sale in the United States. However, revenue generated by our Biodermis subsidiary has not been significant, and we do not expect more than modest internal growth in that segment. For all these reasons, our historic business platform is not necessarily indicative of our future business or prospects.
MediCor and its prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in an early stage of development, particularly companies in rapidly changing and highly regulated markets such as the medical device market.
Risks for our business include the uncertainties associated with developing and implementing our business strategy as described in our Annual Report on form 10-KSB for the year ended June 30, 2006 as we grow and the management of both internal and acquisition-based growth. This is particularly acute in the rapid growth phase of a business, such as we are currently experiencing, and in a rapidly changing and highly regulated market such as the market for medical devices. To address these risks, we must continue to develop the strength and quality of our operations, expend heavily on regulatory applications and compliance, improve and maintain product quality, maximize the value delivered to customers, respond to competitive developments and continue to attract, retain and motivate qualified employees. We may not be successful in addressing these challenges.
If we suffer negative publicity concerning the safety of our products, our sales may be harmed and we may be forced to withdraw products.
Physicians and potential patients may have a number of concerns about the safety of our products and proposed products, whether or not such concerns have a basis in generally accepted science or peer-reviewed scientific research. Negative publicity—whether accurate or inaccurate—about our products, based on, for example, news about breast implant litigation or regulatory actions, could materially reduce market acceptance of our products and could result in product withdrawals. In addition, significant negative publicity could result in an increased number of product liability claims, whether or not these claims have a basis in fact.
Because our strategy is based on successfully making acquisitions and otherwise diversifying or expanding our product offerings, we are exposed to numerous risks associated with acquisitions, diversification and rapid growth.
Our present growth strategy is based in significant part on the acquisition of other companies, products and technologies that meet our criteria for strategic fit, geographic presence, revenues, profitability, growth potential and operating strategy. The successful implementation of this strategy depends on our ability to identify suitable acquisition candidates, finance acquisitions, acquire companies and assets on acceptable terms and integrate those operations successfully.
We may not be able to identify suitable acquisition candidates in our desired product areas or we may not be able to acquire identified candidates on acceptable terms. Moreover, in pursuing acquisition opportunities, we will likely compete with other companies with greater financial and other resources. Competition for these acquisition targets likely could also result in increased prices of acquisition targets and a diminished pool of companies and assets available for acquisition.
Acquisitions also involve a number of other risks, including the risks of acquiring undisclosed or undesired liabilities, acquired in-process technology, stock compensation expense and increased compensation expense resulting from newly hired employees, the diversion of management attention, potential disputes with the sellers of one or more acquired entities and the possible failure to retain key acquired personnel. Client satisfaction or performance problems with an acquired business or product line could also have a negative impact on our reputation as a whole, and any acquired entity or assets could significantly under-perform relative to our expectations. Our ability to meet these challenges has not been established through repeated acquisitions.
Although we were able to use some of our common stock in our Biosil/Nagor acquisition in April 2006, we expect that, at least for the foreseeable future, we may be required to use primarily cash consideration for acquisitions. In addition, we likely will be required to obtain significant third-party financing to accomplish these acquisitions. This financing may not be available on acceptable terms, if at all. In addition, the terms of our Notes contain restrictions on our ability to incur indebtedness subject to a limited exception for indebtedness that is subordinated to the Notes, is not repayable on or prior to the one-year anniversary of the maturity date of the Notes, is unsecured and is not in excess of $10 million,, issue capital stock that is redeemable on or prior to the one-year anniversary of the maturity date of the Notes and issue options or convertible securities that are convertible into or exchangeable or exercisable for shares of our common stock other than certain permitted issuances. In addition, our Note holders have a right of first refusal with respect to new security issuances other than the issuance of common stock in an underwritten public offering of $75 million or more in which the net sale price per share (after deduction of underwriting discounts and commissions) is at or above $8.00. The terms of any future financing may also be restrictive and may be dilutive to existing stockholders.
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Acquisitions, distribution agreement terms, product research and development, and regulatory approvals and compliance can result in significant allowances, write-offs and litigation.
