10-K 1 c81209e10vk.txt FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------- FORM 10-K |X| Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003 COMMISSION FILE NO. 0-18602 ATS MEDICAL, INC. (Exact name of registrant as specified in its charter) MINNESOTA 41-1595629 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 3905 ANNAPOLIS LANE MINNEAPOLIS, MINNESOTA 55447 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (763) 553-7736 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock $.01 par value Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No | | Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. |X| Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes |X| No | | The aggregate market value of voting stock held by nonaffiliates of the registrant as of June 30, 2003, was approximately $87,116,511 (based on the last sale price of such stock as reported by the NASDAQ National Market). The number of shares outstanding of each of the registrant's classes of common stock as of February 27, 2004, was 26,814,089 shares of $.01 par value common stock. DOCUMENTS INCORPORATED BY REFERENCE Pursuant to General Instruction G, the responses to Items 10, 11, 12, and 14 of Part III of this report are incorporated herein by reference to certain information contained in the registrant's definitive Proxy Statement for its 2004 Annual Meeting of Shareholders to be held on May 6, 2004. ATS MEDICAL, INC. 2003 FORM 10-K PART I ITEM 1. BUSINESS OVERVIEW ATS Medical, Inc. is a Minnesota corporation founded in June, 1987. We manufacture and market a mechanical bileaflet heart valve with a unique open pivot design. Our valve is used to treat heart valve failure caused by the natural aging process, rheumatic heart disease, prosthetic valve failure and congenital defects. Mechanical heart valves have been in use since the early 1960s. The worldwide market for mechanical heart valves was estimated to exceed $400 million in 2002. Sulzer Carbomedics ("Carbomedics") developed the basic design from which the ATS heart valve evolved. Carbomedics is a large and experienced manufacturer of pyrolytic carbon components used in mechanical heart valves. Carbomedics has also designed and patented numerous mechanical valves. Carbomedics offered to license a patented and partially developed valve to us if we would complete the development of the valve and agree to purchase carbon components from Carbomedics. On September 24, 1990, we executed a License Agreement, Development Agreement, Supply Agreement, and Option Agreement with Carbomedics and the process to complete the valve design and go to market with the valve commenced. Various parts of these Agreements have been modified through the years, especially the Technology and Supply Agreements. We hold an exclusive, royalty-free, worldwide license to an open pivot, bileaflet mechanical heart valve design from which the ATS heart valve has evolved. In addition, we have an exclusive, worldwide right and license to use Carbomedics' pyrolytic carbon technology to manufacture components for the ATS heart valve, and a non-exclusive worldwide right and license to use the technology to produce pyrolytic carbon components for other devices and manufacturers, including, after 2008, for other heart valve manufacturers. We have future purchase obligations under the Supply Agreement discussed in more detail later in this document. The ATS Open Pivot(R) Heart Valve ("ATS Open Pivot(R)") is designed to be an evolutionary improvement upon other available mechanical heart valves by incorporating a pivot consisting of protruding spheres upon which the leaflets of the valve pivot to open and close. This unique open pivot has been designed to eliminate the cavity associated with the pivot of other bileaflet valves and to improve the ability of the blood to flow through the valve without forming clots. We began selling the ATS Open Pivot(R) in international markets in 1992. In October 2000, we received FDA approval to sell the ATS Open Pivot(R) in the United States. FINANCIAL INFORMATION ABOUT SEGMENTS Since our inception, we have operated in the single industry segment of developing, manufacturing, and marketing medical devices. SEASONALITY Our sales and operating results have varied and are expected to continue to vary significantly from quarter to quarter as a result of seasonal patterns. Although our sales over the past six quarters have grown consecutively, we expect that our business will be seasonal, with the third quarter of each year typically having the lowest sales and the fourth quarter of each year typically having the highest sales. PROSTHETIC HEART VALVE MARKET There are two types of replacement heart valves: tissue and mechanical. Tissue valves are made from animal or cadaver tissue or in some cases the patient's own tissue. Tissue valves do not present the same level of risk of blood clotting around the valve as mechanical valves. Tissue valves, however, have limited long-term durability due to calcification and deterioration. If a tissue valve fails, a new valve must be implanted, requiring another open heart surgery. Mechanical valves are made from durable materials such as metals and carbon. In vitro testing of current 2 pyrolytic carbon mechanical valves has yielded estimated useful lives in excess of any patient's lifetime. Current mechanical valves, however, require the use of anti-coagulants to prevent formation of blood clots; tissue valves generally do not require anti-coagulant treatment. Tissue valves are generally prescribed for patients who are less able to tolerate anti-coagulants due to conditions such as gastrointestinal ulcers or liver dysfunction, elderly patients, women in their childbearing years. Heart surgeons choose a particular type of mechanical valve based on a number of factors. A principal factor in the choice of a valve is the potential for forming blood clots, or thrombosis, resulting from areas in the valve where the blood can stagnate. Blood clots can impair the performance of a valve and, if the clot detaches and moves through the bloodstream (a thromboembolism), result in an arterial blockage or stroke. Another principal factor in the choice of a mechanical valve is the blood flow efficiency, or hemodynamics, of the valve. A mechanical valve should allow blood to flow easily through the valve with minimal pressure required to open the valve and minimal backflow of blood when the valve closes. The valve also should not exert force on the blood that could damage the fragile blood cells. Other factors that are important in a surgeon's choice of a mechanical valve are the ease in implanting and monitoring the valve's performance, the patient's quality of life and the physician's familiarity with and confidence in the valve. In addition to heart surgeons, administrators or business managers at hospitals and clinics have become increasingly influential in the purchase decision-making process in recent years. The increasing emphasis on medical cost containment in most world markets has elevated the decision-making power of the administrator. The administrator tends to focus on cost-effectiveness and, in some markets, primarily on the cost of the valve. We estimate that the total heart valve market in the U.S. in 2002 was approximately $400 million. We estimate that approximately 86,000 heart valve replacement surgeries were conducted in the United States in 2002. THE ATS OPEN PIVOT(R) HEART VALVE Our product is designed to improve upon existing mechanical heart valves by combining a proprietary open pivot design and other innovative features with the widely accepted biocompatibility and durability of pyrolytic carbon. The standard ATS heart valve is available in seven sizes ranging from 19mm to 31mm in diameter, with sewing cuffs for either aortic valve or mitral valve replacement. In 1994, we introduced the Advanced Performance series of the ATS heart valve in international markets. This valve is available in seven sizes ranging from 16mm to 28mm in diameter. Our 16mm valve is currently the world's smallest mechanical valve. The major design features of the ATS Open Pivot(R) Heart Valve are: OPEN PIVOT AREAS. The proprietary open pivot areas of the ATS heart valve feature spherical protrusions from the orifice that match spherical notches in the leaflets. The pivot areas protrude into the orifice and so are exposed to the washing action of the blood flowing through the heart valve. All other currently marketed bileaflet valves contain pivot cavities in the orifice wall into which protrusions from the semi-circular leaflets extend to allow the leaflets to open and close. The open pivot design also features angled inflow and outflow pivot stops. A THIN BUT DURABLE ORIFICE. The orifice of the ATS heart valve is manufactured using a mandrel which is coated with pyrolytic carbon. The mandrel is then removed, leaving a solid pyrolytic carbon orifice. Some competitive products use an orifice composed of a soft graphite substrate coated with pyrolytic carbon. By eliminating the graphite substrate, we have made the orifice wall thinner, resulting in a larger average inside diameter. The orifice is surrounded by a titanium stiffening ring and is rotatable. LOW PROFILE DESIGN. The ATS heart valve has a low profile design. The profile of a mechanical heart valve refers to the extension of the orifice and leaflets above and below the natural tissue anulus, or location of the natural heart valve. The inflow side of the orifice of the ATS heart valve is flat, unlike the most widely used cavity pivot valve which has upward protrusions on the orifice to house the cavity. 3 AN ADVANCED SEWING CUFF. The sewing cuff surrounding the orifice of the ATS heart valve is made of double velour polyester and includes a surgical felt ring for ease of sewing. The Advanced Performance series offers an alternative sewing cuff design that allows a valve with a larger inside diameter to be used in small anulus situations. PYROLYTIC CARBON. Pyrolytic carbon has been used in mechanical heart valves for over 25 years. The orifice of our heart valve is fabricated entirely from pyrolytic carbon, while the leaflets are fabricated by coating pyrolytic carbon on graphite substrates. Pyrolytic carbon used in other mechanical valves has been tested to function longer than any patient's lifetime. Pyrolytic carbon is believed to be superior to metal and plastics in terms of the human body's acceptance of the material, thus resulting in lower rates of thrombosis and thromboembolism than with other materials. Because of its durability and biocompatibility, pyrolytic carbon is used in virtually every mechanical heart valve in the market. TWO LEAFLETS. Bileaflet valve designs represent substantially all mechanical heart valves being marketed today. The leaflets in the ATS heart valve have tungsten impregnated in the substrate to make them visible under x-ray. The ATS Open Pivot(R) Heart Valve is designed to provide the following primary advances over currently available mechanical heart valves: REDUCED RATES OF THROMBOEMBOLIC COMPLICATIONS. The pivot cavities found in other bileaflet heart valves are areas of blood flow stagnation and possible blood clot formation. By eliminating the cavities in the orifice and placing the pivot areas within the normal blood flow, the improved washing action in the ATS heart valve is intended to lower the likelihood of blood clot formation and the resulting incidence of thromboembolism. The open pivot design as well as the angled inflow and outflow pivot stops also result in low levels of hemolysis (damage to blood cells), which may contribute to a low rate of thromboembolic complications and allow for lower levels of anticoagulation related medications. IMPROVED PATIENT QUALITY OF LIFE THROUGH LOWER NOISE LEVELS. Patients with other implanted mechanical heart valves complain of disturbances resulting from the clicking sound created as the valve closes. These disturbances range from irritability and insomnia to paranoia and depression. Spouses of patients with implanted mechanical valves also report disturbances resulting from the noise of the valve. Based on informal surveys and peer reviewed publications, we believe that the ATS heart valve is quieter than our competitors' valves and below the threshold of hearing of many patients. We believe that the reduced noise level of our product further improves the quality of life of the patient. IMPROVED BLOOD FLOW EFFICIENCIES. We have made the orifice of our product durable and thin, resulting in a large inside diameter. The large inside diameter of the ATS heart valve is intended to produce lower pressure gradients. (The term "gradients" refers to the pressure difference between the inflow and outflow side of the valve needed to support the required blood flow through the valves.) The ATS heart valve is also designed to have low regurgitation (backflow of blood when the valve is closing and closed) due to the geometry of its angled inflow and outflow pivot stops which minimize the direct leakage paths. These design characteristics are intended to result in superior blood flow efficiencies which should reduce the workload on the heart. EASE OF IMPLANT. Our product has been designed for ease of use by the heart surgeon. The low profile of the ATS heart valve is intended to minimize implant complications. Leaflets that extend significantly below the natural tissue anulus in the mitral position may obstruct blood outflow or interfere with the septum or other parts of the heart. Protrusions on the inflow side of the annulus in the aortic position may snag sutures used to attach the mechanical valve to the heart. In addition, because the orifice can be rotated, the surgeon can optimize valve orientation by adjusting the position of the leaflets after the ATS heart valve has been sutured in the natural anatomical position in the patient's heart. Suturing the ATS heart valve into the heart is made easier by reducing the number of layers of polyester material in the aortic and mitral cuffs and by adding the surgical felt ring in the sewing cuff, thereby easing the passage of the suture needle through the sewing cuff. The packaging and accessories of the ATS heart valve also are designed to facilitate the implant procedure by including all of the required items pre-assembled in a sterilized dual barrier container. 4 IMPROVED FOLLOW-UP DIAGNOSTIC CAPABILITY. Our product facilitates the follow-up diagnostic process by being more easily visible to x-rays. The titanium stiffening ring provides a clear image on x-rays when taken from any angle. The leaflets also have a higher density of tungsten impregnated in the substrate, making them more visible to x-rays. MARKETING, SALES AND DISTRIBUTION We market the ATS valve in the United States through a sales organization divided into four regions and 28 sales territories. We focus our sales and marketing efforts on developing awareness of our valve in the approximately 970 U.S. open heart centers. We currently work with cardiac surgeons in approximately 170 of these centers. In one international market, France, we have a direct sales organization. In all other international markets, we sell through an independent distribution network. We believe that our distribution partners have provided a rapid and cost efficient means of increasing market penetration and commercial acceptance of the ATS heart valve in key international markets. We have been able to attract experienced mechanical valve sales organizations and people familiar with local markets and customs to serve as our representatives. Each of our independent distributors has the exclusive right to sell the ATS heart valve within a defined territory. These distributors, in some instances, also market other medical products, although they have agreed not to sell other mechanical heart valves. Under most of the distributor agreements, we may, at our option, terminate the agreement upon the departure of certain key employees of the distributor, if our company experiences a change in control, or if key performance criteria, including sales quotas, are not met. We sell the ATS heart valve to each distributor F.O.B. Minneapolis, Minnesota. Sales to international distributors are denominated in U.S. dollars. We have contracts with independent distributors for countries outside the United States. One independent distributor, Century Medical Inc., accounted for more than 10% of our gross sales in 2003. See Note 11 of Notes to Consolidated Financial Statements in Item 8 of this report for information on our net sales by geographic region. Our sales, marketing and customer service personnel provide professional sales, marketing and promotional support to our independent distributors. COMPETITION The prosthetic heart valve market is highly competitive with St. Jude Medical, Inc. as the mechanical valve market share leader. Other companies that sell mechanical valves include Medtronic, Inc., Carbomedics, Edwards Lifesciences, Sorin Biomedica sPa, Medical CV and Medical Carbon Research, Inc. St. Jude Medical, Medtronic, Edward Lifesciences, Sorin Biomedica and CryoLife also sell tissue valves. We are aware of several companies that are developing new prosthetic heart valves. Several companies are developing and testing new autologous (created from the patient's own tissue) valves, potentially more durable tissue valves and new bileaflet and trileaflet mechanical designs. Advancements also are being made in surgical procedures such as mitral valve reconstruction, whereby the natural mitral valve is repaired, delaying the need for a replacement valve. Other companies are pursuing biocompatible coatings to be applied to mechanical valves in an effort to reduce the incidence of thromboembolic events and to treat tissue valves to forestall or eliminate calcific degeneration in these valves. Competition within the prosthetic heart valve market is based on, among other things, clinical performance record, minimalization of complications, ease of use for the surgeon, patient comfort and cost effectiveness. We believe that the most important factors in a heart surgeon's selection of a particular prosthetic valve are the perceived benefits of the valve and the heart surgeon's confidence in the valve design. As a result, valves that have developed a favorable clinical performance record have a significant marketing advantage over new valves. In addition, negative publicity resulting from isolated incidents can have a significant negative effect on a valve's overall acceptance. Our success is dependent upon the surgeon's willingness to use a new prosthetic heart valve as well as the future clinical performance of the ATS heart valve compared with the more established competition. 