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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 SEPTEMBER 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 October 30, 2006, was:
Common Stock, $.01 par value 40,279,892 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 September 30, 2006
and December 31, 2005 3
Consolidated Statements of Operations for the three
and nine months ended September 30, 2006 and 2005 4
Consolidated Statements of Cash Flows for the
nine months ended September 30, 2006 and 2005 5
Notes to Consolidated Financial Statements 6 - 15
ITEM 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 16 - 23
ITEM 3. Quantitative and Qualitative Disclosures About
Market Risk 23
ITEM 4. Controls and Procedures 24
PART II. OTHER INFORMATION
ITEM 1 Legal Proceedings 25
ITEM 1A. Risk Factors 26
ITEM 4. Submission of Matters to a Vote of Security Holders 27
ITEM 6. Exhibits 28
SIGNATURES 29
EXHIBIT INDEX 30
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ATS MEDICAL, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share and share data)
SEPTEMBER 30, DECEMBER 31,
2006 2005
------------- ------------
(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents $ 11,695 $ 16,620
Short-term investments 4,648 5,089
Accounts receivable, net 11,304 10,453
Other receivables 2,017 --
Inventories 19,269 21,286
Prepaid expenses 1,220 1,204
--------- --------
Total current assets 50,153 54,652
Leasehold improvements, furniture and equipment, net 7,991 8,330
Intangible assets 33,807 22,015
Other assets 455 446
--------- --------
Total assets $ 92,406 $ 85,443
========= ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 4,416 $ 3,598
Accrued compensation 2,461 2,394
Accrued distributor liabilities 406 752
Other accrued liabilities 2,088 568
Due to related party -- 90
Current maturities of notes payable 1,133 833
--------- --------
Total current liabilities 10,504 8,235
Convertible senior notes payable, net of unamortized
discounts and bifurcated derivatives of $5,036 and
$3,624 at September 30, 2006 and December 31, 2005 17,364 18,776
Notes payable 1,478 903
Shareholders' equity:
Common stock, $.01 par value:
Authorized shares - 100,000,000
Issued and outstanding shares- 40,274,892 and
31,114,131 at September 30, 2006 and
December 31, 2005 403 311
Additional paid-in capital 166,061 139,743
Deferred compensation -- (566)
Accumulated other comprehensive income (loss) 86 (64)
Accumulated deficit (103,490) (81,895)
--------- --------
Total shareholders' equity 63,060 57,529
--------- --------
Total liabilities and shareholders' equity $ 92,406 $ 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 ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -------------------
2006 2005 2006 2005
-------- -------- -------- --------
Net sales $ 9,122 $ 8,333 $ 29,709 $ 24,703
Cost of goods sold 3,894 5,714 14,302 15,489
-------- -------- -------- --------
Gross profit 5,228 2,619 15,407 9,214
Operating expenses:
Sales and marketing 5,287 4,323 15,233 13,765
Research and development 528 409 1,370 1,118
Acquired in-process research
and development 14,400 -- 14,400 --
General and administrative 2,067 1,928 6,288 5,443
-------- -------- -------- --------
Total operating expenses 22,282 6,660 37,291 20,326
-------- -------- -------- --------
Operating loss (17,054) (4,041) (21,884) (11,112)
Net interest expense (446) (37) (1,235) (58)
Change in value of derivative
liability bifurcated from
convertible senior notes 245 -- 1,525 --
-------- -------- -------- --------
Net loss ($17,255) ($ 4,078) ($21,594) ($11,170)
======== ======== ======== ========
Net loss per share:
Basic and diluted ($0.55) ($0.13) ($0.69) ($0.36)
Weighted average number of shares
used in calculation:
Basic and diluted 31,358 31,039 31,256 30,981
The accompanying notes are an integral part of the consolidated financial
statements.
4
ATS MEDICAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOW
(unaudited)
(in thousands)
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------
2006 2005
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss ($21,594) ($11,170)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation 1,317 1,145
Loss on disposal of equipment 26 --
Stock compensation expense 794 359
Non-cash interest expense 350 22
Lower of cost or market adjustment -- 700
Change in value of convertible senior notes
derivative liability (1,525) --
Acquired in-process research & development 14,400 --
Changes in operating assets and liabilities, net
of the effect of acquisitions:
Accounts and other receivables (844) (2,407)
Inventories 2,609 2,821
Prepaid expenses 121 222
Other (113) (4)
Accounts payable and accrued expenses (873) (1,374)
-------- --------
Net cash used in operating activities (5,332) (9,686)
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of short-term investments (7,725) (497)
Maturities of short-term investments 8,179 6,235
Business acquisition costs, net of cash acquired (555) --
Payments for technology and distribution licenses (210) (1,817)
Purchases of furniture, machinery and equipment (485) (1,507)
-------- --------
Net cash provided by (used in) investing activities (796) 2,414
CASH FLOWS FROM FINANCING ACTIVITIES
Advances on notes payable 1,500 --
Repayments of notes payable (625) (556)
Net proceeds from sales of common stock 178 413
-------- --------
Net cash provided by (used in) financing activities 1,053 (143)
-------- --------
Effect of exchange rate changes on cash 150 132
-------- --------
Decrease in cash and cash equivalents (4,925) (7,283)
Cash and cash equivalents at beginning of period 16,620 8,302
-------- --------
Cash and cash equivalents at end of period $ 11,695 $ 1,019
======== ========
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:
Nine months ended
September 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 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 9.57%, 10.14% and 11.85% to stock options outstanding in
determining its Statement 123(R) stock compensation expense for the quarters
ended September 30, 2006, 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. Option grants generally carry contractual terms of up to
ten years. RSU awards generally carry contractual terms of up to five years.
