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 September 30, 2003 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 1-9341 ICAD, INC. ------------------------------------------------------ (Exact name of registrant as specified in its charter) Delaware 02-0377419 - --------------------------------- ------------------------------------ (State or other jurisdiction (I.R.S. Employer Identification No.) of incorporation or organization) 4 Townsend West, Suite 17, Nashua, NH 03063 - --------------------------------------- --------- (Address of principal executive offices) (Zip Code) (603) 882-5200 ---------------------------------------------------- (Registrant's telephone number, including area code) 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 requirement for the past 90 days. YES |X| NO|_|. Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act) YES |_| NO |X|. As of the close of business on November 10, 2003 there were 27,415,773 shares outstanding of the issuer's Common Stock, $.01 par value. 2 ICAD, INC. INDEX PAGE PART I FINANCIAL INFORMATION Item 1 Financial Statements Consolidated Balance Sheets as of September 30, 2003 (unaudited) and December 31, 2002 4 Consolidated Statements of Operations for the three and nine month periods ended September 30, 2003 and 2002 (unaudited) 5 Consolidated Statements of Cash Flows for the nine month periods ended September 30, 2003 and 2002 (unaudited) 6 Notes to Consolidated Financial Statements (unaudited) 7-10 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 11-16 Item 3 Quantitative and Qualitative Disclosures about Market Risk 16 Item 4 Controls and Procedures 16 PART II OTHER INFORMATION Item 1 Legal Proceedings 17 Item 2 Changes in Securities and Use of Proceeds 17-18 Item 4 Submission of Matters to a Vote of Security Holders 18 Item 6 Exhibits and Reports on Form 8-K 18 Signatures 19 3 ICAD, INC. Consolidated Balance Sheets September 30, 2003 December 31, 2002 -------------------- -------------------- Assets (unaudited) (audited) Current assets: Cash and equivalents $ 587,879 $ 1,091,029 Trade accounts receivable, net of allowance for doubtful accounts of $89,385 in 2003 and $40,000 in 2002 1,027,266 1,550,167 Inventory 531,402 390,349 Prepaid and other 177,713 85,120 ------------ ------------ Total current assets 2,324,260 3,116,665 ------------ ------------ Property and equipment: Equipment 953,722 840,410 Leasehold improvements 21,250 8,051 Furniture and fixtures 35,569 22,271 ------------ ------------ 1,010,541 870,732 Less accumulated depreciation and amortization 666,583 579,545 ------------ ------------ Net property and equipment 343,958 291,187 ------------ ------------ Other assets: Patents 94,643 -- Technology intangible 3,387,125 3,740,553 Distribution agreement -- 1,513,228 Goodwill 17,415,723 17,415,723 ------------ ------------ Total other assets 20,897,491 22,669,504 ------------ ------------ Total assets $ 23,565,709 $ 26,077,356 ============ ============ Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 1,765,368 $ 2,232,262 Accrued interest 262,834 229,078 Accrued expenses 1,309,821 1,776,824 Convertible subordinated debentures 10,000 10,000 Current maturities of notes payable 69,048 65,526 ------------ ------------ Total current liabilities 3,417,071 4,313,690 Loans payable to related party 2,930,000 200,000 Notes payable, less current maturities 56,155 108,390 ------------ ------------ Total liabilities 6,403,226 4,622,080 ------------ ------------ Stockholders' equity: Convertible preferred stock, $.01 par value: authorized 1,000,000 shares; issued and outstanding 8,550 in 2003 and 2002, with the aggregated liquidation value of $2,115,000 in 2002 and 2003, plus 7% annual dividend 86 86 Common stock, $ .01 par value: authorized 50,000,000 shares; issued 27,397,899 in 2003 and 26,418,124 shares in 2002; outstanding 27,330,023 in 2003 and 26,350,248 shares in 2002 273,978 264,181 Additional paid-in capital 88,130,846 85,829,483 Accumulated deficit (70,292,163) (63,688,210) Treasury stock, at cost (67,876 shares) (950,264) (950,264) ------------ ------------ Total stockholders' equity 17,162,483 21,455,276 ------------ ------------ Total liabilities and stockholders' equity $ 23,565,709 $ 26,077,356 ============ ============ See accompanying notes to consolidated financial statements. 4 ICAD, INC. Consolidated Statements of Operations (unaudited) Three Months Nine Months September 30, September 30, ----------------------------- ----------------------------- 2003 2002 2003 2002 ------------ ------------ ------------ ------------ Sales $ 1,387,100 $ 1,286,966 $ 4,938,629 $ 2,839,199 Cost of Sales 731,607 559,079 2,233,775 4,596,838 ------------ ------------ ------------ ------------ Gross Margin 655,493 727,887 2,704,854 (1,757,639) ------------ ------------ ------------ ------------ Operating expenses: Engineering and product development 619,762 478,720 1,813,560 1,005,615 General and administrative 4,870,119 1,698,084 6,370,414 5,982,671 Marketing and sales 530,485 181,739 1,077,189 736,134 ------------ ------------ ------------ ------------ Total operating expenses 6,020,366 2,358,543 9,261,163 7,724,420 ------------ ------------ ------------ ------------ Loss from operations (5,364,873) (1,630,656) (6,556,309) (9,482,059) Interest expense - net 30,494 10,009 47,644 39,238 ------------ ------------ ------------ ------------ Net loss $ (5,395,367) $ (1,640,665) $ (6,603,953) $ (9,521,297) Preferred dividend 37,316 37,316 110,733 110,732 ------------ ------------ ------------ ------------ Net loss available to common shareholders $ (5,432,683) $ (1,677,981) $ (6,714,686) $ (9,632,029) ============ ============ ============ ============ Net loss per share Basic and diluted $ (0.20) $ (0.06) $ (0.25) $ (0.50) Weighted average number of shares used in computing loss per share Basic and diluted 26,858,963 26,141,091 26,531,177 19,134,031 See accompanying notes to consolidated financial statements. 