UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 1999 or / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____ to ____ Commission File Number: 0-26832 Lumisys Incorporated (Exact name of registrant as specified in its charter) Delaware 77-0133232 (State of incorporation) (I.R.S. Employer Identification No.) 225 Humboldt Court, Sunnyvale, CA 94089 (Address of principal executive offices) (Zip Code) (408) 733-6565 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes / X / No / / Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. As of May 7, 1999, 9,509,894 shares of the registrant's Common Stock, $.001 par value, were outstanding. Lumisys Incorporated Index Page Part I. FINANCIAL INFORMATION Item 1. Financial Statements: Condensed Consolidated Balance Sheets at March 31, 1999 and December 31, 1998 3 		 Condensed Consolidated Statements of Income for the Three Months Ended March 31, 1999 and 1998 4 Condensed Consolidated Statements of Cash Flow for the Three Months Ended March 31, 1999 and 1998 5 Notes to Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 8 Item 3. Quantitative and Qualitative Disclosures About Market Risk 16 Part II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K 16 SIGNATURES 17 Part I - FINANCIAL INFORMATION Item 1. Financial Statements Lumisys Incorporated Condensed Consolidated Balance Sheets (Unaudited) (In thousands) March 31, December 31, 1999 1998 --------- ---------- 	 ASSETS Current assets: Cash and cash equivalents $ 13,598 $ 10,651 Short-term investments 3,001 7,007 Accounts receivable, net of allowances of $682 and $717 4,718 4,206 Inventories 4,599 4,046 Deferred tax assets 1,453 1,453 Other current assets 561 571 -------- ---------- Total current assets 27,930 27,934 Property and equipment, net 817 753 Purchased software, net 1,793 1,919 -------- ---------- $ 30,540 $ 30,606 ======== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 1,842 $ 1,601 Accrued expenses 2,307 2,791 Merger and related costs 881 900 -------- ---------- Total current liabilities 5,030 5,292 -------- ---------- Note payable to related party 151 146 Commitments and contingencies Stockholders' equity: Preferred stock, $0.001 par value; 5,000 shares authorized; no shares issued and outstanding --- --- Common stock, $0.001 par value; 25,000 shares authorized; 9,581 and 9,957 shares issued and outstanding, respectively 10 10 Additional paid-in capital 28,822 28,887 Accumulated deficit (3,473) (3,725) Deferred compensation --- (4) -------- ---------- Total stockholders' equity 25,359 25,168 -------- ---------- $ 30,540 $ 30,606 ======== ========== The accompanying notes are an integral part of these financial statements. Lumisys Incorporated Condensed Consolidated Statements of Operations (Unaudited) (n thousands, except per share amounts) Three Months Ended ------------------------- March 31, March 31, 1999 1998 ----------- ----------- Sales $ 6,730 $ 6,472 Cost of sales 3,521 2,884 ------- ------- Gross profit 3,209 3,588 ------- ------- Operating expenses: Sales and marketing 1,060 914 Research and development 917 1,600 General and administrative 964 950 ------- ------- Total operating expenses 2,941 3,464 ------- ------- Income from operations 268 124 Interest income 143 261 ------- ------- Income before income taxes 411 385 Provision for income taxes 159 148 ------- ------- Net income $ 252 $ 237 ======= ======= Net income per share Basic $ 0.03 $ 0.02 ======= ======= Diluted $ 0.03 $ 0.02 ======= ======= Weighted average shares used to compute net income per share: Basic 		 9,593 10,223 ======= ======= Diluted 9,683 10,402 ======= ======= The accompanying notes are an integral part of these financial statements. Lumisys Incorporated Condensed Consolidated Statements of Cash Flow (Unaudited) (In thousands) Three Months Ended ------------------------- March 31, March 31, 1999 1998 ----------- ----------- Cash flow from operating activities: Net income $ 252 $ 237 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 240 75 Other 5 5 Changes in assets and liabilities: Accounts receivable (512) 1,115 Inventories (553) (394) Other assets 10 (17) Accounts payable 241 (16) Accrued expenses (484) (530) Merger and related costs (19) (463) ------ ----- Net cash provided by (used in) operating activities (820) 12 ------ ----- Cash flows from investing activities: Sales (purchases) of short-term investments, net 4,006 (20) Purchases of property and equipment (174) (164) ------ ----- Net cash provided by (used in) investing activities 3,832 (184) ------ ----- Cash flows from financing activities:	 	Proceeds from sale of common stock 3 43 	Purchase of treasury stock (68) (1,456) ------ ----- Net cash used in financing activities (65) (1,413) ------ ----- Net increase (decrease) in cash and cash equivalents 2,947 (1,585) Cash and cash equivalents at beginning of period 10,651 7,522 ------ ----- Cash and cash equivalents at end of period $13,598 $ 5,937 ======= ======= The accompanying notes are an integral part of these financial statements. Lumisys Incorporated Notes to Condensed Consolidated Financial Statements Note 1 - Basis of Presentation The condensed consolidated financial statements of Lumisys Incorporated (the "Company") presented herein have been prepared pursuant to the rules of the Securities and Exchange Commission for quarterly reports on Form 10-Q and do not include all of the information and note disclosures required by generally accepted accounting principles. These statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 1998, included in the Company's Annual Report on Form 10-K as filed with the Securities and Exchange Commission. The condensed consolidated balance sheet as of March 31, 1999, and the condensed consolidated statements of income and of cash flow for the three months ended March 31, 1999 and 1998 are unaudited but, in the opinion of management, include all adjustments (consisting of normal, recurring adjustments) necessary for a fair presentation of the results for these interim periods. The results of operations for the three months ended March 31, 1999, are not necessarily indicative of the results to be expected for the entire fiscal year ending December 31, 1999 or any future period. Note 2 - Net Income Per Share Basic earnings per share is computed by dividing income available to common stockholders by the weighted-average common shares outstanding