The following table summarizes the changes in stock options outstanding under
the Company's stock-based compensation plans during the nine months ended
September 30, 2006:
Stock Options Outstanding Weighted
Under the Plans Average Option
------------------------- Non-Plan Exercise 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 (7,625) -- (32,202) (39,827) 0.91
Options cancelled (46,450) (33,500) (275,000) (354,950) 4.44
--------- ------- --------- --------- -----
Balance at September 30, 2006 952,625 321,500 2,590,700 3,864,825
========= ======= ========= =========
7
The following table summarizes the ranges of exercise prices for outstanding and
exercisable stock options as of September 30, 2006:
Options Outstanding at Options Exercisable at
September 30, 2006: September 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 - $ 0.52 766,000 6.14 years $0.44 641,875 $0.43
0.79 - 2.35 650,000 6.51 years $1.44 467,500 $1.45
2.51 - 3.36 697,700 6.55 years $2.97 605,700 $3.02
3.46 - 3.80 981,750 7.32 years $3.69 959,250 $3.69
3.99 - 8.19 646,875 5.86 years $5.33 646,875 $5.33
8.50 - 12.44 122,500 3.56 years $9.43 122,500 $9.43
--------- ---------- ----- --------- -----
$0.37 - $12.44 3,864,825 6.45 years $2.99 3,443,700 $3.17
========= =========
As of September 30, 2006, the aggregate intrinsic value of options outstanding
and exercisable was $2.1 million and $1.7 million, respectively. The aggregate
intrinsic value of options exercised during the nine months ended September 30,
2006 was approximately $0.1 million. The aggregate intrinsic value represents
the total pre-tax intrinsic value (the difference between the closing price of
the Company's Common Stock on September 30, 2006 of $2.36 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 September 30,
2006.
The following table summarizes the changes in RSU awards outstanding under the
Plan during the nine months ended September 30, 2006:
Weighted Weighted
Average Average
No. of Award Date Remaining
Shares Fair Value Contractual Term
--------- ---------- ----------------
Unvested at December 31, 2005 348,000 $3.25 1.53 years
Awards granted 807,272 2.83 --
Awards vested (87,000) 3.25 --
Awards forfeited (55,000) 3.12 --
--------- ----- ----------
Unvested at September 30, 2006 1,013,272 $2.92 2.11 years
=========
As of September 30, 2006, the aggregate intrinsic value of RSU awards
outstanding was $2.4 million. The aggregate intrinsic value represents the total
pre-tax value of Common Stock RSU holders would have received (based on the
closing price of the Company's Common Stock on September 30, 2006 of $2.36 per
share) had all RSUs vested and Common Stock been issued to the RSU holders on
September 30, 2006.
The Company had a total of 6,049,325 shares of Common Stock reserved for stock
option grants and RSU awards at September 30, 2006, of which 1,171,228 shares
were available for future grants or awards under the Plan.
For the three months ended September 30, 2006, the Company recognized $0.2
million of stock compensation expense in connection with the adoption of
Statement 123(R). Total stock compensation expense recognized during the three
months ended September 30, 2006 totaled $0.3 million (or $0.01 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 nine months ended September 30, 2006, the Company recognized $0.4
million in stock compensation expense in connection with the adoption of
Statement 123(R). Total stock compensation expense recognized during the nine
months ended September 30, 2006 totaled $0.8 million (or $0.03 per share), of
which $0.3 million was included in general and administrative expenses and $0.5
million was included in sales and marketing expenses.
For the three and nine months ended September 30, 2005, the Company recognized
$0.3 million and $0.4 million in stock compensation expense, respectively.
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 nine months ended September
30, 2006.
As of September 30, 2006, the Company had $0.3 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 $1.9 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 (APB
25), 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 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 nine
months ended September 30, 2005. Since stock-based compensation expense for the
three and nine months ended September 30, 2006, was calculated and recorded
under the provisions of Statement 123(R), no pro forma disclosure for those
periods is presented:
Three months ended Nine months ended
(in thousands, except per share data) September 30, 2005 September 30, 2005
- ------------------------------------- ------------------ ------------------
Net loss, as reported ($4,078) ($11,170)
Less: Total stock-based employee compensation
expense determined under fair value based method
for all awards (547) (1,629)
------- --------
Pro forma net loss ($4,625) ($12,799)
======= ========
Net loss per share:
As reported
Basic and diluted ($0.13) ($0.36)
Pro forma
Basic and diluted ($0.15) ($0.41)
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.
NOTE 3. ACQUISITION OF 3F THERAPEUTICS, INC.
On September 29, 2006, the Company completed the 100% acquisition of all voting
and non-voting stock of 3F Therapeutics, Inc. (3F), a privately-held medical
device company specializing in heart tissue valve replacement. The Company views
the acquisition of 3F as a significant step in executing its vision of obtaining
a leadership position in all segments of the cardiac surgery market.
The acquisition was consummated pursuant to an agreement and plan of merger
dated January 23, 2006, as amended (the Merger Agreement). Under the terms of
the Merger Agreement, upon closing, the Company paid 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 deposited 1,425,000
shares of the closing payment in escrow to be held for at
9
least 18 months ("escrow period") after closing of the merger to cover
indemnification claims and certain contingencies. At the conclusion of the
escrow period, the balance of the escrow account 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 of certain key products on or prior to
December 31, 2013, up to an aggregate of 10 million shares of the Company's
Common Stock. Milestone share payments may be accelerated upon completion of
certain transactions involving these key products. These contingent payments are
subject to certain rights of set-off for indemnification claims and certain
other events.
PURCHASE PRICE
The Company has accounted for the acquisition of 3F as a purchase under U.S.
generally accepted accounting principles. Under the purchase method of
accounting, the assets and liabilities of 3F were recorded as of the acquisition
date, at their respective fair values, and consolidated with those of the
Company. The purchase price allocation is based upon preliminary estimates of
the fair value of assets acquired and liabilities assumed. The Company is in the
process of gathering information to finalize its valuation of certain assets,
primarily the valuation of acquired intangible assets. The purchase price
allocation will be finalized once the Company has all the necessary information
to complete its estimate, but no later than one year from the acquisition date.
The preparation of the valuation required the use of significant assumptions and
estimates. Critical estimates included, but were not limited to, future expected
cash flows and the applicable discount rates. These estimates were based on
assumptions that the Company believes to be reasonable. However, actual results
may differ from these estimates.
The preliminary purchase price is as follows (amounts in thousands):
Fair value of ATS Common Stock $26,100
Other estimated acquisition-related costs 3,154
-------
Total preliminary purchase price $29,254
=======
PRELIMINARY PURCHASE PRICE ALLOCATION
The following table summarizes the 3F preliminary purchase price allocation
(amounts in thousands):
Cash $ 2,599
Other current assets 2,846
Intangible assets subject to amortization 7,150
Goodwill 4,662
Other long-term assets 519
Acquired in-process research and development 14,400
Current liabilities (2,922)
-------
Total preliminary purchase price allocation $29,254
=======
In connection with the accounting for the acquisition of 3F, the Company
wrote-up inventory acquired from manufacturing cost to fair value resulting in
an increase of $0.2 million. Fixed assets were also recorded at fair value
resulting in an increase of $0.2 million.
