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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006
COMMISSION FILE NUMBER: 0-18602
ATS MEDICAL, INC.
(Exact name of registrant as specified in its charter)
MINNESOTA 41-1595629
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3905 ANNAPOLIS LANE N., SUITE 105
MINNEAPOLIS, MINNESOTA 55447
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (763) 553-7736
Not Applicable
(Former name, former address and former fiscal year, if changed
since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
--- ---
Indicate by check mark whether the registrant is a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act (Check
One):
Large accelerated filer Accelerated filer X Non-accelerated filer
--- --- ---
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act).
Yes No X
--- ---
The number of shares outstanding of each of the registrant's classes of
common stock as of July 28, 2006, was:
Common Stock, $.01 par value 31,234,127 shares
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TABLE OF CONTENTS
Page(s)
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PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements (Unaudited)
Consolidated Balance Sheets as of June 30, 2006 and
December 31, 2005 3
Consolidated Statements of Operations for the three and
six months ended June 30, 2006 and 2005 4
Consolidated Statements of Cash Flows for the six months
ended June 30, 2006 and 2005 5
Notes to Consolidated Financial Statements 6 - 12
ITEM 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 13 - 20
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk 20
ITEM 4. Controls and Procedures 21
PART II. OTHER INFORMATION
ITEM 1A. Risk Factors 22
ITEM 5. Other Information 22
ITEM 6. Exhibits 22
SIGNATURES 23
EXHIBIT INDEX 24
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ATS MEDICAL, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share and share data)
JUNE 30, DECEMBER 31,
2006 2005
----------- ------------
(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents $ 10,853 $ 16,620
Short-term investments 4,674 5,089
Accounts receivable, net 12,694 10,453
Inventories 19,049 21,286
Prepaid expenses 2,657 1,204
-------- --------
Total current assets 49,927 54,652
Leasehold improvements, furniture and equipment, net 7,628 8,330
Intangible assets 22,074 22,015
Other assets 449 446
-------- --------
Total assets $ 80,078 $ 85,443
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 2,595 $ 3,598
Accrued compensation 2,026 2,394
Accrued distributor liabilities 605 752
Other accrued liabilities 687 568
Due to related party -- 90
Current maturities of notes payable 1,058 833
-------- --------
Total current liabilities 6,971 8,235
Convertible senior notes payable, net of unamortized
discounts and bifurcated derivatives of $4,828 and
$3,624 at June 30, 2006 and December 31, 2005 17,572 18,776
Notes payable 1,761 903
Shareholders' equity:
Common stock, $.01 par value:
Authorized shares - 40,000,000 Issued and outstanding
shares- 31,231,891 and 31,114,131 at June 30, 2006 and
December 31, 2005 312 311
Additional paid-in capital 139,640 139,743
Deferred compensation -- (566)
Accumulated other comprehensive income (loss) 56 (64)
Accumulated deficit (86,234) (81,895)
-------- --------
Total shareholders' equity 53,774 57,529
-------- --------
Total liabilities and shareholders' equity $ 80,078 $ 85,443
======== ========
The accompanying notes are an integral part of the consolidated financial
statements.
3
ATS MEDICAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
(in thousands, except per share data)
THREE MONTHS SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
------------------- -------------------
2006 2005 2006 2005
-------- -------- -------- --------
Net sales $ 10,857 $ 9,307 $ 20,587 $ 16,370
Cost of goods sold 5,410 5,474 10,408 9,775
-------- -------- -------- --------
Gross profit 5,447 3,833 10,179 6,595
Operating expenses:
Sales and marketing 5,112 4,711 9,946 9,442
Research and development 437 407 842 709
General and administrative 2,279 1,826 4,221 3,515
-------- -------- -------- --------
Total operating expenses 7,828 6,944 15,009 13,666
-------- -------- -------- --------
Operating loss (2,381) (3,111) (4,830) (7,071)
Net interest expense (478) (22) (789) (21)
Change in value of derivative
liability bifurcated from
convertible senior notes 95 -- 1,280 --
-------- -------- -------- --------
Net loss ($2,764) ($3,133) ($4,339) ($7,092)
======== ======== ======== ========
Net loss per share:
Basic and diluted ($0.09) ($0.10) ($0.14) ($0.23)
Weighted average number of
shares used in calculation:
Basic and diluted 31,225 30,993 31,206 30,952
The accompanying notes are an integral part of the consolidated financial
statements.
4
ATS MEDICAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOW
(unaudited)
(in thousands)
SIX MONTHS
ENDED JUNE 30,
-------------------
2006 2005
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss ($4,339) ($7,092)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation 875 750
Loss on disposal of equipment 5 17
Stock compensation expense 460 61
Non-cash interest expense 234 15
Change in value of convertible senior notes
derivative liability (1,280) --
Changes in operating assets and liabilities:
Accounts and other receivables (2,241) (1,118)
Inventories 2,237 2,262
Prepaid expenses (1,453) 234
Other (107) (1)
Accounts payable and accrued expenses (1,489) (2,268)
-------- --------
Net cash used in operating activities (7,098) (7,140)
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of short-term investments (3,802) (497)
Maturities of short-term investments 4,217 5,354
Payments for technology and distribution licenses (210) (1,555)
Purchases of furniture, machinery and equipment (178) (1,078)
-------- --------
Net cash provided by investing activities 27 2,224
CASH FLOWS FROM FINANCING ACTIVITIES
Advances on notes payable 1,500 --
Repayments of notes payable (417) (347)
Net proceeds from sales of common stock 101 280
-------- --------
Net cash provided by (used in) financing activities 1,184 (67)
-------- --------
Effect of exchange rate changes on cash 120 (153)
-------- --------
Decrease in cash and cash equivalents (5,767) (5,136)
Cash and cash equivalents at beginning of period 16,620 8,302
-------- --------
Cash and cash equivalents at end of period $10,853 $3,166
======== ========
The accompanying notes are an integral part of the consolidated financial
statements.
5
ATS MEDICAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1. BASIS OF PRESENTATION
The consolidated financial statements included in this Form 10-Q have been
prepared by ATS Medical, Inc. (hereinafter the "Company," "ATS," "we," "us" or
"our") without audit, pursuant to the rules and regulations of the Securities
and Exchange Commission (SEC). The consolidated financial statements include the
accounts of the Company and its subsidiaries, and all significant inter-company
accounts and transactions are eliminated in consolidation. Certain information
and footnote disclosures normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United States
have been condensed or omitted pursuant to these rules and regulations. The
year-end balance sheet was derived from audited financial statements but does
not include all disclosures required by accounting principles generally accepted
in the United States. These unaudited consolidated interim financial statements
should be read in conjunction with the Company's consolidated financial
statements and related notes included in the Company's Annual Report on Form
10-K (as amended) for the fiscal year ended December 31, 2005.
These statements reflect, in management's opinion, all adjustments (which
include only normal, recurring adjustments) necessary for a fair presentation of
the financial position and the results of operations and cash flows for the
periods presented. The results of operations for any interim period may not be
indicative of results for the full year.
NOTE 2. STOCK-BASED COMPENSATION
The Company accounts for its stock-based employee compensation plans under the
recognition and measurement principles of Financial Accounting Standards Board
(FASB) Statement No. 123 (Revised 2004), Share-Based Payment (Statement 123(R)),
which revises FASB Statement No. 123, Accounting for Stock-Based Compensation,
supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and
amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach
in Statement 123(R) is similar to the approach described in Statement No. 123.
However, Statement 123(R) requires all share-based payments to employees to be
recognized in the income statement based on their fair values. Pro forma
disclosure is no longer an alternative.