5 Competition in the medical device industry is intense and is characterized by extensive research efforts and rapid technological progress. We believe that the primary competitive factors include quality, technical capability, innovation, distribution capabilities, and price. Many of our competitors in the heart valve market have greater resources, more widely accepted products, greater technical capabilities, and stronger name recognition than we do. Our competitive capability is affected by our ability to support our products, ensure regulatory compliance for our products, protect the proprietary technology of our product and its manufacturing process, effectively market our product, and maintain and establish distribution relationships. All of these abilities require continuously attracting and retaining skilled and dedicated employees and excellent relationships with physicians and suppliers. We believe that mechanical heart valves are currently being marketed to hospitals at prices that vary significantly from country to country due to market conditions, currency valuations, distributor mark-ups and government regulations. In many markets, government agencies are imposing or proposing price controls or restrictions on medical products. We work with our independent distributors to price the ATS heart valve in each market to meet these limitations. In addition, our primary competitors have the ability, due to their internal carbon manufacturing facilities and economies of scale, to manufacture their valves at a lower cost than we can currently manufacture the ATS heart valve. The market leader has occasionally used price as a method to compete in several markets. RELATIONSHIP WITH SULZER CARBOMEDICS Sulzer Carbomedics ("Carbomedics") developed the basic design from which the ATS heart valve evolved. Carbomedics is a large and experienced manufacturer of pyrolytic carbon components used in mechanical heart valves. Carbomedics has also designed and patented numerous mechanical valves. We have three agreements with Carbomedics: a license agreement and a long-term carbon supply agreement entered into in September 1990, and a carbon technology agreement entered into in December 1999. Under the terms of the license agreement with Carbomedics, we hold an exclusive, royalty-free, worldwide license to an open pivot, bileaflet mechanical heart valve design from which the ATS heart valve has evolved. The license agreement does not include the right to manufacture the pyrolytic carbon components of the ATS heart valve, except that if Carbomedics were unable to produce the components, we would have the right and license to make the components or have them made for us. There currently is not a third party that can produce the pyrolytic carbon components for the ATS valve. After making certain design changes in the valve, we finalized the design of the ATS heart valve and filed and received our own U.S. patent covering the design of the ATS valve. The design modifications and the resulting U.S. patent covering the new design are the exclusive property of ATS. In connection with the execution of the license agreement, we were also required to enter into a long-term supply agreement with Carbomedics under which we have acquired a large inventory of pyrolytic carbon components for the ATS heart valve. In June 2002, the supply agreement was amended to suspend our purchase obligations for the remainder of 2002 (with the exception of approximately eight weeks of work in process) along with 100% of our purchase obligations for 2003, 2004, 2005 and 2006. In January of 2007 the purchase obligations for 2003 will resume, with the obligations for 2004 through 2006 to follow in each subsequent year. In December 1999, we entered into a carbon technology agreement with Carbomedics under which we obtained an exclusive, worldwide right and license to use Carbomedics' pyrolytic carbon technology to manufacture components for the ATS heart valve, and a non-exclusive worldwide right and license to use the technology to produce pyrolytic carbon components for other devices and manufacturers, including, after 2008, for other heart valve manufacturers. Under the agreement Carbomedics also agreed to assist us in designing, building, equipping, qualifying and commencing operations in a pyrolytic carbon component production facility in Minneapolis, Minnesota. In return, we agreed to pay Carbomedics a license fee totaling $41 million. We were also obligated under the carbon technology agreement to pay all of the costs of establishing the new carbon production facility, including hourly fees and out-of-pocket expenses of the Carbomedics employees assigned to assist us in setting up the facility. In August 2003, we satisfied all of our payment obligations under the carbon technology agreement. 6 MANUFACTURING AND SUPPLY Our products are manufactured in ISO 9001 certified facilities. We have two facilities in close proximity in a suburb of Minneapolis, Minnesota for our manufacturing activities. Our pyrolytic carbon components are manufactured in one facility and we assemble the ATS heart valve in a controlled clean room environment in the other facility. Most of the materials we purchase for our products are supplied by a limited number of vendors. We currently have high inventory levels of carbon components purchased under our Amended Supply Agreement with Carbomedics at costs much higher than we expect our manufacturing costs to be in the future. We expect our inventory levels will satisfy our projected requirements for more than one year. Under our Amended Supply Agreement with Carbomedics, we have future purchase obligations for pyrolytic carbon components starting in 2007 and continuing through 2011. We maintain a comprehensive quality assurance and quality control program, which includes documentation of all material specifications, operating procedures, equipment maintenance, and quality control test methods. Our documentation systems comply with appropriate FDA and ISO 9001 requirements. We currently are operating our pyrolytic carbon component facility with limited production. We are currently operating one manufacturing shift at our valve assembly facility. We believe that our properties are adequate to serve our business operations for the foreseeable future. RESEARCH AND DEVELOPMENT Our research and development activities include developing new products, improving our current products, and the clinical and regulatory activities to support our products. These activies are carried out in our Plymouth facilities, although we work with physicians, research hospitals, and universities around the world. None of this work is funded by customers or other outside institutions. The development process for any new product can range from several months to several years, primarily depending on the regulatory pathway required for approval. Research and development expenses totaled $1.8 million in 2003, $2.4 million in 2002, and $3.9 million in 2000. PATENTS AND PROPRIETARY TECHNOLOGY Our policy is to protect our proprietary position by obtaining U.S. and foreign patents to protect technology, inventions and improvements important to the development of our business. The original patent obtained by Carbomedics under which our valve was developed expires in 2004. We subsequently made modifications to the basic design. We were issued a U.S. patent covering our design improvements to the ATS heart valve in October 1994. We also have filed patent applications in Japan, Belgium, France, Germany, Netherlands, Spain, Switzerland and the United Kingdom relating to the design improvements. Patents have been granted in all of these countries. We cannot be certain that any patents will not be challenged or circumvented by competitors. We also rely on trade secrets and technical know-how in the manufacture and marketing of the ATS heart valve. We typically require our employees, consultants and contractors to execute confidentiality agreements with respect to our proprietary information. We claim trademark protection on ATS Medical(TM) and ATS Open Pivot(R). GOVERNMENT REGULATION UNITED STATES Numerous governmental authorities, principally the FDA and corresponding state and foreign regulatory agencies, strictly regulate our products and research and development activities. The Federal Food, Drug, and Cosmetic Act, or FDA Act, the regulations promulgated under this act, and other federal and state statutes and regulations, govern, among other things, the pre-clinical and clinical testing, design, manufacture, safety, efficacy, labeling, storage, record keeping, advertising and promotion of medical devices. The FDA classifies our ATS heart valve as a Class III device, which is subject to the highest level of controls. 7 Generally, before we can market a new medical device, we must obtain marketing clearance through a 510(k) premarket notification, approval of a premarket approval application, or PMA, or approval of product development protocol, or PDP. A PMA or PDP application must be submitted if a proposed device does not qualify for a 510(k) premarket clearance procedure. It generally takes several months from the date of a 510(k) submission to obtain clearance, but it may take longer, particularly if a clinical trial is required. The PMA and PDP process can be expensive, uncertain, require detailed and comprehensive data and generally take significantly longer than the 510(k) process. If human clinical trials of a device are required, either for a 510(k) submission or a PMA application, the sponsor of the trial, usually the manufacturer or the distributor of the device, must file an investigational device exemption, or an IDE, application prior to commencing human clinical trials. The IDE application must be supported by data, typically including the results of animal and/or laboratory testing. If the IDE application is approved by the FDA and one or more appropriate institutional review boards, or IRBs, human clinical trials may begin at a specific number of investigational sites with a specific number of patients, as approved by the FDA. If the device presents a non-significant risk to the patient, a sponsor may begin the clinical trial after obtaining approval for the study by the IRBs without separate approval from the FDA. Submission of an IDE does not give assurance that the FDA will approve the IDE and, if it is approved, there can be no assurance the FDA will determine that the data derived from the studies support the safety and efficacy of the device or warrant the continuation of clinical trials. An IDE supplement must be submitted to and approved by the FDA before a sponsor or investigator may make a change to the investigational plan that may affect its scientific soundness, study indication or the rights, safety or welfare of human subjects. We also are subject to FDA regulations concerning manufacturing processes and reporting obligations. These regulations require that manufacturing steps be performed according to FDA standards and in accordance with documentation, control and testing standards. The FDA monitors compliance with its good manufacturing practices regulations by conducting periodic inspections. We are required to provide information to the FDA on adverse incidents as well as maintain a detailed record keeping system in accordance with FDA guidelines. We expect that our carbon fabrication processes and new manufacturing facility will be subject to domestic and international regulatory inspection and review. The advertising of our product also is subject to both FDA and Federal Trade Commission regulations. In addition, we will be subject to the "fraud and abuse" laws and regulations promulgated by the U.S. Department of Health and Human Services and the U.S. Health Care Finance Administration if we sell the ATS heart valve to Medicare or Medicaid patients. Under these regulations, it is a criminal offense (subject to certain exceptions) to knowingly or willfully offer, pay, solicit, or receive remuneration in order to induce business for which reimbursement may be provided under a Federal health care program. If the FDA believes we are not in compliance with law, it can institute proceedings to detain or seize products, issue a recall, enjoin future violations and assess civil and criminal penalties against us and our officers and employees. If we fail to comply with these regulatory requirements, our business, financial condition and results of operations could be harmed. In addition, regulations regarding the manufacture and sale of our products are subject to change. We cannot predict the effect, if any, that these changes might have on our business, financial condition and results of operations. INTERNATIONAL In order to market our products in European and other foreign countries, we must obtain required regulatory approvals and comply with extensive regulations governing product safety, quality and manufacturing processes. These regulations vary significantly from country to country and with respect to the nature of the particular medical device. The time required to obtain these foreign approvals to market our products may be longer or shorter than that required in the United States, and requirements for licensing may differ from FDA requirements. In order to market our products in the member countries of the European Union, we are required to comply with the medical devices directive and obtain CE mark certification. The CE mark denotes conformity with European standards for safety and allows certified devices to be sold in all European Union countries. Under the medical devices directives, all medical devices including active implants and in-vitro diagnostic products must qualify for CE marking. 8 THIRD PARTY REIMBURSEMENT In the United States, healthcare providers that purchase medical devices, such as our product, generally rely on third-party payors, including Medicare, Medicaid, private health insurance carriers and managed care organizations, to reimburse all or part of the cost and fees associated with the procedures performed using these devices. The commercial success of the ATS heart valve will depend on the ability of health care providers to obtain adequate reimbursement from third-party payors for the surgical procedures in which our products are used. Third-party payors are increasingly challenging the pricing of medical products and procedures. Even if a procedure is eligible for reimbursement, the level of reimbursement may not be adequate. In addition, third-party payors may deny reimbursement if they determine that the device used in the treatment was not cost-effective or was used for a non-approved indication. In international markets, market acceptance of the ATS heart valve depends in part upon the availability of reimbursement from healthcare payment systems. Reimbursement and healthcare payment systems in international markets vary significantly by country. The main types of healthcare payment systems in international markets are government sponsored healthcare and private insurance. Countries with governmental sponsored healthcare, such as the United Kingdom, have a centralized, nationalized healthcare system. New devices are brought into the system through negotiations between departments at individual hospitals at the time of budgeting. In many of the countries where we market, the government sets an upper limit of reimbursement for various valve types. In most foreign countries, there are also private insurance systems that may offer payments for alternative devices. We have pursued reimbursement for our ATS heart valve internationally through our independent distributors. While the healthcare financing issues in these countries are substantial, we have been able to sell the ATS heart valve to private clinics and nationalized hospitals in each of the countries served by our distributors. All third-party reimbursement programs, whether government funded or insured commercially, whether inside the United States or outside, are developing increasingly sophisticated methods of controlling health care costs through prospective reimbursement and capitation programs, group purchasing, redesign of benefits, second opinions required prior to major surgery, careful review of bills, encouragement of healthier lifestyles and exploration of more cost-effective methods of delivering health care. These types of programs can potentially limit the amount which health care providers may be willing to pay for medical devices. PRODUCT LIABILITY AND INSURANCE Cardiovascular device companies are subject to an inherent risk of product liability and other liability claims in the event that the use of their products results in personal injury. A mechanical heart valve is a life-sustaining device, and the failure of any mechanical heart valve usually results in the death of the patient. We have not received any reports of mechanical failure of our valves implanted to date. Any product liability claim could subject us to costly litigation, damages and adverse publicity. We currently maintain product liability insurance policy with an annual coverage limit of $25 million in the aggregate. A $5 million product liability insurance policy is required by the supply agreement with Carbomedics. We are financially responsible for any uninsured claims or claims which exceed the insurance policy limits. Product liability insurance is expensive for mechanical valves. If insurance becomes completely unavailable, we must either develop a self-insurance program or sell without insurance, which would require the consent of Carbomedics. The development of a self-insurance program would require significant capital. Carbomedics has made no warranty on our valve components. We have agreed to hold Carbomedics harmless and indemnify Carbomedics in the event claims are made or damages are assessed against Carbomedics as a result of our valve. 9 EMPLOYEES As of January 1, 2004, we employed approximately 87 full-time and part-time employees. Our employees are vital to our success. We believe we have been successful in attracting and retaining qualified personnel. We believe our employee relations are excellent. AVAILABLE INFORMATION Copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge through our website (www.atsmedical.com) as soon as reasonably practicable after we electronically file the material with, or furnish it to, the Securities and Exchange Commission. ITEM 2. PROPERTIES We lease approximately 50,000 square feet of space in two buildings in a suburb of Minneapolis, Minnesota. The lease covering approximately 27,000 square feet expires on March 31, 2009 and it is used for administrative, production and engineering purposes. The lease on the other 23,000 square feet expires July 31, 2008 and is used for carbon manufacturing. We believe that these facilities are adequate for our current needs. ITEM 3. LEGAL PROCEEDINGS None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers are as follows:
Name Age Position ---- --- -------- Michael D. Dale 44 Chief Executive Officer, President and Director Richard A. Curtis 39 Vice President, Marketing and Business Development John R. Judd 47 Chief Financial Officer Marc R. Sportsman 49 Vice President, Sales
MICHAEL D. DALE has served as our Chief Executive Officer, President and a Director of the Company since October 2002. From 2000 to 2002, Mr. Dale was President of Worldwide Sales and Marketing at Endocardial Solutions, Inc., a company that develops, markets and distributes an advanced cardiac mapping system. Mr. Dale joined Endocardial Solutions, Inc. in December 1998 as Vice President Worldwide Sales. From 1996 to 1998, Mr. Dale was Vice President of Global Sales for Cyberonics, Inc., a medical device company, and additionally was managing director of Cyberonics Europe S.A. From 1988 to 1996, Mr. Dale served in several capacities at St. Jude Medical, Inc. most recently as the Business Unit Director for St. Jude Europe. Mr. Dale is on the Board of Directors of Empath Medical, Inc., a medical products company that designs, develops, manufactures and markets percutaneous delivery solutions. 10 RICHARD A. CURTIS has served as our Vice President of Marketing and Business Development since December 2002. Prior to joining the Company, Mr. Curtis was Vice President of Corporate Development at Cardinal Health, Inc., a provider of healthcare products and services, from September 2001 to November 2002. From 1999 to 2001, Mr. Curtis was Vice President of Business Development for Hill-Rom, Inc., a provider of patient care environment and therapy solutions, and from 1997 to 1999, he was a Director of Corporate Development at Hillenbrand Industries, a health care and funeral services provider. JOHN R. JUDD has served as our Chief Financial Officer since October 2003. Prior to joining the Company, Mr. Judd was Corporate Controller for American Medical Systems, Inc., a provider of medical devices to urologists and gynecologists, from 2000 until 2003. From 1981 until 1999, Mr. Judd was at Apogee Enterprises, Inc., a provider of glass products and services, in various positions within corporate and divisional finance, operations management, and from 1997 until 1999, Chief Financial Officer of the autoglass division. MARC R. SPORTSMAN has served as our Vice President of Sales since April 2003. Mr. Sportsman has over twenty-five years of cardiovascular medical device sales and sales management experience beginning with Shiley, Inc. and starting in 1986 with St. Jude Medical, Inc. His most recent position before joining ATS Medical was as Area Vice President of St. Jude Medical, Inc. where he was responsible for sales of the company's four product groups in an eight state area. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS Our common stock is traded on the Nasdaq National Market under the symbol "ATSI." The following table sets forth, for the periods indicated, the high and low closing sales prices per share of our common stock as reported on the Nasdaq National Market. These prices do not include adjustments for retail mark-ups, mark-downs, or commissions.