10
The excess of the purchase price over the fair value of net tangible assets
acquired was allocated to specific intangible asset categories and in-process
research and development as follows:
Weighted Average
Amount Amortization
(in thousands) Assigned Period
-------- ----------------
Definite-lived intangible assets:
Technology - core $ 5,200 20 years
Technology - developed 700 9 years
Tradenames and trademarks 1,200 15 years
Other 50 7 years
------- --------
Total definite-lived intangible assets $ 7,150 18 years
======= ========
Goodwill $ 4,662
=======
Acquired in-process research
and development $14,400
=======
The Company believes that the estimated intangible assets so determined
represent the fair value at the date of acquisition. The Company used the income
approach to determine the fair value of the amortizable intangible assets and
purchased research and development.
The $14.4 million acquired in-process research and development associated with
the acquisition relates to the Enable product line of 3F and has been recorded
as a non-recurring charge to operations for the three and nine months ended
September 30, 2006. As the acquisition closed on September 29, 2006, no results
of operations of 3F have been included in the Company's Statements of Operations
for the three and nine months ended September 30, 2006, except for the charge
for acquired in-process research and development.
PRO FORMA RESULTS OF OPERATIONS
The following unaudited pro forma information presents a summary of consolidated
results of operations of the Company and 3F as if the acquisition had occurred
at the beginning of the earliest period presented. The historical consolidated
financial information has been adjusted to give effect to pro forma events that
are directly attributable to the merger and are factually supportable. The
unaudited pro forma condensed consolidated financial information is presented
for informational purposes only. The pro forma information is not necessarily
indicative of what the financial position or results of operations actually
would have been had the acquisition been completed at the dates indicated. In
addition, the unaudited pro forma condensed consolidated financial information
does not purport to project the future financial position or operating results
of the Company after completion of the acquisition.
Three Months Ended Nine Months Ended
September 30, September 30,
------------------- --------------------
(in thousands, except per share data) 2006 2005 2006 2005
-------- -------- -------- ---------
Net sales $ 9,130 $ 8,398 $ 29,795 $ 25,014
License revenue 3,650 3,710 11,031 4,943
-------- -------- -------- ---------
Total revenue $ 12,780 $ 12,108 $ 40,826 $ 29,957
======== ======== ======== =========
Net loss ($3,596) ($3,073) ($7,797) ($15,209)
======== ======== ======== =========
Net loss per share - basic and diluted ($ 0.09) ($ 0.08) ($ 0.19) ($ 0.38)
======== ======== ======== =========
License revenue relates to license, supply and training agreements 3F had with
Edwards Life Sciences (Edwards). The Edwards agreements were terminated in the
fourth quarter of 2006 and no additional license revenue will be recognized.
The pro forma net loss for the three and nine months ended September 30, 2006
and 2005 includes $0.1 million in each period for the amortization of purchased
intangible assets and the increase in depreciation expense of 3F related to the
step-up of fixed assets to fair value. The pro forma net loss for the nine
months ended September 30, 2006 and 2005 includes $0.4 million in each period
for the amortization of purchased intangible assets and the increase in
11
depreciation expense for the step-up of fixed assets to fair value. The
unaudited pro forma financial information for all periods presented excludes the
$14.4 million non-recurring charge for acquired in-process research and
development.
NOTE 4. INVENTORIES
Inventories consist of the following, stated at the lower of cost (first-in,
first-out basis) or market:
September 30, December 31,
(in thousands) 2006 2005
------------- ------------
Raw materials $ 4,648 $ 5,047
Work in process 4,349 4,462
Finished goods 10,482 11,992
Obsolescence reserve (210) (215)
------- -------
Total, net $19,269 $21,286
======= =======
NOTE 5. 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 6. 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 7. 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 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
authorized shares of its Common Stock available for the Note holders if
conversion was elected.
The Note holders 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
12
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, in
either 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 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 interpretations and SEC rules. The Company has determined that four such
provisions in the convertible debt agreement are considered derivatives under
FASB Statement No. 133:
1. The embedded written option relating to the Common Stock that may be
potentially issuable upon conversion ("conversion feature derivative")
2. The option for Note holders to put back debt to the Company in
connection with certain corporate change of control transactions
3. The provision relating to an additional payment in connection with the
automatic conversion of the Notes prior to October 15, 2008
4. 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 for the three and nine months ended September 30, 2006
was $0.2 million and $1.5 million, respectively, and was credited to other
income. The derivative liability is presented in the balance sheet within the
same line as the Convertible Senior Notes payable. At its annual shareholder
meeting held on September 25, 2006, the Company received approval from its
shareholders to increase its authorized shares to 100,000,000, eliminating the
previous deficiency in authorized shares. Since the Company now has sufficient
authorized shares to settle the Notes if converted, the conversion feature
derivative is no longer accounted for as an embedded derivative under FASB
Statement No. 133. The remaining fair value of the conversion feature derivative
liability at September 30, 2006 ($1.4 million) was offset against the related
debt discount. The derivative liability remaining at September 30, 2006 was $0.2
million.
The discount related to the derivative liability is being amortized to interest
expense using the effective interest method over 20 years. At September 30,
2006, the remaining unamortized discounts relating to the Warrants and the
derivative liability was $5.3 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
September 30, 2006, the balance due on this note was $1.1 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 September 30, 2006, the
Company was in compliance with these 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, 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
13
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 was outstanding at September 30, 2006.
NOTE 8. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In December 2004, the FASB issued Statement No. 123 (Revised 2004), Share-Based
Payment, 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. Statement
123(R) was adopted by the Company on January 1, 2006. The impact of adopting
this Standard is discussed above in Note 2, "Stock-Based Compensation."
