10-Q 1 w68886e10vq.txt FORM 10-Q FOR ESCALON MEDICAL CORP UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------------- FORM 10-Q (X) Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended September 30, 2004. ( ) Transitional report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transitional period from ________ to________ COMMISSION FILE NUMBER 0-20127 ------------------------------ ESCALON MEDICAL CORP. (Exact name of Registrant as specified in its charter) PENNSYLVANIA 33-0272839 (State or other jurisdiction of (I.R.S. Employer incorporation or organization Identification Number) 575 EAST SWEDESFORD ROAD, SUITE 100, WAYNE, PA 19087 (Address of principal executive offices, including zip code) (610) 688-6830 (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] At November 8, 2004, 5,858,808 shares of common stock were outstanding. ESCALON MEDICAL CORP. FORM 10-Q QUARTERLY REPORT TABLE OF CONTENTS PART I. FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements 2 Condensed Consolidated Balance Sheet as of September 30, 2004 (Unaudited) and June 30, 2004 2 Condensed Consolidated Statement of Operations for the three-month periods ended September 30, 2004 and 2003 (Unaudited) 3 Condensed Consolidated Statement of Cash Flows for the three-month periods ended September 30, 2004 and 2003 (Unaudited) 4 Condensed Consolidated Statement of Shareholders' Equity for the three-month period ended September 30, 2004 (Unaudited) 5 Notes to Condensed Consolidated Financial Statements (Unaudited) 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 18 Item 3. Quantitative and Qualitative Disclosures About Market Risk 35 Item 4. Controls and Procedures 36 PART II. OTHER INFORMATION Item 1. Legal Proceedings 37 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 38 Item 5. Other Information 38 Item 6. Exhibits 38
1 ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS ESCALON MEDICAL CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEET
September 30, June 30, 2004 2004 ------------ ------------ ASSETS (Unaudited) Current assets: Cash and cash equivalents $ 5,862,212 $ 12,601,971 Accounts receivable, net 4,469,782 2,492,689 Inventory, net 4,633,113 1,781,592 Note receivable 150,000 150,000 Other current assets 1,186,054 539,508 ------------ ------------ Total current assets 16,301,161 17,565,760 ------------ ------------ Furniture and equipment, net 1,236,606 409,187 Goodwill 19,214,098 10,591,795 Trademarks and trade names, net 616,906 616,906 Patents, net 615,942 172,078 Other assets 154,459 101,389 ------------ ------------ Total assets $ 38,139,172 $ 29,457,115 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Line of credit $ 1,187,027 $ 250,000 Current portion of long-term debt 221,668 1,621,687 Accounts payable 1,798,502 499,242 Accrued expenses 3,910,326 1,229,498 ------------ ------------ Total current liabilities 7,117,523 3,600,427 Long-term debt, net of current portion 594,214 2,396,019 ------------ ------------ Total liabilities 7,711,737 5,996,446 Shareholders' equity: Preferred stock, $0.001 par value; 2,000,000 shares authorized; no shares issued Common stock, $0.001 par value; 35,000,000 shares authorized; 5,858,808 and 5,017,122 shares issued and outstanding at September 30, 2004 and June 30, 2004, respectively 5,860 5,018 Common stock warrants 1,601,346 1,601,346 Additional paid-in capital 63,270,984 56,438,903 Accumulated deficit (34,468,699) (34,584,598) Accumulated other comprehensive income 17,944 -- ------------ ------------ Total shareholders' equity 30,427,435 23,460,669 ------------ ------------ Total liabilities and shareholders' equity $ 38,139,172 $ 29,457,115 ============ ============
See notes to condensed consolidated financial statements 2 ESCALON MEDICAL CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS (UNAUDITED)
Three Months Ended September 30, ------------------------------- 2004 2003 ----------- ----------- Product revenue $ 4,636,457 $ 2,841,127 Other revenue 655,704 570,515 ----------- ----------- Revenues, net 5,292,161 3,411,642 ----------- ----------- Costs and expenses: Cost of goods sold 2,671,348 1,212,799 Research and development 315,762 207,130 Marketing, general and administrative 2,182,487 1,214,196 ----------- ----------- Total costs and expenses 5,169,597 2,634,125 ----------- ----------- Income from operations 122,564 777,517 ----------- ----------- Other income and expenses: Equity in Ocular Telehealth Management, LLC (29,201) -- Interest income 32,092 679 Interest expense 3,413 (118,559) ----------- ----------- Total other income and expenses 6,304 (117,880) ----------- ----------- Income before income taxes 128,868 659,637 Income taxes 12,969 36,481 ----------- ----------- Net income $ 115,899 $ 623,156 =========== =========== Basic net income per share $ 0.021 $ 0.185 =========== =========== Diluted net income per share $ 0.019 $ 0.154 =========== =========== Weighted average shares - basic 5,564,469 3,365,359 =========== =========== Weighted average shares - diluted 6,141,958 4,049,298 =========== ===========
See notes to condensed consolidated financial statements 3 ESCALON MEDICAL CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
Three Months Ended September 30, --------------------------------- 2004 2003 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 115,899 $ 623,156 Adjustments to reconcile net income to net cash (used in)/ provided by operating activities: Depreciation and amortization 91,885 64,377 Loss of Ocular Telehealth Management, LLC 29,201 -- Change in operating assets and liabilities: Accounts receivable, net (552,060) 295,361 Inventory, net (294,289) (72,715) Other current and long-term assets (306,952) (6,630) Accounts payable, accrued and other liabilities (1,018,470) (256,801) ------------ ------------ Net cash (used in)/provided by operating activities (1,934,786) 646,748 ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of Drew, net of cash 295,373 -- Investment in Ocular Telehealth Management, LLC (130,000) -- ------------ Purchase of fixed assets (39,773) (15,685) ------------ ------------ Net cash (used in)/provided by investing activities 125,600 (15,685) CASH FLOWS FROM FINANCING ACTIVITIES: Line of credit repayment (669,269) (500,000) Principal payments on term loans (4,258,754) (365,233) ------------ ------------ Net cash provided by/(used in) financing activities (4,928,023) (865,233) ------------ ------------ Effect of exchange rate changes on cash & cash equivalents (2,551) -- Net decrease in cash and cash equivalents (6,739,760) (234,170) Cash and cash equivalents, beginning of period 12,601,971 298,390 ------------ ------------ Cash and cash equivalents, end of period $ 5,862,211 $ 64,220 ============ ============ SUPPLEMENTAL SCHEDULE OF CASH FLOW INFORMATION: Interest paid $ 208,019 $ 130,670 ============ ============ Income taxes $ 184,300 $ 92,000 ============ ============ SUPPLEMENTAL SCHEDULE OF NON-CASH INFORMATION: Accounts receivable 1,433,324 -- Inventory 2,562,848 -- Other current assets 577,140 -- Furniture and equipment 868,839 -- Patents 461,779 -- Other long-term assets 264,530 -- Line of credit 1,617,208 -- Current liabilities 4,548,746 -- Liability for shares reserved for future exchange 597,019 -- Long-term debt 767,165 -- Exchange of common stock 6,833,420 --
See notes to condensed consolidated financial statements 4 ESCALON MEDICAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2004 (UNAUDITED)
Accumulated Common Stock Common Additional Other Total ------------------- Stock Paid-in Accumulated Comprehensive Shareholders' Shares Amount Warrants Capital Deficit Income Equity --------- ------ ---------- ----------- ------------ ------------ ------------- Balance at June 30, 2004 5,017,122 $5,018 $1,601,346 $56,438,903 $(34,584,598) $ -- $23,460,669 Acquisition of Drew 841,686 842 -- 6,832,081 -- -- 6,832,923 Foreign currency translation -- -- -- -- -- 17,944 17,944 Net income -- -- -- -- 115,899 -- 115,899 --------- ------ ---------- ----------- ------------ -------- ----------- Balance at September 30, 2004 5,858,808 $5,860 $1,601,346 $63,270,984 $(34,468,699) $ 17,944 $30,427,435 ========= ====== ========== =========== ============ ======== ===========
See notes to condensed consolidated financial statements 5 ESCALON MEDICAL CORP. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION The Company operates in the healthcare market, specializing in the development, manufacture and marketing of (1) ophthalmic medical devices and pharmaceuticals; (2) instrumentation and consumables for use in human and veterinary hematology; (3) instrumentation and consumables for the diagnosing and monitoring of diabetes; and (4) vascular access devices. The accompanying unaudited condensed consolidated financial statements include the accounts of Escalon Medical Corp. and its subsidiaries, collectively referred to as "Escalon" or the "Company." Additionally, the Company's investment in Ocular Telehealth Management, LLC ("OTM") is accounted for under the equity method. All intercompany accounts and transactions have been eliminated. The accompanying condensed consolidated financial statements are unaudited and are presented pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC"). Accordingly, these consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company's 2004 Annual Report on Form 10-K. In the opinion of management, the accompanying consolidated financial statements reflect all adjustments (which are of a normal recurring nature) necessary for a fair presentation of the financial position, results of operations and cash flows for interim periods presented. The results of operations are not necessarily indicative of the results that may be expected for the full year. 2. ACQUISITION OF DREW SCIENTIFIC GROUP, PLC On July 23, 2004, Escalon acquired approximately 67% of the outstanding ordinary shares of Drew Scientific Group Plc ("Drew"), a United Kingdom Company, pursuant to the Company's exchange offer for all of the outstanding ordinary shares of Drew, and since that date has acquired substantially all of the Drew shares. As of September 30, 2004, Escalon had acquired approximately 94% of their ordinary shares of Drew. During the remainder of fiscal 2005, Escalon expects to compel Drew shareholders to tender all of the remaining outstanding Drew shares pursuant to procedures under United Kingdom laws and regulations. The results of Drew's operations have been included in the consolidated financial statements since July 23, 2004, the date on which Escalon acquired approximately 67% of the outstanding ordinary shares of Drew. Drew is a diagnostics company specializing in the design, manufacture and distribution of analytical systems for laboratory testing worldwide. Drew is focused on providing instrumentation and consumables for the diagnosis and monitoring of medical disorders in the areas of diabetes, cardiovascular diseases and hematology. In addition, Drew supplies diagnostic systems that perform blood component tests. Escalon expects to operate Drew as a wholly owned separate business segment. The aggregate purchase price of Drew was $7,857,644, net of acquired cash of $295,373, consisting of direct acquisition costs of $722,578, consisting primarily of investment banking, legal and accounting fees that are directly related to the acquisition of Drew, and 900,000 shares of Escalon common stock valued at $7,430,439. The value of the 900,000 shares issued was based on the market price on the dates of consummation and merger. The remaining shares to be exchanged were recorded as a liability. 