Statement 123(R) was adopted by the Company on January 1, 2006. The Company
adopted Statement 123(R) using the modified prospective transition method. In
accordance with the modified prospective transition method, the Company has not
restated its consolidated financial statements for prior periods. Under this
transition method, stock-based compensation expense for 2006 includes
stock-based compensation expense for all of the Company's stock-based
compensation awards granted prior to, but not yet vested as of, January 1, 2006,
based on the grant-date fair value estimated in accordance with the provision of
Statement No. 123. Stock-based compensation expense for all stock-based
compensation awards granted on or after January 1, 2006 will be based on the
grant-date fair value estimated in accordance with the provisions of Statement
123(R).
The Company uses the Black-Scholes-Merton (Black-Scholes) option pricing model
as its method for determining fair value of stock option grants, which was also
used by the Company for its pro forma information disclosures of stock-based
compensation expense as required under Statement No. 123, prior to the adoption
of Statement 123(R). The weighted average per share fair value of these option
grants is shown below and was estimated at the date of grant using the
Black-Scholes model with the following weighted average assumptions:
Six months
ended June 30,
-------------------
2006 2005
-------- --------
Assumptions used:
Expected volatility 0.83 0.87
Risk-free interest rate 4.8% 3.8%
Expected life 5 years 7 years
Dividend yield 0% 0%
Weighted average per share
fair value of options granted $ 2.03 $ 2.73
6
The expected volatility is a measure of the amount by which the Company's stock
price is expected to fluctuate during the expected term of options granted. The
Company determines the expected volatility solely based upon the historical
volatility of the Company's Common Stock over a period commensurate with the
option's expected life. The Company does not believe that the future volatility
of its Common Stock over an option's expected life is likely to differ
significantly from the past. The risk-free interest rate is the implied yield
available on U.S. Treasury Strip issues with a remaining term equal to the
option's expected life on the grant date. The expected life of options granted
represents the period of time for which options are expected to be outstanding
and is derived from the Company's historical stock option exercise experience
and option expiration data. For purposes of estimating the expected life, the
Company has aggregated all individual option awards into one group as the
Company does not expect substantial differences in exercise behavior among its
employees. The dividend yield is zero since the Company has never declared or
paid any cash dividends on its Common Stock and does not expect to do so in the
foreseeable future.
The fair value of restricted stock unit awards (RSUs) is determined based on the
closing market price on the award date.
The Company uses the single option (i.e. straight-line) method of attributing
the value of stock-based compensation expense for all stock option grants. Upon
adoption of Statement 123(R), the Company changed its method of attributing the
value of stock-based compensation expense on RSUs from the multiple-option (i.e.
accelerated) approach to the single option method. Compensation expense for RSUs
awarded prior to January 1, 2006 will continue to be subject to the accelerated
multiple option method specified in FASB Interpretation No. 28 (FIN 28),
Accounting for Stock Appreciation Rights and Other Variable Stock Option or
Award Plans, while compensation expense for RSUs awarded or granted on or after
January 1, 2006 will be recognized using the single option method. Stock
compensation expense for all stock-based grants and awards is recognized over
the service or vesting period of each grant or award.
Statement 123(R) requires forfeitures to be estimated at the time of grant and
revised, if necessary, in subsequent periods if actual forfeitures differ from
those estimates in order to derive the Company's best estimate of awards
ultimately expected to vest. Forfeitures represent only the unvested portion of
a surrendered option and are typically estimated based on historical experience.
Based on an analysis of the Company's historical data, the Company applied
forfeiture rates of 10.14% and 11.85% to stock options outstanding in
determining its Statement 123(R) stock compensation expense for the quarters
ended June 30, 2006 and March 31, 2006, respectively, which it believes is a
reasonable forfeiture estimate for these periods. In the Company's pro forma
information required under Statement No. 123 for the periods prior to 2006, the
Company accounted for forfeitures as they occurred.
The Company has a Stock Incentive Plan (the Plan) under which stock options to
purchase Common Stock of the Company may be granted or RSUs may be awarded to
employees and non-employees of the Company. Stock options may be granted under
the Plan as incentive stock options (ISO) or as non-qualified stock options
(non-ISO). The Company also has stock options outstanding from a previous equity
compensation plan as well as free-standing options not under any plan. In
addition, the Company has an Employee Stock Purchase Plan (ESPP) under which
employees are eligible to purchase Common Stock of the Company on a quarterly
basis at 85% of the lesser of the market price of the Common Stock on the first
day of the quarter or the last day of the quarter. All stock issued under
options exercised, RSUs awarded or ESPP shares purchased are new shares of the
Company's Common Stock.
The following table summarizes the changes in stock options outstanding under
the Company's stock-based compensation plans during the six months ended June
30, 2006:
Weighted
Stock Options Average
Outstanding Option
Under the Plans Exercise
------------------- Non-Plan Price
ISO Non-ISO Options Total Per Share
--------- ------- --------- --------- ---------
Balance at December 31, 2005 1,006,700 350,000 2,897,902 4,254,602 3.09
Options granted -- 5,000 -- 5,000 2.95
Options exercised (6,500) -- (26,966) (33,466) 0.90
Options cancelled (46,450) (18,500) (100,000) (164,950) 4.97
--------- ------- --------- --------- ----
Balance at June 30, 2006 953,750 336,500 2,770,936 4,061,186 3.04
========= ======= ========= =========
7
The following table summarizes the ranges of exercise prices for outstanding and
exercisable stock options as of June 30, 2006:
Options Outstanding at Options Exercisable at
June 30, 2006: June 30, 2006:
----------------------------------------- ----------------------
Weighted Weighted Weighted
Average Average Average
Range of Number Remaining Exercise Number Exercise
Exercise Prices Outstanding Contractual Life Price Exercisable Price
- --------------- ----------- ---------------- -------- ----------- --------
$0.37 - $ 0.52 767,125 6.40 years $ 0.44 543,000 $ 0.44
0.79 - 2.51 886,236 6.79 years $ 1.72 635,486 $ 1.72
2.70 - 3.60 801,700 7.39 years $ 3.35 755,450 $ 3.35
3.64 - 3.80 826,750 7.29 years $ 3.74 826,750 $ 3.74
3.99 - 8.50 714,375 5.88 years $ 5.63 714,375 $ 5.63
9.00 - 12.44 65,000 3.41 years $10.33 65,000 $10.33
--------- ---------- ------ --------- ------
$0.37 - $12.44 4,061,186 6.72 years $ 3.04 3,540,061 $ 3.29
========= =========
As of June 30, 2006, the aggregate intrinsic value of options outstanding and
exercisable was $2.1 million and $1.5 million, respectively. The aggregate
intrinsic value of options exercised during the six months ended June 30, 2006
was not significant. The aggregate intrinsic value represents the total pre-tax
intrinsic value (the difference between the closing price of the Company's
Common Stock on June 30, 2006 of $2.39 per share and the exercise price of
each-in-the-money option) that would have been received by the option holders
had all option holders exercised their options on June 30, 2006.
The following table summarizes the changes in RSU awards outstanding under the
Stock Incentive Plan during the six months ended June 30, 2006:
Weighted
Weighted Average
Average Remaining
Award Date Contractual
No. of Shares Fair Value Term
------------- ---------- -----------
Unvested at December 31, 2005 348,000 $3.25 1.53 years
Awards granted 613,750 2.97 --
Awards vested (87,000) 3.25 --
Awards forfeited (37,500) 3.19 --
------- ----- ----------
Unvested at June 30, 2006 837,250 $3.05 2.26 years
=======
As of June 30, 2006, the aggregate intrinsic value of RSUs outstanding was $2.0
million.
The Company had a total of 6,240,686 shares of Common Stock reserved for stock
option grants and RSU awards at June 30, 2006, of which 1,342,250 shares were
available for future grants or awards under the Stock Incentive Plan.
For the three months ended June 30, 2006, the Company recognized $0.1 million of
stock compensation expense in connection with the adoption of Statement 123(R).
Total stock compensation expense recognized during the three months ended June
30, 2006 totaled $0.3 million (or $.01 per share), of which $0.1 million was
included in general and administrative expenses and $0.2 million was included in
sales and marketing expenses.