Some aspects of our business, such as acquisitions, distribution agreements with third parties and product research and development, including regulatory approvals and compliance, have significant and sometimes unpredictable events that can result in material financial and accounting events, including allowances, write-offs and litigation. For example, in our Eurosilicone acquisition, we made an aggregate of $941,257 in negative purchase accounting adjustments, we have incurred a total of $7,947,761 in provisions and write-offs in connection with our PIP.America subsidiary’s distribution agreement with PIP because of past uncertainties regarding PIP’s ability to pay its portion of the product replacement program for its products distributed in the United States, and Eurosilicone is party to litigation commenced by the holder of patents relating to texturing of breast implant surfaces in which damages in excess of €3 million are alleged. Failure to timely achieve regulatory approvals and bring a product or products to market delays revenue and may result in not achieving any revenue for those products. Those delays, in addition to resulting in write-offs, would mean that historic expense will not have hoped for future associated revenue. These aspects of our business, such as acquiring companies and technologies, establishing and administering distributor relationships and developing new products, are part of our business strategy. As a result of the significance of these events, their unpredictable timing and frequency and the variance in structure and outcome, these events and their financial impact are unpredictable and can create material fluctuations in our financial results and prospects.
If our intellectual property rights do not adequately protect our products or technologies, others could compete against us more directly.
Our success depends in part on our ability to obtain and retain patents or trademarks or rights to patents or trademarks, protect trade secrets, operate without infringing upon the proprietary rights of others, and prevent others from acquiring or infringing on our patents, trademarks and other intellectual property rights. Eurosilicone is party to litigation commenced by the holder of patents relating to texturing of breast implant surfaces in which damages in excess of €3 million are alleged. We will be able to protect our intellectual property from unauthorized use by third parties only to the extent that it is covered by valid and enforceable patents, trademarks and licenses and we own and are able to enforce those rights. Patent protection generally involves complex legal and factual questions and, therefore, enforceability and enforcement of patent rights cannot be predicted with certainty. Patents, if issued, may be challenged, invalidated or circumvented. Thus, any patents that we own or license from others may not provide adequate protection against competitors. In addition, our pending and future patent applications may fail to result in patents being issued. Also, those patents that are issued may not provide us with adequate proprietary protection or competitive advantages against competitors with similar technologies. Moreover, the laws of certain foreign countries do not protect our intellectual property rights to the same extent as do the laws of the United States.
In addition to patents and trademarks, our intellectual property includes trade secrets and proprietary know-how. We seek protection of this intellectual property primarily through confidentiality and proprietary information agreements with our employees and consultants. These agreements may not provide meaningful protection or adequate remedies for violation of our rights in the event of unauthorized use or disclosure of confidential and proprietary information. Failure to protect our proprietary rights could seriously impair our competitive position.
We depend on distributors in two countries for a significant part of our Eurosilicone revenue and the loss of either of these distributors could adversely affect our ability to sell our products in those countries and our revenues.
Historically, two distributors—Import Medic in Brazil and Corporación Recimédica in Venezuela —have comprised1 approximately 21% of our consolidated revenue. Currently, we are financially dependent on the sales of these two distributors and the acquisition of Biosil and Nagor has not added any further customer concentration. For our distributors, as well as for our own direct sales force, the customer is each doctor that implants or uses our products. If either of these distributors were to decide to no longer sell our products or were unable to sell our products, we would have to seek either to replace them, as we have done in some markets from time to time, or begin selling directly in those markets, as we have done in various markets and as we are currently doing in additional targeted markets. However, we may or may not be able to timely replace a distributor or sell directly in that territory.
We depend on a limited number of suppliers for certain raw materials and the loss of any supplier could adversely affect our ability to manufacture many of our products.
We currently rely on one supplier for silicone raw materials used by our Eurosilicone subsidiary and one different silicone supplier for our Biosil/Nagor subsidiaries. We only have oral supply agreements with these two suppliers, which include understandings that the suppliers will transfer the necessary formulations to us in the event that they cannot meet our requirements. We cannot guarantee that these agreements will be enforceable or that we would be able to produce a sufficient amount of quality silicone raw materials in a timely manner.
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Our international business exposes us to a number of risks.