6 The following table summarizes the preliminary purchase price allocation of estimated fair values of assets acquired and liabilities assumed as of the date of acquisition. Escalon is in the process of obtaining additional data, identifying and valuing intangible assets acquired, obtaining third party appraisals of tangible and intangible assets, and valuing certain pre-acquisition legal contingencies. Therefore, the allocation of the purchase price is subject to future refinement, which is expected to be completed no later than June 30, 2005. Current assets $ 4,573,312 Furniture and equipment 868,839 Patents 461,779 Other long-term assets 264,530 Goodwill 8,622,303 ----------- Total assets acquired $14,790,763 ----------- Line of credit $ 1,617,208 Current liabilities 4,258,981 Long-term debt 1,056,930 ----------- Total liabilities assumed $ 6,933,119 ----------- Net assets acquired $ 7,857,644 ===========
The following pro forma results of operations information has been prepared to give effect to the purchase as if such transaction had occurred at the beginning of the periods being presented. The information presented is not necessarily indicative of results of future operations of the combined companies.
Three Months Ended September 30, -------------------------------- 2004 2003 ---------- ---------- Revenues $5,926,771 $7,231,653 Cost of goods sold 3,088,286 3,840,927 ---------- ---------- Gross profit 2,838,485 3,390,726 Operating expenses 2,810,440 2,960,326 Other expense 522 191,853 ---------- ---------- Net income before taxes 27,523 238,547 Provision for income taxes 12,969 12,481 ---------- ---------- Net income $ 14,554 $ 226,066 ========== ========== Basic net income per share $ 0.003 $ 0.067 ========== ========== Diluted net income per share $ 0.002 $ 0.056 ========== ========== Weighted average shares - basic 5,564,469 3,365,359 ========== ========== Weighted average shares - diluted 6,141,958 4,049,298 ========== ==========
7 3. STOCK-BASED COMPENSATION The Company reports stock-based compensation through the disclosure-only requirements of Statement of Financial Accounting Standards No. 123 ("SFAS 123"), "Accounting for Stock-Based Compensation," as amended by Statement of Financial Accounting Standards No. 148 ("SFAS 148"), "Accounting for Stock-Based Compensation - Transition and Disclosure - an Amendment to FASB No. 123." Compensation expense for options is measured using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Under APB 25, because the exercise price of the Company's employee stock options is generally equal to the market price of the underlying stock on the date of grant, no compensation expense is recognized. SFAS 123 establishes an alternative method of expense recognition for stock-based compensation awards based on fair values. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123.
Three Months Ended September 30, ---------------------------------- 2004 2003 --------- ------------ Net Income, as reported $ 115,899 $ 623,156 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (284,671) (18,103) --------- ------------ Pro forma net income $(168,772) $ 605,053 ========= ============ Earnings per share: Basic - as reported $ 0.021 $ 0.185 ========= ============ Basic - pro forma $ (0.030) $ 0.180 ========= ============ Diluted - as reported $ 0.019 $ 0.154 ========= ============ Diluted - pro forma $ (0.030) $ 0.149 ========= ============
The Company has followed the guidelines of SFAS 123 to establish the valuation of its stock options. The fair value of these equity awards was estimated at the date of grant using the Black-Scholes option pricing method. For the purposes of pro forma disclosures, the estimated fair value of the equity awards is amortized to expense over the options' vesting period. For the purposes of applying SFAS No. 123, the estimated per share value of the options granted during the three-month period ended September 30, 2004 was between $4.92 and $5.06. The fair value was estimated using the following assumptions: dividend yield of 0.0%, volatility of 0.78; risk-free interest rate of 3.30%; and expected life of 10 years. The volatility assumption is based on volatility seen in the Company's stock over the last five years. This assumption was made according to the guidance of SFAS 123. There is no reason to believe that future volatility will compare with the historical volatility. Because the Company's stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the opinion of management, the existing models do not necessarily provide a reliable single measure of the value of its options. 8 4. EARNINGS PER SHARE The Company follows Financial Accounting Standards Board Statement No. 128, "Earnings Per Share," in presenting basic and diluted earnings per share. The following table set forth the computation of basic and diluted earnings per share:
Three Months Ended September 30, -------------------------------- 2004 2003 ---------- ---------- Numerator: Numerator for basic and diluted earnings per share: Net income $ 115,899 $ 623,156 ---------- ---------- Denominator: Denominator for basic earnings per share - weighted average shares 5,564,469 3,365,359 Effect of dilutive securities: Stock options and warrants 519,175 683,939 Shares reserved for future exchange 58,314 -- ---------- ---------- Denominator for diluted earnings earnings per share - weighted average and assumed conversion 6,141,958 4,049,298 ---------- ---------- Basic earnings per share $ 0.021 $ 0.185 ========== ========== Diluted earnings per share $ 0.019 $ 0.154 ========== ==========
5. INVENTORY Inventory, stated at lower of cost (determined on a first-in, first-out basis) or market, consisted of the following:
September 30, June 30, 2004 2004 ----------- ----------- Raw materials $ 2,854,472 $ 1,132,331 Work in process 579,100 287,276 Finished goods 1,204,666 367,110 ----------- ----------- 4,638,238 1,786,717 Valuation allowance (5,125) (5,125) ----------- ----------- Total inventory $ 4,633,113 $ 1,781,592 =========== ===========
6. NOTE RECEIVABLE Escalon entered into an agreement with an individual who was involved in the development of a drug delivery system. The Company holds a note receivable from the individual in the amount of $150,000 that is due in May 2005. 9 7. INTANGIBLE ASSETS ACQUIRED LICENSE AND DISTRIBUTION RIGHTS In connection with the Company's acquisition of assets of Escalon Ophthalmics, Inc. ("EOI") in February 1996, a portion of the purchase price was allocated to certain license and distribution agreements. This cost allocation was based on an evaluation by management, with such costs being amortized over an eight-year period using the straight-line method. The value of these assets is reevaluated periodically to determine if the estimated lives continue to be appropriate. Accumulated amortization of license and distribution rights was $180,182 and $180,182 at September 30, 2004 and June 30, 2004, respectively. Amortization expense for the three-months ended September 30, 2004 and 2003 was $0 and $5,631, respectively. PATENTS It is the Company's practice to seek patent protection on processes and products in various countries. Patent application costs are capitalized and amortized over their estimated useful lives, not exceeding 17 years, on a straight-line basis from the date the related patents are issued. Costs associated with patents no longer being pursued are expensed. Accumulated patent amortization was $131,623 and $122,139 at September 30, 2004 and June 30, 2004, respectively. Amortization expense for the three-months ended September 30, 2004 and 2003 was $9,484 and $2,683, respectively. The aggregate amortization expense for each of the next five years for acquired license and distribution rights and patents is as follows:
Year Ending June 30, ---------- 2005 $ 65,567 2006 65,714 2007 60,515 2008 56,842 2009 54,307 -------- Total $302,945 ========
GOODWILL, TRADEMARKS AND TRADE NAMES Goodwill, trademarks and trade names represent intangible assets obtained from the EOI, Endologix, Inc. ("Endologix"), Sonomed and Drew acquisitions. Goodwill represents the excess of purchase price over the fair market value of net assets acquired. 10 The following table presents unamortized intangible assets by business unit as of September 30, 2004:
Adjusted Gross Gross Carrying Carrying Accumulated Net Carrying GOODWILL Amount Impairment Amount Amortization Value ----------- --------- ----------- ------------ ----------- Sonomed $10,547,488 $-- $10,547,488 $(1,021,938) $ 9,525,550 Drew 8,622,303 -- 8,622,303 -- 8,622,303 Vascular 1,149,813 -- 1,149,813 (208,595) 941,218 Medical/Trek 272,786 -- 272,786 (147,759) 125,027 ----------- ---- ----------- ----------- ----------- Total $20,592,390 $-- $20,592,390 $(1,378,292) $19,214,098 =========== ==== =========== =========== ===========
Adjusted Gross Gross Carrying Carrying Accumulated Net Carrying UNAMORTIZED INTANGIBLE ASSETS Amount Impairment Amount Amortization Value ----------- ---------- ------------ ------------ ------------ Sonomed $665,000 $-- $665,000 $(63,194) $601,806 Sonomed EMS 15,100 -- 15,100 -- 15,100 -------- ---- -------- -------- -------- Total $680,100 $-- $680,100 $(63,194) $616,906 ======== ==== ======== ======== ========
The following table presents unamortized intangible assets by business unit as of June 30, 2004:
Adjusted Gross Gross Carrying Carrying Accumulated Net Carrying GOODWILL Amount Impairment Amount Amortization Value ----------- --------- ----------- ------------ ----------- Sonomed $10,547,488 $-- $10,547,488 $(1,021,938) $ 9,525,550 Vascular 1,149,813 -- 1,149,813 (208,595) 941,218 Medical/Trek 272,786 -- 272,786 (147,759) 125,027 ----------- ---- ----------- ----------- ----------- Total $11,970,087 $-- $11,970,087 $(1,378,292) $10,591,795 =========== ==== =========== =========== ===========