5 ICAD, INC. Consolidated Statements of Cash Flows (unaudited) Nine Months Nine Months September 30, 2003 September 30, 2002 ------------------ ------------------ Cash flows from operating activities: Net loss $(6,603,953) $ (9,521,297) ----------- ------------ Adjustments to reconcile net loss to net cash used for operating activities: Depreciation 87,038 108,934 Amortization 428,385 155,455 Loss on disposal of assets 1,443,628 476,850 Compensation expense relative to issue of stock at merger -- 2,800,000 Legal expense relative to issue of stock 23,377 -- Issuance of common stock for payment of legal settlement 750,000 -- Changes in operating assets and liabilities, net of effects from acquisition of ISSI: Accounts receivable 522,901 593,323 Inventory (141,053) 2,298,772 Prepaid and other (92,593) (16,342) Accounts payable 933,106 200,776 Accrued expenses (543,980) 987,314 ----------- ------------ Total adjustments 3,410,809 7,605,082 ----------- ------------ Net cash used for operating activities (3,193,144) (1,916,215) ----------- ------------ Cash flows from investing activities: Additions to patents, software development and other (100,000) -- Additions to property and equipment (139,809) (76,146) Acquisition of ISSI, net of cash acquired -- 2,202,040 ----------- ------------ Net cash provided by (used for) investing activities (239,809) 2,125,894 ----------- ------------ Cash flows from financing activities: Issuance of common stock for cash 248,516 118,158 Proceeds from investor -- 500,000 Proceeds of convertible note payable to principal stockholders 2,730,000 750,000 Payment of demand note payable to principal stockholders -- (500,000) Payments of note payable (48,713) (45,430) ----------- ------------ Net cash provided by financing activities 2,929,803 822,728 ----------- ------------ Increase (decrease) in cash and equivalents (503,150) 1,032,407 Cash and equivalents, beginning of period 1,091,029 495,360 ----------- ------------ Cash and equivalents, end of period $ 587,879 $ 1,527,767 =========== ============ Supplemental disclosure of non-cash items from investing and financing activities: Conversion of loan to related party into Common Stock $ -- $ 500,000 =========== ============ Issuance of common stock for settlement of liability $ 1,400,000 $ -- =========== ============ Accrued dividends on convertible preferred stock $ 110,733 $ 110,732 =========== ============ Fair market value of iCAD common stock and common stock options issued to acquire capital stock of ISSI $ -- $ 27,673,500 =========== ============ Net tangible assets of ISSI acquired, excluding cash acquired of $2,202,040 $ -- $ 406,433 =========== ============ Fair market value of indentifiable intangible assets acquired from ISSI $ -- $ 5,437,000 =========== ============ See accompanying notes to consolidated financial statements. 6 ICAD, INC. Notes to Consolidated Financial Statements (Unaudited) September 30, 2003 (1) Accounting Policies In the opinion of management all adjustments and accruals (consisting only of normal recurring adjustments), which are necessary for a fair presentation of operating results are reflected in the accompanying consolidated financial statements. Reference should be made to iCAD, Inc.'s ("iCAD" or "Company") Annual Report on Form 10-K for the year ended December 31, 2002 for a summary of significant accounting policies. Interim period amounts are not necessarily indicative of the results of operations for the full fiscal year. (2) Loan Payable to Related Party The Company has a Revolving Loan and Security Agreement (the "Loan Agreement") with Mr. Robert Howard, Chairman of the Board of Directors of the Company, under which Mr. Howard has agreed to advance funds, or to provide guarantees of advances made by third parties in an amount up to $4,000,000. Outstanding advances are collateralized by substantially all of the assets of the Company and bear interest at prime interest rate plus 2% with a minimum of 8%. Mr. Howard is entitled to convert outstanding advances made by him under the Loan Agreement into shares of the Company's common stock at any time based on the closing market price of the Company's common stock at the lesser of the market price at the time each advance is made or at the time of conversion. During the third quarter of 2003 the Company borrowed $2,100,000 pursuant to the Loan Agreement. At September 30, 2003, $2,930,000 was outstanding under the Loan Agreement and $1,070,000 was available for future borrowings. (3) Litigation The Company has been dismissed from a complaint filed against the Company in the United States District Court for the Eastern District of Texas, entitled The Massachusetts Institute of Technology and Electronics for Imaging, Inc. v. Abacus Software Inc. et al., Case No. 501CV344. The plaintiff claimed initially that the Company had infringed a United States patent alleged to cover color reproduction system technology through sale of certain Company products to customers in the graphic arts/prepress and photographic markets. The Company has no liability in this matter, and anticipates no further legal expenses will be incurred with respect to this litigation. As a result, general and administrative expenses incurred during the first quarter of 2003 were reduced by the reversal of the accrued settlement cost in the amount of $383,000. 