for the period. Diluted earnings per share reflects the weighted-average common shares outstanding plus the potential effect of dilutive securities which are convertible to common shares such as options, warrants, convertible debt and preferred stock. The following is a reconciliation between the components of the basic and diluted net income per share calculations for the periods presented below (in thousands): Three Months Ended March 31, 1999 1998 ------ ------ Net income $ 252 $ 237 ====== ====== Weighted average shares outstanding - basic 9,593 10,223 Effect of dilutive securities: Potential common stock Stock options and warrants 90 179 ------ ------ Weighted average shares outstanding - diluted 9,683 10,402 ====== ====== For the period ending March 31 1999 and 1998, respectively, 1,667,087 and 550,308 shares of potential common stock are considered anti-dilutive and are excluded from the calculation of dilutive net income per share. Note 3 - Comprehensive Income Comprehensive income is comprised of net income and other comprehensive earnings such as unrealized gains or losses on available-for-sale short-term investments. The Company's unrealized gains and losses on available-for-sale short-term investments have been insignificant for all periods presented. Note 4 - Composition of Certain Financial Statement Amounts March 31, December 31, 1999 1998 --------- ---------- (In thousands) Inventories: Raw materials $ 4,360 $ 3,649 Work-in-process 783 1,031 Finished goods 584 457 ------- ------- 5,727 5,137 Less: inventory reserves (1,128) (1,091) ------- ------- $ 4,599 $ 4,046 ======= ======= Accrued expenses: Payroll and related benefits $ 713 $ 1,066 Warranty 410 468 Professional fees 100 129 Unearned revenue 459 599 Income taxes 561 354 Other 64 175 ------- ------- $ 2,307 $ 2,791 ======= ======= Note 5- Segment Information The Company organizes its business into two reportable segments: the Lumisys Sunnyvale/Tucson ("Sunnyvale") division and the Imagraph division ("Imagraph"). Sunnyvale manufactures and markets an integrated suite of hardware and software products for digitizing medical images. Imagraph manufactures and markets a full line of precision frame-grabber boards and a software package for machine vision and scientific applications. The segments' accounting policies are the same as those described in the summary of significant accounting policies included in the notes to the financial statements for the year ended December 31, 1998, included in the Company's Annual Report on Form 10-K as filed with the Securities and Exchange Commission. The Company evaluates performance based on net income or loss before income taxes. Wholesale prices are used to report intersegment sales. Sunnyvale's total assets include the initial investment in Imagraph and amounts receivable from Imagraph, which are eliminated in consolidation. The Company's reportable business segments are strategic business units that offer different products. Each segment is managed separately because they require different technologies and market to distinct classes of customers. Elimination Sunnyvale Imagraph of intercompany Total Three months ended March 31, 1998: Sales $ 5,162 $ 1,310 $ --- $ 6,472 Income (loss) before taxes $ 544 $ (159)	 $ --- $ 385 Total assets at December 31, 1998 $30,716 $ 5,001 $(5,111) $30,606 Three months ended March 31, 1999: Sales $ 5,901 $ 842 $ (13) $ 6,730 Income (loss) before taxes $ 1,121 $ (710) $ --- $ 411 Total assets at March 31, 1999 $31,718 $ 4,992 $(6,170) $30,540 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Except for the historical information contained herein, the following discussion contains forward-looking statements within the meaning of section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. As such, they are subject to a number of uncertainties that could cause actual results to differ materially from the statements. The words "expect," "believe," "anticipate," "intend" and words of similar import are intended to identify these statements as forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this section, as well as those discussed in the Company's 1998 Annual Report on Form 10-K and other documents filed by the Company with the Securities and Exchange Commission. The Company does not undertake any obligation to update forward-looking statements. Overview Lumisys Incorporated ("Lumisys" or the "Company") designs, manufactures and markets computed radiography ("CR") systems that scan medical or industrial images from a reusable phosphor plate and a family of precision digitizers that convert medical images on film or video into digital format. Once in digital form, the medical images can be stored, transmitted, viewed, enhanced, manipulated and printed within a medical imaging network. The Company currently offers a comprehensive family of products for digitizing medical images under the Lumiscan label and video images under the Imascan label. These CR and film digitizers process images from all commercially available medical imaging modalities, including x-ray, computed tomography ("CT"), magnetic resonance imaging ("MRI"), ultrasound and nuclear medicine. The Company is the leading supplier of laser-based film digitizers, with sales of approximately 5,000 Lumiscan units since its first product was introduced in 1990. The Company also offers high quality board-level digitization and compression products for the capture of video images, which have applications in medical imaging as well as in scientific, industrial inspection and multimedia imaging. In December 1998, the Company introduced a CR system for use in the medical market, the ACR-2000 DeskTopCR. The medical CR system utilizes many of the design features of the CR system the Company developed for use in the industrial inspection market in 1996. The CR system reads medical or industrial images from reusable phosphor plates, replacing the need for film and film processing. The Company's CR system is a low cost, small system and is particularly suited for low volume environments. Since its introduction in December 1998, the Company has sold over 100 ACR-2000 DeskTopCR systems. Lumisys intends to maintain and enhance its market leadership by leveraging its reputation for high quality, reliable and cost-effective products, broadening its product lines through internal product development, acquiring complementary