In May 2005, the FASB issued Statement No. 154, Accounting Changes and Error
Corrections (Statement 154), which replaces APB Opinion No. 20, Accounting
Changes, and Statement No.3, Reporting Accounting Changes in Interim Financial
Statements. This Statement changes the requirements for the accounting for and
reporting of a change in accounting principle, and applies to all voluntary
changes in accounting principles, as well as changes required by an accounting
pronouncement in the unusual instance it does not include specific transition
provisions. Specifically, this Statement requires retrospective application to
prior periods' financial statements, unless it is impracticable to determine the
period-specific effects or the cumulative effect of the change. When it is
impracticable to determine the effects of the change, the new accounting
principle must be applied to the balances of assets and liabilities as of the
beginning of the earliest period for which retrospective application is
practicable and a corresponding adjustment must be made to the opening balance
of retained earnings for that period rather than being reported in an income
statement. When it is impracticable to determine the cumulative effect of the
change, the new principle must be applied as if it were adopted prospectively
from the earliest date practicable. The adoption of Statement 154 did not have
an impact on the Company's consolidated financial statements.
In July 2006, the FASB issued FASB interpretation (FIN) No. 48, Accounting for
Uncertainty in Income Taxes-an interpretation of FASB Statement 109. FIN 48
prescribes a comprehensive model for recognizing, measuring, presenting and
disclosing in the financial statements tax positions taken or expected to be
taken on a tax return, including the decision whether to file or not to file in
a particular jurisdiction. FIN 48 is effective for fiscal years beginning after
December 15, 2006. If there are changes in net assets as a result of the
application of FIN 48, these will be accounted for as an adjustment to retained
earnings. The Company is currently assessing the impact of FIN 48 on its
consolidated financial position and results of operations.
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements
(Statement 157). Statement 157 establishes a common definition for fair value to
be applied to U.S. GAAP guidance requiring use of fair value, establishes a
framework for measuring fair value, and expands disclosure about such fair value
measurements. Statement 157 is effective for fiscal years beginning after
November 15, 2007. The Company is currently assessing the impact of Statement
157 on its consolidated financial position and results of operations.
In September 2006, the SEC staff issued Staff Accounting Bulletin 108,
Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements (SAB 108). SAB 108 requires
that public companies utilize a "dual-approach" to assessing the quantitative
effects of financial misstatements. This dual-approach includes both an income
statement focused assessment and a balance sheet focused assessment. The
guidance in SAB 108 must be applied to annual financial statements for fiscal
years ending after November 15, 2006. The Company is currently assessing the
impact of adopting SAB 108 but does not expect that it will have a material
effect on the consolidated financial position or results of operations.
14
NOTE 9. LITIGATION
On January 23, 2006, following execution of the Merger Agreement between the
Company and 3F Therapeutics, 3F was informed of a summons and complaint dated
January 19, 2006, which was filed in the United States District Court in the
Southern District of New York by Arthur N. Abbey ("Abbey") against 3F Partners
Limited Partnership II (a major stockholder of 3F, "3F Partners II"), Theodore
C. Skokos (the then chairman of the board and a stockholder of 3F), 3F
Management II, LLC (the general partner of 3F Partners II), and 3F
(collectively, the "Defendants") (the "Abbey I Litigation"). The summons and
complaint alleges that the Defendants committed fraud under federal securities
laws, common law fraud and negligent misrepresentation in connection with the
purchase by Abbey of certain securities of 3F Partners II. In particular, Abbey
claims that Defendants induced Abbey to invest $4 million in 3F Partners II,
which, in turn, invested $6 million in certain preferred stock of 3F, by
allegedly causing Abbey to believe, among other things, that such investment
would be short-term. Pursuant to the complaint, Abbey is seeking rescission of
his purchase of his limited partnership interest in 3F Partners II and return of
the amount paid therefor (together with pre-and post-judgment interest),
compensatory damages for the alleged lost principal of his investment (together
with interest thereon and additional general, consequential and incidental
damages), general damages for all alleged injuries resulting from the alleged
fraud in an amount to be determined at trial and such other legal and equitable
relief as the court may deem just and proper. Abbey did not purchase any
securities directly from 3F and is not a stockholder of 3F. On March 23, 2006,
3F filed a motion to dismiss the complaint. Under the Private Securities
Litigation Reform Act, no discovery will be permitted until the judge rules upon
the motion to dismiss. On May 15, 2006, 3F filed and served a reply memorandum
of law in further support of its motion to dismiss Abbey's complaint with
prejudice.
On or about June 14, 2006, Abbey commenced a second civil action in the Court of
Chancery in the State of Delaware by serving 3F with a complaint naming both 3F
and Theodore C. Skokos as defendants (the "Abbey II Litigation"). The complaint
alleges, among other things, fraud and breach of fiduciary duties in connection
with the purchase by Abbey of his partnership interest in 3F Partners II. The
Delaware action seeks: (1) a declaration that (a) for purposes of the proposed
merger, Abbey is a record stockholder of 3F (even though he is not himself a
record owner of any of the capital stock of 3F) and is thus entitled to withhold
his consent to the merger and seek appraisal rights if the merger is consummated
and (b) the irrevocable stockholder consent submitted by 3F Partners II to
approve the merger be voided as unenforceable; and (2) damages based upon
allegations that 3F aided and abetted Mr. Skokos in breaching Mr. Skokos's
fiduciary duties of loyalty and faith to Abbey. On July 17, 2006, 3F filed a
motion to dismiss the complaint in the Abbey II Litigation, or, alternatively,
to stay the action pending adjudication of the Abbey I Litigation. On October
10, 2006, the Delaware Chancery Court entered an order staying the Delaware
action pending the outcome of the prior action filed in the United States
District Court in the Southern District of New York.
3F has been notified by its director and officer insurance carrier that such
carrier will provide a defense and cover all defense costs as to 3F and Theodore
C. Skokos in the Abbey I Litigation and Abbey II Litigation, subject to policy
terms and full reservation of rights. In addition, under the Merger Agreement,
3F and the 3F stockholder representative have agreed that the Abbey I Litigation
and Abbey II Litigation are matters for which express indemnification is
provided, the effect of which is that the escrow shares and milestone shares (if
any) may be used by ATS to satisfy in part ATS's set-off rights and
indemnification claims for damages and losses incurred by 3F or ATS (and their
directors, officers and affiliates) that are not otherwise covered by applicable
insurance arising from the Abbey I Litigation and Abbey II Litigation. See Note
3 of Notes to Consolidated Financial Statements in this Report for a description
of the escrow and milestone shares. The Company believes that the Abbey I
Litigation and Abbey II Litigation will not result in a material impact on the
Company's financial position or results of operations.
15
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) and in Part II, Item IA
on page 26 of this Report. 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, tissue heart valve therapies, 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 40% for the first nine months of 2006.
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.