Fiscal Year 2002: High Low ----- ----- First Quarter $5.50 $1.75 Second Quarter $2.06 $0.47 Third Quarter $0.64 $0.31 Fourth Quarter $0.85 $0.36
Fiscal Year 2003: High Low ----- ----- First Quarter $1.83 $0.41 Second Quarter $3.95 $1.30 Third Quarter $4.40 $3.07 Fourth Quarter $4.22 $3.50
DIVIDENDS We have never declared or paid cash dividends. We intend to retain all future earnings for the operation and expansion of our business. We do not anticipate declaring or paying cash dividends on our common stock in the foreseeable future. 11 ITEM 6. SELECTED FINANCIAL DATA
Year Ended December 31, -------------------------------------------------- (in thousands, except per share data) 2003 2002 2001 2000 1999 ------------------------------------- -------- -------- -------- ------- ------- STATEMENT OF OPERATIONS DATA: Net sales $18,484 $13,301 $15,080 $14,585 $17,462 Cost of sales 17,632 12,307 10,310 9,559 10,986 -------- -------- -------- ------- ------- Gross profit 852 994 4,770 5,026 6,476 Operating expenses: Sales and marketing 10,180 2,425 3,906 1,912 1,307 Research and development 1,764 3,312 4,904 1,028 841 General and administrative 4,350 3,114 3,844 3,031 2,562 Impairment of technology license -- 8,100 -- -- -- Reorganization expense -- 1,130 -- -- -- Distributor termination expenses -- 821 -- -- -- Gain on extinguishment of debt (2,575) -- -- -- -- -------- -------- -------- ------- ------- Total operating expenses 13,719 18,902 12,654 5,971 4,710 -------- -------- -------- ------- ------- Operating profit (loss) (12,867) (17,908) (7,884) (945) 1,766 Interest income (expense) (425) (304) 1,040 1,524 928 -------- -------- -------- ------- ------- Income (loss) before income taxes (13,292) (18,212) (6,844) 579 2,694 Income tax expense -- -- -- 74 56 -------- -------- -------- ------- ------- Net income (loss) ($13,292) ($18,212) ($ 6,844) $ 505 $ 2,638 ======== ======== ======== ======= ======= Net income (loss) per share: Basic ($0.55) ($0.82) ($0.31) $ 0.03 $ 0.15 Diluted ($0.55) ($0.82) ($0.31) $ 0.02 $ 0.14 Weighted average number of shares outstanding: Basic 24,076 22,259 22,159 20,032 17,858 Diluted 24,076 22,259 22,159 20,868 18,371
As of December 31, ----------------------------------------------- (in thousands) 2003 2002 2001 2000 1999 -------------- ------- ------- ------- -------- ------ BALANCE SHEET DATA: Cash and cash equivalents $ 6,472 $ 7,472 $ 5,079 $ 14,804 4,031 Working capital 31,275 21,674 32,466 85,934 52,637 Total assets 76,134 91,756 94,971 102,354 61,117 Long-term liabilities 307 9,514 -- -- -- Shareholders' equity 72,803 74,127 92,223 98,525 58,842
12 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS EXECUTIVE OVERVIEW We manufacture and market a mechanical bileaflet heart valve with a patented pivot design. Our heart valve is used to treat valvular heart disease caused by the natural aging process, rheumatic heart disease and congenital defects. Sulzer Carbomedics ("Carbomedics") developed the basic design from which the ATS heart valve evolved. Carbomedics is a large and experienced manufacturer of pyrolytic carbon components used in mechanical heart valves. Carbomedics has also designed and patented numerous mechanical valves. Carbomedics offered to license a patented and partially developed valve to us if we would complete the development of the valve and agree to purchase carbon components from Carbomedics. We hold an exclusive, royalty-free, worldwide license to an open pivot, bileaflet mechanical heart valve design owned by Carbomedics from which the ATS heart valve has evolved. In addition, we have an exclusive, worldwide right and license to use Carbomedics' pyrolytic carbon technology to manufacture components for the ATS heart valve. We commenced selling the ATS heart valve in international markets in 1992. In October 2000, we received FDA approval to sell the ATS Open Pivot(R) MHV and commenced sales and marketing of our valve in the United States. The original sales forecasts as well as the pricing models that were used when the original Supply Agreement was signed with Carbomedics proved to be too optimistic. Accordingly, to keep the Supply Agreement active and the license to sell the valve exclusive, we purchased quantities of inventory far in excess of demand. From 1990 through 2002, we paid Carbomedics approximately $125 million for the development of our valve, the technology to manufacture our pyrolytic carbon components, and for pyrolytic valve components manufactured by Carbomedics. On December 31, 2002, we had remaining payments due under the Technology Agreement that totaled $28 million. This led us in 2003 to negotiate an accelerated but reduced payment for all outstanding debts to Carbomedics related to the Technology Agreement. In August 2003 we paid $12 million to satisfy all future obligations under this Agreement. With inventory purchases exceeding sales through the years, we have built inventory levels that today provide a source of cash. We are drawing down these paid for inventories and using the cash it generates to fund operations. Our manufacturing facility for pyrolytic carbon components has been producing limited quantities. We expect to increase production in this facility sometime in 2004 but are carefully considering our options as this decision will require the use of cash as we buy raw materials and hire production workers. In June 2002, we reorganized the company laying off more than half of the work force including all executive management. With the hiring of a new president late in 2002, we have started the process of rebuilding our sales and marketing teams, especially in the United States. This rebuilding is the most significant factor in our expense level during 2003. Because sales prices in the United States exceed selling prices elsewhere, we feel that our future success will depend on achieving increased market share in the U.S. Our U.S. sales as a percentage of our overall sales have grown from 4% in 2000 to 28% in 2003. CRITICAL ACCOUNTING POLICIES AND ESTIMATES We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Management's discussion and analysis of financial condition and results of operation is based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect (1) the reported amounts of assets, liabilities, revenues, and expenses and (2) the related disclosure of contingent liabilities. At each balance sheet date, we evaluate our estimates, including but not limited to, those related to accounts receivable, inventories, long-lived assets, and income taxes. The critical accounting policies that are most important in fully understanding and evaluating the financial condition and results of operations are discussed below. 13 REVENUE RECOGNITION POLICY. A significant portion of our revenue in the United States, Canada, and France is generated from consigned inventory maintained at hospitals or with field representatives. In these situations, revenue is recognized at the time that the product has been implanted or used. In all other instances, revenue is recognized at the time product is shipped. Certain independent distributors in select international markets receive rebates against invoiced sales amounts. In these situations, we accrue for these rebates at the time of the original sale. The total of these accrued rebates was $0.4 million and $0.2 million as of December 31, 2003 and 2002, respectively. ALLOWANCE FOR DOUBTFUL ACCOUNTS. We maintain an allowance for doubtful accounts that is calculated using subjective judgments and estimates to establish this valuation account. Our distribution in international markets through independent distributors concentrates relatively large amounts of receivables in relatively few customer accounts. We have successfully done business with most of these distributors for many years. We monitor amounts that are not paid according to terms. We attempt to accrue for potential losses due to non-payment. Financial conditions in international markets can change very quickly and our allowance for doubtful accounts cannot anticipate all potential changes. Our allowance for doubtful accounts was $0.3 million at December31, 2003 compared to $0.4 million in 2002. As a percentage of total accounts receivable, the allowance was 5.2% on December 31, 2003 and 10.6% in 2002. This reduction in allowance is due to the collection of one account that had been classified as doubtful in previous accounting periods. INVENTORY VALUATION. Inventories are recorded at the lower of manufacturing cost or net realizable value. We have historically had manufacturing costs exceeding net realizable values in certain international markets requiring us to write-down certain inventories to expected selling prices due to high purchase prices of pyrolytic valve components under our Supply Agreement with Carbomedics. This lower of cost or market adjustment is charged to cost of sales and is calculated by estimating future selling volume and prices by market and comparing this to actual inventory levels, both finished goods and work in process. An adjustment is made in those cases where our manufacturing costs are or will be greater than our eventual selling price. If our estimates of future selling prices or volumes prove incorrect, future adjustments to inventory carrying values would be necessary and could have a material impact on operations. Lower of cost or market adjustments were $4.4 million, $2.4 million, and $1.0 million during 2003, 2002, and 2001, respectively. We believe that future manufacturing costs will be lower as we manufacture our own pyrolytic carbon components. This should decrease the risk of these adjustments as current inventories are depleted. We maintain an obsolescence allowance against certain raw material inventory items used in our valve assembly manufacturing process. This allowance totals $0.2 million at December 31, 2003 and 2002. A portion of inventories on hand at December 31, 2003 and 2002 are not likely to be sold in the following twelve months periods and therefore are not classified as a current asset. The estimate of inventories necessary to support current sales includes our projections not only of sales but inventories for new consignment accounts and contingencies. Accordingly, these amounts are classified as a current asset. LONG TERM ASSETS--TECHNOLOGY LICENSE. We assess the carrying value of our technology license annually in accordance with the provisions of FAS Statement 142 (FAS No. 142), Goodwill and Other Intangible Assets. The assessment of potential impairment requires certain judgments and estimates, including the determination of an event indicating impairment, the future cash flows to be generated by the asset, risks associated with those cash flows, and the discount rate to be utilized. As of December 31, 2003, we believe that the carrying value of our technology license is recoverable and no impairment charge is currently necessary. DEFERRED TAX ASSETS. We have incurred tax losses of approximately $42 million. The losses are carried forward for U. S. and state corporate income taxes and can be used to reduce future taxes. At December 31, 2003 we had deferred tax assets totaling $17.3 million. We have taken a valuation allowance against this asset for its full amount because the carryforwards have a limited life and other limitations. An alternative accounting judgment would be to record the entire asset on our balance sheet and in subsequent periods, if it became apparent that a portion of the asset would not be realized, write it off against income in that period. In order to utilize that treatment we would have to decide that it was more likely than not that we would realize the deferred tax assets and credits. 14 RESULTS OF OPERATIONS The following table provides the dollar and percentage change in our Statements of Operations for 2003 compared to 2002 and 2002 compared to 2001.
Year Ended December 31, ------------------------------------------------------------------------------------ Increase Increase (in thousands) 2003 2002 (Decrease) % 2002 2001 (Decrease) % -------------- -------- -------- ---------- ------ -------- ------- ---------- ------ Net sales $ 18,484 $ 13,301 $ 5,183 39.0% $ 13,301 $15,080 ($ 1,779) -11.8% Cost of sales 17,632 12,307 5,325 43.3% 12,307 10,310 1,997 19.4% -------- -------- ------- ------ -------- ------- ---------- ------ Gross profit 852 994 (142) -14.3% 994 4,770 (3,776) -79.2% Operating expenses: Sales and marketing 10,180 3,312 6,868 207.4% 3,312 4,904 (1,592) -32.5% Research and development 1,764 2,425 (661) -27.3% 2,425 3,906 (1,481) -37.9% General and administrative 4,350 3,114 1,236 39.7% 3,114 3,844 (730) -19.0% Impairment of technology license -- 8,100 (8,100) -100.0% 8,100 -- 8,100 -- Reorganization expense -- 1,130 (1,130) -100.0% 1,130 -- 1,130 -- Distributor termination expenses -- 821 (821) -100.0% 821 -- 821 -- Gain on extinguishment of debt (2,575) -- (2,575) -- -- -- -- -- -------- -------- ------- ------ -------- ------- ---------- ------ Total operating expenses 13,719 18,902 (5,183) -27.4% 18,902 12,654 6,248 49.4% -------- -------- ------- ------ -------- ------- ---------- ------ Operating loss (12,867) (17,908) 5,041 28.1% (17,908) (7,884) (10,024) -127.1% Interest income (expense) (425) (304) (121) 39.8% (304) 1,040 (1,344) -129.2% -------- -------- ------- ------ -------- ------- ---------- ------ Net loss ($13,292) ($18,212) $ 4,920 27.0% ($18,212) ($6,844) ($11,368) -166.1% ======== ======== ======= ====== ======== ======= ========== ======
The following table presents the statement of operations as a percentage of sales for 2003, 2002, and 2001.
Year Ended December 31, ----------------------- 2003 2002 2001 ----- ------ ----- Net sales 100.0% 100.0% 100.0% Cost of sales 95.4% 92.5% 68.4% ----- ------ ----- Gross profit 4.6% 7.5% 31.6% Operating expenses: Sales and marketing 55.1% 24.9% 32.5% Research and development 9.5% 18.2% 25.9% General and administrative 23.5% 23.4% 25.5% Impairment of technology license 0.0% 60.9% 0.0% Reorganization expense 0.0% 8.5% 0.0% Distributor termination expenses 0.0% 6.2% 0.0% Gain on extinguishment of debt -13.9% 0.0% 0.0% ----- ------ ----- Total operating expenses 74.2% 142.1% 83.9% ----- ------ ----- Operating loss -69.6% -134.6% -52.3% Interest income (expense) -2.3% -2.3% 6.9% ----- ------ ----- Net loss -71.9% -136.9% -45.4% ===== ====== =====
15 NET SALES. The following tables compare net sales during 2003, 2002, and 2001.
Year Ended December 31, ------------------------------------------------------------------------------- Increase Increase (in thousands) 2003 2002 (Decrease) % 2002 2001 (Decrease) % -------------- ------- ------- ---------- ----- ------- ------- ---------- ----- United States $ 5,141 $ 2,535 $2,606 102.8% $ 2,535 $ 2,613 ($78) -3.0% Outside United States 13,343 10,766 2,577 23.9% 10,766 12,467 (1,701) -13.6% ------- ------- ------ ----- ------- ------- ------- ----- Total $18,484 $13,301 $5,183 39.0% $13,301 $15,080 ($1,779) -11.8% ======= ======= ====== ===== ======= ======= ======= =====
2003 Change in 2002 Change in ----------------------- ----------------------- Average Average Sales Unit Sales Unit Price Sales Total Price Sales Total ------- ----- ----- ------- ----- ----- United States 5.9% 91.4% 102.8% -2.0% -1.0% -3.0% Outside United States -15.6% 46.8% 23.9% -12.8% -1.0% -13.6% ------ ---- ----- ----- ---- ----- Total -7.9% 50.9% 39.0% -10.9% -1.0% -11.8% ====== ==== ===== ===== ==== =====
Year Ended December 31, ----------------------- 2003 2002 2001 ----- ----- ----- Share of total sales: United States 27.8% 19.1% 17.3% Outside United States 72.2% 80.9% 82.7% ----- ----- ----- Total 100.0% 100.0% 100.0% ===== ===== =====
In June 2002, the majority of our U.S. sales persons were terminated. In the fourth quarter of 2002, we hired a new CEO and began building our "new sales organization" in the U.S. consisting of four area directors managing 28 sales territories. Our representation within these territories now consists of both direct sales representatives and independent agents. This new sales organization and overall greater sales efforts contributed to our increase in sales in 2003 as compared to 2002 and to our sales within the U.S. accounting for a larger percentage of overall sales. During 2003 we aggressively entered several international markets that represented opportunities for greater sales unit growth but at prices lower than our other markets. Prices in some of these territories are lower than our current manufacturing costs. We feel this strategy is reasonable because if allows us to increase our market share while reducing our high priced but paid for inventories. Once we have exhausted our high priced components, we expect to have lower manufacturing costs per valve which will allow us to realize gross profit in these international markets. COST OF GOODS SOLD. We have made write-downs to our inventories the past three years due to future selling prices being lower than manufacturing costs in select international markets. Following is a summary of our cost of goods sold divided between sales of products and lower of cost or market adjustments.