For the six months ended June 30, 2006, the Company recognized $0.2 million in
stock compensation expense in connection with the adoption of Statement 123(R).
Total stock compensation expense recognized during the six months ended June 30,
2006 totaled $0.5 million (or $.02 per share), of which $0.2 million was
included in general and administrative expenses and $0.3 million was included in
sales and marketing expenses.
For both the three and six months ended June 30, 2005, the Company recognized
$0.1 million in stock compensation expense. Stock compensation expense
recognized for the quarter ended March 31, 2005 was not significant.
8
Because the Company maintained a full valuation allowance on its U.S. deferred
tax assets, the Company did not recognize any tax benefit related to its
stock-based compensation expense for the three or six months ended June 30,
2006.
As of June 30, 2006, the Company had $0.4 million of total unrecognized
compensation expense, net of estimated forfeitures, related to stock options
that will be recognized over a weighted average period of approximately one
year, and $1.7 million of total unrecognized compensation expense, net of
estimated forfeitures, related to RSU awards that will be recognized over a
weighted average period of approximately two years.
Prior to the adoption of Statement 123(R), the Company accounted for its
stock-based employee compensation plans under the recognition and measurement
principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and
related interpretations. The exercise price of the Company's employee stock
options generally equaled the market price of the underlying stock on the date
of grant for all options granted, and thus, under APB No. 25, no compensation
expense was recognized. Pro forma information regarding net loss and net loss
per share is required by Statement No. 123 and has been determined as if the
Company had accounted for its employee stock options under the fair value method
of Statement No. 123.
The following table illustrates the pro forma effect on net loss and net loss
per share if the Company had applied the fair value recognition provisions of
Statement No. 123 to stock-based employee compensation for the three and six
month periods ended June 30, 2005. Since stock-based compensation expense for
the three and six month periods ended June 30, 2006, was calculated and recorded
under the provisions of Statement 123(R), no pro forma disclosure for that
period is presented:
Three months Six months
ended ended
(in thousands, except per share data) June 30, 2005 June 30, 2005
------------- -------------
Net loss, as reported ($3,133) ($7,092)
Less: Total stock-based employee compensation
expense determined under fair value based
method for all awards (563) (1,082)
------- -------
Pro forma net loss ($3,696) ($8,174)
======= =======
Net loss per share:
As reported
Basic and diluted ($0.10) ($0.23)
Pro forma
Basic and diluted ($0.12) ($0.26)
In December 2005, the Company authorized the acceleration of vesting of all
otherwise unvested stock options held by its employees with an exercise price of
$3.00 or greater granted under its Stock Incentive Plan or as a free- standing
option not under any plan. Options to purchase 1,294,232 shares of common stock
(affecting 86 employees) were subject to this acceleration. The decision to
accelerate vesting of these underwater options was made primarily to minimize
future compensation expense that the Company would otherwise recognize in its
consolidated statement of operations with respect to these options pursuant to
Statement 123(R). The aggregate future expense eliminated as a result of the
acceleration of the vesting of these options was approximately $3.3 million.
9
NOTE 3. INVENTORIES
Inventories consist of the following:
June 30, December 31,
(In thousands) 2006 2005
-------- ------------
Raw materials $ 4,762 $ 5,047
Work in process 4,407 4,462
Finished goods 10,045 11,992
Obsolescence reserve (165) (215)
------- -------
Total, net $19,049 $21,286
======= =======
NOTE 4. COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) for the Company includes gains and losses from
foreign currency translation which are charged or credited to the cumulative
translation account within shareholders' equity. Gains and losses from foreign
currency translation are not material. Comprehensive income also includes
unrealized gains and losses on the Company's investment portfolio, which are
also charged or credited to shareholders' equity. Unrealized gains and losses on
investments are not material.
NOTE 5. INTANGIBLE ASSETS
The Company applies Statement of Financial Accounting Standard 142 (SFAS 142),
Goodwill and Other Intangible Assets, to its intangible assets, which prohibits
the amortization of intangible assets with indefinite useful lives and requires
that these assets be reviewed for impairment at least annually. Management
reviews indefinite-lived intangible assets for impairment annually as of the
last day of the second quarter, or more frequently if a change in circumstances
or occurrence of events suggests the remaining value may not be recoverable. The
test for impairment requires management to make estimates about fair-value,
which are based either on the expected undiscounted future cash flows or on
other measures of value such as the market capitalization of the Company. If the
carrying amount of the assets is greater than the measures of fair value,
impairment is considered to have occurred and a write-down of the asset is
recorded. Management completed the annual impairment tests in the second quarter
of 2006 and determined that the Company's indefinite-lived intangible assets
were not impaired.
NOTE 6. LONG-TERM DEBT
On October 7, 2005 and October 12, 2005, the Company sold a combined $22.4
million aggregate principal amount of 6% Convertible Senior Notes due 2025
(Notes) and issued warrants to purchase 1,344,000 shares of the Company's Common
Stock (Warrants). Interest is payable under the Notes each April and October,
beginning in 2006.
The Warrants are exercisable at $4.40 per share and expire in 2010. The Company
has reserved 105% of the shares necessary for the exercise of the warrants. The
Warrants were valued at $1.13 per share using the Black-Scholes valuation model.
The total value of the Warrants on the date of issuance was $1.5 million, is
treated as a discount to the Convertible Senior Notes and is amortized to
interest expense over the 20 year life of the Notes using the effective interest
method.
The Notes are convertible into common stock at any time at a fixed conversion
price of $4.20 per share, subject to adjustment under certain circumstances
including, but not limited to, the payment of cash dividends on common stock. If
fully converted, the Notes would convert into 5,333,334 shares of the Company's
common stock. At the date of issuance of the Notes, the Company had 19,222
shares of its common stock available for the Note holders if conversion was
elected. The Company has agreed to ask its shareholders for approval to increase
its authorized shares at its next regularly scheduled shareholder meeting. If
the Note holders convert their notes prior to receiving approval for additional
authorized shares, the Company has the right to make settlement in cash, or at
the Company's option, with a combination of cash and shares.
The Note holders also have the right to require the Company to repurchase the
Notes at 100% of the principal amount plus accrued and unpaid interest on
October 15 in 2010, 2015 and 2020 or in connection with certain corporate change
of control transactions. If the Note holders elect to convert the Notes prior to
October 15, 2010 in
10
connection with certain corporate change of control transactions, the Company
will increase the conversion rate for the notes surrendered for conversion by a
number of additional shares based on the stock price of the Company on the date
of the change of control.
The Company has the right to redeem the Notes at 100% of the principal amount
plus accrued and unpaid interest at any time on or after October 20, 2008. At
any time prior to maturity, the Company may also elect to automatically convert
some or all of the Notes into shares of its common stock if the closing price of
the common stock exceeds $6.40 for a period as specified in the indenture. If an
automatic conversion of the Notes occurs prior to October 15, 2008, the Company
will make an additional payment to the Note holders equal to three full years of
interest, less any interest actually paid or provided for prior to the
conversion date. This payment can be made, at the option of the Company, either
in cash or common stock.
The Company agreed to file a Registration Statement on Form S-3 covering the
resale of all of the shares of the Company's Common Stock issuable upon
conversion of the Notes and exercise of the Warrants using its best efforts to
have the Registration Statement declared effective within 120 days of the
closing. Depending on the length of time after this 120 day period for the
Registration Statement to be declared effective, the penalty can range from .8%
to 1.2% of the principal amount of the Notes and Warrants. The maximum penalty
that may be incurred is approximately $0.6 million.
The Company has analyzed all of the above provisions in the Notes and related
agreements for embedded derivatives under FASB Statement No. 133, Accounting for
Derivative Instruments and Hedging Activities, and related Emerging Issues Task
Force (EITF) interpretations and Securities and Exchange Commission (SEC) rules.