7 ICAD, INC. Notes to Consolidated Financial Statements (Unaudited) September 30, 2003 (3) Litigation (continued) On June 3, 2002, Intelligent Systems Software, Inc. ("ISSI") was sued in United States District Court for the District of Delaware by R2 Technology, Inc. ("R2") and Shih-Ping Wang. The lawsuit alleged that ISSI's MammoReader device infringed certain patents owned by plaintiff. The complaint requested treble damages, but did not specify the amount of damages sought. The complaint also sought to enjoin ISSI from further infringement. On July 11, 2002, subsequent to the acquisition of ISSI by the Company, the plaintiffs amended their complaint to add the Company and its subsidiary ISSI Acquisition Corp. as additional parties. In July 2003, the Company filed suit in the United States District Court for the District of New Hampshire against R2 for infringement of certain patents licensed by Company. The complaint requested treble damages, costs and legal fees, but did not specify the amount of damages sought. On September 8, 2003, the Company announced the settlement of all patent infringement litigation with R2. Under the terms of the settlement, both actions were dismissed with prejudice and iCAD was granted a non-exclusive license to the patents named in the suit filed by R2. In connection with the settlement of the suit, iCAD agreed to pay R2 an aggregate of $1,250,000, of which $1,000,000 was paid in September 2003, with $250,000 deferred and payable in equal installments on a quarterly basis through December, 2005. In addition, iCAD issued to R2 shares of iCAD Common Stock valued at $750,000 and has filed a registration statement intended to cover the resale of shares by R2. iCAD also agreed to certain continuing royalties, which are based on the category and configuration of products sold by iCAD. Further, iCAD granted R2 a partial credit against potential future purchases by R2 of iCAD digitizers worth up to $2,500,000 over five years to encourage R2 to purchase film digitizers manufactured by iCAD. This partial credit was meant to provide a significant purchasing advantage to R2, while maintaining a reasonable profit margin and creating additional economies of scale for iCAD. Subsequently, R2 agreed to accept an additional 75,000 share of iCAD Common Stock in satisfaction of any royalties it otherwise would have been entitled to receive under the settlement agreement. (4) Exclusive Distribution Agreement In the third quarter of 2003, the Company elected to take a one-time write-off of the remaining asset of $1,443,628 attributable to its distribution agreement with Instrumentarium Imaging, Inc. ("Instrumentarium"). This write-off came after assessing the performance of Instrumentarium under the distribution agreement, and in light of the Company's implementation of alternative distribution channels. While Instrumentatium continues to offer the iCAD product line through the fourth quarter of 2003 on a non-exclusive basis, newly established distribution channels are expected by the Company to account for all of the Company's CAD product revenue in the future. 8 ICAD, INC. Notes to Consolidated Financial Statements (Unaudited) September 30, 2003 (5) Stock-Based Compensation The Company accounts for its stock based compensation plans in accordance with the provisions of APB Opinion 25, "Accounting for Stock Issued to Employees," and complies with the disclosure provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," and SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure". Under APB Opinion 25, when the exercise price of the Company's employee stock options equals the market price of the exercise price of the underlying stock on the date of grant, no compensation cost is recognized. The Company estimates the fair value of each granting of options at the grant date using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2003: no dividends paid; expected volatility of 79.4%; risk-free interest rate of 2.91%, 2.34% and 2.63% and expected live of 5 years. The weighted-average assumptions used for grants in 2002 were: no dividends paid; expected volatility of 79%; risk-free interest rate of 2.01%, 4.86% and 3.37% and expected live of 1 to 9 years. Had compensation cost for the Company's option plans been determined using the fair value method at the grant dates, the effect on the Company's net loss and loss per share for the three and nine month periods ended September 30, 2003 and 2002 would have been as