Adjusted Gross Gross UNAMORTIZED INTANGIBLE Carrying Carrying Accumulated Net Carrying ASSETS Amount Impairment Amount Amortization Value ----------- ---------- ------------ ------------ ------------ Sonomed $ 665,000 $-- $ 665,000 $ (63,194) $ 601,806 Sonomed EMS 15,100 -- 15,100 -- 15,100 ----------- ---- ----------- ----------- ----------- Total $ 680,100 $-- $ 680,100 $ (63,194) $ 616,906 =========== ==== =========== =========== ===========
The following table presents amortized intangible assets by business unit as of September 30, 2004:
Adjusted AMORTIZED INTANGIBLE Gross Gross ASSETS Carrying Carrying Accumulated Net Carrying PATENTS Amount Impairment Amount Amortization Value ----------- --------- ----------- ------------ ----------- Drew $453,348 $-- $453,348 (6,802) $446,546 Vascular (pending issuance 36,916 -- 36,916 -- 36,916 Medical/Trek 257,301 -- 257,301 (124,821) 132,480 Sonomed EMS -- -- -- -- -- -------- --- -------- --------- -------- Total $747,565 $-- $747,565 $(131,623) $615,942 ======== === ======== ========= ========
11 The following table presents amortized intangible assets by business unit as of June 30, 2004:
Adjusted AMORTIZED INTANGIBLE Gross Gross ASSETS Carrying Carrying Accumulated Net Carrying PATENTS Amount Impairment Amount Amortization Value ----------- --------- ----------- ------------ ----------- Vascular (pending issuance) $ 36,916 $-- $ 36,916 -- $ 36,916 Medical/Trek 257,301 -- 257,301 (122,139) 135,162 Sonomed EMS -------- --- --------- --------- -------- Total $294,217 $-- $ 294,217 $(122,139) $172,078 ======== === ======== ========= ========
8. ACCRUED EXPENSES Accrued expenses consisted of the following:
September 30, June 30, 2004 2004 ---------- ---------- (unaudited) Accrued compensation $ 802,068 $ 908,568 Acquisition expense accruals 516,126 -- Severance accruals 721,029 -- Shares reserved for future exchange 597,019 -- Other accruals 1,274,084 320,930 ---------- ---------- Total $3,910,326 $1,229,498 ========== ==========
Accrued compensation as of September 30, 2004 primarily relates to payroll, bonus, vacation accruals and payroll tax liabilities. Acquisition expense accruals as of September 30, 2004 primarily relate to professional fees (attorneys, accountants and other consultants) accruals related directly to the acquisition of Drew. Severance accruals as of September 30, 2004 relate to certain former directors and officers of Drew who management had the intent to terminate as of the consummation date of the transaction. Shares reserved for future exchange as of September 30, 2004 relate to the remaining 58,314 shares that Escalon expects to issue to Drew shareholders who are compelled to exchange their Drew shares pursuant to procedures under United Kingdom laws and regulations. This liability has been valued using the market price of Escalon on the date Escalon could begin to compel Drew shareholders to tender all remaining shares. This liability will be reduced as the shareholders exchange the remaining shares. In addition to normal accruals, other accruals as of September 30, 2004 relate to the remaining lease payments on a facility that had been exited prior to the acquisition, accruals for litigation existing prior to the acquisition, franchise and ad valorem tax accruals, royalty accruals and other sundry operating expenses and accruals. 9. LINE OF CREDIT AND LONG-TERM DEBT On December 23, 2002, a lender acquired the Company's bank debt, which consisted of term debt of $5,850,000 and $1,475,000 outstanding on a $2,000,000 available line of credit. On February 13, 2003, the Company entered into an Amended Agreement with the lender. The primary amendments of the amended Loan Agreement were to reduce quarterly principal payments, extend the term of the repayments and to alter the covenants of the original bank agreement. On September 30, 2004, the Company paid off 12 and terminated both the remaining term debt and the outstanding balance on this line of credit. In November 2001, the Company issued the lender 60,000 warrants to purchase the Company's common stock at $3.66 per share in connection with this debt. The warrants will expire in November 2006. On January 21, 1999, the Company's Vascular subsidiary and Endologix entered into an Assets Sale and Purchase Agreement. Pursuant to this agreement, the Company acquired for cash the assets of Endologix's vascular access business in exchange for cash and also agreed to pay royalties to Endologix based on future sales of the vascular access business for a period of five years following the closing of the sale, with a guaranteed minimum royalty of $300,000 per year. On February 1, 2001, the parties amended the agreement to eliminate any future royalty payments to Endologix. Pursuant to this amendment, the Company paid $17,558 in cash to Endologix, delivered a short-term note in the amount of $64,884 that was satisfied in January 2002, a note in the amount of $717,558 payable in 11 quarterly installments that commenced on April 15, 2002, and the Company issued 50,000 shares of its common stock to Endologix. On September 30, 2004, the Company paid off the balance of the term debt. As of September 30, 2004, Drew had an overdraft line of credit with a United Kingdom financial institution. The amount available on the line is $651,344. The interest rate is 2.00% over the United Kingdom prime rate (4.75% at September 30, 2004). The line is secured by Drew's assets and is personally guaranteed by certain of Drew's current and former directors. The balance as of September 30, 2004 is $655,791. Drew also has long-term debt facilities through the Texas Mezzanine Fund and through Symbiotics, Inc. The Texas Mezzanine Fund term debt is payable in monthly installments of $14,200, which includes interest at a fixed rate of 8.00%. The note is due in April 2008 and is secured by certain assets of Drew. The outstanding balance at September 30, 2004 is $515,880. The Symbiotics, Inc. term debt, which originated from the acquisition of a product line from Symbiotics, Inc., is payable in monthly installments of $8,333 with interest at a fixed rate of 5.00%. The outstanding balance at September 30, 2004 is $300,002. Drew has a line of credit with a domestic financial institution secured by certain assets of Drew. The amount available on the line of credit is $2,000,000. Interest is at the federal prime rate plus 4.00% (8.75% at September 30, 2004). The outstanding balance as of September 30, 2004 was $531,236. The schedule below presents principal amortization for the next five years under each of the Company's loan agreements as of September 30, 2004:
Texas Twelve Months Ending Mezzanine Symbiotics Total -------------------- -------- ---------- -------- 2005 $121,672 $ 99,996 $221,668 2006 143,721 99,996 243,717 2007 155,821 100,010 255,831 2008 94,666 -- 94,666 2009 -- -- -- -------- -------- -------- Total $515,880 $300,002 $815,882 ======== ======== ========
10. OTHER REVENUE Other revenue includes quarterly payments received from (1) Bausch & Lomb in connection with the sale of their Silicone Oil product line, (2) royalty payments received from IntraLase Corp. ("IntraLase")relating to the licensing of the Company's intellectual laser technology, and (3) royalty payments received from Bio-Rad Laboratories, Inc. ("Bio-Rad"). For the three-months ended September 30, 2004, and 2003, Silicone Oil revenue totaled $417,000 and $509,000, respectively, laser technology totaled $239,000 and $62,000, respectively, and the Bio-Rad 13 royalty was $0 for the period ended September 30, 2004. Accounts receivable at September 30, 2004 and June 30, 2004 related to other revenue was $417,000 and $459,000, respectively. BAUSCH & LOMB SILICONE OIL The agreement with Bausch & Lomb, which commenced on August 13, 2000, is structured so that the Company receives consideration from Bausch & Lomb based on its adjusted gross profit from its sales of Silicone Oil on a quarterly basis. The consideration is subject to a factor, which steps down through the termination date (August 2005) according to the following schedule: From 8/13/00 to 8/12/01 100% From 8/13/01 to 8/12/02 82% From 8/13/02 to 8/12/03 72% From 8/13/03 to 8/12/04 64% From 8/13/04 to 8/12/05 45%
INTRALASE: LICENSING OF LASER TECHNOLOGY The material terms of the license of the Company's laser patents to IntraLase, which expires in 2014, provide that the Company will receive a 2.5% royalty on product sales that are based on the licensed laser patents, subject to deductions for royalties payable to third parties up to a maximum of 50% of royalties otherwise due and payable to the Company, and a 1.5% royalty on product sales that are not based on the licensed laser patents. The Company receives a minimum annual license fee of $15,000 per year during the remaining term of the license. The minimum annual license fee is offset against the royalty payments. In addition, the Company owns 252,535 common shares of IntraLase pursuant to the license agreement. See also Note 11 Commitments and Contingencies. The license was dated October 23, 1997, was amended and restated in October 2000 and expires on the latest of the following events: - The last to expire of the laser patents; - Ten years from the effective date of the amended and restated agreement; - The fifth anniversary date of the first commercial sale. The material termination provisions of the license of the laser technology are as follows: - The Company has the right to terminate if IntraLase defaults in the payment of any royalty; - The Company has the right to terminate if IntraLase makes any false report; - The Company has the right to terminate if IntraLase defaults in the making of any required report; - The commission of any material breach of any covenant or promise under the license agreement; or - The termination of the license by IntraLase after 90 days notice (if IntraLase were to terminate, they would not be permitted to utilize the licensed technology necessary to manufacture their current products). 14 BIO-RAD ROYALTY The royalty received from Bio-Rad relates to a certain non-exclusive Eighth Amendment to OEM Agreement "OEM" Agreement) between the Company's Drew business and Bio-Rad, dated July 19, 1994. Bio-Rad pays a royalty based on sales of certain of Drew's products in certain specifically identified geographic regions. The material terms of the OEM Agreement which expires May 15, 2005 provide as follows: * Drew receives a royalty of 19.5 cents per test * The royalty payment are due 30 days after the end of the month * Royalty payments will be made depending on the volume of tests provided by Bio-Rad if less than 3,750 tests per month, Bio-Rad will calculate the number of tests used on a quarterly basis in arrears and pay Drew within 45 days of the end of the quarter. If more than 3,750 tests per month Bio-Rad will pay an estimated month royalty and within 45 days of the end of the quarter make final settlement upon actual number of tests per month. 11. COMMITMENTS AND CONTINGENCIES COMMITMENTS Escalon leases its manufacturing, research and corporate office facilities and certain equipment under non-cancelable operating lease arrangements. The Company has also entered into an agreement whereby the Company is obligated to purchase a contracted minimum amount of product from the other party to the agreement. The future minimum payments to be paid under these arrangements as of September 30, 2004 are as follows:
Lease Purchase Twelve Months Ending Obligations Commitments Total -------------------- ---------- ----------- ---------- 2005 $ 773,154 $700,000 $1,473,154 2006 764,873 -- 764,873 2007 567,844 -- 567,844 2008 312,606 -- 312,606 2009 270,164 -- 270,164 Thereafter 583,381 -- 583,381 ---------- -------- ---------- Total $3,272,022 $700,000 $3,972,022 ========== ======== ==========
Rent expense charged to operations during the three months ended September 30, 2004 and 2003 was $141,191 and $86,424, respectively. CONTINGENCIES ROYALTY AGREEMENT: CLINICAL DIAGNOSTIC SOLUTIONS Drew and Clinical Diagnostic Solutions, Inc. ("CDS") entered into a Private Label/Manufacturing Agreement dated April 1, 2002 for the right to sell formulations or products of CDS including reagents, controls and calibrators ("CDS products") on a private label basis. The agreement term is 15 years and automatically renews year-to-year thereafter. Drew is obligated to pay CDS a royalty of 7.5% on all sales of CDS products produced from Drew's United Kingdom facility. The amount of royalties paid during the three months ended September 30, 2004 was $4,509. LEGAL PROCEEDINGS: INTRALASE On June 10, 2004, Escalon provided notice to Intralase of the Company's intention to terminate the license agreement with Intralase due to Intralase's failure to pay certain royalties that the Company believes are due under the license agreement. On June 21, 2004, Intralase sought a preliminary injunction and a temporary restraining order with the United States District Court for the Central District of California, Southern District against Escalon to prevent the termination of the license agreement with Intralase. The parties subsequently agreed to stipulate to the temporary restraining order to prevent a termination of the license agreement and, on July 6, 2004, as mutually agreed by Intralase and Escalon, the same district court entered a stipulation and order to delay the requested hearing on the preliminary injunction until November 1, 2004. The Company does not believe that this matter has had or is likely to have a material adverse effect on the Company's business, financial condition or future results of operations. 15 LEGAL PROCEEDINGS: DREW Escalon is aware of three lawsuits involving Drew. The first lawsuit involves the principal shareholders of an entity previously acquired by Drew for the collection of unpaid expenses. A counterclaim was filed for breach of intellectual property rights and for breach of the principal shareholders' covenants not to compete. This action was filed in the state courts of Connecticut. The second lawsuit was filed in the state court of Minnesota, but transferred to the Federal District Court of Minnesota. This action was brought by a distributor against an entity previously acquired by Drew claiming a breach of a marketing and distribution agreement. The parties have reached a tentative settlement of this matter. The third action involves a suit instituted in California in connection with a dispute from a customer claiming a refund for a product purchase. The Company does not believe that the resolution of these matters has had or is likely to have a material adverse effect on the Company's business, financial condition or future results of operations. OTHER LEGAL PROCEEDINGS Furthermore, Escalon, from time to time is involved in various legal proceedings and disputes that arise in the normal course of business. These matters have included intellectual property disputes, contract disputes, employment disputes and other matters. The Company does not believe that the resolution of any of these matters has had or is likely to have a material adverse effect on the Company's business, financial condition or results of operations. 16 12. SEGMENTAL INFORMATION During the three-month periods ended September 30, 2004 and 2003, the Company operations were classified into four principal reportable segments that provide different products or services. This represents a change from fiscal 2004. The Company acquired Drew on July 23, 2004, and subsequently, Drew has been added as an additional business segment. During the first quarter of fiscal 2005, management also changed the structure of its internal organization that caused Medical/Trek and EMI to be reported as one reportable segment. The corresponding interim period has been restated to present comparative information. Separate management of each segment is required because each business unit is subject to different marketing, production and technology strategies. SEGMENTAL STATEMENTS OF OPERATIONS (IN THOUSANDS) - THREE MONTHS ENDED SEPTEMBER 30,
Drew Sonomed Vascular Medical/Trek/EMI Total ---------------- -------------------- ------------------ ------------------ -------------------- 2004 2003 2004 2003 2004 2003 2004 2003 2004 2003 -------- ---- -------- -------- ------- ------- ------- ------- -------- -------- Product revenue $ 1,904 $-- $ 1,644 $ 1,705 $ 695 $ 734 $ 393 $ 402 $ 4,636 $ 2,841 Other revenue -- -- -- -- -- -- 656 571 656 571 -------- ---- -------- -------- ------- ------- ------- ------- -------- -------- Total revenue 1,904 -- 1,644 1,705 695 734 1,049 973 5,292 3,412 -------- ---- -------- -------- ------- ------- ------- ------- -------- -------- Costs and expenses: Cost of goods sold 1,251 -- 859 681 320 296 241 236 2,671 1,213 Operating expenses 937 -- 629 712 409 434 523 276 2,498 1,422 -------- ---- -------- -------- ------- ------- ------- ------- -------- -------- Total costs and expenses 2,188 -- 1,488 1,393 729 730 764 512 5,169 2,635 -------- ---- -------- -------- ------- ------- ------- ------- -------- -------- Income from operations (284) -- 156 312 (34) 4 285 461 123 777 Other income and expenses: Equity in OTM -- -- -- -- -- -- (29) -- (29) -- Interest income 4 -- -- -- -- -- 137 1 141 1 Interest expense (24) -- (81) (115) (1) (4) -- -- (106) (119) -------- ---- -------- -------- ------- ------- ------- ------- -------- -------- Total other income and expenses (20) -- (81) (115) (1) (4) 108 1 6 (118) -------- ---- -------- -------- ------- ------- ------- ------- -------- -------- Income before taxes (304) -- 75 197 (35) -- 393 462 129 659 Income taxes -- -- -- -- -- -- 13 36 13 36 -------- ---- -------- -------- ------- ------- ------- ------- -------- -------- Net income (loss) $ (304) $-- $ 75 $ 197 $ (35) $-- $ 380 $ 426 $ 116 $ 623 ======== ==== ======== ======== ======= ======= ======= ======= ======== ======== Depreciation and amortization $ 46 $-- $ 7 $ 6 $ 11 $ 11 $ 28 $ 48 $ 92 $ 65 Assets $ 15,128 $-- $ 12,844 $ 12,562 $ 2,226 $ 2,142 $ 7,941 $14,753 $ 38,139 $ 29,457 Expenditures for long-lived assets $ 2 $-- $ 19 $-- $ 7 $-- $ 11 $ 16 $ 39 $ 16
13. SHAREHOLDERS' EQUITY WARRANTS TO PURCHASE COMMON STOCK In connection with debt issued by a former lender to Escalon in November 2001, the Company issued the lender warrants to purchase 60,000 shares of the Company's common stock at $3.66 per share. The warrants are currently exercisable and will expire in November 2006. In connection with the private placement of Escalon's common stock in March 2004, the Company issued several accredited investors warrants to purchase 120,000 shares of the Company's common stock. The warrants are exercisable at $15.60 per share and expire in five years from the placement date. 17 EXCHANGE OFFER FOR DREW SCIENTIFIC GROUP, PLC During the three months ended September 30, 2004, the Company issued 841,686 shares of its common stock pursuant to its exchange offer for all of the outstanding shares of Drew, and had acquired approximately 94% of the outstanding shares of Drew as of that date. During the remainder of fiscal 2005, Escalon expects to compel Drew shareholders to tender all of the remaining outstanding Drew shares pursuant to procedures under United Kingdom laws and regulations. A total of 58,314 shares are reserved for future issuance in connection with this final exchange. 14. RELATED PARTY TRANSACTIONS Escalon and a member of the Company's Board of Directors are founding and equal members of Ocular Telehealth Management, LLC ("OTM"). OTM is a diagnostic telemedicine company providing remote examination, diagnosis and management of disorders affecting the human eye. OTM's initial solution focuses on the diagnosis of diabetic retinopathy by creating access and providing annual dilated retinal examinations for the diabetic population. OTM was founded to harness the latest advances in telecommunications, software and digital imaging in order to create greater access and a more successful disease management for populations that are susceptible to ocular disease. Through September 30, 2004, Escalon has invested $130,000 in OTM and has committed to invest an additional $126,000 through March 31, 2005. As of September 30, 2004, Escalon owned 50% of OTM. The members of OTM have agreed to review the operations of OTM after 24 months, at which time the members each have the right to sell their membership interest back to OTM at fair market value. The Company will provide administrative support functions to OTM. Through September 30, 2004, OTM had revenue of $115 and incurred expenses of $58,517. This investment is accounted for under the equity method of accounting and is included in other assets. Commencing in July 2004, a relative of a senior executive officer of Escalon began providing legal services to the Company in connection with various legal proceedings. Expenses incurred through this individual were $13,062 during the three-month period ended September 30, 2004. 