Substantially all of our current sales are and a significant part of our projected future sales will be derived from international operations. In addition, we have and anticipate having in the future material international suppliers and operations, including manufacturing operations. Accordingly, we are exposed to risks associated with international operations, including risks associated with re-valuation of the local currencies of countries where we purchase or sell our products or conduct business, which may result in our purchased products becoming more expensive to us in U.S. dollar terms or sold products becoming more expensive in local currency terms, thus reducing demand and sales of our products or increased costs to us. Our operations and financial results also may be significantly affected by other international factors, including:
· foreign government regulation of medical devices;
· product liability claims;
· new export license requirements;
· political or economic instability in our target markets;
· trade restrictions;
· changes in tax laws and tariffs;
· inadequate protection of intellectual property rights in some countries;
· managing foreign distributors, manufacturers and staffing;
· managing foreign branch offices; and
· foreign currency translations.
If these risks actually materialize, our sales to international customers, as well as those domestic customers that use products manufactured abroad, may decrease or our supplier or manufacturing costs may materially increase.
Our failure to attract and retain key managerial, technical, selling and marketing personnel could adversely affect our business.
Our success will depend upon our ability to attract and retain key managerial, financial, technical, selling and marketing personnel. The lack of key personnel might significantly delay or prevent the achievement of our development and strategic objectives. Although we maintain a key man policy on two of our Eurosilicone managers for the benefit of our commercial bank lenders, we do not maintain any other key man life insurance on any of our employees. Other than certain of our executives who are parties to employment agreements, none of our employees is under any obligation to continue providing services to us. We are continuing to build our management and technical staffs. We believe that our success will depend to a significant extent on the ability of our key personnel, including the new management and technical staffs, to operate effectively, both individually and as a group. Competition for highly skilled employees in our industry is high, and we cannot be certain that we will be successful in recruiting or retaining these personnel. We may also face litigation from competitors with hiring personnel formerly employed by them.
MediCor’s future growth will place a significant strain on our managerial, operational, financial and other resources.
Our success will depend upon our ability to manage our internal and acquisition-based growth effectively. This will require that we continue to implement and improve our operational, administrative and financial and accounting systems and controls and continue to expand, train and manage our employee base. We anticipate that we will need to hire and retain numerous additional employees and consultants for both internal and acquisition-based growth for some time. Integration of these employees and consultants and employee and consultant loss in the process will require significant management attention and resources. Our systems, procedures, controls and personnel may not be adequate to support our future operations and our management may not be able to achieve the rapid execution necessary to exploit the market for our business model.
In connection with our acquisition of Biosil and Nagor, we entered into significant put and call arrangements, which may require us to pay substantial amounts to purchase the shares of our common stock issued to the sellers. Those payments could reduce our cash flow and the funds available to expand our business.
In connection with our acquisition of Biosil and Nagor, we entered into put and call option agreements with each of the former shareholders of Biosil and Nagor, pursuant to which the former shareholders have the right under certain circumstances to put to us the 2,640,000 shares of our common stock issued to them in connection with acquisition at a purchase price ranging between $5.50 and $7.50 per share. These agreements may require us to pay substantial amounts to purchase these shares, which could decrease our liquidity and the funds available to expand our business, and we presently have no specific contingency plan for this possible future event. These agreements are described in the Management’s Discussion and Analysis or Plan of Operation—Liquidity and Capital Resources section of this quarterly report.
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If our suppliers, collaborative partners or consultants do not perform, we will be unable to obtain, develop, market or sell products as anticipated and we may be exposed to additional risks.
We have in the past and will in the future enter into supply, collaborative or consulting arrangements with third parties to supply or develop products. These arrangements may not produce or provide successful products even though they receive substantial investment. If we fail to establish these arrangements, the number of products from which we could receive future revenues will be limited.
Our dependence on supply, collaborative or consulting arrangements with third parties subjects us to a number of risks. These arrangements may not be on terms favorable to us. Agreements with suppliers may limit our supply of products or require us to purchase products we can not profitably sell. They may also restrict our ability to market or distribute other products. Agreements with consultants or collaborative partners typically allow the third parties significant discretion in electing whether or not to pursue any of the planned activities. We cannot with certainty control the amount and timing of resources our suppliers, collaborative partners or consultants may devote to our products and these third parties may choose to pursue alternative products. These third parties also may not perform their obligations as expected. Business combinations, significant changes in their business strategy, or their access to financial resources may adversely affect a supplier’s, partner’s or consultant’s willingness or ability to complete its obligations under the arrangement. Moreover, we could become involved in disputes with our suppliers, partners or consultants, which could lead to delays or termination of the arrangements and time-consuming and expensive litigation or arbitration.