follows: Three Months Nine Months September 30, September 30, --------------------------- ---------------------------- 2003 2002 2003 2002 Net loss available to common stockholders as reported $(5,432,683) $(1,677,981) $(6,714,686) $ (9,632,029) Deduct: Total stock-based employee compensation determined under fair value method for all awards, net of related tax effects (34,084) (455,916) (196,487) (1,355,089) ----------- ----------- ----------- ------------ Pro forma net loss available to common stockholders $(5,466,767) $(2,133,897) $(6,911,173) $(10,987,118) =========== =========== =========== ============ Basic and diluted loss per share As reported $ (.20) $ (.06) $ (.25) $ (.50) Pro forma $ (.20) $ (.08) $ (.26) $ (.57) 9 ICAD, INC. Notes to Consolidated Financial Statements (Unaudited) September 30, 2003 (6) New Accounting Pronouncements In May 2003, the FASB issued SFAS 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. The changes in this Statement improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. This Statement is effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS 149 did not have a material affect on the Company's financial position, results of operations, or cash flows. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances), because that instrument represents an obligation. Many of those instruments were previously classified as equity. The statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have a material affect on the Company's financial position, results of operations, or cash flows. 10 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations "Safe Harbor" Statement under the Private Securities Litigation Reform Act of 1995: Certain information included in this Item 2 and elsewhere in this Form 10-Q that are not historical facts contain forward looking statements that involve a number of known and unknown risks, uncertainties and other factors that could cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievement expressed or implied by such forward looking statements. These risks and uncertainties include, but are not limited to, uncertainty of future sales levels, protection of patents and other proprietary rights, the impact of supply and manufacturing constraints or difficulties, product market acceptance, possible technological obsolescence of products, increased competition, litigation and/or government regulation, changes in Medicare reimbursement policies, competitive factors, the effects of a decline in the economy in markets served by the Company and other risks detailed in the Company's other filings with the Securities and Exchange Commission. The words "believe", "demonstrate", "intend", "expect", "estimate", "anticipate", "likely", "seek", "should" and similar expressions identify forward-looking statements. Readers are cautioned not to place undue reliance on those forward-looking statements, which speak only as of the date the statement was made. Results of Operations Overview On June 28, 2002, the Company completed the acquisition of ISSI pursuant to a previously reported plan and agreement of merger. The Company acquired all of the issued and outstanding capital stock of ISSI, a privately held company based in Boca Raton, Florida. Consistent with the Company's intention to concentrate its efforts after the merger in the imaging and scanning business on higher margin medical and Computer Aided Detection (CAD) applications, the Company has discontinued sales of its graphic arts and photographic product lines. Early detection of breast cancer saves lives. The Company designs, develops, manufactures and markets CAD imaging technology for mammography applications. Computer aided detection from iCAD, can detect 23% of breast cancers, an average of 14 months earlier than screening mammography alone. iCAD offers the fastest CAD system available, the only system to look for asymmetries, and the most effective system available to detect breast masses. In May 2003 the Company's MammoReader(TM) was designated the top-rated CAD system for early breast cancer detection by MD Buyline, an independent evaluator of medical capital equipment. The Company's MammoReader product retained a top rating in MD Buyline's November 2003 report. Management believes that the iCAD system is the only CAD system designed on a relational database platform, which can improve productivity and reduce operating and capital costs at women's health centers by offering computer-assisted detection as an integrated or integration-ready part of current or anticipated informatics systems, digital imaging resources, and workflows. The Company recently received clearance from the U.S. Food and Drug Administration to sell and market it's new iCAD iQ(TM) CAD system, designed specifically for clinics that perform less than 20 mammography procedures per day. Shipment of the iQ system is scheduled to begin during the 11 fourth quarter of 2003. The Company believes that the iCAD iQ is a category-defining CAD system, in the sense that it is the first product on the market that will allow lower-volume clinics to provide CAD services to women on a cost-effect basis. The iQ has been designed to fit within the limited space requirement of smaller mammography clinics, and will be priced about 