businesses or technologies and penetrating new geographic markets. The Company sells its products primarily to original equipment manufacturers ("OEMs") and value added resellers ("VARs"), who then integrate the Company's products into teleradiology and Picture Archiving and Communication Systems ("PACS") and mini-PACS networks. Lumisys has established close working relationships with leading suppliers of these systems including Access Radiology, Agfa, GE, Kodak and Philips. In November 1997, Lumisys merged with CompuRAD, a leading provider of software that enables healthcare clinicians to access medical images and clinical information at any point of care. CompuRAD pioneered the use of personal computer software in the point-to-point, on call teleradiology market, with the introduction of its PC Teleradiology product. As part of a restructuring of the software group, the Company no longer sells through a direct sales force. The Company currently sells its software products exclusively to its existing OEM and VAR customers. In 1998, the Company began bundling digitizer software with its family of laser and CCD film digitizers and CR software with its new ACR-2000 product Results of Operations Total sales for the first quarter of 1999 increased 4.0% to $6.7 million from $6.5 million for the first quarter of 1998. The increase was due to the first full quarter of sales of the ACR-2000 which was introduced in December 1998. Sales of the Company's digitizer products in the U.S. continued to decline, while international sales were consistent with the same quarter in the prior year. Sales by the Company's Imagraph division decreased by 36.1% from the prior year due to consolidation of distributors and changes in technology needs. Gross profit for the first quarter of 1999 decreased 10.6% to $3.2 million from $3.6 million for the corresponding period of 1998. Gross margin decreased to 47.7% in the first quarter of 1998 from 55.4% in the first quarter of 1998, primarily due to the transfer of the manufacturing engineering function from research and development to manufacturing overhead in late 1998, upon the completion of the ACR-2000. In addition, material costs increased due to the current product mix. If sales volume of the ACR- 2000 increases and as the sheet metal versions of the digitizer are phased out, the Company believes margins should improve. Sales and marketing expenses increased 16.0% in the first quarter of 1999 to $1.1 million from $914,000 in the first quarter of 1998. The increase was primarily due to the introduction of the ACR-2000 and the expansion of the international sales force. The Company expects its sales and marketing expenses to increase to further develop and support the CR distribution channel. As a percentage of sales, these expenses increased to 15.8% in the first quarter of 1999 from 14.1% in the first quarter of 1998. Research and development expenses decreased 42.7% in the first quarter of 1999 to $917,000 from $1.6 million in the same quarter of 1998, primarily due to restructuring following the acquisition of CompuRAD. In addition, the ACR-2000 project was completed in 1998 and transferred to manufacturing. As a percentage of sales, research and development expenses also decreased to 13.6% in the first quarter of 1999 from 24.7% in the same quarter of 1998. The Company expects its research and development expenditures to decrease as a percent of revenue since the initial CR and video film digitizer developments are near completion and follow on development efforts will be less comprehensive than the initial development projects. The development of a new product will require additional research and development resources and therefore the research and development expenses will increase if and when the next new product is identified. General and administrative expenses increased slightly by 1.5% in the first quarter of 1999 to $964,000 from $950,000 in the first quarter of 1998. Economies achieved by the restructuring following the acquisition of CompuRAD were offset by amortization expense related to the purchased software. As a percentage of sales, general and administrative expenses remained almost constant at 14.3% in the first quarter of 1999 compared to 14.7% in the first quarter of 1998. The Company recognized a provision for income taxes in the first quarter of 1999 of $159,000 compared with a provision of $148,000 in the corresponding period of 1998. The Company has provided a partial valuation allowance against the balance of the deferred tax assets remaining as of March 31, 1999. The Company expects to continue to be subject to an effective tax rate of approximately 39% for the remainder of 1999. Liquidity and Capital Resources At March 31, 1999, the Company's working capital was $22.9 million. The Company had cash, cash equivalents and short-term investments of approximately $16.6 million at March 31, 1999, compared with $17.7 million at December 31, 1998. The decrease is primarily due to $820,000 used in operating activities in the first quarter 1999, and to a lesser extent, $174,000 of expenditures for capital property and equipment, primarily related to the upgrades to the manufacturing facility for production of the ACR-2000. In addition, the Company repurchased 20,000 shares of the Company's common stock for a total of $68,000 under it's stock repurchase plan. The Company believes that its existing cash, cash equivalents, short-term investments and funds to be generated by operations will satisfy the Company's cash flow requirements through at least 1999. Thereafter, if cash generated from operations is insufficient to satisfy the Company's projected requirements, the Company may be required to sell additional equity or debt securities or obtain bank or other credit facilities. There can be no assurance that the Company will be able to sell such securities or obtain such credit facilities on acceptable terms in the future, if at all. The sale of additional equity or debt securities could result in additional dilution to the Company's stockholders. Impact of the Year 2000 The rapid approach of Year 2000 presents significant issues for many computer systems, since much of the software in use today may not accurately process data beyond 1999. The Company has recently implemented new information systems and accordingly does not anticipate any internal Year 2000 issue