15. SUBSEQUENT EVENT - INTRALASE INITIAL PUBLIC OFFERING In October 1997, Escalon licensed its intellectual laser properties to IntraLase in exchange for an equity interest of 252,535 shares of common stock (as adjusted for splits), as well as royalties on future product sales. On October 7, 2004, IntraLase announced the initial public offering of shares of its common stock at a price of $13.00 per share. The shares of common stock are restricted for a period of less than one year and may be sold after April 4, 2005 pursuant to a certain Fourth Amended Registration Rights Agreement between the Company and IntraLase. The shares have been classified as available-for-sale-securities. The Company has historically accounted for these shares at $0 basis because a readily determinable market value was not available. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS Certain statements contained in, or incorporated by reference in, the Quarterly Report on Form 10-Q, are forward-looking statements, made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, which provide current expectations or forecasts of future events. Such statements can be identified by the use of terminology such as "anticipate," "believe," "could," "estimate," "expect," "forecast," "intend," "may," "plan," "possible," "project," "should," "will" and similar words or expressions. The Company's forward-looking statements include certain information relating to general business strategy, growth strategies, financial results, liquidity, product development, the introduction of new products, the potential markets and uses for the Company's products, the Company's regulatory filings with the United States Food and Drug Administration (the "FDA"), acquisitions, the development of joint venture opportunities, the effect of competition on the structure of the markets in which the Company competes and defending the Company in litigation matters. One must carefully consider forward-looking 18 statements and understand that such statements involve a variety of risks and uncertainties, known and unknown, and may be affected by assumptions that fail to materialize as anticipated. Consequently, no forward-looking statement can be guaranteed, and actual results may vary materially. It is not possible to foresee or identify all factors affecting the Company's forward-looking statements, and one therefore should not consider the following list of such factors to be an exhaustive statement of all risks, uncertainties or potentially inaccurate assumptions. The Company undertakes no obligation to update any forward-looking statement. Although it is not possible to create a comprehensive list of all factors that may cause actual results to differ from the Company's forward-looking statements, the most important factors include without limitation, the following: THE COMPANY'S PRODUCTS ARE SUBJECT TO STRINGENT ONGOING REGULATION BY THE FDA AND SIMILAR HEALTH AUTHORITIES, AND IF THE FDA'S APPROVALS OR CLEARANCES OF THE COMPANY'S PRODUCTS ARE RESTRICTED OR REVOKED, THE COMPANY COULD FACE DELAYS THAT WOULD IMPAIR THE COMPANY'S ABILITY TO GENERATE FUNDS FROM OPERATIONS. The FDA and similar health authorities in foreign countries extensively regulate Escalon's activity. The Company must obtain either 510(K) clearances or pre-market approvals and new drug application approvals prior to marketing a product in the United States. Foreign regulation also requires that Escalon obtain other approvals from foreign government agencies prior to the sale of products in those countries. Also, Escalon may be required to obtain FDA approval before exporting a product or device that has not received FDA marketing clearance or approval. Escalon has received the necessary FDA approvals for all products that the Company currently markets. Any restrictions on or revocation of the FDA approvals and clearances that the Company has obtained, however, would prevent the continued marketing of the impacted products and other devices. The restrictions or revocations could result from the discovery of previously unknown problems with the product. Consequently, FDA revocation would impair the Company's ability to generate funds from operations. The FDA and comparable agencies in state and local jurisdictions and in foreign countries impose substantial requirements upon the manufacturing and marketing of pharmaceutical and medical device equipment and related disposables, including the obligation to adhere to the FDA's Good Manufacturing Practice regulations. Compliance with these regulations requires time-consuming detailed validation of manufacturing and quality control processes, FDA periodic inspections and other procedures. If the FDA finds any deficiencies in the validation processes, for example, the FDA may impose restrictions on marketing the specific products until such deficiencies are corrected. Escalon has received CE approval on several of the Company's products that allows the Company to sell the products in the countries comprising the European community. In addition to the CE mark, however, some foreign countries may require separate individual foreign regulatory clearances. Escalon cannot assure that the Company will be able to obtain regulatory clearances for other products in the United States or foreign markets. The process for obtaining regulatory clearances and approvals underlying clinical studies for any new products or devices and for multiple indications for existing products is lengthy and will require substantial commitments of Escalon's financial resources and Escalon's management's time and effort. Any delay in obtaining clearances or approvals or any changes in existing regulatory requirements would materially adversely affect the Company's business. Escalon's failure to comply with the applicable regulations would subject the Company to fines, delays or suspensions of approvals or clearances, seizures or recalls of products, operating restrictions, injunctions or civil or criminal penalties, which would adversely affect the Company's business, financial condition and results of operations. 19 FAILURE OF THE MARKET TO ACCEPT THE COMPANY'S PRODUCTS COULD ADVERSELY IMPACT THE COMPANY'S BUSINESS AND FINANCIAL CONDITION. The Company's business and financial condition will depend upon the market acceptance of the Company's products. The Company cannot assure that the Company's products will achieve market acceptance. Market acceptance depends upon a number of factors: - The price of the products; - The receipt of regulatory approvals for multiple indications; - The establishment and demonstration of the clinical safety and efficacy of the Company's products; and - The advantages of the Company's products over those marketed by the Company's competitors. Any failure to achieve significant market acceptance of the Company's products will have a material adverse effect on the Company's business. THE SUCCESS OF COMPETITIVE PRODUCTS COULD HAVE AN ADVERSE EFFECT ON THE COMPANY'S BUSINESS. The Company faces intense competition in the medical device and pharmaceutical markets, which are characterized by rapidly changing technology, short product life cycles, cyclical oversupply and rapid price erosion. Many of the Company's competitors have substantially greater financial, technical, marketing, distribution and other resources. The Company's strategy is to compete primarily on the basis on technological innovation, reliability, quality and price of the Company's products. Without timely introductions of new products and enhancements, the Company's products will become technologically obsolete over time, in which case the Company's revenues and operating results would suffer. The success of the Company's new product offerings will depend on several factors, including the Company's ability to: - Properly identify customer needs; - Innovate and develop new technologies, services and applications; - Establish adequate product distribution coverage; - Obtain and maintain required regulatory approvals from the FDA and other regulatory agencies; - Protect the Company's intellectual property; - Successfully commercialize new technologies in a timely manner; - Manufacture and deliver the Company's products in sufficient volumes on time; - Differentiate the Company's offerings from the offerings of the Company's competitors; - Price the Company's products competitively; - Anticipate competitors' announcements of new products, services or technological innovations; and - General market and economic conditions. 20 The Company cannot assure that the Company will be able to compete effectively in the competitive environments in which it operates. THE COMPANY'S PRODUCTS EMPLOY PROPRIETARY TECHNOLOGY, AND THIS TECHNOLOGY MAY INFRINGE ON THE INTELLECTUAL PROPERTY RIGHTS OF THIRD PARTIES. The Company holds several United States and foreign patents for the Company's products. Other parties, however, hold patents relating to similar products and technologies. If patents held by others were adjudged valid and interpreted broadly in an adversarial proceeding, the court or agency could deem them to cover one or more aspects of the Company's products or procedures. Any claims for patent infringements or claims by the Company for patent enforcement would consume time, result in costly litigation, divert technical and management personnel or require the Company to develop non-infringing technology or enter into royalty or licensing agreements. The Company cannot be certain that the Company will not be subject to one or more claims for patent infringement, that the Company would prevail in any such action or that the Company's patents will afford protection against competitors with similar technology. If a court determines that any of the Company's products, infringes, directly or indirectly, on a patent in a particular market, the court may enjoin the Company from making, using or selling the product. Furthermore, the Company may be required to pay damages or obtain a royalty-bearing license, if available, on acceptable terms. THE COMPANY WILL NO LONGER RECEIVE REVENUE FROM THE SALE OF SILICONE OIL BY BAUSCH & LOMB SUBSEQUENT TO AUGUST 13, 2005. The Company realized 7.88% and 14.91% of its net revenue during the three-month periods ended September 30, 2004 and 2003, respectively, from Bausch & Lomb's sales of Silicone Oil. The Company is entitled to receive this revenue from Bausch & Lomb, in varying amounts, through August 2005. The agreement with Bausch & Lomb, which commenced on August 13, 2000, is structured such that the Company receives consideration from Bausch & Lomb based on its adjusted gross profit from its sales of Silicone Oil on a quarterly basis. The consideration is subject to a factor, which steps down according to the following schedule: From 8/13/00 to 8/12/01 100% From 8/13/01 to 8/12/02 82% From 8/13/02 to 8/12/03 72% From 8/13/03 to 8/12/04 64% From 8/13/04 to 8/12/05 45%