30% below currently available CAD systems. Furthermore, the iQ may be made available to mammography facilities that cannot afford the outright purchase of a CAD system, through a simple 'fee-per-procedure' program that the Company recently announced and branded ClickCAD(TM). Under the ClickCAD program, the Company plans and expects to install iCAD iQ(TM) systems in qualified mammography clinics at little or no up-front capital cost. The clinics will then pay iCAD a fee approximating $6.50 for each CAD procedure performed, an amount that represents less than 35% of the current standard $19.13 Federal reimbursement rate for CAD procedures. The Company believes that this program will allow mammography clinics to improve the health care delivered to women at risk, strengthen their marketing position in attracting and keeping patients concerned about breast cancer, reduce the legal risks associated with failure to detect early-stage cancers, and increase their net revenues. While the Company believes the impact of iCAD iQ systems that it expects to ship during 2003 upon 2003 sales will be minimal, it believes that the new product line should contribute to its sales and shipments in future years. In support of this new product, the Company has established an internal field sales support team that has begun to identify and develop new sales channels. The Company recently announced that it was ending its reliance on Instrumentarium as the sole distributor of the Company's MammoReader products. The Company anticipates that Instrumentarium will no longer sell iCAD's products by December 31, 2003, as the Company focuses on different distribution channels. In October 2003, the Company entered into a distribution agreement with National Imaging Resources (NIR), a leading medical sales and equipment organization, that provides more than thirty NIR member resellers the opportunity to market, sell and support iCAD's computer aided detection products. In November 2003, the Company entered into an additional distribution agreement with Merry X-Ray Corporation, a leading distributor of radiology equipment and products, with 38 Merry X-Ray branch offices in the U.S. The Company is continuing efforts to expand its reseller network which the Company believes will improve sales levels in future periods. On November 7, 2003, iCAD entered into a two year, dual source purchasing agreement for Computer Aided Detection for Mammography Equipment with the purchasing company for Kaiser Permanente Kaiser Permanente is America's largest not-for-profit health care organization serving 8.1 million members in 9 states and the District of Columbia. The purchasing agreement generally requires the 129 Kaiser Permanente hospitals and facilities in nine states and the District of Columbia that elect to purchase a Computer Aided Detection of breast cancer system to purchase either an iCAD product or a product manufactured by one other vendor. Each facility that elects to purchase a Computer Aided detection of breast cancer system during the contract period will make an independent purchasing decision on the CAD system that best suits its needs and environment. Quarter Ended September 30, 2003 compared to Quarter Ended September 30, 2002 and Nine Months Ended September 30, 2003 compared to Nine Months Ended September 30, 2002 Sales. Sales of the Company's CAD and medical imaging products for the three months ended September 30, 2003, totaled $1,387,100, a slight increase compared with sales of medical imaging products of $1,286,966 in the quarter ended September 30, 2002. Sales of the Company's CAD and medical imaging products for the nine months ended September 30, 2003, totaled $4,938,629, compared with sales of medical imaging products and total sales of $2,414,244 and $2,839,199, respectively, in the nine month period ended September 30, 2002. This reflects an increase of 105% in medical sales and 74% in total sales when compared with the prior-year period. Sales of graphic arts and photographic 12 products totaled $424,955 in the nine month period ended September 30, 2002. The Company exited the graphic arts and photographic products business in June 2002, and there were no sales of such products in the nine months ended September 30, 2003. In the third quarter 2003, Instrumentarium, which had been the exclusive distributor of the Company's MammoReader(TM) computer aided detection products, received orders for 14 MammoReader systems and shipped 15 MammoReader systems to hospitals, women's health centers and mammography clinics. Depleting its own stock of demonstration units, Instrumentarium purchased only four MammoReader units from iCAD during the third quarter. Although the Company's relationship with new resellers was just beginning in the third quarter, more sales were to new resellers during this period than to Instrumentarium. While Instrumentarium continues to offer the iCAD product line through the fourth quarter of 2003, on a non-exclusive basis, the Company anticipates that newly established product distribution channels will account for all of its CAD product revenues in future periods. iCAD reports that, to date, approximately 87 MammoReader systems have been sold and installed by Instrumentarium and by iCAD's new