from its own information systems, databases or programs. However, the Company could be adversely impacted by Year 2000 issues faced by major distributors, suppliers, customers, vendors and financial service organizations with which the Company interacts. The Company is currently taking steps to address the impact, if any, of the Year 2000 issue on the operations of the Company. There can be no assurances that such a review will detect all potential failures of the Company's and/or third-party's computer systems. A significant failure of the Company's or a third-party's computer system could have a material adverse effect on the Company's business, financial condition and results of operations. Certain software products currently installed at customer sites will require upgrade or other remediation to become Year 2000 compliant. The Company believes that it is not legally responsible for costs incurred by its customers to achieve their Year 2000 compliance. However, the Company is taking steps to identify affected customers, raise customer awareness related to noncompliance of the Company's older products, and assist the customer base to assess their risks. The Company may see increasing customer satisfaction costs related to these actions over the next few years. The potential impact on the Company's business, financial condition and results of operations is not known at this time. Risk Factors Significant Fluctuations in Operating Results. There can be no assurance that the Company will be profitable on a quarterly or annual basis in the future. The Company has experienced quarterly fluctuations in operating results caused by various factors, including the timing of orders by major customers, customer inventory levels, mergers and acquisitions by the Company's customers, shifts in product mix, the incurrence of acquisition-related costs by the Company and general conditions in the healthcare industry which have reduced capital equipment budgets and delayed or reduced the adoption of teleradiology, Picture Archiving and Communications Systems ("PACS") and mini- PACS. The Company expects that these fluctuations will continue. The Company typically does not obtain long-term volume purchase contracts from its customers, and a substantial portion of the Company's backlog is scheduled for delivery within 90 days or less. Customers may cancel orders and change volume levels or delivery times without penalty. Quarterly sales and operating results therefore depend on the volume and timing of the backlog as well as bookings received during the quarter. A significant portion of the Company's operating expenses are fixed, and planned expenditures are based primarily on sales forecasts and product development programs. If sales do not meet the Company's expectations in any given period, the materially adverse impact on operating results may be magnified by the Company's inability to adjust operating expenses sufficiently or quickly enough to compensate for such a shortfall. Furthermore, the Company's gross margins may decrease in the future due to increasing sales of lower margin products and volume discounts. Results of operations in any period should not be considered indicative of the results to be expected for any future period. Fluctuations in operating results may also result in fluctuations in the price of the Company's Common Stock. New Product Development in Hardware and Software Products; Uncertainty of Market Acceptance. The Company's success is dependent on market acceptance of its new and existing products. There can be no assurance that sales of new products will achieve significant market acceptance in the future. The market for PACS and teleradiology software is uncertain. Current and future competitors are likely to introduce competing hardware and software, making it difficult to predict the rate at which the market will grow, if at all, or the rate at which new or increased competition will result in market saturation. If the market for such software and hardware fails to grow or grows more slowly than anticipated, the Company's business, financial condition and results of operations would be materially adversely affected. The Company expects that the sales cycle for PACS and teleradiology software and new computed radiography ("CR") hardware through the OEM and System Integrator sales channels will be longer than that for its other existing hardware products. Accordingly, the Company's quarterly revenues and operating results may be subject to greater fluctuation as the Company begins to market and sell PACS and teleradiology software and CR hardware through these new channels. Additionally, the Company has limited experience in marketing, installing and supporting its software and CR hardware through these sales channels, and there can be no assurance that the Company can obtain the necessary resources to market, install and support its PACS and teleradiology software and CR hardware in an efficient, cost-effective and competitive manner. The failure of PACS and teleradiology software to achieve market acceptance for any reason could have a material adverse effect on the Company's business, financial condition and results of operations. Significant Risks Associated with Acquisitions. The integration of any acquisitions will require special attention from management, which may temporarily distract its attention from the day-to-day business of the Company. Any acquisitions will also require integration of the companies' product offerings and coordination of research and development and sales and marketing activities. Furthermore, as a result of acquisitions, the Company may enter markets in which it has no or little direct prior experience. There can also be no assurance that the Company will be able to retain key technical personnel of an acquired company or recruit new management personnel for the acquired businesses, or that the Company will, or may in the future, realize any benefits as a result of such acquisitions. Acquisitions by the Company may result in potentially dilutive issuances of equity securities, the incurrence of debt, one-time acquisition charges and amortization expenses related to goodwill and intangible assets, each of which could be significant and could materially adversely affect the Company's financial condition and results of operations. In addition, the Company believes