16
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 September 29, 2006, the Company completed the acquisition of 3F Therapeutics,
Inc. (3F), a privately-held medical device company specializing in heart tissue
valve replacement. The Company views the acquisition of 3F as a significant step
in executing its vision of obtaining a leadership position in all segments of
the cardiac surgery market.
The acquisition was consummated pursuant to an agreement and plan of merger
dated January 23, 2006, as amended (the Merger Agreement). Under the terms of
the Merger Agreement, upon closing, the Company paid 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 deposited 1,425,000
shares of the closing payment in escrow to be held for at least 18 months
("escrow period") after closing of the merger to cover indemnification claims
and certain contingencies. At the conclusion of the escrow period, the balance
of the escrow account 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. See Note 3 of "Notes to Consolidated Financial Statements"
in this report for additional information regarding the acquisition, including
the purchase price and the preliminary allocation of the purchase price.
Also in September 2006, we entered into an exclusive distribution agreement with
Novare Surgical Systems, Inc. for Novare's Enclose II(R) cardiac anastomosis
assist device. We will distribute the device in the United States, Germany,
France and the United Kingdom. The Enclose II anastomosis assist device is used
by cardiac surgeons to attach a bypass vessel to the aorta during coronary
artery bypass graft surgery.
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 (Statement 123(R)), 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 "Results of Operations-General & Administrative" below for
additional information regarding stock-based compensation plans and our adoption
of Statement 123(R).
17
RESULTS OF OPERATIONS
The following table provides the dollar and percentage change in the Statements
of Operations for the three and nine month periods ended September 30, 2006 and
2005.
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
------------------------------------------ -------------------------------------------
Increase (Decrease) Increase (Decrease)
------------------- -------------------
(In thousands) 2006 2005 $ % 2006 2005 $ %
--------- -------- ------- ------ --------- --------- ------- ------
Net sales $ 9,122 $ 8,333 $ 789 9.5% $ 29,709 $ 24,703 $ 5,006 20.3%
Cost of goods sold 3,894 5,714 (1,820) (31.9)% 14,302 15,489 (1,187) (7.7)%
--------- -------- ------- ------ --------- --------- ------- ------
Gross profit 5,228 2,619 2,609 99.6% 15,407 9,214 6,193 67.2%
Gross profit % 57.3% 31.4% 51.9% 37.3%
Operating expenses:
Sales and marketing 5,287 4,323 964 22.3% 15,233 13,765 15,233 10.7%
Research and development 528 409 119 29.1% 1,370 1,118 252 22.5%
Acquired in-process R & D 14,400 -- 14,400 -- 14,400 -- 14,400 --
General and administrative 2,067 1,928 139 7.2% 6,288 5,443 845 15.5%
--------- -------- ------- ------ --------- --------- ------- ------
Total operating expenses 22,282 6,660 15,622 234.6% 37,291 20,326 16,965 83.5%
--------- -------- ------- ------ --------- --------- ------- ------
Operating loss (17,054) (4,041) 13,013 (322.0)% (21,884) (11,112) 10,772 96.9%
Net interest income (expense) (446) (37) 409 1105.4% (1,235) (58) 1,177 2029.3%
Change in value of derivative
liability bifurcated from
convertible senior notes 245 -- 245 -- 1,525 -- 1,525 --
--------- -------- ------- ------ --------- --------- ------- ------
Net loss ($17,255) ($4,078) $13,177 323.1% ($21,594) ($11,170) $10,424 93.3%
========= ======== ======= ====== ========= ========= ======= ======
The following table presents the Statements of Operations as a percentage of net
sales for the three and nine month periods ended September 30, 2006 and 2005.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
2006 2005 2006 2005
------ ----- ----- -----
Net sales 100.0% 100.0% 100.0% 100.0%
Cost of goods sold 42.7% 68.6% 48.1% 62.7%
------ ----- ----- -----
Gross profit 57.3% 31.4% 51.9% 37.3%
Operating expenses:
Sales and marketing 58.0% 51.9% 51.3% 55.7%
Research and development 5.8% 4.9% 4.6% 4.5%
Acquired in-process R & D 157.9% 0.0% 48.5% 0.0%
General and administrative 22.7% 23.1% 21.2% 22.0%
------ ----- ----- -----
Total operating expenses 244.3% 79.9% 125.5% 82.3%
------ ----- ----- -----
Operating loss (187.0)% (48.5)% (73.7)% (45.0)%
Net interest income (expense) (4.9)% (0.4)% (4.2)% (0.2)%
Change in value of derivative
liability bifurcated from
convertible senior notes 2.7% 0.0% 5.1% 0.0%
------ ----- ----- -----
Net loss (189.2)% (48.9)% (72.7)% (45.2)%
====== ===== ===== =====
18
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 nine
month periods ended September 30, 2006 and 2005.
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
----------------------------------- -------------------------------------
Increase Increase
(In thousands) 2006 2005 (Decrease) % 2006 2005 (Decrease) %
------ ------ ---------- ---- ------- ------- ---------- ----
United States and Canada $3,799 $3,392 $407 12.0% $11,859 $ 9,514 $2,345 24.6%
Outside U. S. and Canada 5,323 4,941 382 7.7% 17,850 15,189 2,661 17.5%
------ ------ ---- ---- ------- ------- ------ ----
Total $9,122 $8,333 $789 9.5% $29,709 $24,703 $5,006 20.3%
====== ====== ==== ==== ======= ======= ====== ====
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 nine month periods
ended September 30, 2006 and 2005.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
2006 2005 2006 2005
----- ----- ----- -----
Share of total sales:
United States and Canada 41.6% 40.7% 39.9% 38.5%
Outside U. S. and Canada 58.4% 59.3% 60.1% 61.5%
----- ----- ----- -----
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 83% of the Company's worldwide sales base for the first nine
months of 2006, were flat in the United States and Canada for the quarter ended
September 30, 2006, and increased 5.5% for the nine months ended September 30,
2006, compared to the same periods in the prior year. Average selling price
(ASP) in the United States and Canada for the first nine months of 2006 was
approximately 3% lower compared to the same period in 2005 due primarily to
initial stocking sales to a new Canadian distributor.
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
3.5% in international markets for the quarter ended September 30, 2006, and
increased 11.9% for the nine months ended September 30, 2006, compared to the
same periods in the prior year. International ASP was approximately 5% lower for
the first nine months 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 17% of our worldwide revenue for
the first nine months of 2006 was derived from non-mechanical heart valve
products commercialized within the past 24 months.