Our quarterly operating results are subject to substantial fluctuations and any failure to meet financial expectations for any fiscal quarter may disappoint securities analysts and investors and could cause our stock price to decline.
Our quarterly operating results may vary significantly due to a combination of factors, many of which are beyond our control. These factors include:
· changes in demand for our products;
· our ability to meet the demand for our products;
· movement in various foreign currencies, primarily the euro, the British pound and the U.S. dollar;
· existing and increased competition, including the particular selling strategies and other actions of our competitors;
· our ability to compete against significantly larger and better funded competitors;
· the number, timing, pricing and significance of new products and product introductions and enhancements by us and our competitors;
· our ability to develop, introduce and market new and enhanced versions of our products on a timely basis;
· changes in pricing policies by us and our competitors;
· the timing of significant orders and shipments;
· regulatory approvals or other regulatory action affecting new or existing products;
· litigation with respect to product liability claims or product recalls and any insurance covering such claims or recalls; and
· general economic factors.
As a result, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and investors should not rely upon these comparisons as indications of future performance. These factors may cause our operating results to be below market analysts’ expectations in some future quarters, which could cause the market price of our stock to decline.
If we default on the terms of the Notes our bank debt, our lenders could accelerate our indebtedness, foreclose on our assets and force us out of business.
On April 26, 2006, we sold the Notes in the aggregate principal amount of $50 million. In addition in 2004, our ES Holdings subsidiary also entered into a bank loan agreement. Our obligation to repay the Notes is secured by a first lien on substantially all of our assets, including all of the assets of certain of our subsidiaries that guaranteed payment and performance of all or any portion of the obligations by us to the Note holders. If we are unable to make timely payment of principal or interest on the Notes or on the bank debt, or if we default on any of the covenants or other requirements of the Note, or other agreements relating to the Note or to the banknote financing, the lenders may accelerate our indebtedness and our Note holders will be able to accelerate our indebtedness or foreclose on our assets. Any such default, acceleration or foreclosure could force us out of business.
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If we are unable to avoid significant product liability claims or product recalls, we may be forced to pay substantial damage awards and other expenses that could exceed our allowances and any applicable insurance coverage.
In the past, the breast implant manufacturing industry has been subject to significant litigation alleging product liability. We also have in the past been, currently are, and may in the future be subject to product liability claims alleging that the use of our technology or products has resulted in adverse health effects. These claims may be brought even with respect to products that have received, or in the future may receive, regulatory approval for commercial sale. In particular, the manufacture and sale of breast implant products entails significant risk of product liability claims due to potential allegations of possible disease transmission and other health factors, rupture or other product failure. Some breast implant manufacturers that suffered these types of claims in the past have been forced to cease operations or even to declare bankruptcy. We may also face a substantial risk of product liability claims from other products we may choose to sell. In addition to product liability claims, we may in the future need to recall or issue field corrections related to our products due to manufacturing deficiencies, labeling errors, or other safety or regulatory reasons. Product liability claims, relating to alleged product defects, are distinguishable from product replacement claims, which relate to allegations that products do not meet warranties of merchantability or fitness for a particular purpose. We address the substance of potential product replacement claims relating to products distributed by us in the United States and other countries through our product replacement programs discussed elsewhere in this Business section.
Presently, we do not have liability insurance to protect us from the costs of claims for damages due to the use or recall of our products, except that our Biodermis subsidiary carries a limited amount of product liability insurance related to its products and our Biosil and Nagor subsidiaries carry product liability insurance excluding the United States. We may in the future seek additional insurance, which will be limited in both circumstance of coverage and amount. Recent premium increases and coverage limitations, including specifically limitations or prohibitions by insurers on insurance covering breast implant manufacturers, may make this insurance uneconomic or even unavailable. However, even if we obtain or increase insurance, one or more product liability claims or recall orders could exceed any coverage we may hold. If we continue to have limited or no coverage or our insurance does not provide sufficient coverage, product liability claims or recalls could result in losses in excess of our allowances.
Lawsuits, including those seeking class action status, may, if successful, cause us to incur substantial liability, including damage awards and significant legal fees that may exceed our allowances.