that it may be required to expand and enhance its financial and management controls, reporting systems and procedures as it integrates acquisitions. There can be no assurance that the Company will be able to do so effectively, and failure to do so when necessary would have a material adverse effect upon the Company's business and results of operations. New Product Development; Rapid Technological Change; Risk in Delays of Product Development. The market for the Company's products is characterized by rapid technological advances, changes in customer requirements and frequent new product introductions and enhancements. The Company's future success will depend upon its ability to enhance its current products, to develop and introduce new products that keep pace with technological developments and to respond to evolving customer requirements. Any failure by the Company to anticipate or respond adequately to technological developments by its competitors or to changes in customer requirements, or any significant delays in product development or introduction, could result in a loss of competitiveness or revenues. In the past, the Company has experienced delays in the development and introduction of new products and product enhancements, and there can be no assurance that the Company will not experience such delays in the future. In addition, new product introductions or enhancements by the Company's competitors or the use of other technologies that do not depend on film digitization, computed radiography or video frame grabbers could cause a decline in sales or loss of market acceptance of the Company's products. In particular, several companies have announced developments leveraging the technology used in flat panel displays to produce high-resolution, two dimensional image sensor arrays that make it possible for x-ray images to be captured digitally without film or chemical processing. While this emerging technology, known as digital radiography ("DR"), is expensive, there can be no assurance that future advances in this technology or other technologies will not produce systems better positioned for the marketplace that will therefore reduce the digitizer and CR market to the then installed base of imaging systems. There can be no assurance that the Company will be successful in developing and marketing new products or product enhancements on a timely or cost-effective basis, and such failure could have a material adverse effect on the Company's business and results of operations. Risks Associated With Software Products. Software and systems as complex as those offered by the Company frequently contain undetected errors or failures when first introduced or when new versions are released. The Company has in the past discovered bugs and system errors in certain of its software enhancements, both before and after initial shipment. There can be no assurance that, despite testing by the Company, errors will not occur in the Company's products resulting in loss of, or delay in, the Company's business, financial condition and results of operations. Peripherals and hardware from third party manufacturers also may contain defects and incompatibilities which could adversely affect market acceptance of the Company's software products. Long Sales Cycles. The OEM and System Integrator sales cycle for the Company's products is lengthy. The sales cycle of the Company's products is subject to delays associated with changes or the anticipation of changes in the regulatory environment affecting healthcare enterprises, changes in the customer's strategic system initiatives, competing information systems projects within the customer organization such as, but not limited to, the year 2000 compliance issues, consolidation in the healthcare industry in general, the highly sophisticated nature of the Company's software and competition in the PACS and teleradiology markets in general. The time required from initial contact to purchase order typically ranges from one to six months, and the time from purchase order to delivery and recognition of revenue typically ranges from one to six months. During the sales process, the Company expends substantial time, effort and funds preparing a contract proposal, demonstrating the software and negotiating the purchase order. For these and other reasons, the Company cannot predict when or if the sales process with a prospective customer will result in a purchase order. Competition. Competition in the CR market is well established and includes Fuji, Agfa and Kodak. Furthermore, other healthcare and non-healthcare equipment companies not presently offering competing products may enter the CR market. Increased competition could result in price reduction, reduced gross margins and loss of market share, any of which could materially adversely effect the Company's business, financial condition and results of operations. In addition, many of the Company's competitors and potential competitors have significantly greater financial, technical, product development, marketing and other resources and market recognition than the Company in the CR area. Many of the Company's competitors also currently have, or may develop or acquire, substantial installed customer bases in the healthcare industry. As a result of these factors, the Company's competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements or to devote greater resources to the development, promotion and sale of their products than the Company. There can be no assurances that the Company will be able to compete successfully against current and future competitors or that competitive pressures faced by the Company will not have a materially adverse effect on its business, financial condition or results of operations. Competition in the United States laser-based film digitizer market has not been significant. In 1996, CLS entered the market with a product similar to the laser-based film digitizers offered by Lumisys and in 1998, General Scanning introduced a laser-based film digitizer. To date, the Company is unaware of any sales made by CLS or General Scanning. In addition, several Japanese competitors such as Konica, Nishimoto Sangyo and Abe Sekkei offer competitive products on an international basis and may decide in the future to devote additional resources to marketing competitive products in the United States. The markets for medical film