resellers. Gross Margins. During the three month period ending September 30, 2003, gross margins decreased to 47%, compared to 57% for the same period in 2002, as a result of a high percentage of lower margin digitizer sales during the quarter, and to temporary price promotions aimed at supporting the Company's former exclusive CAD product distributor. For the nine month period ended September 30, 2003, gross margin improved to 55% compared to (62%) for the same period in 2002, as a result of increasing sales of higher margin CAD products and write-offs of inventory recorded in the quarter ended June 30, 2002. In the second quarter of 2002 the Company incurred a charge to cost of sales consisting of a charge for an inventory reserve and a write-off of prepaid royalty relating to its graphic arts and photographic products in the amount of $2,837,196. If such write-offs are excluded, gross margins for the nine month period of 2003 improved to 55%, compared to 38% for the nine month period ended September 30, 2002. The Company expects margins to improve as a result of increasing sales of its higher margin CAD products. Engineering and Product Development. Engineering and product development costs for the three and nine month periods ended September 30, 2003 increased from $478,720 and $1,005,615, in 2002 to $619,762 and $1,813,560, respectively, in 2003. The increase in engineering and product development costs results primarily from the Company's addition, as a result of its acquisition of ISSI, of a software technology development group to support its CAD products. Additionally, the Company continues its development of its Fulcrum(TM) medical film digitizer product and its iCAD iQ(TM) CAD product. The Company expects engineering and product development costs to increase for the remainder of 2003 over the comparable period of 2002. General and Administrative. General and administrative expenses for the three month period ended September 30, 2003 increased by $3,172,035, from $1,698,084 in 2002 to $4,870,119 in 2003. The increase resulted from the write-off of $1,443,628 associated with the Instrumentarium exclusive distribution agreement. After assessing the performance of Instrumentarium in the third quarter, and in light of the Company's implementation of alternative distribution channels, the Company elected to take a one-time write-off, thereby eliminating the distribution agreement as a depreciating asset. Additionally, during the third quarter of 2003, the Company accounted for over 13 $2,702,000 in non-recurring expenses related to the settlement of R2 patent infringement litigation and legal expenses. In the settlement agreement the Company agreed to pay R2 an aggregate of $1,250,000, of which $1,000,000 was paid in September 2003, with $250,000 deferred and payable in equal installments on a quarterly basis through December, 2005. In addition, the Company issued to R2 shares of iCAD Common Stock valued at $750,000. During this period the Company recorded approximately $702,000 in legal and related expenses associated with the R2 litigation. Since the Company's acquisition of ISSI in June 2002, the Company has recorded approximately $1,857,000 in legal and related expenses associated with the R2 litigation. General and administrative expenses for the nine month period ended September 30, 2003 increased by $387,743, from $5,982,671 in 2002 to $6,370,414 in 2003. The increase in expenses for the nine month period ended September 30, 2003, related to the write-off of the distribution agreement with Instrumentarium and the R2 settlement, were almost entirely offset by the $2,800,000 non-cash charge associated with the acquisition of ISSI in June 2002, as well as a reversal in the second quarter of 2003, of accrued settlement costs in the amount of $383,000 in connection with the dismissal of the Company as a defendant in the action brought by The Massachusetts Institute of Technology and Electronics for Imaging, Inc. See Part II, Item 1, Legal Proceedings. Marketing and Sales Expenses. Marketing and sales expenses for the three and nine month periods ended September 30, 2003 increased 192% and 46%, respectively, from $181,739 and $736,134 in 2002 to $530,485 and $1,077,189, respectively, in 2003. This increase is due primarily to the addition of sales support personnel engaged to develop a broad reseller channel for sale of the Company's CAD products, and advertising, direct mail, consulting, trade show and promotional expenses incurred in the third quarter 2003. The Company expects marketing and sales expenses to increase over the remainder of 2003 over the comparable period of 2002, as it continues to develop a more comprehensive sales and support capability and increase direct marketing and advertising activities. The Company believes that additional marketing and advertising expenditures will be required as additional competitors secure FDA approval and enter the market for computer aided detection of breast cancer solutions. Interest Expense. Net interest expense for the three and nine month periods ended September 30, 2003 increased to $30,494 and $47,644, respectively, from $10,009 and $39,238, respectively, in 2002. This increase is due primarily to the increase in loan balances. As a result of the foregoing, the Company recorded a net loss of $5,395,367 or $0.20 per share for the three month period ended September 30, 2003 on sales of $1,387,100 compared to a net loss of $1,640,665 or $0.06 per share for the same period in 2002 on sales of $1,286,966. The loss for the nine months ended September 30, 2003 was $6,603,953 or $0.25 per share on sales of $4,938,629 compared with a net loss of $9,521,297 or $0.50 per share on sales of $2,839,199 for the nine months ended September 30, 2002. 