The Company has determined that four such provisions in the convertible debt
agreement are considered derivatives under FASB Statement No. 133:
- The embedded written option relating to the common stock that may be
potentially issuable upon conversion
- The option for Note holders to put back debt to the Company in
connection with certain corporate change of control transactions
- The provision relating to an additional payment in connection with the
automatic conversion of the Notes prior to October 15, 2008
- The provision to increase the conversion rate in the event of a change
in control transaction
The Company prepared valuations of each of the above derivatives and recorded a
$5.5 million liability on the date of issuance of the Notes, with an offsetting
discount to the Notes.
The derivative liability is adjusted to fair value on a quarterly basis. The
adjustment to fair value at June 30, 2006 was $0.1 million and was credited to
other income. The liability was $1.9 million at June 30, 2006. The derivative
liability is presented in the balance sheet within the same line as the
Convertible Senior Notes payable.
The discount related to the derivative liability is being amortized to interest
expense using the effective interest method over 20 years. At June 30, 2006, the
remaining unamortized discounts relating to the Warrants and the derivative
liability totaled $6.7 million.
In 2004, the Company entered into a secured credit facility with a bank,
consisting of a $2.5 million term note and a $6.0 million line of credit. The
Company fully drew down the $2.5 million term note, which calls for equal
installment payments over 36 months, which commenced in February 2005. As of
June 30, 2006, the balance due on this note was $1.3 million. The Company is
subject to certain financial covenants under the secured credit facility
agreement, as amended, to maintain a liquidity ratio of not less than 2.0 to 1.0
and a net tangible net worth of at least $40 million. At June 30, 2006, the
Company was in compliance with its financial covenants.
On March 29, 2006, the Company entered into a second amendment to the secured
credit facility whereby the bank agreed to waive the prohibition set forth in
the credit facility agreement with respect to the Company's pending acquisition
of 3F Therapeutics, Inc., and the bank consented to such acquisition. In
addition, the bank agreed to provide for advances of up to $1.5 million, which
the Company may use to finance or refinance eligible equipment purchased on or
after June 1, 2005 and on or before May 31, 2006. Such equipment advances will
be amortized over a 60-month period and carry an interest rate of prime plus
1.75%. On March 31, 2006, the Company fully drew down the $1.5 million advance
amount, all of which is outstanding at June 30, 2006.
11
NOTE 7. ACQUISITION OF 3F THERAPEUTICS, INC.
On January 23, 2006, the Company entered into an agreement and plan of merger
(the Merger Agreement) with 3F Therapeutics, Inc. (3F). Under the terms of the
Merger Agreement, upon closing, the Company will pay each 3F stockholder its
pro-rata portion of an initial payment of 9 million shares of the Company's
common stock, subject to certain adjustments. The Company will deposit 900,000
shares of the closing payment in escrow to be held for at least 18 months after
closing of the merger to cover indemnification claims and certain contingencies,
and the balance will be distributed pro-rata to holders of 3F capital stock. In
addition to the initial closing payment, the Company will be obligated to make
additional contingent payments to 3F stockholders of up to 5 million shares of
the Company's common stock upon obtaining either CE mark or FDA approval for
3F's key products on or prior to December 31, 2013, up to an aggregate of 10
million shares of the Company's common stock. Milestone events also include
certain transactions involving these key products. These contingent payments are
subject to certain rights of set-off for indemnification claims and certain
other events.
The consummation of the merger is subject to customary conditions, and the
Merger Agreement is subject to approval by the Company's shareholders. The
Merger Agreement has already been approved by the requisite number of 3F
stockholders. Subject to these conditions being resolved, the Company
anticipates that the merger will close in the third quarter of fiscal 2006.
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This document contains forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. Words such as "may," "expect,"
"believe," "anticipate," or "estimate," identify such forward-looking
statements. These statements by their nature involve substantial risks and
uncertainties, and actual results may differ materially from those expressed in
such forward-looking statements. Some of the factors that could cause such
material differences are identified in Part I, Item 1A of our Annual Report on
Form 10-K for the fiscal year ended December 31, 2005 (as amended). We undertake
no obligation to correct or update any forward-looking statements, whether as a
result of new information, future events, or otherwise. You are advised,
however, to consult any future disclosures we make on related subjects in future
filings with the SEC.
EXECUTIVE OVERVIEW
We develop, manufacture, and market medical devices. Our primary interest lies
with devices used by cardiovascular surgeons in the cardiac surgery operating
theater. Currently, we participate in the markets for mechanical bileaflet
replacement heart valves, allograft tissues, the surgical treatment of atrial
fibrillation, and the market for surgical tools and accessories. We also are
engaged in a development project for autotransfusion products.
Sulzer Carbomedics (Carbomedics) developed the basic design from which the ATS
heart valve evolved. Carbomedics is a large and experienced manufacturer of
pyrolytic carbon components used in mechanical heart valves. Carbomedics has
also designed and patented numerous mechanical valves. In 1990, Carbomedics
offered to license a patented and partially developed valve to us if we would
complete the development of the valve and agree to purchase carbon components
from Carbomedics. As a result, we executed technology and license agreements
with Carbomedics and now hold an exclusive, royalty-free, worldwide license to
an open pivot, bileaflet mechanical heart valve design owned by Carbomedics from
which the ATS heart valve has evolved. In addition, we have an exclusive,
worldwide right and license to use Carbomedics' pyrolytic carbon technology to
manufacture components for the ATS heart valve.
We commenced selling the ATS heart valve in international markets in 1992. In
October 2000, we received FDA approval to sell the ATS Open Pivot(R) MHV and
commenced sales and marketing of our valve in the United States. The original
sales forecasts as well as the pricing models that were used when our original
supply agreement was signed with Carbomedics proved to be too optimistic.
Accordingly, to keep the supply agreement active and the license to sell the
valve exclusive, we purchased quantities of inventory far in excess of demand.
With inventory purchases exceeding sales through the years, we built up our
inventory levels. Since 2002, we have drawn down these paid-for inventories and
used the cash it generated to fund operations. During 2004 and 2005, we
developed and implemented a plan to ramp-up our own manufacturing facility for
pyrolytic carbon. By the end of 2005, this process was substantially complete.
From 1990 through 2003, we paid Carbomedics approximately $125 million for the
development of our valve, the technology to manufacture pyrolytic carbon
components, and for pyrolytic valve components manufactured by Carbomedics. By
the end of 2002, we had remaining payments due under the technology agreement
that totaled $28 million. This led us in 2003 to negotiate an accelerated but
reduced payment for all outstanding debts to Carbomedics related to the
technology agreement. In 2003, we paid $12 million to satisfy all future
obligations under this agreement.
During 2002, we reorganized the Company, laying off more than half of the work
force, including all executive management. With the hiring of a new president
late in 2002, we started the process of rebuilding our sales and marketing
teams, especially in the United States. This rebuilding is the most significant
factor in our operating expense levels during the last three fiscal years.
Because sales prices in the United States exceed selling prices elsewhere, we
feel that our future success will depend on achieving increased market share in
the United States. Our U.S. sales as a percentage of our overall sales have
grown from 4% in 2000 to 38% in 2005.
13
During 2004, we made our first investments outside the mechanical heart valve
market by completing two business development agreements. The first, signed in
April, was with ErySave AB, a Swedish research firm, for exclusive worldwide
rights to ErySave's PARSUS filtration technology for cardiac surgery procedures.
We had no revenues in 2005 nor do we expect any for 2006 from this technology.
In November 2004, we completed a global partnership agreement with CryoCath
Technologies, Inc. (CryoCath) to market CryoCath's surgical cryotherapy products
for the ablation of cardiac arrhythmias. The agreement with CryoCath has
resulted in revenue for our Company in both 2005 and 2006.