Year Ended December 31, --------------------------- (in thousands) 2003 2002 2001 -------------- ------- ------- ------- Cost of goods sold, as reported $17,632 $12,307 $10,310 Less: Cost of good sold related to a lower of cost or market adjustment 4,400 2,400 1,000 ------- ------- ------- Cost of goods sold related to product sales $13,232 $ 9,907 $ 9,310 ======= ======= ======= Cost of good sold related to product sales as a percentage of net sales 71.6% 74.5% 61.7%
16 Our costs of goods sold as a percentage of net sales has varied due to changes in average selling price. Our gross margin is anticipated to improve as sales within the Unites States increase as a percentage of total sales and as we start selling valves that have been entirely manufactured in our facilities. Our inventories of high priced carbon components currently exceed our expected sales during 2004. The ATS valve is made of materials that do not deteriorate. Other than the need to resterilize them periodically, there is no risk of perishability. Pyrolytic carbon, which is the substrate used in manufacturing our valves, has been the only material used to manufacture mechanical heart valves for humans for many years and remains the most advanced raw material for our products. The other sources of prosthetic heart valves for humans are cadaver and porcine tissues, however, obsolescence issue because of this are remote because of certain advantages offered by mechanical heart valves including superior durability. Similarly, we believe that, given the lead time that would be required, there is no material risk that there would be the introduction and FDA approval of another substrate that would replace pyrolytic carbon prior to the end of the period over which we expect to sell our inventory of valves. SALES AND MARKETING. Cost increases in 2003 over 2002 were for the building of our "new sales and marketing organizations". In June 2002, the majority of our U.S. sales persons were terminated resulting in a substantial decrease in expenses during 2002 compared to 2001. In the fourth quarter of 2002, we hired a new CEO and thereafter began the process of hiring and training the new employees in the new sales and marketing organizations. We have substantially completed the hiring and training of our new sales and marketing organizations. RESEARCH AND DEVELOPMENT. Research and development expenses include the costs to develop and improve current and future products, the costs for regulatory and clinical activities for these products, and the costs to set up and maintain our carbon components manufacturing facility while it is in pre-production mode. The operational qualification and validation of the carbon production equipment and making pilot coating runs have been charged to research and development costs. The following table compares the different components of research and development costs for 2003, 2002, and 2001.
Year Ended December 31, ------------------------ (in thousands) 2003 2002 2001 -------------- ------ ------ ------ Costs related to manufacturing facility $1,209 $1,795 $3,052 All other R&D costs 555 630 854 ------ ------ ------ Total $1,764 $2,425 $3,906 ====== ====== ======
On May 29, 2002, we received notification from the FDA of full approval of our carbon manufacturing facility. The decrease in research and development expenses during 2003 is attributable to the costs of setting up and qualifying our manufacturing facility to receive this approval during the first half of 2002. We expect to increase production capacity of our carbon components during 2004. Accordingly, the costs of this facility that are now classified as research and development costs will be included as costs of goods sold after the date on which we commence increased production of these carbon components. GENERAL AND ADMINISTRATIVE. During 2003, we incurred legal, accounting, and other professional services substantially for legal support, recruitment, and the hiring of our new executive team that totaled $0.8 million. In addition, management bonus accruals increased by $0.6 million, for management's attainment of increased financial performance. The decrease in expenses during 2002 compared to 2001 is due to fewer personnel as a result of certain reorganization initiatives during the second half of 2002. IMPAIRMENT CHARGE. During the first quarter of 2002, we evaluated the carrying value of its technology license asset of $13 million in accordance with the provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets. While this evaluation indicated that the asset's carrying value was recoverable, changes in sales volumes and selling prices during the second quarter of 2002 necessitated a revaluation of the recoverability of that asset. As a result of this updated cash flow analysis, we recorded an $8.1 million non-cash 17 charge during the second quarter of 2002. We believe our current carrying value of the technology license is recoverable and no further impairment charges have been taken. DISTRIBUTOR TERMINATION EXPENSES. During the fourth quarter of 2002, we terminated our relationship with our distributor who covered France and Belgium because of violations of several conditions of the distributor agreement. The distributor had the right to return its inventory of valves to us as a result of the early termination clause within the distributor agreement. We accrued an estimated termination charge of $0.8 million, representing the margin on the valves that were expected to be returned and the estimated cost related to restocking such inventory for resale. The entire charge was paid for in 2003. REORGANIZATION EXPENSE. In June 2002, the Board of Directors decided to significantly decrease our workforce. As part of these cost reduction measures, one half of the workforce, including the executive officers of the Company, were released from employment. A charge of $1.1 million was recorded as reorganization expense at that time. GAIN ON EXTINGUISHMENT OF DEBT. On July 21, 2003, we entered into an agreement and on August 21, 2003, we paid Centerpulse USA Holdings Co.(Centerpulse) $12 million in exchange for cancellation of all of our payment obligations under our carbon technology agreement and after which we would own a fully paid exclusive license to use the carbon technology to produce components for our valve. Prior to this agreement, we were obligated to pay Centerpulse an aggregate of $28 million under the technology agreement over a period of approximately four years. These payments were accrued as milestones were met. Of the total $28 million, there were two uncompleted milestones totaling $12 million that were not accrued. Since the amount accrued exceeded the amount we paid, we realized a non-cash gain on the extinguishment of debt in the amount of $2.6 million on this transaction. NET INTEREST INCOME (EXPENSE). Our interest expense was primarily attributable to imputed interest on our long-term debt previously owed to Centerpulse. Our interest income is primarily attributable to the investment of our cash balances. INCOME TAXES. We have accumulated approximately $42 million of net operating loss (NOL) carryforwards for U.S. tax purposes. We believe that our ability to fully utilize the existing NOL carryforwards could be restricted on a portion of the NOL for changes in control that may have occurred or may occur in the future. We have not conducted a formal study of whether a change in control of ATS has occurred in the past that impairs our NOL carryforwards because we are unable to utilize such NOL carryforwards until we achieve profitability and because this study would be very expensive to complete. When we attain profitability, we will conduct a formal study of any restrictions on our carryforwards. We have not recorded any net assets related to our NOL carryforwards and other deferred items as we currently cannot determine that it is reasonably likely that this asset will be realized and we, therefore, have provided a valuation allowance for the entire asset. NET LOSS. Our decrease in net loss in 2003 compared to 2002 and the increase in net loss in 2002 compared to 2001 resulted from changes in sales offset by changes in operating costs, all of which are described above. LIQUIDITY AND CAPITAL RESOURCES Cash, cash equivalents, and short-term investments totaled $8.5 million and $10.0 million on December 31, 2003 and December 31, 2002, respectively. OPERATING ACTIVITIES. During 2003 we received cash payments from customers of $17.1 million. We made cash payments to employees and suppliers of $17.2 million. Our operating loss during 2003 of $12.9 million was substantially funded through the depletion of inventories. During 2003, we incurred significant expenses commercializing the ATS heart valve in the United States. As we build sales in future periods and our cost of inventories decrease, our operating losses will decrease and we will move steadily towards a cash flow breakeven on sales and eventually to profitability. We believe our current cash balances are adequate to fund our operating activities during 2004. 18 INVESTING AND FINANCING ACTIVITIES. We historically have funded our operations through equity investments. During 2003, we raised $11.6 million through an equity offering and the issuance of stock through the exercise of stock options. During 2003, we paid $12.0 million of debt related to our Carbon Technology Agreement. We have no future payment obligations under this Agreement. During 2003 we purchased property and equipment totaling $0.7 million. Our current level of property and equipment is adequate to support operations in 2004 and purchases of equipment will approximate 2003 spending in 2004. CASH MANAGEMENT During 2004 and into 2005, we expect to increase production of pyrolytic carbon components in our own factory. This will require the use of cash as we purchase raw materials and hire employees to make the inventory. Current inventory levels are adequate into 2005. We estimate that operating costs will remain high in comparison to sales during 2004 and 2005 and will require the use of cash to fund operations. We will draw down cash balances to build inventories and fund operations during 2004 and 2005. Based upon the current forecast of sales and operating expenses, we anticipate having cash to fund our operations through 2004. However, as identified under the heading of "Cautionary Statements" below, any adverse change that affects our revenue, access to the capital markets or future demand for our products will affect our long term viability. Maintaining adequate levels of working capital depends in part upon the success of our products in the marketplace, the relative profitability of those products and our ability to control operating and capital expenses. Funding of our operations in future periods may require additional investments in ATS in the form of equity or debt. There can be no assurance that we will achieve desired levels of sales or profitability, or that future capital infusions will be available. OFF-BALANCE SHEET ARRANGEMENTS We do not have any "off-balance sheet arrangements" (as such term is defined in Item 303 of Regulation S-K) that are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. CONTRACTUAL OBLIGATIONS The following table sets forth our future payment obligations.
Payments Due By Period ------------------------------------------------- Less One to Four to More than than Three Five Five (thousands) Total One year Years Years Years ----------- ------- -------- ------ ------- --------- Operating leases $ 2,294 $429 $1,293 $ 531 $ 41 Purchase obligations $23,500 -- 3,500 10,000 10,000 ------- ---- ------ ------- ------- Total $25,794 $429 $4,793 $10,531 $10,041 ======= ==== ====== ======= =======
CAUTIONARY STATEMENTS This document contains forward-looking statements within the meaning of federal securities laws that may include statements regarding intent, belief or current expectations of our Company and our management. The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements to encourage companies to provide prospective information without fear of litigation so long as those statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected in the statement. We desire to take advantage of these "safe harbor" provisions. Accordingly, we hereby identify the following important factors which could cause our 19 actual results to differ materially from any such results which may be projected, forecast, estimated or budgeted by us in forward-looking statements made by us from time to time in reports, proxy statements, registration statements and other written communications, or in oral forward-looking statements made from time to time by the company's officers and agents. We do not intend to update any of these forward-looking statements after the date of this Form 10-K to conform them to actual results. IF OUR HEART VALVE DOES NOT ACHIEVE WIDESPREAD MARKET ACCEPTANCE IN THE UNITED STATES, OUR OPERATING RESULTS WILL BE HARMED AND WE MAY NOT ACHIEVE PROFITABILITY. Our success will depend, in large part, on the medical community's acceptance of the ATS heart valve in the United Sates, which is the largest revenue market in the world for heart valves. The U.S. medical community's acceptance of the ATS heart valve will depend upon our ability to demonstrate the safety and efficacy, advantages, long-term clinical performance and cost-effectiveness of the ATS heart valve as compared to other prosthetic heart valves. We cannot predict whether the U.S. medical community will accept the ATS heart valve or, if accepted, the extent of its use. Negative publicity resulting from isolated incidents involving the ATS heart valve or other prosthetic heart valves could have a significant adverse effect on the overall acceptance of our heart valve. If we encounter difficulties developing a market for the ATS heart valve in the United States, we may not be able to increase our revenue enough to achieve profitability and our business and results of operations will be seriously harmed. WE CURRENTLY RELY ON THE ATS HEART VALVE AS OUR SOLE SOURCE OF REVENUE. IF WE ARE NOT SUCCESSFUL IN SELLING THIS PRODUCT, OUR OPERATING RESULTS WILL BE HARMED. We have developed only one product, which is currently being sold primarily outside the United States. Even if we were to develop additional products, regulatory approval would likely be required to sell them. Clinical testing and the approval process itself are very expensive and can take many years. Therefore, we do not expect to be in a position to sell additional products in the foreseeable future. Adverse rulings by regulatory authorities, product liability lawsuits, the failure to achieve widespread U.S. market acceptance, the loss of market acceptance outside of the United States, or other adverse publicity may significantly and adversely affect our sales of the ATS heart valve, and, as a result, would adversely affect our business, financial condition and results of operations. IN 2002 WE BEGAN USING A COMBINATION OF DIRECT SALES PERSONS AND INDEPENDENT MANUFACTURING REPRESENTATIVES TO SELL OUR VALVES IN THE UNITED STATES. IF OUR NEW U.S. SALES STRATEGY IS NOT SUCCESSFUL, WE WILL NOT BE ABLE TO CONTINUE OUR OPERATIONS AS PLANNED. Our sales approach for the sale of the ATS valve in the United States consists primarily of direct salespersons with a few independent manufacturer's representatives. We will need to continue to expend significant funds and management resources to develop and maintain this hybrid sales force. We believe there is significant competition for sales personnel and independent manufacturing representatives with the advanced sales skills and technical knowledge we need. If we are unable to recruit, retain and motivate qualified personnel and representatives, U.S. sales of the ATS valve could be adversely affected. The loss of key salespersons or independent manufacturer's representatives could have a material adverse effect on our sales or potential sales to current customers and prospects serviced by such salespersons or representatives. Further, we cannot assure the successful expansion of our network of independent manufacturer's representatives on terms acceptable to ATS, if at all, or the successful marketing of our products by our hybrid sales force. To the extent we rely on sales through independent manufacturer's representatives, any revenues we receive will depend primarily on the efforts of these parties. We do not control the amount and timing of marketing resources that these third parties devote to our product. If our U.S. sales strategy is not successful, we may be forced to change our U.S. sales strategy again. Any such change could disrupt sales in the United States. Further, any change in our U.S. sales strategy could be expensive and would likely have a material adverse impact on our results of operations. WE CURRENTLY DEPEND ON THE MARKETING AND SALES EFFORTS OF INTERNATIONAL INDEPENDENT DISTRIBUTORS, AND OUR SALES HAVE BEEN CONCENTRATED IN THREE COUNTRIES. The ATS heart valve is sold internationally through independent distributors. The loss of an international distributor could seriously harm our business and results of operations if a new distributor could not be found on a timely basis in the relevant geographic market. We do not control the amount and timing of marketing resources that these third 20 parties devote to our product. Furthermore, to the extent we rely on sales through independent distributors, any revenues we receive will depend primarily on the efforts of these parties. WE ARE DEPENDENT UPON SALES OUTSIDE THE UNITED STATES, WHICH ARE SUBJECT TO A NUMBER OF RISKS INCLUDING A DROP IN SALES DUE TO CURRENCY FLUCTUATIONS. As December 31, 2003, 72% of our net sales are derived from international operations. We expect that international sales will account for a substantial majority of our revenue until the ATS heart valve receives wider market acceptance from U.S. customers. Accordingly, any material decrease in foreign sales may materially and adversely affect our results of operations. We sell in U.S. dollars to most of our customers abroad. An increase in the value of the U.S. dollar in relation to other currencies can and has adversely affected our sales outside of the United States. In prior years, the decrease in sales was due primarily to the change in the value of the U.S. dollar against the Euro, as well as competitor price pressure. Our dependence on sales outside of the United States will continue to expose us to U.S. dollar currency fluctuations for the foreseeable future. Our future results of operations could also be harmed by risks inherent in doing business in international markets, including: - unforeseen changes in regulatory requirements and government health programs; - weaker intellectual property rights protection in some countries; - new export license requirements, changes in tariffs or trade restrictions; - political and economic instability in our target markets; and - greater difficulty in collecting payments from product sales. In 2001, we experienced a slow collection of receivables from our Italian distributor. As a result, we ceased recognizing sales to this distributor upon shipment, and instead recognize sales to this distributor only upon receipt of payment. Slow payment of receivables by other international distributors, or the occurrence of any of the other factors listed above, could harm our ability to successfully commercialize our product internationally and could harm our business. WE HAVE A HISTORY OF NET LOSSES. IF WE DO NOT HAVE NET INCOME IN THE FUTURE, WE MAY BE UNABLE TO CONTINUE OUR OPERATIONS. We are not currently profitable and have a very limited history of profitability. As of December 31, 2003, we had an accumulated deficit of $50.9 million. We expect to incur significant expenses over the next several years as we continue to devote substantial resources to the commercialization of the ATS heart valve in the United States. We will not generate net income unless we are able to significantly increase revenue from U.S. sales. If we continue to sustain losses, we may not be able to continue our business as planned. WE CHANGED MANAGEMENT IN LATE 2002. OUR FAILURE TO RETAIN THE CURRENT MANAGEMENT OR OUR MANAGEMENT'S FAILURE TO IMPROVE SALES AND ACHIEVE PROFITABILITY COULD ADVERSELY IMPACT OUR RESULTS OF OPERATIONS. In October 2002 we hired a new President and Chief Executive Officer. Since then, we have hired the rest of our current executive team. Most of the members of our executive team have extensive experience in sales and marketing medical device products. There is substantial competition for executives with this kind of experience. Therefore, we cannot assure you that we will be able to retain our management team. Replacing our management team could substantially disrupt our prospects, business and operations. Further, the failure of the current management team to substantially increase sales and return the company to profitability could negatively affect our continued ability to sell products to existing customers. THE MARKET FOR PROSTHETIC HEART VALVES IS HIGHLY COMPETITIVE, AND A NUMBER OF OUR COMPETITORS ARE LARGER AND HAVE MORE FINANCIAL RESOURCES. IF WE DO NOT COMPETE EFFECTIVELY, OUR BUSINESS WILL BE HARMED. 