14 Liquidity and Capital Resources The Company's ability to generate cash adequate to meet its requirements depends primarily on operating cash flow and the availability of a $4,000,000 credit line under the Loan Agreement with its Chairman, Mr. Robert Howard. The Company has a Loan Agreement with its Chairman, Mr. Robert Howard, under which Mr. Howard has agreed to advance funds, or to provide guarantees of advances made by third parties in an amount up to $4,000,000. Outstanding advances are collateralized by substantially all of the assets of the Company and bear interest at prime interest rate plus 2% with a minimum of 8%. Mr. Howard is entitled to convert outstanding advances made by him under the Loan Agreement into shares of the Company's common stock at any time based on the outstanding closing market price of the Company's common stock at the lesser of the market price at the time each advance is made or at the time of conversion. During the third quarter of 2003 the Company borrowed $2,100,000 pursuant to the Loan Agreement. At September 30, 2003, $2,930,000 was outstanding under the Loan Agreement and $1,070,000 was available for future borrowings. At September 30, 2003 the Company had current assets of $2,324,260, current liabilities of $3,417,071 and working capital deficit of $1,092,811. The ratio of current assets to current liabilities was 0.7:1 Net cash used for operating activities for the nine months ended September 30, 2003 was $3,193,144, compared to $1,916,215 for the same period in 2002. The cash was used to fund the $6,603,953 loss from operations which included $1,000,000 related to the R2 settlement. Investing activities for the 2003 period included the addition of $239,809 for tooling, computer equipment, leasehold improvements and patents. Financing activities in the 2003 period included the borrowing of $2,730,000 pursuant to the Loan Agreement with Mr. Howard. Subsequent Event During the fourth of quarter 2003 the Company borrowed an additional $550,000 pursuant to the Loan Agreement with Mr. Howard. At November 10, 2003, $3,480,000 was outstanding under the Loan Agreement and $520,000 was available for future borrowings. Although iCAD believes that Mr. Howard will lend it additional funds beyond the $4 million limit of iCAD's current loan arrangement with him, in the event that iCAD requires additional funds and is unable to obtain the funds from Mr. Howard or elsewhere, it could adversely affect iCAD's operations and financial condition. New Accounting Pronouncements In May 2003, the FASB issued SFAS 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. The changes in this Statement improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. This Statement is effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS 149 did not have a material affect on the Company's financial position, results of operations, or cash flows. 15 In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances), because that instrument represents an obligation. Many of those instruments were previously classified as equity. The statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have a material affect on the Company's financial position, results of operations, or cash flows. Item 3. Quantitative and Qualitative Disclosures about Market Risk Not applicable. Item 4. Controls and Procedures An evaluation was carried out under the supervision and with the participation of the Company's management, including the Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), of the effectiveness of the Company's disclosure controls and procedures as of the end of the quarter ended September 30, 2003. Based on that evaluation, the CEO and CFO have concluded that the Company's disclosure controls and procedures are effective to provide reasonable assurance that that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. In addition, during the quarter ended September 30, 2003 there were no changes in the Company's internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company's internal controls over financial reporting. PART II OTHER INFORMATION Item 1. Legal Proceedings The Company has been dismissed from a complaint filed against the Company in the United States District Court for the Eastern District of Texas, entitled The Massachusetts Institute of Technology and Electronics for Imaging, Inc. v. Abacus Software Inc. et al., Case No. 501CV344, The plaintiff claimed initially that the Company had infringed a United States patent alleged to cover color reproduction system technology through sale of certain Company products to customers in the graphic arts/prepress and photographic markets. The Company has no liability in this matter, and anticipates no further legal expenses will be incurred with respect to this litigation. As a result, general and administrative expenses incurred during the first quarter of 2003 were reduced by the reversal of the accrued settlement cost in the amount of $383,000. 