Lawsuits have been filed naming us or our PIP.America subsidiary, the French manufacturer from which we purchase breast implant products, and the U.S. distributor of those same products who preceded our subsidiary in the U.S. market. In these suits the plaintiffs have sought or currently seek, among other things, class action status for claims, including claims for breach of warranty. The claims arise from products distributed both before and after our subsidiary that distributed the products came into existence. Although certain of the claims arise from products distributed by the other distributor prior to our subsidiary coming into existence, we have still been named as a defendant. While we have provided an amount equal to the outstanding product replacement claims for claims arising from products our PIP.America subsidiary distributed, the plaintiffs are seeking to hold our subsidiary responsible for more damages. There can be no assurance that we can terminate the litigation as to our subsidiary for amounts already provided. Although our subsidiary is indemnified by three separate entities, including PIP, the French manufacturer, PIP/USA, Inc., the previous distributor, and Mr. Jean Claude Mas, personally, there can be no assurance this indemnity will protect us, as there is no guarantee that the French manufacturer, the previous distributor, or Mr. Mas will, or will be able to, honor the indemnification they have provided. Eurosilicone is also a party to litigation commenced by the holder of patents relating to texturing of breast implant surfaces in which damages in excess of €3 million are alleged.
If our subsidiaries are unsuccessful in defending against the claims involved in these suits, or if class action status is achieved in the product replacement case, and the indemnification were to prove non-reliable, our subsidiary named in that litigation could be responsible for significant damages above the allowances provided and available assets needed to satisfy such a judgment. Eurosilicone does not have any allowances relating to the patent action against it.
Our product replacement programs may expose us to uninsured risk.
Eurosilicone has not in the past had a formal or informal product replacement program or any similar program, though now it has enhanced its product replacement programs. Nagor provides a standard manufacturers’ warranty on all products sold with no time limit, and has a warranty program called “NagorEnhance,” which applies to all breast implant products implanted within the United Kingdom. While these subsidiaries have not had a history of material product-related litigation, we believe the limited nature of the litigation is in part due to the limited nature of these historic programs and in part due to not selling products in the United States, which historically has been much more litigious than the rest of the world. Eurosilicone and Nagor also have in the past relied on third-party distributors to support their products in almost all countries. We also expect to develop similar programs for the Biosil products marketed by Nagor and our other subsidiaries. These
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product replacement programs and changes in litigation experience outside the United States may expose our subsidiaries to additional potential liability. In addition, although Biosil and Nagor carry limited product liability insurance (excluding the United States) and Eurosilicone carries limited product liability insurance, these policies only cover product failure, whereas our replacement programs cover more than just failure. Although we have policies of carefully observing corporate formalities and otherwise seeking to preserve the protection of the corporate form, there can be no assurance that some or all of these potential liabilities will not expose us or our other subsidiaries to potential liabilities as well.
If third parties claim we are infringing their intellectual property rights, we could suffer significant litigation or licensing expenses or be prevented from marketing our products.
Our commercial success depends significantly on our ability to operate without infringing upon the patents and other proprietary rights of others. However, regardless of our intent, our technologies may infringe the patents or violate other proprietary rights of third parties. In the event of such infringement or violation, we may face litigation and may be prevented from pursuing product development or commercialization. Eurosilicone is party to litigation commenced by the holder of patents relating to texturing of breast implant surfaces in which damages in excess of €3 million are alleged. Eurosilicone has not established any allowances relating to this litigation.
We are subject to substantial government regulation, which could adversely affect our business.
The production and marketing of our products and intended products and our research and development, pre-clinical testing and clinical trial activities are subject to extensive regulation and review by numerous governmental authorities, both in the United States and abroad. Most of the medical devices we sell or intend to sell or develop must undergo rigorous pre-clinical testing and clinical trials and an extensive regulatory approval process before they can be marketed. This process makes it longer, more uncertain and more costly to bring the products to market, and some of these products may not be approved, or, once approved, they may be recalled. The pre-market approval process can be particularly expensive, uncertain and lengthy. Many devices for which FDA approval has been sought by other companies have never been approved for marketing. This could happen to us. In addition to testing and approval procedures, extensive regulations also govern marketing, manufacturing, distribution, labeling, and record-keeping procedures. If we or our suppliers or collaborative partners do not comply with applicable regulatory requirements, this could result in warning letters, non-approval, suspensions of regulatory approvals, civil penalties and criminal fines, product seizures and recalls, operating restrictions, injunctions, and criminal prosecution.