21 The market for prosthetic heart valves is highly competitive. We expect that competition will intensify as additional companies enter the market or modify their existing products to compete directly with us. Our primary competitor, St. Jude Medical, Inc., currently controls approximately 50% of the worldwide mechanical heart valve market. Many of our competitors have long-standing FDA approval for their valves and extensive clinical data demonstrating the performance of their valves. In addition, they have greater financial, manufacturing, marketing and research and development capabilities than we have. For example, many of our competitors have the ability, due to their internal carbon manufacturing facilities and economies of scale, to manufacture their heart valves at a lower cost than we can manufacture our ATS heart valve. Our primary competitor has recently used price as a method to compete in several international markets. If heart valve prices decline significantly we might not be able to compete successfully, which would harm our results of operations. OUR FUTURE RESULTS WILL BE HARMED IF THE USE OF MECHANICAL HEART VALVES DECLINES. Our business could suffer if the use of mechanical heart valves declines. Historically, mechanical heart valves have accounted for over two-thirds of all heart valve replacements. Recently, there has been an increase in the use of tissue valves. We estimate that mechanical heart valves are currently being used in 40 to 65% of all heart valve replacements, depending on the geographic market, down from 65 to 75% about ten years ago. We believe the tissue manufacturers' claims of improvements in tissue valve longevity and an increase in the average age of valve patients have contributed to the recent increase in the use of tissue valves. NEW PRODUCTS OR TECHNOLOGIES DEVELOPED BY OTHERS COULD RENDER OUR PRODUCT OBSOLETE. The medical device industry is characterized by significant technological advances. Several companies are developing new prosthetic heart valves based on new or potentially improved technologies. Significant advances are also being made in surgical procedures, which may delay the need for replacement heart valves. A new product or technology may emerge that renders the ATS heart valve noncompetitive or obsolete. This could materially harm our results of operations or force us to cease doing business altogether. WE MAINTAIN A LARGE VOLUME OF INVENTORY, WHICH EXCEEDS THE CURRENT DEMAND FOR THE ATS HEART VALVE. IF SALES OF OUR PRODUCT DO NOT INCREASE, THE VALUE OF OUR INVENTORY COULD DECREASE SUBSTANTIALLY. We purchased pyrolytic carbon components under a long-term supply agreement with Carbomedics, Inc. (formerly Sulzer Carbomedics, Inc.) through June 2002 and we are required to resume purchases of such components in 2007. To date, our purchases of pyrolytic carbon components have exceeded our sales of the ATS heart valves. We currently have in inventory enough pyrolytic carbon components to satisfy our projected requirements through 2004. If we are unable to achieve widespread acceptance for the ATS heart valve or if competitive pressures result in price reductions, the value of the excess inventory would likely decrease, which could seriously harm our results of operations and financial condition. Because the pyrolytic carbon components are made to meet the unique specifications of the ATS heart valve, our inventory may have little, if any, value in the open market. WE LICENSE PATENTED TECHNOLOGY AND OTHER PROPRIETARY RIGHTS FROM CARBOMEDICS. IF THESE AGREEMENTS ARE BREACHED OR TERMINATED, OUR RIGHT TO MANUFACTURE THE ATS HEART VALVE COULD BE TERMINATED. Under our carbon technology agreement with Carbomedics, we have obtained a license to use Carbomedics' pyrolytic carbon technology to manufacture components for the ATS heart valve. If this agreement is breached or terminated, we would be unable to manufacture our own product. If our inventory is exhausted and we do not have any other sources of carbon components, we would be forced to cease doing business. A DELAY OR INTERRUPTION IN THE SUPPLY OF PYROLYTIC CARBON COMPONENTS COULD DELAY PRODUCT DELIVERY OR FORCE US TO CEASE OPERATIONS. We cannot be certain that, after our current inventory is exhausted, sufficient quantities of pyrolytic carbon components will be available to assemble the ATS heart valve. Other than our carbon facility, the only other FDA-approved alternate supplier of our pyrolytic carbon components is Carbomedics. Although we have a supply agreement with Carbomedics under which it agrees to supply us with a minimum annual number of pyrolytic carbon components in 2007 through 2011, the amounts available under this agreement are not expected to be sufficient to 22 supply all of our needs for components in those years. If our inventory is exhausted and we are unable to manufacture carbon components or obtain them from other sources, we could be forced to reduce or cease operations. BECAUSE WE LACK MANUFACTURING EXPERIENCE, WE MAY NOT REALIZE EXPECTED SAVINGS FROM MANUFACTURING OUR OWN PRODUCT. IN ADDITION, WE COULD EXPERIENCE PRODUCTION DELAYS AND SIGNIFICANT ADDITIONAL COSTS. Under our agreement with Carbomedics, we have been granted an exclusive worldwide license to manufacture pyrolytic carbon components for the ATS heart valve. We cannot be certain that our strategy to establish internal manufacturing capabilities will result in a cost-effective means for manufacturing the ATS heart valve. We have limited experience in manufacturing pyrolytic carbon. Although we have an FDA-approved carbon manufacturing facility, it is currently operating at the minimal level necessary to maintain the plant and our technical expertise in producing carbon components. In the future when we increase production at the plant we may encounter difficulties in maintaining and expanding our manufacturing operations, including problems involving: - production yields; - quality control; - per unit manufacturing costs; - shortages of qualified personnel; and - compliance with FDA and international regulations and requirements regarding good manufacturing practices. Difficulties encountered by us in establishing or maintaining a commercial-scale manufacturing facility may limit our ability to manufacture our heart valve and therefore could seriously harm our business and results of operations. OUR BUSINESS COULD BE SERIOUSLY HARMED IF THIRD-PARTY PAYORS DO NOT REIMBURSE THE COSTS FOR OUR HEART VALVE. Our ability to successfully commercialize the ATS heart valve depends on the extent to which reimbursement for the cost of our product and the related surgical procedure is available from third-party payors, such as governmental programs, private insurance plans and managed care organizations. Third-party payors are increasingly challenging the pricing of medical products and procedures that they consider are not cost-effective or are used for a non-approved indication. The failure by physicians, hospitals and other users of our product to obtain sufficient reimbursement from third-party payors would seriously harm our business and results of operations. In recent years, there have been numerous proposals to change the health care system in the United States. Some of these proposals have included measures that would limit or eliminate payment for medical procedures or treatments. In addition, government and private third-party payors are increasingly attempting to contain health care costs by limiting both the coverage and the level of reimbursement. In international markets, reimbursement and health care payment systems vary significantly by country. In addition, we have encountered price resistance from government-administered health programs. Significant changes in the health care system in the United States or elsewhere, including changes resulting from adverse trends in third-party reimbursement programs, could have a material adverse effect on our business and results of operations. WE MAY FACE PRODUCT LIABILITY CLAIMS, WHICH COULD RESULT IN LOSSES IN EXCESS OF OUR INSURANCE COVERAGE AND WHICH COULD NEGATIVELY AFFECT OUR ABILITY TO ATTRACT AND RETAIN CUSTOMERS. The manufacture and sale of mechanical heart valves entail significant risk of product liability claims and product recalls. A mechanical heart valve is a life-sustaining device and the failure of any mechanical heart valve usually results in the patient's death or need for reoperation. A product liability claim or product recall, regardless of the ultimate outcome, could require us to spend significant time and money in litigation or to pay significant damages and could seriously harm our business. We currently maintain product liability insurance coverage in an aggregate amount of $25 million. However, we cannot assure you that our current insurance coverage is adequate to cover the costs of any product liability claims made against us. Product liability insurance is expensive and does not cover the costs of a product recall. In the future, product liability insurance may not be available at satisfactory rates or in adequate amounts. A product liability claim or product recall could also materially and adversely affect our ability to attract and retain customers. 23 OUR BUSINESS WOULD BE ADVERSELY AFFECTED IF WE ARE NOT ABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS. Our success depends in part on our ability to maintain and enforce our patents and other proprietary rights. We rely on a combination of patents, trade secrets, know-how and confidentiality agreements to protect the proprietary aspects of our technology. These measures afford only limited protection and competitors may gain access to our intellectual property and proprietary information. The patent positions of medical device companies are generally uncertain and involve complex legal and technical issues. Litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets and to determine the validity and scope of our proprietary rights. Any litigation could be costly and divert our attention from the growth of the business. We cannot assure you that our patents and other proprietary rights will not be successfully challenged, or that others will not independently develop substantially equivalent information and technology or otherwise gain access to our proprietary technology. WE MAY BE SUED BY THIRD PARTIES WHICH CLAIM THAT OUR PRODUCT INFRINGES ON THEIR INTELLECTUAL PROPERTY RIGHTS. ANY SUCH SUITS COULD RESULT IN SIGNIFICANT LITIGATION OR LICENSING EXPENSES OR WE MIGHT BE PREVENTED FROM SELLING OUR PRODUCT. We may be exposed to future litigation by third parties based on intellectual property infringement claims. Any claims or litigation against us, regardless of the merits, could result in substantial costs and could harm our business. In addition, intellectual property litigation or claims could force us to: - cease manufacturing and selling our product, which would seriously harm us; - obtain a license from the holder of the infringed intellectual property right, which license may not be available on reasonable terms, if at all; or - redesign our product, which could be costly and time-consuming. WE ARE SUBJECT TO EXTENSIVE GOVERNMENTAL REGULATION, WHICH IS COSTLY, TIME CONSUMING AND CAN SUBJECT US TO UNANTICIPATED DELAYS. The ATS heart valve and our manufacturing activities are subject to extensive regulation by a number of governmental agencies, including the FDA and comparable international agencies. We are required to: - maintain the approval of the FDA and international regulatory agencies to continue selling the ATS heart valve; - obtain the approval of international regulatory agencies in countries where the ATS heart valve is not yet marketed; - satisfy content requirements for all of our labeling, sales and promotional materials; - comply with manufacturing and reporting requirements; and - undergo rigorous inspections by these agencies. Compliance with the regulations of these agencies may delay or prevent us from introducing any new or improved products. Violations of regulatory requirements may result in fines, marketing restrictions, product recall, withdrawal of approvals and civil and criminal penalties. THE PRICE OF OUR COMMON STOCK HAS BEEN VOLATILE, WHICH MAY RESULT IN LOSSES TO INVESTORS. The minimum bid price of our common stock was below $1.00 per share during a ten-month period beginning in 2002 and ending in March 2003. As a result, our common stock lost its eligibility to be traded on The Nasdaq National Market and instead was traded on The Nasdaq SmallCap Market until July 2003, when our common stock was relisted on The Nasdaq National Market after again meeting that market's eligibility criteria. If the minimum bid price of our stock again falls below $1.00 for an extended period of time, we may be forced to relist our stock on The Nasdaq SmallCap Market. If our common stock fails to meet the eligibility criteria for continued listing on either The Nasdaq National Market or The Nasdaq SmallCap Market, the price of our stock would, in all likelihood, decline, and our investors would find it more difficult to dispose of or to obtain accurate quotations as to the market value of our common stock. 24 Historically, the market price of our common stock has fluctuated over a wide range and it is likely that the price of our common stock will fluctuate in the future. The market price of our common stock could be impacted by the following: - the success of our management in operating ATS effectively; - the failure of the ATS valve to gain market acceptance in the United States; - announcements of technical innovations or new products by our competitors; - the status of component supply arrangements; - changes in reimbursement policies; - government regulation; - developments in patent or other proprietary rights; - public concern as to the safety and efficacy of products developed by us or others; and - general market conditions. In addition, due to one or more of the foregoing factors, in future years, our results of operations may fall below the expectations of securities analysts and investors. In that event, the market price of our common stock could be materially and adversely affected. Finally, in recent years the stock market has experienced extreme price and volume fluctuations. This volatility has had a significant effect on the market prices of securities issued by many companies for reasons unrelated to their operating performance. These broad market fluctuations may materially adversely affect our stock price, regardless of our operating results. OUR CHARTER DOCUMENTS AND MINNESOTA LAW MAY DISCOURAGE AND COULD DELAY OR PREVENT A TAKEOVER OF OUR COMPANY. Provisions of our articles of incorporation, bylaws and Minnesota law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our shareholders. These provisions include the following: - No cumulative voting by shareholders for directors; - The ability of our board to set the size of the board of directors, to create new directorships and to fill vacancies; - The ability of our board, without shareholder approval, to issue preferred stock, which may have rights and preferences that are superior to our common stock; - The ability of our board to amend the bylaws; and - Restrictions under Minnesota law on mergers or other business combinations between us and any holder of 10% or more of our outstanding common stock. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The primary objective of our investments activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may cause the fair market value of the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then prevailing rate and the prevailing interest rate later rises, the fair value of the principal amount of our investment will probably decline. To minimize this risk, our portfolio of cash equivalents and short-term investments may be invested in a variety of securities, including commercial paper, money market funds, and both government and non-government debt securities. The average duration of all our investments has generally been less than one year. Due to the short-term nature of these investments, we believe we have no material exposure to interest rate risk arising from our investments. In the United States, Canada, and France, we sell our products directly to hospitals. In other international markets, we sell our products to independent distributors who, in turn, sell to medical hospitals. Loss, termination, or ineffectiveness of distributors to effectively promote our product would have a material adverse effect on our financial condition and results of operations. 25 Transactions with U.S. and non-U.S. customers and distributors, other than in France, are entered into in U.S. dollars, precluding the need for foreign currency hedges on such sales. Sales through our French subsidiary, which was established in 2002 to replace a distributor, are in Euros, so we are subject to profitability risk arising from exchange rate movements. We have not used foreign exchange contract or similar devices to reduce this risk. We will evaluate the need to use foreign exchange contracts or similar devices, if sales in France increase substantially. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Our Consolidated Financial Statements and the report of our independent auditors are included in this Annual Report on Form 10-K beginning on page F-1. The index to this report and the financial statements is included in Item 15 (a) (1) below. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9a. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(f) under the Exchange Act). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in timely alerting them to the material information relating to us required to be included in our periodic SEC filings. (b) Changes in Internal Control During the most recent fiscal quarter, there has been no change in our internal controls over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 26 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT See Part I of this Report for certain information regarding the Company's executive officers. Pursuant to General Instruction G(3), reference is made to information contained under the headings "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive proxy statement for its 2004 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission on or before April 30, 2004, which information is incorporated herein. ITEM 11. EXECUTIVE COMPENSATION Pursuant to General Instruction G(3), reference is made to information contained under the headings "Executive Compensation" and "Compensation of Directors" in the Company's definitive proxy statement for its 2004 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission on or before April 30, 2004, which information is incorporated herein, excluding the "Report of the Compensation Committee Concerning Executive Compensation." ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS Pursuant to General Instruction G(3), reference is made to information contained under the headings "Security Ownership of Certain Beneficial Owners and Management", "Equity Compensation Plan Information" and "Election of Directors" in the Company's definitive proxy statement for its 2004 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission on or before April 30, 2004, which information is incorporated herein. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES Information required by this Item appears under the heading "Audit Fees" of the Proxy Statement and is incorporated herein by reference. 27 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A) 1. FINANCIAL STATEMENTS Our Consolidated Financial Statements and the Independent Auditor's Report Thereon are included herein (page numbers refer to pages in this Annual Report on Form 10-K): Report of Independent Auditors Page F-1 Consolidated Statements of Financial Position as of December 31, 2003 and 2002 Page F-2 Consolidated Statements of Operations for the years end December 31, 2003, 2002, and 2001 Page F-3 Consolidated Statement of Shareholder's Equity for the years ended December 31, 2003, 2002, and 2001 Page F-4 Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002, and 2001 Page F-5 Notes to Consolidated Financial Statements for the years ended December 31, 2003, 2002, and 2001 Page F-6 through F-15 28 (A) 2. FINANCIAL STATEMENT SCHEDULES ATS MEDICAL, INC. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (in thousands)
ADDITIONS - ----------------------- CHARGED TO BALANCE AT CHARGED TO OTHER BALANCE AT BEGINNING COSTS AND ACCOUNTS- DEDUCTIONS END OF DESCRIPTION OF PERIOD EXPENSES DESCRIBE DESCRIBE PERIOD ----------- ---------- ---------- ---------- ---------- ---------- COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E ----------- ---------- ----------------------- ---------- ---------- VALUATION ACCOUNTS: Year Ended December 31, 2003 Deducted from asset accounts Allowance for doubtful accounts $420 $ 0 $0 ($150)(1) $270 Allowance for obsolete inventories $200 $ 0 $0 $ 0 $200 Year ended December 31, 2002 Allowance for doubtful accounts $400 $ 20 $0 $ 0 $420 Allowance for obsolete inventories $200 $ 0 $0 $ 0 $200 Year ended December 31, 2001 Allowance for doubtful accounts $425 $198 $223 (2) $400 Allowance for obsolete inventories $200 $ 0 $0 $ 0 $200
(1) Changes in estimate recovered through a reduction in expenses. (2) Uncollectible accounts written off, net of recoveries. All other schedules have been omitted because of absence of conditions under which they are required or because the required information is included in the financial statements or notes thereto. (A) 3. LISTING OF EXHIBITS
EXHIBIT NUMBER DESCRIPTION ------- ----------- 3.1 Restated Articles of Incorporation, as amended to date (Incorporated by reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1993 (the "1993 Form 10-K")). 3.2 Bylaws of the Company, as amended to date (Incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (the "1996 Form 10-K")). 4.1 Specimen certificate for shares of Common Stock of the Company (Incorporated by reference to Exhibit 4.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997 (the "1997 Form 10-K")). 10.1** 1987 Stock Option and Stock Award Plan, as restated and amended to date (Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997). 10.2** ATS Medical Inc. 2000 Stock Incentive Plan (Incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended September 30, 2000).