During 2005, we continued to develop our business outside the mechanical heart
valve market by entering into two additional business development agreements. In
June, we entered into a marketing services agreement with Alabama Tissue Center,
Inc. (ATC, a/k/a Regeneration Technologies, Inc. - Cardiovascular), a subsidiary
of Regeneration Technologies, Inc. Under the terms of the agreement, ATC has
appointed us as its exclusive marketing services representative to promote,
market and solicit orders for ATC's processed cardiovascular allograft tissue
from doctors, hospitals, clinics and patients throughout North America. The
agreement with ATC has also resulted in revenue for our Company in both 2005 and
2006. Also in June 2005, we entered into an exclusive development, supply and
distribution agreement with Genesee BioMedical, Inc. (GBI), under which GBI will
develop, supply and manufacture cardiac surgical products to include
annuloplasty repair rings, c-rings and accessories, and we will have exclusive
worldwide rights to market and sell such products. Our agreement with GBI has
produced revenue for our Company in 2006.
On January 23, 2006, we entered into an agreement and plan of merger with 3F
Therapeutics, Inc. (3F). Under the terms of the merger agreement, upon closing
we will pay each 3F stockholder its pro-rata portion of an initial payment of 9
million shares of our common stock, subject to certain post-closing adjustments
and a 10% escrow fund. In addition to the initial closing payment, we will be
obligated to deliver up to an additional 10 million shares of our common stock
to 3F stockholders. These additional shares will be made in two payments of up
to 5 million shares each, each of which is contingent upon ATS obtaining either
CE mark or FDA approval for 3F's key products on or prior to December 31, 2013.
The consummation of the merger with 3F is subject to customary conditions, and
the merger agreement is subject to approval by our shareholders and the
stockholders of 3F; however, the requisite number of 3F stockholders has already
approved the merger agreement. We anticipate that the merger will close in the
third quarter of fiscal 2006.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
We base our estimates on historical experience and on various other assumptions
that we believe to be reasonable under the circumstances. Management's
discussion and analysis of financial condition and results of operations are
based upon the consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
The preparation of these financial statements requires us to make estimates and
judgments that affect (1) the reported amounts of assets, liabilities, revenues
and expenses; and (2) the related disclosure of contingent assets and
liabilities. At each balance sheet date, we evaluate our estimates and
judgments. The critical accounting policies that are most important to fully
understanding and evaluating the financial condition and results of operations
are discussed in our most recent Annual Report on Form 10-K, as amended, on file
with the SEC.
The Financial Accounting Standards Board issued FASB Statement No. 123 (Revised
2004), Share-Based Payment, which was adopted by ATS on January 1, 2006, using
the modified prospective transition method. Statement 123(R) requires all
share-based payments to employees, including grants of employee stock options
and restricted stock unit awards, to be recognized in the income statement based
on their fair values. Pro forma disclosure is no longer an alternative. See Note
2 of "Notes to Consolidated Financial Statements" and the discussion under
"General & Administrative" below in this report for additional information
regarding stock-based compensation plans and our adoption of Statement 123(R).
14
RESULTS OF OPERATIONS
The following table provides the dollar and percentage change in the Statements
of Operations for the three and six month periods ended June 30, 2006 and 2005.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
----------------------------------------- -----------------------------------------
Increase (Decrease) Increase (Decrease)
------------------- -------------------
(In thousands) 2006 2005 $ % 2006 2005 $ %
-------- -------- ------ ------- -------- -------- -------- --------
Net sales $ 10,857 $ 9,307 $1,550 16.7% $ 20,587 $ 16,370 $ 4,217 25.8%
Cost of goods sold 5,410 5,474 (64) (1.2)% 10,408 9,775 633 6.5%
-------- -------- ------ ------- -------- -------- -------- -------
Gross profit 5,447 3,833 1,614 42.1% 10,179 6,595 3,584 54.3%
Gross profit % 50.2% 41.2% 49.4% 40.3%
Operating expenses:
Sales and marketing 5,112 4,711 401 8.5% 9,946 9,442 504 5.3%
Research and development 437 407 30 7.4% 842 709 133 18.8%
General and administrative 2,279 1,826 453 24.8% 4,221 3,515 706 20.1%
-------- -------- ------ ------- -------- -------- -------- -------
Total operating expenses 7,828 6,944 884 12.7% 15,009 13,666 1,343 9.8%
-------- -------- ------ ------- -------- -------- -------- -------
Operating loss (2,381) (3,111) (730) (23.5)% (4,830) (7,071) (2,241) (31.7)%
Net interest income (expense) (478) (22) 456 2,072.7% (789) (21) 768 3,657.1%
Change in value of derivative
liability bifurcated from
convertible senior notes 95 -- 95 NM 1,280 -- 1,280 NM
-------- -------- ------ ------- -------- -------- -------- -------
Net loss ($2,764) ($3,133) $ (369) (11.8)% ($4,339) ($7,092) ($2,753) (38.8)%
======== ======== ====== ======= ======== ======== ======== =======
The following table presents the Statements of Operations as a percentage of net
sales for the three and six month periods ended June 30, 2006 and 2005.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ----------------
2006 2005 2006 2005
----- ----- ----- -----
Net sales 100.0% 100.0% 100.0% 100.0%
Cost of goods sold 49.8% 58.8% 50.6% 59.7%
----- ----- ----- -----
Gross profit 50.2% 41.2% 49.4% 40.3%
Operating expenses:
Sales and marketing 47.1% 50.6% 48.3% 57.7%
Research and development 4.0% 4.4% 4.1% 4.3%
General and administrative 21.0% 19.6% 20.5% 21.5%
----- ----- ----- -----
Total operating expenses 72.1% 74.6% 72.9% 83.5%
----- ----- ----- -----
Operating loss (21.9)% (33.4)% (23.5)% (43.2)%
Net interest income (expense) (4.4)% (0.2)% (3.8)% (0.1)%
Change in value of derivative
liability bifurcated from
convertible senior notes 0.9% 0.0% 6.2% 0.0%
----- ----- ----- -----
Net loss (25.5)% (33.7)% (21.1)% (43.3)%
===== ===== ===== =====
15
NET SALES. The following table provides the dollar and percentage change in net
sales inside and outside the United States and Canada for the three and six
month periods ended June 30, 2006 and 2005.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
------------------------------------ -------------------------------------
Increase Increase
(In thousands) 2006 2005 (Decrease) % 2006 2005 (Decrease) %
------- ------ ---------- ---- ------- ------- ---------- ----
United States and
Canada $ 4,166 $3,252 $ 914 28.1% $ 8,060 $ 6,122 $1,938 31.7%
Outside U. S. and
Canada 6,691 6,055 636 10.5% 12,527 10,248 2,279 22.2%
------- ------ ------ ---- ------- ------- ------ ----
Total $10,857 $9,307 $1,550 16.7% $20,587 $16,370 $4,217 25.8%
======= ====== ====== ==== ======= ======= ====== ====
The following table provides net sales inside and outside the United States and
Canada as a percentage of total net sales for the three and six month periods
ended June 30, 2006 and 2005.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ----------------
2006 2005 2006 2005
----- ----- ----- -----
Share of total sales:
United States and
Canada 38.4% 34.9% 39.2% 37.4%
Outside U. S. and
Canada 61.6% 65.1% 60.8% 62.6%
----- ----- ----- -----
Total 100.0% 100.0% 100.0% 100.0%
===== ===== ===== =====
Since late 2002, we have been building a new sales organization in the United
States, which has grown to four area directors managing more than 30 sales
territories. Our representation within these territories consists of both direct
sales representatives and independent agents. This new sales organization and
overall greater sales efforts contributed to our net sales increases in the
United States and Canada. Mechanical heart valve sales, which comprise
approximately 85% of the Company's current sales base, increased 7% in the
United States and Canada for the quarter ended June 30, 2006, and increased 8%
for the six months ended June 30, 2006, compared to the same periods in the
prior year. Average selling price (ASP) in the United States and Canada for the
first half of 2006 was 3% lower compared to the same period in 2005 due to
initial stocking sales to a new Canadian distributor and to sales of trunk stock
to commissioned agents in the United States.