The revenue associated with the sale of Silicone Oil by Bausch & Lomb has no associated expense and consequently provides a gross margin of 100%. Any significant reduction in this revenue can have a significant negative impact on gross margin. Any significant decrease in Silicone Oil revenue received by the Company would have an impact on the Company's financial position, results of operations and cash flows and the Company's stock price could be negatively impacted. LACK OF AVAILABILITY OF KEY SYSTEM COMPONENTS COULD RESULT IN DELAYS, INCREASED COSTS OR COSTLY REDESIGN OF THE COMPANY'S PRODUCTS. Although some of the parts and components used to manufacture the Company's products are available from multiple sources, the Company currently purchases most of the Company's components from single sources in an effort to obtain volume discounts. Lack of availability of any of these parts and components could result in production delays, increased costs, or costly redesign of the Company's products. Any loss of availability of an essential component could result in a material adverse change to Escalon's business, financial condition and results of operations. Some of the Company's suppliers are also subject to the FDA's Good Manufacturing Practice regulations. Failure of these suppliers to comply 21 with these regulations could result in the delay or limitation of the supply of parts or components to the Company, which would adversely affect the Company's financial condition and results of operations. THE COMPANY'S ABILITY TO MARKET OR SELL THE COMPANY'S PRODUCTS MAY BE ADVERSELY AFFECTED BY LIMITATIONS ON REIMBURSEMENTS BY GOVERNMENT PROGRAMS, PRIVATE INSURANCE PLANS AND OTHER THIRD PARTY PAYORS. The Company's customers bill various third party payors, including government programs and private insurance plans, for the health care services provided to their patients. Third party payors may reimburse the customer, usually at a fixed rate based on the procedure performed, or may deny reimbursement if they determine that the use of the Company's products was elective, unnecessary, inappropriate, not cost-effective, experimental or used for a non-approved indication. Third party payors may deny reimbursement notwithstanding FDA approval or clearance of a product and may challenge the prices charged for the medical products and services. The Company's ability to sell the Company's products on a profitable basis may be adversely impacted by denials of reimbursement or limitations on reimbursement, compared with reimbursement available for competitive products and procedures. New legislation that further reduces reimbursements under the capital cost pass-through system utilized in connection with the Medicare program could also adversely affect the marketing of the Company's products. FUTURE LEGISLATION OR CHANGES IN GOVERNMENT PROGRAMS MAY ADVERSELY AFFECT THE MARKET FOR THE COMPANY'S PRODUCTS. In the past several years, the federal government and Congress have made proposals to change aspects of the delivery and financing of health care services. The Company cannot predict what form any future legislations may take or its effect on the Company's business. Legislation that sets price limits and utilization controls may adversely affect the rate of growth of ophthalmic and vascular access product markets. If any future health care legislation were to adversely impact those markets, the Company's product marketing could also suffer, which would adversely impact the Company's business. THE COMPANY MAY BECOME INVOLVED IN PRODUCT LIABILITY LITIGATION, WHICH MAY SUBJECT THE COMPANY TO LIABILITY AND DIVERT MANAGEMENT ATTENTION. The testing and marketing of the Company's products for applications in ophthalmology and vascular access, the Company's pharmaceutical products and vascular access products entail and inherent risk of product liability, resulting in claims based upon injuries or alleged injuries associated with a defect in the products' performance. Some of these injuries may not become evident for a number of years. Although the Company is not currently involved in any product liability litigation, the Company may be party to litigation in the future as a result of an alleged claim. Litigation, regardless of the merits of the claim or outcome, could consume a great deal of the Company's time and money and would divert management time and attention away from the Company's core businesses. The Company maintains limited product liability insurance coverage of $1,000,000 per occurrence and $2,000,000 in the aggregate, with umbrella policy coverage of up to $5,000,000 in excess of such amounts. A successful product liability claim in excess of any insurance coverage may adversely impact the Company's financial condition and results of operations. The Company cannot assure you that product liability insurance coverage will continue to be available to the Company in the future on reasonable terms or at all. THE COMPANY'S INTERNATIONAL OPERATIONS COULD BE ADVERSELY IMPACTED BY CHANGES IN LAWS OR POLICIES OR FOREIGN GOVERNMENTAL AGENCIES AND SOCIAL AND ECONOMIC CONDITIONS IN THE COUNTRIES IN WHICH THE COMPANY OPERATES. The Company derives a portion of its revenues from sales outside the United States. Changes in the laws or policies of governmental agencies, as well as social and economic conditions, in the countries in which the Company operates could affect the Company's business in these countries and the Company's results of operations. Also, economic factors, including inflation and fluctuations in interest rates and foreign currency exchange rates, and competitive factors such as price competition, business combinations 22 of competitors or a decline in industry sales from continued economic weakness, both in the United States and other countries in which the Company conducts business, could adversely affect the Company's results of operations. THE COMPANY IS DEPENDENT ON ITS MANAGEMENT AND KEY PERSONNEL TO SUCCEED. The Company's principal executive officers and technical personnel have extensive experience with the Company's products, the Company's research and development efforts, the development of marketing and sales programs and the necessary support services to be provided to the Company's customers. Also, the Company competes with other companies, universities, research entities and other organizations to attract and retain qualified personnel. The loss of the services of any of the Company's executive officers or other technical personnel, or the Company's failure to attract and retain other skilled and experienced personnel, could have a material adverse effect on the Company's ability to maintain or expand its businesses. ANY ACQUISITIONS, STRATEGIC ALLIANCES, JOINT VENTURES AND DIVESTITURES THAT THE COMPANY EFFECTS COULD RESULT IN FINANCIAL RESULTS THAT DIFFER FROM MARKET EXPECTATIONS. In the normal course of business, the Company engages in discussions with third parties regarding possible acquisitions, strategic alliances, joint ventures and divestitures. As a result of any such transactions, the Company's financial results may differ from the investment community's expectations in a given quarter. In addition, acquisitions and alliances may require the Company to integrate a different company culture, management team and business infrastructure. The Company may have difficulty developing, manufacturing and marketing the products of a newly acquired company in a way that enhances the performance of the Company's combined businesses or product lines to realize the value from expected synergies. Depending on the size and complexity of an acquisition, the Company's successful integration of the entity depends on a variety of factors including the retention of key employees and the management of facilities and employees in separate geographical areas. These efforts require varying levels of management resources, which may divert the Company's attention from other business operations. The Company acquired Drew during the first quarter of fiscal 2005. Drew does not have a history of producing positive operating cash flows and, as a result, at the time of acquisition, was operating under financial constraints and was under-capitalized and is expected to negatively impact the Company's financial results in the short term. If the Company does not realize the expected benefits or synergies of such transactions, the Company's consolidated financial position, results of operations and stock price could be negatively impacted. THE MARKET PRICE OF THE COMPANY'S STOCK HAS HISTORICALLY BEEN VOLATILE, AND THE COMPANY HAS NOT PAID CASH DIVIDENDS. The volatility of the Company's common stock imposes a greater risk of capital losses on shareholders as compared to less volatile stocks. In addition, such volatility makes it difficult to ascribe a stable valuation to a shareholder's holdings of the Company's common stock. The following factors have and may continue to have a significant impact on the market price of the Company's common stock: - Announcements of technological innovations; - Changes in marketing, product pricing and sales strategies or new products by the Company's competitors; - Any acquisitions, strategic alliances, joint ventures and divestitures that the Company effects; - Changes in domestic or foreign governmental regulations or regulatory requirements; and - Developments or disputes relating to patent or proprietary rights and public concern as to the safety and efficacy of the procedures for which the Company's products are used. 23 Moreover, the possibility exists that the stock market, and in particular the securities of technology companies such as Escalon, could experience extreme price and volume fluctuations unrelated to operating performance. The Company has not paid any cash dividends on its common stock and does not anticipate paying any cash dividends in the foreseeable future. THE COMPANY'S RESULTS FLUCTUATE FROM QUARTER TO QUARTER The Company has experienced quarterly fluctuations in operating results and anticipates continued fluctuations in the future. A number of factors contribute to these fluctuations: - Acquisitions (such as Drew) and subsequent integration of the acquired company, - Changes in the mix of products sold; - The timing and expense of new product introductions by the Company or its competitors; - Fluctuations in royalty income; - Announcements