29 10.3** Agreement between the Company and Manuel A. Villafana dated September 11, 2001 (Incorporated by reference to Exhibit 10.3 to the Company's Form 10-K for the year ended December 31, 2001 (the "2001 Form 10-K")). 10.4 Lease Agreement between the Company and Crow Plymouth Land Limited Partnership dated December 22, 1987 (Incorporated by reference to Exhibit 10(d) to the Company's Registration Statement on Form S-18, File No. 33-34785-C (the "Form S-18")). 10.5 Amendment No. 1 to Lease Agreement between the Company and Crow Plymouth Land Limited Partnership, dated January 5, 1989 (Incorporated by reference to Exhibit 10(e) to the Form S-18). 10.6 Amendment No. 2 to Lease Agreement between the Company and Crow Plymouth Land Limited Partnership, dated January 1989 (Incorporated by reference to Exhibit 10(f) to the Form S-18). 10.7 Amendment No. 3 to Lease Agreement between the Company and Crow Plymouth Land Limited Partnership, dated June 14, 1989 (Incorporated by reference to Exhibit 10(g) to the Form S-18). 10.8 Amendment No. 4 to Lease Agreement between the Company and Plymouth Business Center Limited Partnership, dated February 10, 1992 (Incorporated by reference to Exhibit 10.8 to the 1996 Form 10-K). 10.10* O.E.M. Supply Contract dated September 24, 1990, with CarboMedics, Inc. (confidential treatment granted) (Incorporated by reference to Exhibit 10.10 to the 1996 Form 10-K). 10.11* License Agreement dated September 24, 1990, with CarboMedics, Inc. (confidential treatment granted) (Incorporated by reference to Exhibit 10.11 to the 1996 Form 10-K). 10.12** Employment Agreement between the Company and Michael D. Dale dated September 18, 2002 (Incorporated by reference to Exhibit 10.12 to the Company's Form 10-K for the year ended 2002 (the "2002 Form 10-K")). 10.13 Helix BioCore, Inc. Self-Insurance Trust Agreement dated February 28, 1991 (Incorporated by reference to Exhibit 10.13 to the 1996 Form 10-K). 10.14* Amendment 1 to License Agreement dated December 16, 1993, with CarboMedics, Inc. (confidential treatment granted) (Incorporated by reference to Exhibit 10.17 to the 1993 Form 10-K). 10.15* Amendment 4 to O.E.M. Supply Contract dated December 16, 1993, with CarboMedics, Inc. (confidential treatment granted) (Incorporated by reference to Exhibit 10.18 to the 1993 Form 10-K). 10.16* Amendment 5 to O.E.M. Supply Contract dated September 1, 1994, with CarboMedics, Inc. (confidential treatment granted) (Incorporated by reference to Exhibit 10.19 to the 1994 Form 10-K). 10.17 Letter Agreement between the Company and Sulzer Carbomedics, Inc., dated June 27, 2002 (Incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended June 20, 2002). 10.18 Line of Credit dated August 11, 1994, between the Company and First Bank National Association (Incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended September 30, 1994). 10.19 Form of International Distributor Agreement (Incorporated by reference to Exhibit 10.22 to the 1994 Form 10-K).
30 10.20** Form of Agreement between ATS Medical, Inc. and each officer dated June 30, 1995, concerning severance benefits upon a change in control (Incorporated by reference to Exhibit 10.23 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995 (the "1995 Form 10-K")). 10.21** ATS Medical, Inc. Change in Control Severance Pay Plan (Incorporated by reference to Exhibit 10.24 to the 1995 Form 10-K). 10.22 Amendment No. 5 to Lease Agreement between the Company and St. Paul Properties, Inc., dated May 30, 1996 (Incorporated by reference to Exhibit 10.22 to the 1996 Form 10-K). 10.23** Letter Agreement dated November 1, 2002, extending the agreement dated September 11, 2001 between the Company and Manuel A. Villafana (Incorporated by reference to Exhibit 10.23 to the 2002 Form 10-K). 10.24 Amendment No. 6 to Lease Agreement between the Company and St. Paul Properties, Inc., dated November 25, 1997 (Incorporated by reference to Exhibit 10.23 to the 1997 Form 10-K). 10.25 1998 Employee Stock Purchase Plan (Incorporated by reference to Exhibit 4 to the Company's Registration Statement on Form S-8, File No. 333-57527). 10.26** 1998 Management Incentive Compensation Plan (Incorporated by reference to Exhibit 10.25 to the 1998 Form 10-K). 10.27* Carbon Agreement by and between Sulzer Carbomedics, Inc. and ATS Medical, Inc., dated December 29, 1999 (confidential treatment granted) (Incorporated by reference to Exhibit 99.1 to the Current Report on Form 8-K filed on January 13, 2000 (the "January 2000 Form 8-K"). 10.28* Amendment 7 to OEM Supply Contract by and between Sulzer Carbomedics, Inc. and ATS Medical, Inc., dated December 29, 1999 (confidential treatment granted) (Incorporated by reference to Exhibit 99.2 to the January 2000 Form 8-K). 10.29* Amendment 2 to License Agreement by and between Sulzer Carbomedics, Inc. and ATS Medical, Inc., dated December 29, 1999 (confidential treatment granted) (Incorporated by reference to Exhibit 99.3 to the January 2000 Form 8-K). 10.30 Amendment No. 7 to Lease Agreement between the Company and St. Paul Properties, Inc., dated May 18, 2000 (Incorporated by reference to Exhibit 10.2 to the Company's Form 10-Q for the quarter ended June 30, 2000). 10.31 Lease Agreement between the Company and St. Paul Properties, Inc., dated April 29, 2000 (Incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended June 30, 2000). 10.32 Amendment No. 8 to Lease Agreement between the Company and St. Paul Properties, Inc., dated December 14, 2000 (Incorporated by reference to Exhibit 10.32 to the Company's Annual Report on Form 10-K for the year ended December 31, 2000 (the "2000 Form 10-K")). 10.33* Amendment 8 to OEM Supply Contract by and between Sulzer Carbomedics, Inc. and ATS Medical, Inc., dated November 3, 2000 (confidential treatment granted) (Incorporated by reference to Exhibit 10.33 to the 2000 Form 10-K). 10.34 Form of U.S. Distribution Agreement (incorporated by reference to Exhibit 10.34 to the 2002 Form 10-K). 10.35 Amendment No. 9 to Lease Agreement between the Company and St. Paul Properties, Inc., dated September 8, 2003 (incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended September 30, 2003).
31 10.36 2004 Management Incentive Compensation Plan. 21 List of Subsidiaries (incorporated by reference to Exhibit 21 to the Company's Form 10-K for the year ended 2002). 23 Consent of Ernst & Young LLP. 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended. 31.2 Certification of Chief financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended. 32.1 Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended, confidential portions of this exhibit have been redacted. ** Represents a management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 15(c) of Form 10-K. (B) 1. REPORTS ON FORM 8-K We furnished (in accordance with Item 12 of Form 8-K) reports on Form 8-K under Items 7 and 12, as follows: On October 22, 2003, our results of operations and financial condition for the fiscal quarter ended September 30, 2003. On January 9, 2004, our results of operations and financial condition for the fiscal quarter ended December 31, 2003. On February 11, 2004, our results of operations and financial condition for the fiscal quarter ended December 31, 2003. 32 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. Dated: March 15, 2004 ATS MEDICAL, INC. By /s/ Michael D. Dale ------------------------------------ Michael D.Dale Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. SIGNATURE TITLE --------- ----- /s/ Manuel A. Villafana Chairman and Director ---------------------------------------- Chief Executive Officer, President and Director /s/ Michael D. Dale (principal executive officer) ---------------------------------------- Chief Financial Officer (principal financial and /s/ John R. Judd accounting officer) ---------------------------------------- /s/ David L. Boehnen Director ---------------------------------------- /s/ A. Jay Graf Director ---------------------------------------- /s/ Eric W. Sivertson Director ---------------------------------------- /s/ Robert Munzenrider Director ---------------------------------------- 33 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION ------- ----------- 3.1 Restated Articles of Incorporation, as amended to date (Incorporated by reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1993 (the "1993 Form 10-K")). 3.2 Bylaws of the Company, as amended to date (Incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (the "1996 Form 10-K")). 4.1 Specimen certificate for shares of Common Stock of the Company (Incorporated by reference to Exhibit 4.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997 (the "1997 Form 10-K")). 10.1** 1987 Stock Option and Stock Award Plan, as restated and amended to date (Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997). 10.2** ATS Medical Inc. 2000 Stock Incentive Plan (Incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended September 30, 2000). 10.3** Agreement between the Company and Manuel A. Villafana dated September 11, 2001 (Incorporated by reference to Exhibit 10.3 to the Company's Form 10-K for the year ended December 31, 2001 (the "2001 Form 10-K")). 10.4 Lease Agreement between the Company and Crow Plymouth Land Limited Partnership dated December 22, 1987 (Incorporated by reference to Exhibit 10(d) to the Company's Registration Statement on Form S-18, File No. 33-34785-C (the "Form S-18")). 10.5 Amendment No. 1 to Lease Agreement between the Company and Crow Plymouth Land Limited Partnership, dated January 5, 1989 (Incorporated by reference to Exhibit 10(e) to the Form S-18). 10.6 Amendment No. 2 to Lease Agreement between the Company and Crow Plymouth Land Limited Partnership, dated January 1989 (Incorporated by reference to Exhibit 10(f) to the Form S-18). 10.7 Amendment No. 3 to Lease Agreement between the Company and Crow Plymouth Land Limited Partnership, dated June 14, 1989 (Incorporated by reference to Exhibit 10(g) to the Form S-18). 10.8 Amendment No. 4 to Lease Agreement between the Company and Plymouth Business Center Limited Partnership, dated February 10, 1992 (Incorporated by reference to Exhibit 10.8 to the 1996 Form 10-K). 10.10* O.E.M. Supply Contract dated September 24, 1990, with CarboMedics, Inc. (confidential treatment granted) (Incorporated by reference to Exhibit 10.10 to the 1996 Form 10-K). 10.11* License Agreement dated September 24, 1990, with CarboMedics, Inc. (confidential treatment granted) (Incorporated by reference to Exhibit 10.11 to the 1996 Form 10-K). 10.12** Employment Agreement between the Company and Michael D. Dale dated September 18, 2002 (Incorporated by reference to Exhibit 10.12 to the Company's Form 10-K for the year ended 2002 (the "2002 Form 10-K")).
34 10.13 Helix BioCore, Inc. Self-Insurance Trust Agreement dated February 28, 1991 (Incorporated by reference to Exhibit 10.13 to the 1996 Form 10-K). 10.14* Amendment 1 to License Agreement dated December 16, 1993, with CarboMedics, Inc. (confidential treatment granted) (Incorporated by reference to Exhibit 10.17 to the 1993 Form 10-K). 10.15* Amendment 4 to O.E.M. Supply Contract dated December 16, 1993, with CarboMedics, Inc. (confidential treatment granted) (Incorporated by reference to Exhibit 10.18 to the 1993 Form 10-K). 10.16* Amendment 5 to O.E.M. Supply Contract dated September 1, 1994, with CarboMedics, Inc. (confidential treatment granted) (Incorporated by reference to Exhibit 10.19 to the 1994 Form 10-K). 10.17 Letter Agreement between the Company and Sulzer Carbomedics, Inc., dated June 27, 2002 (Incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended June 20, 2002). 10.18 Line of Credit dated August 11, 1994, between the Company and First Bank National Association (Incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended September 30, 1994). 10.19 Form of International Distributor Agreement (Incorporated by reference to Exhibit 10.22 to the 1994 Form 10-K). 10.20** Form of Agreement between ATS Medical, Inc. and each officer dated June 30, 1995, concerning severance benefits upon a change in control (Incorporated by reference to Exhibit 10.23 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995 (the "1995 Form 10-K")). 10.21** ATS Medical, Inc. Change in Control Severance Pay Plan (Incorporated by reference to Exhibit 10.24 to the 1995 Form 10-K). 10.22 Amendment No. 5 to Lease Agreement between the Company and St. Paul Properties, Inc., dated May 30, 1996 (Incorporated by reference to Exhibit 10.22 to the 1996 Form 10-K). 10.23** Letter Agreement dated November 1, 2002, extending the agreement dated September 11, 2001 between the Company and Manuel A. Villafana (Incorporated by reference to Exhibit 10.23 to the 2002 Form 10-K). 10.24 Amendment No. 6 to Lease Agreement between the Company and St. Paul Properties, Inc., dated November 25, 1997 (Incorporated by reference to Exhibit 10.23 to the 1997 Form 10-K). 10.25 1998 Employee Stock Purchase Plan (Incorporated by reference to Exhibit 4 to the Company's Registration Statement on Form S-8, File No. 333-57527). 10.26** 1998 Management Incentive Compensation Plan (Incorporated by reference to Exhibit 10.25 to the 1998 Form 10-K). 10.27* Carbon Agreement by and between Sulzer Carbomedics, Inc. and ATS Medical, Inc., dated December 29, 1999 (confidential treatment granted) (Incorporated by reference to Exhibit 99.1 to the Current Report on Form 8-K filed on January 13, 2000 (the "January 2000 Form 8-K"). 10.28* Amendment 7 to OEM Supply Contract by and between Sulzer Carbomedics, Inc. and ATS Medical, Inc., dated December 29, 1999 (confidential treatment granted) (Incorporated by reference to Exhibit 99.2 to the January 2000 Form 8-K).