digitizers incorporating CCD's are highly competitive. Lumisys faces competition from companies such as Vidar Systems Inc., Canon Inc., Hell Linotype and Howtek in the CCD-based film digitizer market. There can be no assurance that Lumisys' competitors will not develop enhancements to, or future generations of, competitive products that will offer superior price or performance features that render Lumisys' products less competitive or obsolete. In addition, large companies, such as Kodak, Sterling, Fuji, GE, Siemens, Philips and Agfa, have the technical and financial ability to design and market CR and digitizer products competitive with Lumisys' products, and some of them have in the past produced and marketed such products. While many of these companies currently purchase products from Lumisys, Lumisys believes that it will be required to continue to improve the price and performance characteristics of its products to retain their business especially in view of the fact that these customers are not contractually required to purchase their CR and digitizers exclusively or at all from Lumisys. All of these companies have significantly greater financial, marketing and manufacturing resources than Lumisys and would be significant competitors if they decided to enter this market. The markets for medical video image digitizers are also highly competitive. Competitors in the video digitizer market are Precision Digital Images Corp., Epix, Inc. and Matrox Electronic Systems Ltd. Competition in the markets for PACS and teleradiology software products and services is intense and is expected to increase. The Company's software products support the Company's CR and film digitizers and do not generate significant income as stand-alone products. By bundling software with the CR and film digitizers the Company allows its OEM and VAR customers to utilize either the Company's software or at their discretion, their own or competing software. The principal providers of software in the PACS and teleradiology market are ISG, Applicare Medical Imaging B.V., Mitra Imaging Inc., and Access Radiology Corporation. The success of the Company's software does not have a direct impact on the Company's financial condition or results of operations but rather adds additional value to the Company's CR and digitizer products. There can be no assurances that the Company will be able to compete successfully against current and future competitors or that competitive pressures faced by the Company will not have a materially adverse effect on its business, financial condition or results of operations. Competition in the machine vision and scientific markets for frame grabbers and software is well established and includes Matrox, Imaging Technologies and Integral Technologies. Many of the Company's competitors and potential competitors have significantly greater financial, technical, product development, marketing and other resources and market recognition than the Company in the machine vision and scientific imaging areas. Many of the Company's competitors also currently have, or may develop or acquire, substantial installed customer bases in the healthcare industry. As a result of these factors, the Company's competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements or to devote greater resources to the development, promotion and sale of their products than the Company. There can be no assurances that the Company will be able to compete successfully against current and future competitors or that competitive pressures faced by the Company will not have a materially adverse effect on its business, financial condition or results of operations. Proprietary Rights. The Company relies on a combination of trade secrets, copyright and trademark laws, nondisclosure and other contractual provisions to protect its proprietary rights. The Company currently has no blocking patents covering its technology and it has not registered any of its trademarks. There can be no assurance that measures taken by the Company to protect its intellectual property will be adequate or that the Company's competitors will not independently develop systems and services that are substantially equivalent or superior to those of the Company. Substantial litigation regarding intellectual property rights exists in the industry, and the Company expects that its products may be increasingly subject to third- party infringement claims as the number of competitors in the Company's industry segment grows and the functionality of systems overlap. Although the Company believes that its systems and applications do not infringe upon the proprietary rights of third-parties, there can be no assurance that third- parties will not assert infringement claims against the Company in the future, that the Company would prevail in any such dispute or that a license or similar agreement will be available on reasonable terms in the event of an unfavorable ruling on any such claim. In addition, any such claim may require the Company to incur substantial litigation expenses or subject the Company to significant liabilities and could have a material adverse effect on the Company's business, financial condition and results of operations. Customer Concentration; Reliance on OEMs. For the first quarter of 1999, two customers represented 14% and 10%, respectively, of the Company's total sales. Large customers also accounted for a significant portion of the Company's backlog at March 31, 1999. The Company expects to continue to depend upon its principal customers for a significant portion of its sales, although there can be no assurance that the Company's principal customers will continue to purchase products and services from the Company at current levels, if at all. The loss of one or more major customers or a change in their buying patterns could have a material adverse effect on the Company's business and results of operations. Single-Source Suppliers. The Company purchases industry-standard parts and components for the assembly of its products, generally from multiple vendors. Although the Company relies on single-source suppliers for certain components, such as lasers, photomultiplier tubes and certain electronic components primarily to control price and quality, the Company believes that alternate sources of supply are available from other vendors for such components and has qualified second source