Delays in or rejection of FDA or other government entity approval of new products would adversely affect our business.
Delays or rejection may be encountered due to a number of reasons identified above in this Risks and Uncertainties section. In the United States, there has been a continuing trend of more stringent FDA oversight in product clearance and enforcement activities, causing medical device manufacturers to experience longer approval cycles, more uncertainty, greater risk, and higher expenses. Internationally, there is also risk that we or our suppliers or collaborative partners may not be successful in meeting the quality standards or other certification requirements. Regulatory approval of any given product is highly uncertain and may not be forthcoming despite extraordinary expense and diligence. Even if regulatory approval of a product is granted, this approval may entail limitations on uses for which the product may be labeled and promoted. It is possible, for example, that we or our suppliers or collaborative partners may not receive FDA approval to market our current or future products for intended indications or for broader or different applications or to market updated products that represent extensions of our, our suppliers’ or collaborative partners’ basic technology. In addition, we or our suppliers or collaborative partners may not receive export or import approval for products in the future, and countries to which products are to be exported may not approve them for import.
Government regulation of manufacturing of medical devices is expensive, time consuming and uncertain for manufacturers and may result in product unavailability or recalls.
Medical device manufacturing facilities also are subject to continual governmental review and inspection. The FDA has stated publicly that compliance with manufacturing regulations will be scrutinized strictly. A governmental authority may challenge our or our suppliers’ or collaborative partners’ compliance with applicable federal, state and foreign regulations. In addition, any discovery of previously unknown problems with products or facilities may result in restrictions on the product or the facility, including withdrawal of the product from the market or other enforcement actions.
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If changes in the economy and consumer spending reduce consumer demand for our products or our products in development, our sales and profitability will suffer.
Breast augmentation and reconstruction and other aesthetics procedures are elective procedures. Other than U.S. federally mandated insurance reimbursement for post-mastectomy reconstructive surgery that is available in some cases, breast augmentations and other cosmetic procedures are not typically covered by insurance. Adverse changes in the economy may cause consumers to reassess their spending choices and reduce the demand for cosmetic surgery. This shift could have an adverse effect on our projected future sales and profitability.
If our use of hazardous materials results in contamination or injury, we could suffer significant financial loss.
Our manufacturing and research activities involve the controlled use of hazardous materials. We cannot eliminate the risk of accidental contamination or injury from these materials. In the event of an accident or environmental discharge, we may be held liable for any resulting damages, which may exceed our financial resources.
ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Not Applicable.
ITEM 3 - DEFAULTS UPON SENIOR SECURITIES
Not Applicable.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable.
ITEM 5 – OTHER INFORMATION
Not Applicable.
ITEM 6 – EXHIBITS
The following exhibits are filed as part of this Quarterly Report on Form 10-Q:
Exhibit No. | | Description |
10.1 | | Lease Agreement between Laboratoires Eurosilicone SAS and the Commune of Apt dated May 25, 1999 |
10.2 | | Lease Agreement between Laboratoires Eurosilicone SAS and the Commune of Apt dated May 17, 2000 |
10.3 | | Lease Agreement between Laboratoires Eurosilicone SAS and Natiocredimurs Partnership dated March 8, 2001 |
31.1 | | Principal Executive Officer Certification Pursuant To 17 C.F.R. Section 240.13a-14(a). |
31.2 | | Principal Financial Officer Certification Pursuant To 17 C.F.R. Section 240.13a-14(a). |
32.1 | | Principal Executive Officer Certification Pursuant To 18 U.S.C. Section 1350. |
32.2 | | Principal Financial Officer Certification Pursuant To 18 U.S.C. Section 1350. |
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SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| MEDICOR LTD. |
| |
| |
| By: | /s/ Theodore R. Maloney |
| | Theodore R. Maloney
Chief Executive Officer (Principal Executive Officer)
November 2, 2006 |
| | |
| By: | /s/ Paul R. Kimmel |
| | Paul R. Kimmel
Chief Financial Officer (Principal Financial and Accounting Officer)
November 2, 2006 |
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