35 10.29* Amendment 2 to License Agreement by and between Sulzer Carbomedics, Inc. and ATS Medical, Inc., dated December 29, 1999 (confidential treatment granted) (Incorporated by reference to Exhibit 99.3 to the January 2000 Form 8-K). 10.30 Amendment No. 7 to Lease Agreement between the Company and St. Paul Properties, Inc., dated May 18, 2000 (Incorporated by reference to Exhibit 10.2 to the Company's Form 10-Q for the quarter ended June 30, 2000). 10.31 Lease Agreement between the Company and St. Paul Properties, Inc., dated April 29, 2000 (Incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended June 30, 2000). 10.32 Amendment No. 8 to Lease Agreement between the Company and St. Paul Properties, Inc., dated December 14, 2000 (Incorporated by reference to Exhibit 10.32 to the Company's Annual Report on Form 10-K for the year ended December 31, 2000 (the "2000 Form 10-K")). 10.33* Amendment 8 to OEM Supply Contract by and between Sulzer Carbomedics, Inc. and ATS Medical, Inc., dated November 3, 2000 (confidential treatment granted) (Incorporated by reference to Exhibit 10.33 to the 2000 Form 10-K). 10.34 Form of U.S. Distribution Agreement (incorporated by reference to Exhibit 10.34 to the 2002 Form 10-K). 10.35 Amendment No. 9 to Lease Agreement between the Company and St. Paul Properties, Inc., dated September 8, 2003 (incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended September 30, 2003). 10.36 2004 Management Incentive Compensation Plan. 21 List of Subsidiaries (incorporated by reference to Exhibit 21 to the Company's Form 10-K for the year ended 2002). 23 Consent of Ernst & Young LLP. 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended. 31.2 Certification of Chief financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended. 32.1 Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended, confidential portions of this exhibit have been redacted. ** Represents a management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 15(c) of Form 10-K. 36 REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders ATS Medical, Inc. We have audited the accompanying consolidated statements of financial position of ATS Medical, Inc. and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of operations, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ATS Medical, Inc. and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ Ernst & Young LLP Minneapolis, Minnesota February 6, 2004 F-1 ATS Medical, Inc. Consolidated Statements of Financial Position (In Thousands, Except Share Data)
DECEMBER 31 ------------------- 2003 2002 -------- -------- ASSETS Current assets: Cash and cash equivalents $ 6,472 $ 7,472 Short-term investments 2,003 2,502 -------- -------- 8,475 9,974 Accounts receivable, less allowance of $270 in 2003 and $420 in 2002 4,939 3,557 Inventories 20,377 15,876 Prepaid expenses 508 382 -------- -------- Total current assets 34,299 29,789 Leasehold improvements, furniture, and equipment, net 5,895 6,026 Inventories 17,000 37,000 Technology license 18,500 18,500 Other assets 440 441 -------- -------- Total assets $ 76,134 $ 91,756 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 989 $ 511 Due to related party 217 192 Accrued reorganization charges 9 493 Accrued payroll and expenses 1,334 322 Accrued distributor liabilities 475 1,597 Notes payable -- 5,000 -------- -------- Total current liabilities 3,024 8,115 Due to related party 307 434 Long-term debt -- 9,080 Shareholders' equity: Common Stock, $0.01 par value: Authorized shares - 40,000,000 Issued and outstanding shares - 26,778,557 in 2003 and 22,305,920 in 2002 268 223 Additional paid-in capital 123,412 111,474 Accumulated deficit (50,858) (37,566) Deferred compensation (70) -- Accumulated other comprehensive income (loss) 51 (4) -------- -------- Total shareholders' equity 72,803 74,127 -------- -------- Total liabilities and shareholders' equity $ 76,134 $ 91,756 ======== ========
See accompanying notes. F-2 ATS Medical, Inc. Consolidated Statements of Operations (In Thousands, Except Per Share Amounts)
YEAR ENDED DECEMBER 31 ----------------------------- 2003 2002 2001 -------- -------- ------- Net sales $ 18,484 $ 13,301 $15,080 Cost of goods sold 17,632 12,307 10,310 -------- -------- ------- Gross profit 852 994 4,770 Operating expenses: Sales and marketing 10,180 3,312 4,904 Research and development 1,764 2,425 3,906 General and administrative 4,350 3,114 3,844 Impairment of technology license -- 8,100 -- Reorganization expenses -- 1,130 -- Gain on extinguishment of debt (2,575) -- -- Distributor termination expenses -- 821 -- -------- -------- ------- Total operating expenses 13,719 18,902 12,654 -------- -------- ------- Operating loss (12,867) (17,908) (7,884) Interest income 81 176 1,040 Interest expense (506) (480) -- -------- -------- ------- Net loss $(13,292) $(18,212) $(6,844) ======== ======== ======= Net loss per share: Basic and diluted $ (0.55) $ (0.82) $ (0.31) Weighted average number of shares outstanding: Basic and diluted 24,076 22,259 22,159
See accompanying notes. F-3 ATS Medical, Inc. Consolidated Statement of Changes in Shareholders' Equity (In Thousands)
ACCUMULATED OTHER COMMON STOCK ADDITIONAL COMPREHENSIVE --------------- PAID-IN INCOME DEFERRED ACCUMULATED SHARES AMOUNT CAPITAL (LOSS) COMPENSATION DEFICIT TOTAL ------ ------ ---------- ------------- ------------ ----------- -------- Balance at December 31, 2000 22,097 $221 $110,814 $-- $ -- $(12,510) $ 98,525 Common Stock issued under the Employee Stock Purchase Plan 40 -- 211 -- -- -- 211 Stock options exercised 67 1 330 -- -- -- 331 Net loss and comprehensive loss for the year -- -- -- -- -- (6,844) (6,844) ------ ---- -------- --- ----- -------- -------- Balance at December 31, 2001 22,204 222 111,355 -- -- (19,354) 92,223 Common Stock issued under the Employee Stock Purchase Plan 102 1 119 -- -- -- 120 Change in foreign currency translation -- -- -- (4) -- -- (4) Net loss for the year -- -- -- -- -- (18,212) (18,212) -------- Comprehensive loss (18,216) ------ ---- -------- --- ----- -------- -------- Balance at December 31, 2002 22,306 223 111,474 (4) -- (37,566) 74,127 Common Stock issued under the Employee Stock Purchase Plan 37 1 55 -- 56 Stock options exercised 36 -- 111 -- -- -- 111 Common stock issued in private placement, net of offering costs 4,400 44 11,381 -- -- -- 11,425 Stock option issued for services -- -- 218 -- -- -- 218 Deferred compensation -- related to stock options -- -- 173 -- (173) -- Amortization of deferred -- compensation -- -- -- -- 103 -- 103 Change in foreign currency translation -- -- -- 55 -- -- 55 Net loss for the year -- -- -- -- -- (13,292) (13,292) -------- Comprehensive loss (13,237) ------ ---- -------- --- ----- -------- -------- Balance at December 31, 2003 26,779 $268 $123,412 $51 $ (70) $(50,858) $ 72,803 ====== ==== ======== === ===== ======== ========
See accompanying notes. F-4 ATS Medical, Inc. Consolidated Statements of Cash Flows (In Thousands)
YEAR ENDED DECEMBER 31 ------------------------------ 2003 2002 2001 -------- -------- -------- OPERATING ACTIVITIES Net loss $(13,292) $(18,212) $ (6,844) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation 792 713 688 Loss on disposal of equipment 4 35 14 Imputed interest long-term debt 320 480 -- Compensation expense stock options 321 -- -- Impairment of technology license -- 8,100 -- Gain on extinguishment of debt (2,575) -- -- Lower of cost or market adjustment 4,400 2,200 1,000 Changes in operating assets and liabilities: Accounts receivable (1,382) 526 2,498 Prepaid expenses (126) 188 46 Other assets 1 (2) (14) Inventories 11,099 2,273 (6,861) Accounts payable and accrued expenses (42) 800 (1,081) -------- -------- -------- Net cash used in operating activities (480) (2,899) (10,554) INVESTING ACTIVITIES Purchases of short-term investments (5,231) (5,663) (19,290) Maturities of short-term investments 5,729 10,860 27,865 Payments for technology license (12,000) -- (5,000) Purchases of leasehold improvements, furniture, and equipment (665) (186) (3,288) Proceeds on disposal of equipment -- 165 -- -------- -------- -------- Net cash provided by (used in) investing activities (12,167) 5,176 287 FINANCING ACTIVITIES Net proceeds from issuance of common stock 11,592 120 542 -------- -------- -------- Net cash provided by financing activities 11,592 120 542 Effect of exchange rate changes 55 (4) -- -------- -------- -------- (Decrease) increase in cash and cash equivalents (1,000) 2,393 (9,725) Cash and cash equivalents at beginning of year 7,472 5,079 14,804 -------- -------- -------- Cash and cash equivalents at end of year $ 6,472 $ 7,472 $ 5,079 ======== ======== ========
See Accompanying Notes. F-5 ATS Medical, Inc. Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BUSINESS ACTIVITY ATS Medical, Inc. (the Company) manufactures and markets a bileaflet mechanical heart valve. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and both of its wholly owned subsidiaries, ATS Medical Sales, Inc. and ATS Medical France SARL, after elimination of intercompany accounts and transactions. CASH EQUIVALENTS The Company considers all highly liquid investments with maturities of three months or less at the time of purchase to be cash equivalents. Cash equivalents are carried at cost which approximates market value. SHORT-TERM INVESTMENTS Short-term investments are comprised of debt securities and are classified as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax, reported as a component of comprehensive income (loss) in shareholders' equity. Realized gains and losses and declines in value judged to be other than temporary on available-for-sale securities are included in other income. ACCOUNTS RECEIVABLE Credit is extended based on evaluation of a customer's financial condition and, generally, collateral is not required. Accounts receivable are due within 30-180 days and are stated at amounts due from customers net of an allowance for doubtful accounts. Accounts receivable outstanding longer than the contractual payment terms are considered past due. The Company determines its allowance by considering a number of factors, including the length of time trade accounts receivable are past due, the Company's previous loss history, the customer's current ability to pay its obligation to the Company, and the condition of the general economy and the industry as a whole. The Company writes-off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts. INVENTORIES Inventories are carried at the lower of cost (first-in, first-out basis) or market. The majority of the inventories consist of purchased components. The Company has recorded a valuation reserve against inventories of $0.2 million as of December 31, 2003 and 2002. The Company has written down a portion of its inventories to provide for the lower of cost or market value expected to be realized on its sales in less developed countries. The write-down was $4.4 million, $2.4 million, and $1.0 million in 2003, 2002, and 2001, respectively, and was included in cost of goods sold in the statement of operations. At December 31, 2003 and 2002, the Company's inventory is in excess of its current requirements based on the historical and anticipated level of sales. Management believes that excess quantities will be utilized over several years. The Company has classified $17.0 million and $37.0 million of inventories as non-current assets at December 31, 2003 and 2002, respectively. OTHER ASSETS Prior to obtaining directors' and officers' liability insurance, the Company had placed monies into a self-insurance trust to provide coverage for potential issues. At December 31, 2003 and 2002, the deposits within the trust amounted to $0.4 million. F-6 ATS Medical, Inc. Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) LEASEHOLD IMPROVEMENTS, FURNITURE, AND EQUIPMENT Leasehold improvements, furniture, and equipment are stated at cost. Depreciation is provided using the straight-line method over the estimated useful lives of the assets as follows: Furniture and fixtures 7 years Equipment 5 to 7 years Computers 2 years
Leasehold improvements are amortized over the related lease term or estimated useful life, whichever is shorter. TECHNOLOGY LICENSE The Company has exclusive, worldwide right and license to use Sulzer Carbomedics, Inc. (Carbomedics) pyrolytic carbon technology (see Note 4). The technology license will be tested annually for impairment in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, GOODWILL AND OTHER INTANGIBLE ASSETS. IMPAIRMENT OF LONG-LIVED ASSETS The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the assets to undiscounted future net cash flows expected to be generated by the assets. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. REVENUE RECOGNITION A significant portion of the Company's revenue in the United States, Canada, and France is generated from consigned inventory maintained at hospitals or with field representatives. In these situations, revenue is recognized at the time that the product has been implanted or used. In all other instances, revenue is recognized at the time product is shipped. Certain independent distributors in select international markets receive rebates against invoiced sales amounts. In these situations, the Company accrues for these rebates at the time of the original sale. USE OF ESTIMATES The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. INCOME TAXES Income taxes are accounted for under the liability method. Deferred income taxes are provided for temporary differences between financial reporting and tax bases of assets and liabilities. F-7 ATS Medical, Inc. Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) WARRANTIES The Company adopted Financial Accounting Standards Board Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Indebtedness to Others (FIN 45), during the first quarter of 2003. FIN 45 requires disclosures concerning the Company's obligations under certain guarantees. The Company has indemnified a supplier of its valve components against claims made or damages assessed as the result of the supplier's manufacture of the valve components. The Company has determined that given its history of no reports of product failures or liability claims, the likelihood of claims and subsequent payments is remote, and accordingly, no liabilities in conjunction with this indemnification have been accrued. STOCK-BASED COMPENSATION The Company has a stock-based employee compensation plan, which is described more fully in Note 7. This plan is accounted for under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Under APB No. 25, when the exercise price of stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized, and reflected in the net loss. The following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation (in thousands, except per share amounts):
YEAR ENDED DECEMBER 31 ----------------------------- 2003 2002 2001 -------- -------- ------- Net loss as reported $(13,292) $(18,212) $(6,844) Deduct total stock-based employee compensation expense determined under fair value-based method for all awards (1,357) (1,149) (1,909) -------- -------- ------- Pro forma net loss $(14,649) $(19,361) $(8,753) ======== ======== ======= Net loss per share: Basic and diluted - as reported $ (0.55) $ (0.82) $ (0.31) Basic and diluted - pro forma $ (0.61) $ (0.87) $ (0.39)
Pro forma information regarding net loss and net loss per share is required by SFAS No. 123 and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS No. 123. The fair value of these options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for 2003, 2002, and 2001: risk-free interest rate of 3.71%, 3.65%, and 5.18%, respectively; dividend yield of 0%; volatility factor of the expected market price of the Company's Common Stock of .93, .95, and .77, respectively; and a weighted average expected life of the option of seven years. The pro forma effect on net loss is not representative of the pro forma effect on net income (loss) in future years. F-8 ATS Medical, Inc. Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) NET LOSS PER SHARE Basic net loss per share is computed by dividing net loss by the weighted average shares outstanding and excludes any dilutive effects of options, warrants, and convertible securities. For all periods presented, diluted net loss per share is equal to basic net loss per share because the effect of including potential common shares for stock options outstanding would have been anti-dilutive. For the year ended December 31, 2003, the effect of options was anti-dilutive due to the net loss incurred during the period. Had net income been achieved, approximately 1,182,000 of common stock equivalents would have been included in the computation of diluted net income per share for the year ended December 31, 2003. RECLASSIFICATIONS Certain prior year balances were reclassified to conform with the current year presentation. RECENT ACCOUNTING PRONOUNCEMENTS In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46, CONSOLIDATION OF VARIABLE INTEREST ENTITIES (FIN 46). FIN 46 requires companies that control another entity through interests other than voting interests to consolidate the controlled entity. FIN 46 was effective immediately for variable interest entities created, or in which the company obtains an interest, after January 31, 2003. For all variable interest entities created on or before January 31, 2003, the provisions are effective July 31, 2003. The Company does not believe it has interests in variable interest entities. 2. SHORT-TERM INVESTMENTS As of December 31, 2003 and 2002, the cost of short-term investments held by the Company of $2.0 million and $2.5 million, respectively, which have maturity dates of one year or less, approximated their fair value. As a result, no unrealized gains or losses were recognized at December 31, 2003 and 2002. 3. LEASEHOLD IMPROVEMENTS, FURNITURE, AND EQUIPMENT, NET Leasehold improvements, furniture, and equipment consist of the following (in thousands):
DECEMBER 31 --------------- 2003 2002 ------ ------ Furniture and fixtures $ 372 $ 361 Equipment 2,918 2,340 Leasehold improvements 3,227 3,227 Construction in progress 3,309 3,309 ------ ------ 9,826 9,237 Less accumulated depreciation 3,931 3,211 ------ ------ $5,895 $6,026 ====== ======
4. IMPAIRMENT OF TECHNOLOGY LICENSE At the end of the first quarter of 2002, the Company evaluated the carrying value of its technology license asset in accordance with the provisions of SFAS No. 142, which were effective for the Company as of January 1, 2002. Utilizing a discounted cash flow model, that analysis indicated the asset's carrying value was recoverable and the Company recognized no impairment as a result of the adoption of SFAS No. 142. In the second quarter of 2002, the Company experienced decreased sales volumes, decreased average selling prices and initiated certain restructuring activities pertaining to its executive team and the manner in F-9 ATS Medical, Inc. Notes to Consolidated Financial Statements 4. IMPAIRMENT OF TECHNOLOGY LICENSE (CONTINUED) which it sells its product from a direct sales force to a hybrid sales force of a few direct salespeople and several independent manufacturers representatives. In response to these conditions, the Company modified its pricing strategy and sales volume estimates in conjunction with the reorganization plan implemented and the increased competitive pressures in the European market. As a result of these conditions and changes, the Company reviewed its future cash flow analysis and changed its expectations of the sales volume estimates and its selling prices of the heart valve in the cash flow model to evaluate the recoverability of its technology license. When compared to the revised fair value as calculated by discounting the changed future cash flows at June 30, 2002, the Company determined a noncash charge representing an impairment of this asset needed to be recognized in the amount of $8.1 million in the second quarter of 2002. This charge also reflects, in part, the effect of the amended milestone payments in the early years of the technology transfer agreement relative to the benefits of lower-cost carbon not being realized until future years after the depletion of inventories currently on hand at the time of the analysis. There was no additional impairment to the technology license during 2003. 5. PRIVATE PLACEMENT In August 2003, the Company completed a private placement of Common Stock selling 4.4 million shares at $2.80 a share for gross proceeds of $12.3 million. The proceeds received were used to pay Centerpulse in conjunction with the agreement reached in July 2003 for the remaining obligations in conjunction with the technology license purchase (see Note 11). 6. EXTINGUISHMENT OF DEBT In July 2003, the Company entered into an agreement with Centerpulse USA Holdings, Co. (Centerpulse) under which the Company would pay Centerpulse $12 million in exchange for cancellation of all of the Company's payment obligations under its carbon technology agreement with Carbomedics Inc. and provide for Company ownership of the technology license. Prior to this agreement, the Company was obligated to pay Centerpulse an aggregate of approximately $28 million under the technology agreement over a period of approximately four years. The obligations per the agreement were accrued as specific criteria were met. Of the total $28 million, there were two uncompleted milestones totaling $12 million not accrued at the time of the July 2003 agreement. As the $12 million dollar payment made under the agreement was exceeded by the Company's accrued liability by approximately $2.6 million, the Company recognized a gain in the quarter ended September 30, 2003. 7. EMPLOYEE STOCK PURCHASE PLAN In May 1998, the Company implemented the 1998 ATS Medical, Inc. 423 Employee Stock Purchase Plan. Under the terms of the plan, employees are eligible to purchase Common Stock of the Company on a quarterly basis. Employees can purchase Common Stock at 85% of the lesser of the market price of the Common Stock on the first day of the quarter or the last day of the quarter.