Also during the last three years we have aggressively entered several
international markets that represented opportunities for greater mechanical
heart valve sales unit growth but at prices lower than our other direct markets.
Prices in some of these territories are lower than our historical manufacturing
costs. We believed this strategy was reasonable because it allowed us to
increase our market share while reducing our high priced but paid-for
inventories. We also believe that future lower product costs, related to carbon
components manufactured internally, will allow us to achieve reasonable profit
margins in these international markets. Mechanical heart valve sales increased
3% in international markets for the quarter ended June 30, 2006, and increased
16% for the six months ended June 30, 2006, compared to the same periods in the
prior year. International ASP was 10% lower for the first half of 2006 compared
to the same period in 2005 due to a shift in sales mix from higher-margin
industrialized countries to lower-margin lesser-developed countries. This mix
shift occurred primarily in the second quarter of 2006 and was due in part to
negotiations on a new distribution arrangement with one of our larger
industrialized- country distributors.
Both domestic and international net sales in 2006 have been favorably impacted
by revenue from the new business initiatives and partnerships discussed above,
mainly revenue derived from surgical cryotherapy products and processed
cardiovascular allograft tissue. Approximately 15% of our worldwide revenue for
the first six months of 2006 was derived from non-mechanical heart valve
products commercialized within the past 24 months.
COST OF GOODS SOLD AND GROSS PROFIT. Our costs of goods sold and gross profit as
a percentage of net sales has improved over the last several years due in part
to increases in our mechanical heart valve average selling prices, which are
much higher in the United States than in international markets. Our gross profit
is anticipated to continue
16
improving as sales within the United States increase as a percentage of total
sales and as we start selling lower cost valves that have been entirely
manufactured in our facilities.
By the end of the first quarter of 2006, we had substantially depleted our high
priced but paid-for inventories of carbon components purchased from Carbomedics,
moving into lower cost carbon material FIFO cost layers. This favorably impacted
our second quarter and year-to-date 2006 gross profit by approximately $1.0
million and $1.5 million, respectively, and improved our gross profit percentage
of net sales by approximately 9.0% and 7.5%, respectively.
Our gross profit as a percentage of net sales has also been favorably impacted
by the new business initiatives and partnerships discussed above, principally
surgical cryotherapy repair products and processed cardiovascular allograft
tissue. Revenue and gross profit from these new business initiatives caused
second quarter 2006 and 2005 gross profit percentages to be higher by
approximately 2.2% and 1.8%, respectively, and caused year-to-date 2006 and 2005
gross profit percentages to be higher by approximately 3.0% and 3.9%,
respectively.
Our gross profit was negatively impacted in the second quarter of 2006 as a
result of the shift in international sales mix discussed above, which decreased
the gross profit as a percentage of net sales by approximately 2.8% for the
second quarter of 2006 as compared to first quarter 2006.
We have made write-downs to our inventories during the past three fiscal years
due to future selling prices being lower than manufacturing costs in select
international markets. These write-downs resulted in lower-of-cost-or-market
(LCM) inventory reserves, which were used as high-cost pyrolytic carbon
components purchased from Carbomedics were sold into low selling-price
international markets. During the first quarter of 2006, the remaining LCM
reserves were fully utilized in connection with the depletion of our high priced
but paid-for inventories of carbon components discussed above. Consequently, LCM
inventory write-downs are not anticipated in 2006.
The ATS valve is made of materials that do not deteriorate. Other than the need
to resterilize the valves periodically, there is no risk of perishability.
Pyrolytic carbon, which is the substrate used in manufacturing our valves, has
been the only material used to manufacture mechanical heart valves for humans
for many years and remains the most advanced raw material for our products. The
other sources of prosthetic heart valves for humans are cadaver and animal
tissues. For our heart valves, however, obsolescence issues are remote due to
certain advantages offered by mechanical heart valves, including superior
durability. Similarly, we believe that, given the lead time that would be
required, there is no material risk that there would be the introduction and FDA
approval of another substrate that would replace pyrolytic carbon prior to the
end of the period over which we expect to sell our inventory of valves.
SALES AND MARKETING. In the United States, our sales and marketing costs rose
modestly in the second quarter of 2006 to $3.44 million, compared to $3.22
million for the second quarter of the prior year. For the first six months of
2006, our U.S. sales and marketing costs rose to $7.01 million, compared to
$6.76 million for the same period in the prior year. These increases are due
primarily to $0.3 million of stock compensation expense recognized in 2006
related to the adoption of Statement 123(R) on January 1, 2006. During the past
three fiscal years, our U.S. sales and marketing organization has steadily grown
to more than 30 sales territories in the United States and has a marketing
department that now consists of 14 employees.
Internationally, our sales and marketing costs increased 12% in the second
quarter of 2006 to $1.67 million, compared to $1.49 million for the second
quarter in 2005. For the first six months of 2006, our international sales and
marketing costs increased 10% to $2.94 million, compared to $2.68 million for
same period in 2005. The increases in 2006 over the prior year reflect our
continued investment in international markets, including the early 2005 set up
of direct sales operations in Germany and increased sales management.
RESEARCH AND DEVELOPMENT. Research and development (R & D) expenses increased
7.4% in the second quarter of 2006 and 18.8% for the first half of 2006,
compared to the same periods in 2005, due to increased costs to develop and
improve current and future products and the related regulatory and clinical
activities for these products. R & D costs also increased due to staff additions
and an increase in the number of R & D programs.
GENERAL AND ADMINISTRATIVE. General and administrative (G & A) expenses
increased $0.5 million to $2.3 million for the second quarter of 2006 and
increased $0.7 million to $4.2 million for the first six months of 2006 over the
same periods in 2005. Major cost increases in G & A expenses for the second
quarter of 2006 over the same period in 2005 were for bad debt expense
recognized in the second quarter of 2006 related to an international distributor
17
termination of $0.3 million, non-cash stock compensation expense of $0.1 million
and outside consulting, legal and professional services of $0.1 million. These
increases were partially offset by lower annual meeting and shareholder
relations expenses due to the delay of the 2006 annual shareholder's meeting
until the third quarter.
Major cost increases in G & A expenses for the first half of 2006 over the same
period in 2005 were for bad debt expense recognized in the second quarter 2006
related to an international distributor termination of $0.3 million, non-cash
stock compensation expense of $0.1 million, outside consulting, legal and
professional services of $0.2 million and higher expensed equipment costs due to
an increase in the capitalization threshold policy to $2,000 in 2006. These
increases were partially offset by lower annual meeting and shareholder
relations expenses and the allocation, beginning in 2006, of 401(K) company
match expense from G & A to individual operating departments.
We recognized total stock compensation expense in the first six months of 2006
of $0.5 million, of which $0.2 million was included in G & A expenses and $0.3
million in sales & marketing expenses. Of the $0.5 million total stock
compensation expense for the first six months of 2006, $0.2 million was
attributable to the adoption of FASB Statement No. 123 (Revised 2004),
Share-Based Payment, which we adopted on January 1, 2006. For the full year
2006, we estimate $0.4 to $0.6 million of additional stock compensation expense
attributable to the adoption of Statement 123(R).
In December 2005, we authorized the acceleration of vesting of all otherwise
unvested stock options held by our employees with an exercise price of $3.00 or
greater granted under the 2000 Stock Incentive Plan or as a free standing option
not under any plan. Options to purchase 1,294,232 shares of common stock
(affecting 86 employees) were subject to this acceleration. The decision to
accelerate vesting of these underwater options was made primarily to minimize
future compensation expense that we would otherwise recognize in our
consolidated statement of operations with respect to these options pursuant to
Statement 123(R). We believe that the aggregate future expense eliminated as a
result of the acceleration of the vesting of these options is approximately $3.3
million.