19
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 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 cost layers. This favorably
impacted our third quarter and year-to-date 2006 gross profit by approximately
$1.4 million and $3.6 million, respectively, and improved our gross profit
percentage of net sales by approximately 15.0% and 9.7%, 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 2006
third quarter and year-to-date gross profit percentages to be higher by
approximately 1.8% and 2.7%, respectively, and caused 2005 third quarter and
year-to-date gross profit percentages to be higher by approximately 6.6% and
3.5%, respectively.
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 third quarter of 2005, we recorded LCM
write-downs of $0.7 million, which lowered our 2005 third quarter and
year-to-date gross profit percentages by 8.4% and 2.8%, respectively. 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 mechanical heart 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 mechanical 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
21% in the third quarter of 2006 to $3.77 million, compared to $3.12 million for
the third quarter of the prior year. For the first nine months of 2006, our U.S.
sales and marketing costs rose 9% to $10.77 million, compared to $9.88 million
for the same period in the prior year. These increases are due primarily to
$0.46 million of stock compensation expense recognized in 2006 related to the
adoption of Statement 123(R) on January 1, 2006, and to increased costs
associated with our attendance at the European Association for Cardio Thoracic
Surgeons trade show in Stockholm, Sweden in September 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 15 employees.
Internationally, our sales and marketing costs increased 27% in the third
quarter of 2006 to $1.52 million, compared to $1.20 million for the third
quarter in 2005. For the first nine months of 2006, our international sales and
marketing costs increased 15% to $4.46 million, compared to $3.89 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, the establishment of a European export
company in the third quarter of 2006, higher sales and marketing expenses in
Eastern Europe, Asia and China, and increased sales management.
RESEARCH AND DEVELOPMENT. Research and development (R & D) expenses increased
29% in the third quarter of 2006 and 23% for the first nine months 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.
20
IN-PROCESS R & D. In connection with our acquisition of 3F, we recorded a
non-recurring in-process R & D charge of $14.4 million in September 2006. See
Note 3 of "Notes to Consolidated Financial Statements" in this report for
additional information regarding the acquisition, including the purchase price
and the preliminary allocation of the purchase price.
GENERAL AND ADMINISTRATIVE. General and administrative (G & A) expenses
increased $0.1 million to $2.1 million for the third quarter of 2006 and
increased $0.8 million to $6.3 million for the first nine months of 2006 over
the same periods in 2005. Major cost increases in G & A expenses for the first
nine months of 2006 over the same period in 2005 were for outside consulting,
legal and professional services of $0.4 million ($0.2 million in the third
quarter of 2006) and bad debt expense of 0.4 million ($0.1 million in the third
quarter of 2006) related primarily to the termination of an international
distributor. These increases were partially offset by the allocation of 401(k)
company match expense from G & A to individual operating departments beginning
in 2006.
We recognized total stock compensation expense in the first nine months of 2006
of $0.8 million, of which $0.3 million was included in G & A expenses and $0.5
million in sales & marketing expenses. Of the $0.8 million total stock
compensation expense for the first nine months of 2006, $0.4 million was
attributable to the adoption of Statement 123(R), which we adopted on January 1,
2006. For the full year 2006, we estimate $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 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
third quarter and first nine months of 2006 was $0.5 million and $1.6 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 7 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 $0.17 million and $0.02 million for the third quarters of 2006 and 2005,
respectively, and $0.54 million and $0.13 million for the first nine 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 third quarter and first nine months of 2006, we recorded
non-operating income of $0.24 million and $1.52 million to adjust the Notes
derivative liability to fair value. See Note 7 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 third quarter and first nine 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.
21
LIQUIDITY AND CAPITAL RESOURCES
Cash, cash equivalents and short-term investments totaled $16.3 million at
September 30, 2006 (including $2.6 million in cash acquired from 3F
Therapeutics) compared to $21.7 million at December 31, 2005.
OPERATING ACTIVITIES. During the first nine months of 2006, we received cash
payments from customers of $28.8 million and made payments to employees and
suppliers of $33.3 million. During the first nine months of 2005, we received
cash payments from customers of $22.6 million and made cash payments to
employees and suppliers of $31.9 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, combined with cash generated from
operations, will be adequate to fund our operating activities during the next
twelve months.
INVESTING ACTIVITIES. We incurred $3.2 million of transaction costs related to
the acquisition of 3F, including professional, investment banking, attorneys and
accounting fees, offset in large part by $2.6 million in cash acquired in the
transaction. In the second quarter of 2006, we made a $0.2 million additional
license fee payment in connection with our global partnership agreement with
CryoCath. We purchased property and equipment of $0.5 million and $1.5 million
during the first nine 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 received proceeds of approximately $0.2 million and
$0.4 million during the first nine months of 2006 and 2005, respectively, from
the issuance of Common Stock through exercises of stock options and purchases
under 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 each of the first nine
months of 2006 and 2005 we repaid $0.6 million 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 September 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, 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. Repayments on this advance begin October 2006.
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.
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 7 of "Notes to Consolidated Financial Statements" in this report
for a full description of the terms and provisions of the Notes.
22
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 believe we
will have adequate cash to fund our operations for the next twelve months.
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.
23
ITEM 4. CONTROLS AND PROCEDURES
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 Principal Executive Officer as appropriate, to
allow timely decisions regarding required disclosure.
Under the supervision and with the participation of our management, including
our Principal Executive Officer and our Principal Financial Officer, 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 Principal Executive Officer and Principal
Financial Officer concluded that, as of the end of the period covered by this
report, our disclosure controls and procedures were effective.
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 September 30,
2006 that has materially affected, or is reasonably likely to materially affect
our internal control over financial reporting. We completed the acquisition of
3F on September 29, 2006 and had not completed our documentation and testing of
3F's internal control over financial reporting as of the end of the period
covered by this Report.
In the third quarter of 2006 we strengthened our internal controls over
financial reporting by hiring a Senior Director of Finance. The responsibilities
of this new position will include oversight of the worldwide finance and
accounting functions, internal and external financial reporting, planning and
analysis, treasury and cash management. The addition of this position adds depth
to our finance organization and increases our internal knowledge of generally
accepted accounting principles and 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 required
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.