Fiscal Year Number of Shares Price Range ----------- ---------------- -------------- 2003 36,762 $0.41 - $ 2.72 2002 101,980 0.46 - 2.21 2001 39,885 3.24 - 10.84
F-10 ATS Medical, Inc. Notes to Consolidated Financial Statements 8. COMMON STOCK AND STOCK OPTIONS The Company has a Stock Option Plan and a Stock Award Plan (the Plans) under which options to purchase Common Stock of the Company may be awarded to employees and nonemployees of the Company. The options may be granted under the Plans as incentive stock options (ISO) or as non-qualified stock options (non-ISO). The following table summarizes the options to purchase shares of the Company's Common Stock under the Plans:
STOCK OPTIONS OUTSTANDING WEIGHTED SHARES UNDER THE PLANS AVERAGE RESERVED ------------------------- NON-PLAN EXERCISE PRICE FOR GRANT ISO NON-ISO OPTIONS PER SHARE --------- --------- --------- -------- -------------- Balance at December 31, 2000 697,500 1,016,460 899,851 25,000 $8.15 Options granted (496,857) 322,415 174,442 -- 8.42 Options exercised -- (40,115) (1,439) (25,000) 5.78 Options canceled 85,399 (108,874) (25,325) -- 9.54 ISO shares made non-qualified in 2001 -- (81,050) 81,050 -- -- --------- --------- --------- --------- Balance at December 31, 2001 286,042 1,108,836 1,128,579 -- 8.17 Options granted (595,000) 195,000 300,000 325,000 0.45 Options canceled 328,221 (545,709) (430,912) -- 8.30 --------- --------- --------- --------- Balance at December 31, 2002 19,263 758,127 997,667 325,000 5.07 Increase in shares reserved for grant 1,000,000 -- -- -- -- Options granted (848,448) 828,448 20,000 2,500,000 2.49 Options exercised -- (5,875) (30,000) -- 3.11 Options canceled 369,059 (285,404) (99,167) (100,000) 5.34 --------- --------- --------- --------- Balance at December 31, 2003 539,874 1,295,296 888,500 2,725,000 3.32 ========= ========= ========= =========
OPTIONS OUTSTANDING OPTIONS EXERCISABLE -------------------------------------- ---------------------- WEIGHTED AVERAGE WEIGHTED WEIGHTED REMAINING AVERAGE AVERAGE RANGE OF NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE EXERCISE PRICES OUTSTANDING LIFE PRICE EXERCISABLE PRICE --------------- ----------- ----------- -------- ----------- -------- $0.35 - $ 1.82 1,911,250 9.05 years $0.88 201,167 $0.44 2.35 - 3.97 2,066,345 9.41 years 3.33 71,845 3.35 5.06 - 12.44 931,201 5.53 years 8.29 772,839 8.17 --------- --------- 0.35 - 12.44 4,908,796 8.54 years 3.32 1,045,851 6.35 ========= =========
F-11 ATS Medical, Inc. Notes to Consolidated Financial Statements 8. COMMON STOCK AND STOCK OPTIONS (CONTINUED) The weighted average fair value of options granted during the years ended December 31, 2003, 2002, and 2001, was $2.05, $0.37, and $6.15, respectively. At December 31, 2003, 2002, and 2001, Plan and non-Plan options for 1,045,851, 857,145, and 1,216,082 shares of Common Stock, respectively, were exercisable at a weighted average price of $6.35, $7.61, and $7.49 per share, respectively. Options can be exercised by tendering shares previously acquired. In 2001, non-Plan options to purchase 25,000 shares, exercisable at $3.63 per share, were exercised. In 2002, 325,000 non-Plan options were granted at an average exercise price of $0.47. These options vest ratably over three or four year periods. Of the total non-Plan options granted, 50,000 options were granted to a non-employee in December 2002, the non-Plan options granted to non-employees, vest over three years to coincide with the period of service. As such, these options are revalued at each reporting date using an accelerated expense attribution method and expensed over the vesting periods. In 2003, the Company recognized $0.2 million of deferred compensation and $0.1 million of expenses related to those non-Plan, non-employee options. In 2003, 2,500,000 non-Plan options were granted at an average exercise price of $2.32. These options vest ratably over two or four year periods. Of the total non-Plan options granted, 120,000 options were granted to non-employees for prior services rendered, where the Company recognized $0.2 million in compensation expense during 2003. The Company has 2,723,670 shares of Common Stock reserved for issuance under the Plans. 9. LEASES The Company has operating leases for its facilities in Plymouth, Minnesota as well as France and China. These leases expire at various dates through November 2011. Future minimum lease payments under these agreements are as follows (in thousands): Year ending December 31: 2004 $ 429 2005 447 2006 419 2007 427 2008 376 2009 and thereafter 196 ------ $2,294 ======
The rent expense was $0.3 million for 2003 and $0.4 million for 2002 and 2001. 10. INCOME TAXES At December 31, 2003, the Company had net operating loss carryforwards of approximately $41.8 million and credits for increasing research and development costs of approximately $0.6 million, which are available to offset future taxable income or reduce taxes payable through 2023. These loss carryforwards will begin expiring in 2007. The credits continue to expire in 2004 through 2018. Included as part of the Company's net operating loss carryforwards are approximately $2.3 million in tax deductions that resulted from the exercise of stock options. When these loss carryforwards are realized, the corresponding change in valuation allowance will be recorded as additional paid-in capital. F-12 ATS Medical, Inc. Notes to Consolidated Financial Statements 10. INCOME TAXES (CONTINUED) Components of deferred tax assets and liabilities are as follows (in thousands):
DECEMBER 31 ------------------- 2003 2002 -------- -------- Deferred tax assets (liabilities): Net operating loss carryforwards $ 15,482 $ 10,661 Research and development credits 647 633 Inventory reserves 1,962 1,158 Depreciation 490 302 Technology license amortization (1,672) (1,016) Compensation reserves 90 277 Other 319 470 -------- -------- Net deferred tax assets before valuation allowance 17,318 12,485 Less valuation allowance (17,318) (12,485) -------- -------- Net deferred tax assets $ -- $ -- ======== ========
The Company's ability to utilize its net operating loss carryforwards to offset future taxable income is subject to certain limitations under Section 382 of the Internal Revenue Code due to changes in the equity ownership of the Company. Reconciliation of the statutory federal income tax rate to the Company's effective tax rate is as follows:
2003 2002 2001 ----- ----- ----- Tax at statutory rate (34.0)% (34.0)% (34.0)% State income taxes (4.0) (4.0) (4.0) Impact of changes in valuation allowance 38.0 38.0 38.0 ----- ----- ----- --% --% --% ===== ===== =====
11. COMMITMENTS In June 2002, the Company amended the supply and technology transfer agreements. The amendment to the supply agreement suspended component set purchases until January 2007. This postpones component purchases totaling approximately $23.5 million for the years ended December 31, 2003 to 2006. In January of 2007, the purchase obligations for 2003 would resume, with the obligations for 2004 through 2006 to follow in each subsequent year. 12. BENEFIT PLAN The Company has a defined contribution salary deferral plan covering substantially all employees under Section 401(k) of the Internal Revenue Code. The plan allows eligible employees to contribute up to 12% of their annual compensation, with the Company contributing an amount equal to 25% of each employee's contribution. The Company recognized expense for contributions to the plan of $64,451, $61,397, and $76,167, during 2003, 2002, and 2001, respectively. F-13 ATS Medical, Inc. Notes to Consolidated Financial Statements 13. SIGNIFICANT CUSTOMERS AND CONCENTRATION OF CREDIT RISK The Company operates in one segment, the sale of a bileaflet mechanical heart valve. As a result, the information disclosed herein materially represents all of the financial information related to the Company's principal operating segment. The Company derived the following percentages of its net sales from the following geographic regions:
2003 2002 2001 ---- ---- ---- Asia Pacific 32% 42% 34% Europe 29 26 36 North America 28 19 19 Emerging Markets 11 13 11
Shown below are the percentage of sales of specific customers which exceeded 10% for the years shown:
2003 2002 2001 ---- ---- ---- Customer A 21.4% 31.3% 23.6% Customer B -- 12.0 10.3
The Company had balances owing by two customers, which represented 11%, 34%, and 4% of its outstanding accounts receivable balances, respectively, at December 31, 2003, 2002, and 2001. 14. ACCRUED DISTRIBUTOR LIABILITIES The Company recognized $0.8 million of expense in the year ended December 31, 2002 related to the termination of its France and Belgium distributor. The Company bought back inventory from this distributor, in accordance with the termination terms as provided for in the distributor agreements. The Company paid approximately $1.1 million for all costs associated with this termination in fiscal 2003. The charge represents the margin on valves that were returned to the Company and the costs associated with restocking such inventories for resale. 15. REORGANIZATION EXPENSES In June 2002, the Board of Directors decided to implement new cost containment measures and to seek a new management team to lead the business. As part of these cost-reduction measures, approximately one-half of the workforce, including all of the executive officers of the Company, have been released from employment. The Company had 46 employees at December 31, 2002 compared to 89 employees at December 31, 2001. The Company recorded an expense of $1.1 million in conjunction with the reorganization in fiscal 2002. The reorganization expenses consist of approximately $1.0 million of severance pay and benefits, and $0.1 million of rent that was expensed for the vacated portion of the Company's leased facility. Of the total reorganization expenses, $9,000 and $0.5 million had not been paid as of December 31, 2003 and 2002, respectively. 16. RELATED-PARTY TRANSACTION For the years ended December 31, 2003, 2002, and 2001, the Company had a consulting agreement with a director of the Company, which provided for future annual compensation. The agreement provides for compensation through fiscal 2004. An expense has been recognized as a result of this agreement in the amount of $0.1 million, $0.2 million, and $0.6 million for the years ended December 31, 2003, 2002, and 2001, respectively. An expense for a portion of the compensation was recognized at the time the agreement was signed, as the Company has deferred only the fair value of expected services to be received under the agreement. F-14 ATS Medical, Inc. Notes to Consolidated Financial Statements 17. QUARTERLY FINANCIAL DATA (UNAUDITED) Quarterly data for 2003 and 2002 was as follows (in thousands, except loss per share):
QUARTER -------------------------------------- FIRST SECOND THIRD FOURTH ------- -------- ------ ------- YEAR ENDED DECEMBER 31, 2003 Net sales $ 3,965 $ 4,246 $4,639 $ 5,634 Gross profit 1,217 998 1,384 (2,747) Net loss (1,539) (3,103) (307) (8,343) Net basic and diluted loss per share $ (0.07) $ (0.14) $(0.01) $ (0.31) YEAR ENDED DECEMBER 31, 2002 Net sales $ 3,902 $ 2,475 $3,184 $ 3,739 Gross profit 1,211 151 1,005 (1,373) Net loss (1,483) (11,368) (589) (4,772) Net basic and diluted loss $ (0.07) $ (0.51) $(0.03) $ (0.21)
The Company recorded lower of cost or market value adjustments against inventories of $4.4 million and $2.2 million in the fourth quarter of 2003 and 2002, respectively. In the third quarter of 2003, the Company recognized a $2.6 million gain on the extinguishment of debt. In the second quarter of 2002, the Company recorded an $8.1 million impairment of technology license. In 2002, the Company recorded reorganization charges of $0.9 million and $0.2 million in the second quarter and fourth quarter, respectively. Gross profit in the second quarter of 2002 was also affected by a $0.35 million sales rebate. F-15