of new strategic relationships by the Company or its competitors; - The cancellation or delays in the purchase of the Company's products; - The gain or loss of significant customers; - Fluctuations in customer demand for the Company's products; and - Competitive pressures on prices at which the Company can sell its products. The Company sets its spending levels in advance of each quarter based, in part, on the Company's expectations of product orders and shipments during that quarter. A shortfall in revenue, therefore, in any particular quarter as compared to the Company's plan could have a material adverse effect on the Company's results of operations and cash flows. Also, the Company's quarterly results could fluctuate due to general conditions in the healthcare industry or global economy generally, or market volatility unrelated to the Company's business and operating results. THE IMPACT OF TERRORISM OR ACTS OF WAR COULD HAVE A MATERIAL ADVERSE EFFECT ON THE COMPANY'S BUSINESS. Terrorist acts or acts of war, whether in the United States or abroad, could cause damage or disruption to the Company's operations, its suppliers, channels to market or customers, or could cause costs to increase, or create political or economic instability, any of which could have a material adverse effect on the Company's business. THE COMPANY'S CHARTER DOCUMENTS AND PENNSYLVANIA LAW MAY INHIBIT A TAKEOVER. Certain provisions of Pennsylvania law and our Bylaws could delay or impede the removal of incumbent directors and could make it more difficult for a third party to acquire, or could discourage a third party from attempting to acquire, control of the Company. These provisions could limit the price that certain investors might be willing to pay in the future for shares of the Company's common stock. The Company's Board of Directors is divided into three classes, with directors in each class elected for three-year terms. The bylaws impose various procedural and other requirements that could make it more difficult for shareholders to effect certain corporate actions. The Company's Board of Directors may issue shares of preferred stock without shareholder approval on such terms and conditions, and having such rights, privileges and preferences, as the Board may determine. The rights of the holders of common stock will be 24 subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The Company has no current plans to issue any shares of preferred stock. The reader must carefully consider forward-looking statements and understand that such statements involve a variety of risks and uncertainties, known an unknown, and may be affected by inaccurate assumptions. It is not possible to foresee or identify all factors that may affect the Company's forward-looking statements, and the reader should not consider any list of such factors to be an exhaustive list of all risks, uncertainties or potentially inaccurate assumptions affecting such forward-looking statements. The Company cautions the reader to consider carefully these factors as well as the specific factors discussed with each specific forward-looking statement in this quarterly report and in the Company's other filings with the Securities and Exchange Commission. In some cases, these factors have affected, and in the future (together with other unknown factors) could affect the Company's ability to implement the Company's business strategy and may cause actual results to differ materially from those contemplated by such forward-looking statements. No assurance can be made that any expectation, estimate or projection contained in a forward-looking statement can be achieved. The Company also cautions the reader that forward-looking statements speak only as of the date made. The Company undertakes no obligation to update any forward-looking statement, but investors are advised to consult any further disclosures by the Company on this subject in the Company's filings with the Securities and Exchange Commission, especially on Forms 10-K, 10-Q and 8-K, in which the Company discusses in more detail various important factors that could cause actual results to differ from expected or historical results. The Company intends to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 regarding the Company's forward-looking statements, and are including this sentence for the express purpose of enabling the Company to use the protections of the safe harbor with respect to all forward-looking statements. EXECUTIVE OVERVIEW - THREE-MONTH PERIOD ENDED SEPTEMBER 30, 2004 The following highlights are discussed in further detail within this Form 10-Q. The reader is encouraged to read this Form 10-Q in its entirety to gain a more complete understanding of factors affecting Company performance and financial condition. - On July 23, 2004, Escalon acquired approximately 67% of the outstanding ordinary shares of Drew pursuant to the Company's exchange offer for all of the outstanding ordinary shares of Drew, and since that date has acquired substantially all of the Drew shares. During the remainder of fiscal 2005, Escalon expects to compel Drew shareholders to tender all of the remaining outstanding Drew shares pursuant to procedures under United Kingdom laws and regulations. Drew's revenue during the period from July 24, 2004 through September 30, 2004 was $1,904,000 and Drew's operations resulted in a net loss of $304,000. Prior to acquisition, Drew's ability to obtain raw materials and components was severely restricted due to prolonged liquidity constraints. These constraints were pervasive through all of Drew's locations and affected all aspects of Drew's operations. Escalon's immediate operational priorities with respect to Drew have been to stabilize and increase Drew's revenue base and to infuse Drew with the working capital in the areas of manufacturing, sales and marketing and product development in order to remove the pre-acquisition liquidity constraints. - In connection with the acquisition of Drew, the Company issued 841,686 shares of its common stock during the three-month period ended September 30, 2004. As of September 30, 2004, 58,314 shares of the Company's common stock remain reserved for future exchange for Drew shares. - During the three-month period ended September 30, 2004, the Company paid off all of its term debt that existed prior to the acquisition of Drew as well as the outstanding line of credit that existed prior to the acquisition. The total pre-acquisition debt paid off during the three-month period ended September 30, 2004 was $4,268,000. - When Drew is excluded, product revenue decreased 3.84% during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. The decrease is primarily related to the Sonomed business unit. The decrease in Sonomed product revenue was primarily caused by a decrease in demand for the Company's pachymeter product. 25 - Other revenue increased 14.93% during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. The increase relates to an increase in royalty payments received from Intralase. During the three-month period ended September 30, 2004, 63.56% of the Company's other revenue was received from Bausch & Lomb in connection with the Silicone Oil product line. The Bausch & Lomb contract for this revenue expires in August 2005. - When Drew is excluded, cost of goods sold as a percentage of product revenue increased to 52.01% of product revenue during the three-month period ended September 30, 2004, as compared to 42.70% of product revenue, for the same period last fiscal year. The increase is primarily related to the Sonomed business unit. The primary factors affecting Sonomed were product mix, most notably the decrease in pachymeter sales, in addition to an increase in international sales, where the Company generally experiences lower price per unit on its products. - When Drew is excluded, operating expenses increased 9.87% during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. The increase primarily relates to the Company's continuing efforts to strengthen its sales channels domestically and overseas as well as increases in administrative headcount. - Interest expense decreased during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. The Company paid off several of its debt facilities to several entities in advance of their maturity dates. Additionally, the Company reversed accrued loan commitment fees pursuant to the satisfaction of the debt and release by the lender of those fees. The fees were originally accrued based on contractual terms. COMPANY OVERVIEW The following discussion should be read in conjunction with interim condensed consolidated financial statements and the notes thereto, which are set forth elsewhere in this report on Form 10-Q. The Company operates in the healthcare market, specializing in the development, manufacture, marketing and distribution of medical devices and pharmaceuticals in the areas of ophthalmology, diabetes, cardiovascular disease, hematology and vascular access. The Company and its products are subject to regulation and inspection by the FDA. The FDA requires extensive testing of new products prior to sale and has jurisdiction over the safety, efficacy and manufacturing of products, as well as product labeling and marketing. The Company's Internet address is www.escalonmed.com. In February 1996, the Company acquired substantially all of the assets and certain liabilities of EOI a developer and distributor of ophthalmic surgical products. Prior to this acquisition, the Company devoted substantially all of its resources to the research and development of ultrafast laser systems designed for the treatment of ophthalmic disorders. As a result of the EOI acquisition, Escalon changed its market focus and is no longer developing laser technology. In October 1997, the Company licensed its intellectual laser property to IntraLase, in return for an equity interest and future royalties on sales of products relating to the laser technology. IntraLase undertook the responsibility for funding and developing the laser technology through to commercialization. IntraLase began selling products related to the laser technology during fiscal 2002. The Company is in dispute with IntraLase over royalty payments owed to the Company. See Part II, Item 1. Legal Proceedings, for further information. IntraLase completed its initial public offering in October 2004. See the Notes to Condensed Consolidated Financial Statements for further information. To further diversify its product portfolio, in January 1999, the Company's Vascular subsidiary acquired the vascular access product line from Endologix, formerly Radiance Medical Systems, Inc. Vascular's products use Doppler technology to aid medical personnel in locating arteries and veins in difficult circumstances. Currently, this product line is concentrated in the cardiac catheterization market. In January 2000, the Company purchased Sonomed, a privately held manufacturer of ophthalmic ultrasound diagnostic equipment. 