24
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On January 23, 2006, following execution of the Merger Agreement between the
Company and 3F Therapeutics, 3F was informed of a summons and complaint dated
January 19, 2006, which was filed in the United States District Court in the
Southern District of New York by Arthur N. Abbey ("Abbey") against 3F Partners
Limited Partnership II (a major stockholder of 3F, "3F Partners II"), Theodore
C. Skokos (the then chairman of the board and a stockholder of 3F), 3F
Management II, LLC (the general partner of 3F Partners II), and 3F
(collectively, the "Defendants") (the "Abbey I Litigation"). The summons and
complaint alleges that the Defendants committed fraud under federal securities
laws, common law fraud and negligent misrepresentation in connection with the
purchase by Abbey of certain securities of 3F Partners II. In particular, Abbey
claims that Defendants induced Abbey to invest $4 million in 3F Partners II,
which, in turn, invested $6 million in certain preferred stock of 3F, by
allegedly causing Abbey to believe, among other things, that such investment
would be short-term. Pursuant to the complaint, Abbey is seeking rescission of
his purchase of his limited partnership interest in 3F Partners II and return of
the amount paid therefor (together with pre-and post-judgment interest),
compensatory damages for the alleged lost principal of his investment (together
with interest thereon and additional general, consequential and incidental
damages), general damages for all alleged injuries resulting from the alleged
fraud in an amount to be determined at trial and such other legal and equitable
relief as the court may deem just and proper. Abbey did not purchase any
securities directly from 3F and is not a stockholder of 3F. On March 23, 2006,
3F filed a motion to dismiss the complaint. Under the Private Securities
Litigation Reform Act, no discovery will be permitted until the judge rules upon
the motion to dismiss. On May 15, 2006, 3F filed and served a reply memorandum
of law in further support of its motion to dismiss Abbey's complaint with
prejudice.
On or about June 14, 2006, Abbey commenced a second civil action in the Court of
Chancery in the State of Delaware by serving 3F with a complaint naming both 3F
and Theodore C. Skokos as defendants (the "Abbey II Litigation"). The complaint
alleges, among other things, fraud and breach of fiduciary duties in connection
with the purchase by Abbey of his partnership interest in 3F Partners II. The
Delaware action seeks: (1) a declaration that (a) for purposes of the proposed
merger, Abbey is a record stockholder of 3F (even though he is not himself a
record owner of any of the capital stock of 3F) and is thus entitled to withhold
his consent to the merger and seek appraisal rights if the merger is consummated
and (b) the irrevocable stockholder consent submitted by 3F Partners II to
approve the merger be voided as unenforceable; and (2) damages based upon
allegations that 3F aided and abetted Mr. Skokos in breaching Mr. Skokos's
fiduciary duties of loyalty and faith to Abbey. On July 17, 2006, 3F filed a
motion to dismiss the complaint in the Abbey II Litigation, or, alternatively,
to stay the action pending adjudication of the Abbey I Litigation. On October
10, 2006, the Delaware Chancery Court entered an order staying the Delaware
action pending the outcome of the prior action filed in the United States
District Court in the Southern District of New York.
3F has been notified by its director and officer insurance carrier that such
carrier will provide a defense and cover all defense costs as to 3F and Theodore
C. Skokos in the Abbey I Litigation and Abbey II Litigation, subject to policy
terms and full reservation of rights. In addition, under the Merger Agreement,
3F and the 3F stockholder representative have agreed that the Abbey I Litigation
and Abbey II Litigation are matters for which express indemnification is
provided, the effect of which is that the escrow shares and milestone shares (if
any) may be used by ATS to satisfy in part ATS's set-off rights and
indemnification claims for damages and losses incurred by 3F or ATS (and their
directors, officers and affiliates) that are not otherwise covered by applicable
insurance arising from the Abbey I Litigation and Abbey II Litigation. See Note
3 of Notes to Consolidated Financial Statements in this Report for a description
of the escrow and milestone shares. We believe that the Abbey I Litigation and
Abbey II Litigation will not result in a material impact on the Company's
financial position or results of operations.
25
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. We are
updating the risk factors set forth in our Annual Report on Form 10-K by adding
the following risk factors.
Purchase accounting treatment of the merger with 3F could result in net losses
for the foreseeable future.
We have accounted for the merger with 3F using the purchase method of
accounting. Under purchase accounting, the estimated market value of shares of
our Common Stock issued in the merger and the amount of the merger transaction
costs were recorded as the cost of acquiring 3F. That cost has been allocated on
a preliminary basis to the individual assets acquired and liabilities assumed,
including various identifiable intangible assets such as acquired technology,
acquired trademarks and tradenames, based on their estimated fair values at the
date of acquisition. The excess of the purchase price over the fair market value
of the net assets has been allocated as goodwill. The amount of purchase price
currently allocated to goodwill and the other intangible assets is approximately
$11.8 million. Our estimates are based upon currently available information and
assumptions that we believe are reasonable. We are in the process of gathering
information to finalize the valuation of certain assets, primarily the valuation
of acquired intangible assets. However, there can be no assurance that the
actual useful lives will not differ significantly from the current estimates.
The amortization of goodwill and the other intangible assets could result in net
losses for ATS for the foreseeable future, which could have a material adverse
effect on the market value of our Common Stock.
We ultimately may experience a delay in introducing, or may not successfully
complete development of, products that are currently under development,
resulting in harm to our business.
Both ATS and 3F are in the process of developing certain products, including but
not limited to 3F's Enable and Entrata products. The Enable product is currently
in the early phases of clinical trials, and the Entrata product is still under
development. In 2006, ongoing clinical trial results in Europe have resulted in
3F undertaking a review of the Enable valve cuff design. Successfully completing
the development of these products and technologies presents substantial
technical, medical and engineering challenges as well as regulatory hurdles. We
may not successfully complete the development of these products, or these
products may fail to work in the manner intended. If we are unable to
successfully develop the products that are currently under development, we may
suffer financial difficulties, which may have a material adverse effect on our
business, financial condition and results of operations.