suppliers for some, but not all, single-sourced parts. The Company maintains good relationships with its vendors and, to date, has not experienced any material supply problems. While the Company seeks to maintain an adequate inventory of single-sourced components, there can be no assurance that such inventories will be sufficient or that delays in part or component deliveries will not occur in the future, which could result in delays or reductions in product shipments. Furthermore, even if currently single-sourced components could be replaced by other qualified parts, product redesign and testing could be costly and time consuming. These factors could have a material adverse effect on the Company's business, financial condition and results of operations. Government Regulation. The manufacturing and marketing of the Company's digitizer, CR product, video board, and software products are subject to extensive government regulation in the United States and in other countries, and the process of obtaining and maintaining required regulatory approvals is lengthy, expensive and uncertain. If a medical device manufacturer can establish that a newly developed device is "substantially equivalent" to a device that was legally marketed prior to May 1976, the date on which the Medical Device Amendments of 1976 were enacted, or to a device the FDA found to be substantially equivalent to a legally marketed pre-1976 device, the manufacturer may seek marketing clearance from the FDA to market the device by filing a 510(k) premarket notification. The 510(k) premarket notification must be supported by appropriate data establishing the claim of substantial equivalence to the satisfaction of the FDA. Receipt of 510(k) clearance normally takes at least three months, but may take much longer and may require the submission of clinical safety and efficacy data to the FDA. All of the Company's laser-based film digitizers, the CCD-based film digitizer, CR product and software products that are commercially available have received 510(k) clearance. There can be no assurance that 510(k) clearance for any future product or any modification of an existing product will be granted, or that the process will not be unduly lengthy. In the future, the FDA may require manufacturers of certain medical devices to engage in a more thorough and time consuming approval process than the 510(k) process, which could have a material adverse effect on the Company's business and results of operations. The Company is also required to register as a Class II medical device manufacturer with the FDA and state agencies, such as the California Department of Health Services ("CDHS"). As such, the Company may be inspected on a routine basis by both the FDA and the CDHS for compliance with the FDA's Good Manufacturing Practices ("GMP"), Quality Standard Regulations ("QSR") and other applicable regulations. These regulations require that the Company manufacture its products and maintain its documents in a prescribed manner with respect to manufacturing, reporting of product malfunctions and other matters. If the FDA believes that a company is not in compliance with federal regulatory requirements, it can institute proceedings to detain or seize products, issue a recall, prohibit marketing and sales of the company's products and assess civil and criminal penalties against the company, its officers or its employees. Failure to comply with the regulatory requirements could have a material adverse effect on the Company's business and results of operations. The Sunnyvale facility of the Company was inspected by the CDHS and the FDA in 1996 and was found to be compliant with both the CDHS's and FDA's GMP regulations. In the second quarter of 1998 the Tucson facility of the Company was inspected by the FDA and was found to have some items not in compliance with the FDA's GMP regulations. The Company took corrective action on the FDA's observations and was re-inspected at the Tucson facility in the first quarter of 1999 and found to be in compliance with the FDA's GMP regulations. Sales of the Company's products outside the United States are subject to foreign regulatory requirements that vary from country to country. Additional approvals from foreign regulatory authorities may be required, and there can be no assurance that the Company will be able to obtain foreign approvals on a timely basis or at all, or that it will not be required to incur significant costs in obtaining or maintaining its foreign regulatory approvals. Starting in mid 1998, the Company has been required to obtain certifications necessary to enable the "CE" mark to be affixed to the Company's products to continue commercial sales in member countries of the European Union. The CE mark is an international symbol of quality and complies with applicable European information device equipment directives. The Company has obtained this CE certification. Failure to comply with foreign regulatory requirements could have a material adverse effect on the Company's business, financial condition and results of operations. Litigation. On July 9, 1997 and July 10, 1997 two securities class action lawsuits were filed in the Superior Court of the State of California, County of Santa Clara, and the United States District Court for the Northern District of California against the Company, several of its current and former officers and directors, and its underwriters. The complaints are brought on behalf of all persons who purchased the Company's common stock between November 15, 1995 and July 11, 1996. The complaints allege that defendants made material false statements and omitted to disclose material information concerning the Company's actual and expected performance, causing the price of the Company's stock to be artificially inflated. The federal complaint alleges claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934; the state complaint alleges claims under California's securities statutes. Neither complaint specifies the amount of damages sought. The Company and the other defendants deny all allegations of wrongdoing. On January 9, 1998, the court dismissed the state court complaint with leave to amend. On March 31, 1998, the court dismissed the federal complaint with leave to amend. On May 26, 1998, the state court dismissed plaintiff's first amended complaint with leave to amend. Plaintiffs have filed a