NET INTEREST INCOME (EXPENSE). In 2006, net interest expense was attributable
primarily to the October 2005 sale of $22.4 million aggregate principal amount
of 6% Convertible Senior Notes (Notes). Interest expense on the Notes in the
second quarter and first half of 2006 was $0.6 million and $1.0 million,
respectively, which also includes amortization of financing costs, the discount
related to the implied value of common stock warrants sold with the Notes and
the discounts related to the bifurcated Notes derivatives. See Note 6 of "Notes
to Consolidated Financial Statements" in this report for more information
regarding the Notes discounts. Interest expense in both 2006 and 2005 is also
attributable to our credit facility with Silicon Valley Bank. Interest income
was $0.18 million and $0.04 million for the second quarters of 2006 and 2005,
respectively, and $0.37 million and $0.11 million for the first six months of
2006 and 2005, respectively. Interest income is attributable to the investment
of our cash balances.
CHANGE IN VALUE OF DERIVATIVE LIABILITY BIFURCATED FROM CONVERTIBLE SENIOR
NOTES. In the second quarter of 2006, we recorded a non-operating gain of $0.1
million to adjust the Notes derivative liability to fair value at June 30, 2006.
See Note 6 of "Notes to Consolidated Financial Statements" in this report for
more information regarding the Notes derivative liability and the accounting for
this liability under FASB Statement No.133, Accounting for Derivative
Instruments and Hedging Activities.
INCOME TAXES. At the end of 2005, we had accumulated approximately $81 million
of net operating loss (NOL) carryforwards for U.S. tax purposes. We believe that
our ability to fully utilize the existing NOL carryforwards could be restricted
on a portion of the NOL for changes in control that may have occurred or may
occur in the future. We have not conducted a formal study of whether a change in
control of ATS has occurred in the past that impairs our NOL carryforwards
because we are unable to utilize such NOL carryforwards until we achieve
profitability and because this study would be very expensive to complete. When
we attain profitability, we will conduct a formal study of any restrictions on
our carryforwards. We have not recorded any deferred tax asset related to our
NOL carryforwards and other deferred items as we currently cannot determine that
it is more likely than not that this asset will be realized and we, therefore,
have provided a valuation allowance for the entire asset.
NET LOSS. Our decrease in net loss for the second quarter and first six months
of 2006 compared to the same periods in 2005 resulted from changes in sales
offset by changes in operating costs and non-operating income and expenses, all
of which are described above.
18
LIQUIDITY AND CAPITAL RESOURCES
Cash, cash equivalents and short-term investments totaled $15.5 million and
$21.7 million at June 30, 2006 and December 31, 2005, respectively.
OPERATING ACTIVITIES. During the first six months of 2006, we received cash
payments from customers of $18.3 million and made payments to employees and
suppliers of $24.8 million. During the first six months of 2005, we received
cash payments from customers of $15.3 million and made cash payments to
employees and suppliers of $22.5 million. Our operating losses during the past
three fiscal years were significantly funded through the depletion of
inventories and the use of existing cash and investment balances. Since 2002, we
have incurred significant expenses commercializing the ATS heart valve in the
United States. As we build sales in future periods and our cost of inventories
decrease, we believe our operating losses will decrease and we will move
steadily towards a cash flow breakeven on sales and eventually to profitability.
We believe our current cash balances are adequate to fund our operating
activities during 2006.
INVESTING ACTIVITIES. We purchased property and equipment of $0.2 million and
$1.1 million during the first six months of 2006 and 2005, respectively. Capital
purchases during 2005 were mainly in support of increasing production in our
pyrolytic carbon facility. During 2006, our spending on property and equipment
should decline as a significant portion of our 2005 purchases supported our
pyrolytic carbon facility production increase efforts, which are substantially
completed.
FINANCING ACTIVITIES. We raised approximately $0.1 million and $0.3 million
during the first six months of 2006 and 2005 through the issuance of common
stock through stock options and our employee stock purchase plan.
In 2004 we entered into a secured credit facility consisting of a $2.5 million
term note and a $6.0 million line of credit. We fully drew down the $2.5 million
term note, which was used to fund equipment purchases for our pyrolytic carbon
facility. The term note calls for equal installment payments over 36 months,
which commenced in February 2005. Accordingly, during the first six months of
2006 and 2005 we repaid $0.4 million and $0.3 million, respectively, on the
note. We are subject to certain financial covenants under the secured credit
facility agreement, as amended, to maintain a liquidity ratio of not less than
2.0 to 1.0 and a net tangible net worth of at least $40 million. At June 30,
2006, we were in compliance with these financial covenants.
On March 29, 2006, we entered into a second amendment to the secured credit
facility whereby the bank agreed to waive the prohibition set forth in the
credit facility agreement with respect to our pending acquisition of 3F
Therapeutics, Inc., and the bank consented to such acquisition. In addition, the
bank agreed to provide for advances of up to $1.5 million which we may use to
finance or refinance eligible equipment purchased on or after June 1, 2005 and
on or before May 31, 2006. Such equipment advances will be amortized over a 60
month period and carry an interest rate of prime plus 1.75%. On March 31, 2006,
we fully drew down the $1.5 million advance amount.
In October 2005, we sold a combined $22.4 million aggregate principal amount of
6% Convertible Senior Notes (Notes) due 2025 and issued warrants to purchase
1,344,000 shares of our Common Stock (Warrants). The Warrants are exercisable at
$4.40 per share and expire in 2010. We are using these proceeds for general
corporate purposes, working capital, capital expenditures and to fund business
development opportunities. The first interest payment on these Notes, totaling
$0.7 million, was paid in April 2006.
The Notes are convertible into common stock at any time at a fixed conversion
price of $4.20 per share, subject to certain adjustments. If fully converted,
the Notes would convert into approximately 5,333,334 shares of our common stock
and would require us to increase our authorized shares. If the Notes are
converted under certain circumstances on or prior to October 15, 2008, we will
pay the investors the interest they would have received on the Notes through
that date. We have the right to redeem the Notes at 100% of the principal amount
plus accrued interest at any time on or after October 20, 2008, and the
investors have the right to require us to repurchase the Notes at 100% of the
principal amount plus accrued interest on October 15 in 2010, 2015 and 2020. See
Note 6 of "Notes to Consolidated Financial Statements" in this report for a full
description of the terms and provisions of the Notes.
19
CASH MANAGEMENT
By the end of the first quarter of 2006, we had substantially depleted our high
priced but paid-for inventories of pyrolytic carbon components. During the last
two years we have been increasing production of these components in our own
factory. We estimate that operating costs will remain high in comparison to
sales during 2006 and will require the use of cash to fund operations. We will
draw down cash balances to fund operations during 2006.
Based upon the current forecast of sales and operating expenses, we anticipate
having cash to fund our operations through 2006. However, any adverse change
that affects our revenue, access to the capital markets or future demand for our
products will affect our long-term viability. Maintaining adequate levels of
working capital depends in part upon the success of our products in the
marketplace, the relative profitability of those products and our ability to
control operating and capital expenses. Funding of our operations in future
periods may require additional investments in ATS in the form of equity or debt.
There can be no assurance that we will achieve desired levels of sales or
profitability, or that future capital infusions will be available.
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any "off-balance sheet arrangements" (as such term is defined in
the rules and regulations of the SEC) that are reasonably likely to have a
current or future effect on our financial condition, changes in financial
condition, revenues or expenses, results of operations, liquidity, capital
expenditures or capital resources.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The primary objective of our investment activities is to preserve principal
while at the same time maximizing the income we receive from our investments
without significantly increasing risk. Some of the securities that we invest in
may have market risk. This means that a change in prevailing interest rates may
cause the fair market value of the principal amount of the investment to
fluctuate. For example, if we hold a security that was issued with a fixed
interest rate at the then prevailing rate and the prevailing interest rate later
rises, the fair value of the principal amount of our investment will probably
decline. To minimize this risk, our portfolio of cash equivalents and short-term
investments may be invested in a variety of securities, including commercial
paper, money market funds, and both government and non-government debt
securities. The average duration of all our investments has generally been less
than one year. Due to the short-term nature of these investments, we believe we
have no material exposure to interest rate risk arising from our investments. We
do not use derivative financial instruments to manage interest rate risk or to
speculate on future changes in interest rates.