16 On June 3, 2002, Intelligent Systems Software, Inc. ("ISSI") was sued in United States District Court for the District of Delaware by R2 Technology, Inc. ("R2") and Shih-Ping Wang. The lawsuit alleged that ISSI's MammoReader device infringed certain patents owned by plaintiff. The complaint requested treble damages, but did not specify the amount of damages sought. The complaint also sought to enjoin ISSI from further infringement. On July 11, 2002, subsequent to the acquisition of ISSI by the Company, the plaintiffs amended their complaint to add the Company and its subsidiary ISSI Acquisition Corp. as additional parties. In July 2003, the Company filed suit in the United States District Court for the District of New Hampshire against R2 for infringement of certain patents licensed by Company. The complaint requested treble damages, costs and legal fees, but did not specify the amount of damages sought. On September 8, 2003, the Company announced the settlement of all patent infringement litigation with R2. Under the terms of the settlement, both actions were dismissed with prejudice and iCAD was granted a non-exclusive license to the patents named in the suit filed by R2. In connection with the settlement of the suit, iCAD agreed to pay R2 an aggregate of $1,250,000, of which $1,000,000 was paid in September 2003, with $250,000 deferred and payable in equal installments on a quarterly basis through December, 2005. In addition, iCAD issued to R2 shares of iCAD Common Stock valued at $750,000 and has filed a registration statement intended to cover the resale of the shares by R2. iCAD also agreed to certain continuing royalties, which are based on the category and configuration of products sold by iCAD. Further, iCAD granted R2 a partial credit against potential future purchases by R2 of iCAD digitizers worth up to $2,500,000 over five years to encourage R2 to purchase film digitizers manufactured by iCAD. This partial credit was meant to provide a significant purchasing advantage to R2, while maintaining a reasonable profit margin and creating additional economies of scale for iCAD. Subsequently, R2 agreed to accept an additional 75,000 shares of iCAD Common Stock in satifaction of any royalties it otherwise would have been entitled to receive under the settlement agreement. Item 2. Changes in Securities and Use of Proceeds During the quarter ended September 30, 2003 the Company issued 250,954 shares of its common stock as part of the settlement of its patent infringement litigation with R2. The Company also issued 500,000 shares to its counsel in satisfaction of certain legal and related expenses incurred by the Company in connection with the litigation with R2. The foregoing shares of common stock were issued in private transactions pursuant to the exemption from registration under Section 4(2) of the Securities Act of 1933 and/or Regulation D promulgated thereunder. Item 4. Submission of Matters to a Vote of Security Holders On September 23, 2003, the Company held an Annual Meeting of Stockholders at which the following matters were voted on by the security holders of iCAD, Inc.. The results of the vote are as follows: 1. To elect two Class I directors to hold office until the Annual Meeting of Stockholders to be held in 2006 and until their respective successors have been duly elected and qualified; 17 Names of Nominees Number of Number of Number Class I Votes For Votes Withheld Not Voted - --------- --------- -------------- --------- Brett Smith 20,501,836 406,953 6,752,159 Kevin Woods 20,873,159 35,630 6,752,159 2. Approval to adopt an amendment to the provision of the Company's Line of Credit Agreement with the Company's Chairman of the Board, Robert Howard, to amend the interest paid on advances under the agreement to bear interest at a rate equal to 2% above the prime interest rate with a minimum of 8% and to increase the line of credit to $4,000,000 and to extend the term of the agreement, 20,137,940 votes FOR approval, 89,315 votes AGAINST approval, 2,679,659 ABSTENTIONS and 4,754,034 NOT VOTED. 3. Ratification of the appointment of BDO Seidman, LLP as the Company's independent auditors for the fiscal year ending December 31, 2003, 22,884,671 votes FOR approval, 2,250 votes AGAINST approval, 17,993 ABSTENTIONS and 4,756,034 NOT VOTED. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit No. Description - ----------- ----------- 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) During the quarter ended September 30, 2003 a Form 8-K was furnished under item 9 and 12, to report the issuance of a press release announcing iCAD's financial results for the quarter ended June 30, 2003. 18 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. iCAD, Inc. (Registrant) Date: November 14, 2003 By: /s/ W. Scott Parr ------------------------------ --------------------------------- W. Scott Parr Chief Executive Officer, Director Date: November 14, 2003 By: /s/ Annette L. Heroux ------------------------------ --------------------------------- Annette L. Heroux Chief Financial Officer, Controller