first amended complaint in the federal action, and a second amended complaint in the state action. Defendants have filed motions to dismiss both of these complaints. There can be no assurance that the Company will prevail in this action or that the plaintiffs will not recover damages. Third-Party Reimbursement. Third-party payers, such as governmental programs and private insurance plans, can indirectly affect the pricing or the relative attractiveness of the Company's products by regulating the maximum amount of reimbursement that they will provide for the taking, storing and interpretation of medical images. In recent years, healthcare costs have risen substantially, and third-party payers have come under increasing pressure to reduce such costs. In this regard, extensive studies undertaken by the Clinton Administration, even though not successfully translated into regulatory action, have stimulated widespread analysis and reaction in the private sector focused on healthcare cost reductions, which may involve reductions in reimbursement rates in radiology. A decrease in the reimbursement amounts for radiological procedures may decrease the amount which physicians, clinics and hospitals are able to charge patients for such services. As a result, adoption of teleradiology, PACS and mini-PACS may slow as capital investment budgets Are reduced, and the demand for the Company's products could be significantly reduced. Product Liability and Insurance. The manufacture and sale of medical products entails significant risk of product liability claims. While the Company believes that its current insurance coverage is appropriate, there can be no assurance that such coverage is adequate to protect the Company from any liabilities it might incur in connection with the sale of the Company's products. In addition, the Company may require increased product liability coverage as additional products are commercialized. Such insurance is expensive and in the future may not be available on acceptable terms, if at all. A successful product liability claim or series of claims brought against the Company in excess of its insurance coverage could have a material adverse effect on the Company's business and results of operations. Volatility of Stock Prices. The market price of the Company's Common Stock has been and may continue to be volatile. This volatility may result from a number of factors, including fluctuations in the Company's quarterly revenues and net income, announcements of technical innovations or new commercial products by the Company or its competitors, and conditions in the market for medical image digitizers and the teleradiology and health care industry and for PACS and teleradiology products and healthcare information systems and services. Also, the stock market has experienced and continues to experience extreme price and volume fluctuations which have affected the market prices of securities, particularly those of medical technology companies, and which often have been unrelated to the operating performance of the companies. These broad market fluctuations, as well as general economic and political conditions, may adversely affect the market price of the Company's Common Stock in future periods. Impact of the Year 2000 The rapid approach of Year 2000 presents significant issues for many computer systems, since much of the software in use today may not accurately process data beyond 1999. The Company has recently implemented new information systems and accordingly does not anticipate any internal Year 2000 issue from its own information systems, databases or programs. However, the Company could be adversely impacted by Year 2000 issues faced by major distributors, suppliers, customers, vendors and financial service organizations with which the Company interacts. The Company is currently taking steps to address the impact, if any, of the Year 2000 issue on the operations of the Company. There can be no assurances that such a review will detect all potential failures of the Company's and/or third-party's computer systems. A significant failure of the Company's or a third-party's computer system could have a material adverse effect on the Company's business, financial condition and results of operations. Certain software products currently installed at customer sites will require upgrade or other remediation to become Year 2000 compliant. The Company believes that it is not legally responsible for costs incurred by its customers to achieve their Year 2000 compliance. However, the Company is taking steps to identify affected customers, raise customer awareness related to noncompliance of the Company's older products, and assist the customer base to assess their risks. The Company may see increasing customer satisfaction costs related to these actions over the next few years. The potential impact on the Company's business, financial condition and results of operations is not known at this time. Item 3. Quantitative and Qualitative Disclosures About Market Risk Lumisys has an investment portfolio of fixed income securities that are classified as "available-for-sale securities." These securities, like all fixed income instruments, are subject to interest rate risk and will fall in value if market interest rates increase. Lumisys attempts to limit this exposure by investing primarily in short-term securities. From time to time, Lumisys makes certain capital equipment or other purchases denominated in foreign currencies. As a result, Lumisys' cash flows and earnings are exposed to fluctuations in interest rates and foreign currency exchange rates. Lumisys attempts to limit these exposures through operational strategies and generally has not hedged currency exposures. Part 2 - OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K Exhibits furnished: 	 Exhibit Number Description of Document - ----------- -------------------------------- Financial Data Schedule (b). Reports on Form 8-K: The Company filed no Current Reports on Form 8-K in the three months ended March 31, 1999. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized in Sunnyvale, California, on May 14, 1999: LUMISYS INCORPORATED Dated: May 13, 1999 By: /s/ Phillip Berman ---------------------- Phillip Berman, M.D. Chief Executive Officer 	 /s/ Dean MacIntosh ---------------------- Dean MacIntosh Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) 18