26
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Our Annual Meeting of Shareholders was held on September 25, 2006 at which time
the following proposals were approved:
1) The issuance of up to 19,000,000 shares of our Common Stock pursuant to an
Agreement and Plan of Merger, dated as of January 23, 2006, by and between
us, Seabiscuit Acquisition Corp., our subsidiary, 3F Therapeutics, Inc. and
Mr. Boyd D. Cox, as representative of the 3F Therapeutics stockholders, as
amended by Amendment No. 1, dated June 13, 2006, and Amendment No. 2, dated
August 10, 2006, by and among the same parties (collectively, as amended,
the "Amended Merger Agreement");
2) An amendment to the our Restated Articles of Incorporation to increase the
number of authorized shares of our capital stock from 40,000,000 to
100,000,000, and to authorize the filing of an amendment to the Restated
Articles of Incorporation in connection herewith;
3) The election of four directors to our Board of Directors to hold office for
the ensuing year and until their successors are elected and qualified;
4) An amendment to the ATS Medical, Inc. 1998 Employee Stock Purchase Plan to
increase the number of shares of our Common Stock which may be purchased
under the plan by 500,000 shares; and
5) An amendment to the ATS Medical 2000 Stock Incentive Plan to provide that,
in lieu of automatic non-qualified stock option grants, non-employee
directors will be automatically granted restricted stock units upon
election and re-election to our Board of Directors.
Proxies for the Company were solicited pursuant to Section 14(a) of the Exchange
Act, and there was no solicitation in opposition to management's solicitations.
All nominees for directors as listed in the proxy statement were elected. The
voting results were as follows:
Broker
For Withhold Against Abstain Non-Votes
---------- -------- --------- ------- ----------
Issuance of up to 19,000,000 shares of our
common stock pursuant to the Amended
Merger Agreement 12,951,512 -- 191,529 255,043 13,746,233
Amendment to Restated Articles of
Incorporation to increase the number
of authorized shares of capital stock 25,633,687 -- 1,356,788 153,824 --
Election of Directors:
Michael D. Dale 26,892,150 252,149 -- -- --
Steven M. Anderson 26,896,115 248,184 -- -- --
Robert E. Munzenrider 26,793,469 350,830 -- -- --
Eric W. Sivertson 26,409,248 735,051 -- -- --
Amendment to 1998 Employee Stock
Purchase Stock Plan 12,852,744 -- 395,631 149,691 13,746,233
Amendment to 2000 Stock Incentive Plan 12,567,788 -- 610,572 219,706 13,746,233
27
ITEM 6. EXHIBITS
2.1 Amendment No. 2 to Agreement and Plan of Merger, dated as of August 10,
2006, by and among the Company, 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 August 15, 2006)
3.1 Second Restated Articles of Incorporation of ATS Medical, Inc, filed
herewith
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* Exclusive Distribution Agreement, effective as of October 1, 2006, by
and between the Company and Novare Surgical Systems, Inc., filed
herewith
10.2 Amendment No. 2 dated September 1, 2006, to Original Lease Agreement
dated April 29, 2000, by and between the Company and St. Paul
Properties, Inc., filed herewith
10.3 Amendment No. 11 dated September 1, 2006, to Original Lease Agreement
dated December 22, 1987, by and between the Company and St. Paul
Properties, Inc., filed herewith
10.4 Amendment, dated August 15, 2006, to the Loan and Security Agreement
between Silicon Valley Bank and the Company, dated July 28, 2004
(Incorporated by reference to Exhibit 10.1 to the Company's Current
Report on Form 8-K filed on August 17, 2006)
10.5 ATS Medical, Inc. 1998 Employee Stock Purchase Plan, as amended through
September 25, 2006 (Incorporated by reference to Exhibit 10.1 to the
Company's Current Report on Form 8-K filed on September 29, 2006)
10.6 ATS Medical, Inc. 2000 Stock Incentive Plan, as amended through
September 25, 2006 (Incorporated by reference to Exhibit 10.1 to the
Company's Current Report on Form 8-K filed on September 29, 2006)
31.1 Certification of Principal 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 Principal 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 Principal Executive Officer pursuant to 18 U.S.C.
Section 1350 (Section 906 Certification)
32.2 Certification of the Principal Financial Officer pursuant to 18 U.S.C.
Section 1350 (Section 906 Certification)
- ----------
* Pursuant to Rule 24b-2 of the Exchange Act, confidential portions of this
exhibit have been deleted and filed separately with the Securities and
Exchange Commission pursuant to a request for confidential treatment.
28
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: November 8, 2006 ATS MEDICAL, INC.
By: /s/ Michael D. Dale
------------------------------------
Michael D. Dale, Chief Executive
Officer (Duly Authorized Officer)
By: /s/ Michael R. Kramer
------------------------------------
Michael R. Kramer, Senior Director
of Finance (Principal Financial
Officer)
29
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
2.1 Amendment No. 2 to Agreement and Plan of Merger, dated as of August
10, 2006, by and among the Company, 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 August 15, 2006)
3.1 Second Restated Articles of Incorporation of ATS Medical, Inc, filed
herewith
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* Exclusive Distribution Agreement, effective as of October 1, 2006, by
and between the Company and Novare Surgical Systems, Inc., filed
herewith
10.2 Amendment No. 2 dated September 1, 2006, to Original Lease Agreement
dated April 29, 2000, by and between the Company and St. Paul
Properties, Inc., filed herewith
10.3 Amendment No. 11 dated September 1, 2006, to Original Lease Agreement
dated December 22, 1987, by and between the Company and St. Paul
Properties, Inc., filed herewith
10.4 Amendment, dated August 15, 2006, to the Loan and Security Agreement
between Silicon Valley Bank and the Company, dated July 28, 2004
(Incorporated by reference to Exhibit 10.1 to the Company's Current
Report on Form 8-K filed on August 17, 2006)
10.5 ATS Medical, Inc. 1998 Employee Stock Purchase Plan, as amended
through September 25, 2006 (Incorporated by reference to Exhibit 10.1
to the Company's Current Report on Form 8-K filed on September 29,
2006)
10.6 ATS Medical, Inc. 2000 Stock Incentive Plan, as amended through
September 25, 2006 (Incorporated by reference to Exhibit 10.1 to the
Company's Current Report on Form 8-K filed on September 29, 2006)
31.1 Certification of the Principal 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 Principal 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 Principal Executive Officer pursuant to 18 U.S.C.
Section 1350 (Section 906 Certification)
32.2 Certification of the Principal Financial Officer pursuant to 18 U.S.C.
Section 1350 (Section 906 Certification)
* Pursuant to Rule 24b-2 of the Exchange Act, confidential portions of this
exhibit have been deleted and filed separately with the Securities and
Exchange Commission pursuant to a request for confidential treatment.
30