In the United States, Canada, France and Germany, we sell our products directly
to hospitals. In other international markets, we sell our products to
independent distributors who, in turn, sell to medical hospitals. Loss,
termination, or ineffectiveness of distributors to effectively promote our
product would have a material adverse effect on our financial condition and
results of operations.
Transactions with U.S. and non-U.S. customers and distributors, other than in
France and Germany, are entered into in U.S. dollars, precluding the need for
foreign currency hedges on such sales. Sales through our French and German
subsidiaries are in Euros, so we are subject to profitability risk arising from
exchange rate movements. We have not used foreign exchange contracts or similar
instruments to reduce this risk. We will evaluate the need to use foreign
exchange contracts or similar instruments if sales in France and Germany
increase substantially.
We do not believe that inflation has had a material effect on our results of
operations in recent years and periods. There can be no assurance, however, that
our business will not be adversely affected by inflation in the future.
20
ITEM 4. CONTROLS AND PROCEDURES
(A) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures, which are designed to ensure
that information required to be disclosed in the reports we file or submit under
the Securities Exchange Act of 1934, as amended (Exchange Act), is recorded,
processed, summarized and reported within the time periods specified in the
SEC's rules and forms, and that such information is accumulated and communicated
to our management, including our Chief Executive Officer as appropriate, to
allow timely decisions regarding required disclosure.
Under the supervision and with the participation of our management, including
our Chief Executive Officer and our Controller, we evaluated the effectiveness
of the design and operation of our disclosure controls and procedures (as
defined in Rule 13a-15(e) under the Exchange Act). Based on that evaluation, the
Chief Executive Officer and Controller concluded that, as of the end of the
period covered by this report, our disclosure controls and procedures were
effective.
(B) CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
Other than in connection with the restatements described below, there has been
no change in our internal control over financial reporting (as defined in Rule
13a-15(f) under the Exchange Act) during the fiscal quarter ended June 30, 2006
that has materially affected, or is reasonably likely to materially affect our
internal control over financial reporting.
RESTATEMENTS
The Company has restated its financial statements as of and for the year ended
December 31, 2005 and the three months ended March 31, 2006. The determination
to restate these financial statements was made after an error was discovered in
June 2006 in the accounting for embedded derivatives related to its Convertible
Senior Notes (the Notes) under FASB Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities and related Emerging Issues Task Force
interpretations and SEC rules.
The Notes agreement permits Note holders to exchange their debt instruments for
common stock at a conversion rate of $4.20 per share. The Company had
insufficient authorized common shares as of the closing date, which requires
this embedded instrument to be bifurcated from the debt agreement and classified
as a liability in accordance with EITF 00-19.
After management's review of the Note agreements, our historical accounting for
the Notes and the related derivative accounting requirements connected with the
Notes, management recommended to the Audit Committee that, based on our analysis
of the impact of the items described above, our previously filed financial
statements be restated to reflect the correction of these items. The Audit
Committee agreed with this recommendation. On July 13, 2006, the Audit Committee
approved our restated financial statements and authorized their filing in
amendments to our Form 10-K for the year ended December 31, 2005 and our Form
10-Q for the quarter ended March 31, 2006.
21
PART II. OTHER INFORMATION
ITEM 1A. RISK FACTORS
In addition to the other information set forth in this report, you should
carefully consider the factors discussed in Part I, Item 1A of our Annual Report
on Form 10-K for the fiscal year ended December 31, 2005 (as amended), which
could have a material impact on our business, financial condition or results of
operations. The risks described in our Annual Report on Form 10-K are not the
only risks facing the Company. Additional risks and uncertainties not presently
known to us or that we currently believe to be immaterial may also adversely
affect our business, financial condition or results of operations.
ITEM 5. OTHER INFORMATION
During the quarter ended June 30, 2006, our Board of Directors approved a new
form of Change In Control Agreement for execution by our executive officers, a
copy of which is filed as an exhibit to this Quarterly Report on Form 10-Q.
ITEM 6. EXHIBITS
2.1 Amendment No. 1 to Agreement and Plan of Merger, dated as of June 13,
2006, by and among ATS Medical, Inc., Seabiscuit Acquisition Corp., 3F
Therapeutics, Inc. and Boyd D. Cox, as stockholder representative
(Incorporated by reference to Exhibit 2.1 to the Company's Current
Report on Form 8-K filed on June 19, 2006)
3.1 Restated Articles of Incorporation, as amended to date (Incorporated by
reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K for
the year ended December 31, 1993)
3.2 Bylaws of the Company, as amended to date (Incorporated by reference to
Exhibit 3.2 to the Company's Annual Report on Form 10-K for the year
ended December 31, 1996)
4.1 Specimen certificate for shares of Common Stock of the Company
(Incorporated by reference to Exhibit 4.1 to the Company's Annual Report
on Form 10-K for the year ended December 31, 1997)
10.1 2006 ATS Medical Management Incentive Compensation Plan
10.2 Form of Change in Control Agreement executed by executive officers of
the Company
31.1 Certification of Chief Executive Officer pursuant to Rules
13a-15(e)/15d-15(e) of the Securities Exchange Act, as amended (Section
302 Certification)
31.2 Certification of Chief Financial Officer pursuant to Rules
13a-15(e)/15d-15(e) of the Securities Exchange Act, as amended (Section
302 Certification)
32.1 Certification of the Chief Executive Officer pursuant to 18 U.S.C.
Section 1350 (Section 906 Certification)
32.2 Certification of the Chief Financial Officer pursuant to 18 U.S.C.
Section 1350 (Section 906 Certification)
22
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: August 8, 2006 ATS MEDICAL, INC.
By: /s/ Michael D. Dale
------------------------------------
Michael D. Dale,
Chief Executive Officer
(Duly Authorized Officer)
By: /s/ Deborah K. Chapman
------------------------------------
Deborah K. Chapman, Controller
(Principal Financial and
Accounting Officer)
23
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
2.1 Amendment No. 1 to Agreement and Plan of Merger, dated as of June 13,
2006, by and among ATS Medical, Inc., Seabiscuit Acquisition Corp., 3F
Therapeutics, Inc. and Boyd D. Cox, as stockholder representative
(Incorporated by reference to Exhibit 2.1 to the Company's Current
Report on Form 8-K filed on June 19, 2006)
3.1 Restated Articles of Incorporation, as amended to date (Incorporated
by reference to Exhibit 3.1 to the Company's Annual Report on Form
10-K for the year ended December 31, 1993)
3.2 Bylaws of the Company, as amended to date (Incorporated by reference
to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the
year ended December 31, 1996)
4.1 Specimen certificate for shares of Common Stock of the Company
(Incorporated by reference to Exhibit 4.1 to the Company's Annual
Report on Form 10-K for the year ended December 31, 1997)
10.1 2006 ATS Medical Management Incentive Compensation Plan
10.2 Form of Change in Control Agreement executed by executive officers of
the Company
31.1 Certification of the Chief Executive Officer pursuant to Rules
13a-15(e)/15d-15(e) of the Securities Exchange Act, as amended
(Section 302 Certification)
31.2 Certification of the Chief Financial Officer pursuant to Rules
13a-15(e)/15d-15(e) of the Securities Exchange Act, as amended
(Section 302 Certification)
32.1 Certification of the Chief Executive Officer pursuant to 18 U.S.C.
Section 1350 (Section 906 Certification)
32.2 Certification of the Chief Financial Officer pursuant to 18 U.S.C.
Section 1350 (Section 906 Certification)
24