26 On July 23, 2004, Escalon acquired approximately 67% of the outstanding ordinary shares of Drew, a United Kingdom company, pursuant to the Company's exchange offer for all of the outstanding ordinary shares of Drew, and since that date has acquired substantially all of the Drew shares. During the remainder of fiscal 2005, Escalon expects to compel Drew shareholders to tender all of the remaining outstanding Drew shares pursuant to procedures under United Kingdom laws and regulations. Drew is a diagnostics company specializing in the design, manufacture and distribution of analytical systems for laboratory testing worldwide. Drew is focused on providing instrumentation and consumables for the diagnosis and monitoring of medical disorders in the areas of diabetes, cardiovascular diseases and hematology. In addition, Drew supplies diagnostic systems that perform blood component tests. CRITICAL ACCOUNTING POLICIES The preparation of financial statements requires management to make estimates and assumptions that affect amounts reported therein. The most significant of those involve the application of SFAS 142, discussed further in the Notes to the Condensed Consolidated Financial Statements included in this Form 10-Q. The financial statements are prepared in conformity with accounting principles generally accepted in the United States of America, and, as such, include amounts based on informed estimates and judgments of management. For example, estimates are used in determining valuation allowances for deferred income taxes, uncollectible receivables, obsolete inventory, sales returns and rebates and purchased intangible assets. Actual results achieved in the future could differ from current estimates. The Company used what it believes are reasonable assumptions and, where applicable, established valuation techniques in making its estimates. REVENUE RECOGNITION The Company recognizes revenue from the sale of its products at the time of shipment, when title and risk of loss transfer. The Company provides products to its distributors at agreed wholesale prices and to the balance of its customers at set retail prices. Distributors can receive discounts for accepting high volume shipments. The discounts are reflected immediately in the net invoice price, which is the basis for revenue recognition. No further material discounts are given. The Company's considerations for recognizing revenue upon shipment of product to a distributor are based on the following: - Persuasive evidence that an arrangement (purchase order and sales invoice) exists between a willing buyer (distributor) and the Company that outlines the terms of the sale (company information, quantity of goods, purchase price and payment terms). The buyer (distributor) does not have an immediate right of return. - Shipping terms are ex-factory shipping point. At this point the buyer (distributor) takes title to the goods and is responsible for all risks and rewards of ownership, including insuring the goods as necessary. - The Company's price to the buyer (distributor) is fixed and determinable as specifically outlined on the sales invoice. The sales arrangement does not have customer cancellation or termination clauses. - The buyer (distributor) places a purchase order with the Company; the terms of the sale are cash, COD or credit. Customer credit is determined based on the Company's policy and procedures related to the buyer's (distributor's) creditworthiness. Based on this determination, the Company believes that collectibility is reasonably assured. Escalon assesses collectibility based on creditworthiness of the customer and past transaction history. The Company performs ongoing credit evaluations of its customers and does not require collateral from its 27 customers. For many of Escalon's international customers, the Company requires an irrevocable letter of credit to be issued by the customer before the purchase order is accepted. VALUATION OF INTANGIBLE ASSETS Escalon annually evaluates for impairment its intangible assets and goodwill in accordance with SFAS 142, "Goodwill and Other Intangible Assets," or whatever events or changes in circumstances indicate that the carrying value may not be recoverable. These intangible assets include goodwill, trademarks and trade names. Factors the Company considers important that could trigger an impairment review include significant under-performance relative to historical or projected future operating results or significant negative industry or economic trends. If these criteria indicate that the value of the intangible asset may be impaired, an evaluation of the recoverability of the net carrying value of the asset is made. If this evaluation indicates that the intangible asset is not recoverable, the net carrying value of the related intangible asset will be reduced to fair value. Any such impairment charge could be significant and could have a material adverse effect on the Company's financial statements if and when an impairment charge is recorded. No impairment losses were recorded for goodwill, trademarks and trade names during any of the periods presented based on these evaluations. TAXES Estimates of taxable income of the various legal entities and jurisdictions are used in the tax rate calculation. Management uses judgment in estimating what the Company's income will be for the year. Since judgment is involved, there is risk that the tax rate may significantly increase or decrease in any period. In determining income (loss) for financial statement purposes, management must make certain estimates and judgments. These estimates and judgments occur in the calculation of certain tax liabilities and in the determination of the recoverability of certain of the deferred tax assets, which arise from temporary differences between the tax and financial statement recognition of revenue and expense. SFAS 109 also requires that the deferred tax assets be reduced by a valuation allowance, if based on the weight of available evidence, it is more likely than not that all or some portion of the recorded deferred tax assets will not be realized in future periods. In evaluating Escalon's ability to recover the Company's deferred tax assets, management considers all available positive and negative evidence including the Company's past operating results, the existence of cumulative losses and near-term forecasts of future taxable income. Management develops assumptions that require significant judgment about the near-term forecasts of future taxable income that is consistent with the plans and estimates management is using to manage the underlying businesses. Through September 30, 2004, Escalon has recorded a full valuation allowance against the Company's net operating losses due to the uncertainty of their realization as a result of the Company's earnings history, the number of years the Company's operating losses and tax credits can be carried forward, the existence of taxable temporary differences and near-term earnings expectations. The amount of the valuation allowance could decrease if facts and circumstances change that materially increase taxable income prior to the expiration of the loss carryforwards. Any reduction would reduce (increase) the income tax expense (benefit) in the period such determination is made by the Company. 28 THREE-MONTH PERIODS ENDED SEPTEMBER 30, 2004 AND 2003 The following table shows consolidated product revenue by business segment as well as identifying trends in business segment product revenues for the three-month periods ended September 30, 2004 and 2003.
Three-Month Periods Ended September 30, ------------------------------------------ 2004 2003 % Change -------- ------- --------- Product revenue: Drew $1,904 $ - 100.00% Sonomed 1,644 1,705 -3.58% Vascular 695 734 -5.31% Medical/Trek/EMI 393 402 -2.24% -------- ------- --------- $4,636 $2,841 63.18% ======== ======= =========
Product revenue increased $1,795,000, or 63.18%, to $4,636,000 during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. The increase in revenue is attributed to the acquisition of Drew on July 23, 2004. If Drew is excluded, product revenue decreased $109,000, or 3.84%, to $2,732,000 during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. In the Sonomed business unit, revenue decreased $61,000, or 3.58%, to $1,644,000 during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. The decrease in Sonomed product revenue was primarily caused by a decrease in demand for the Company's pachymeter product. Unit sales of the pachymeter decreased by 90.99% as compared to the same period last fiscal year. The domestic market for pachymeters had previously expanded due to enhanced techniques in glaucoma screening performed by optometrists. Historically, the typical optometrist had not been a user of the pachymeter. Domestic demand for the Company's pachymeter returned to historic levels in the fourth quarter of fiscal 2004. Sales of Sonomed's new EZ-Scan product line have partially offset the aforementioned declines. In the Vascular business unit, revenue decreased $39,000, or 5.31%, to $695,000 during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. The decrease in product revenues in the Vascular business unit was primarily the result of the Company providing relief from the contracted minimum monthly purchase requirements to several of its distributors. The Company provided this relief to prevent the distributors from becoming overstocked with the Company's product. In the Medical/Trek/EMI business unit, revenue decreased $9,000, or 2.24%, to $393,000 during the three-month period ended September 30, 2004. Please see the executive overview for further information regarding the operating results of Drew. Other revenue increased $85,000, or 14.93%, to $656,000 during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. The increase relates to a $177,000 increase in royalty payments received from Intralase related to the licensing of the Company's intellectual laser technology. The royalty received from Bausch & Lomb in connection with their sales of Silicone Oil decreased $92,000. The Company's contract with Bausch & Lomb calls for annual step-downs in the calculation of Silicone Oil revenue to be received by the Company from 64% from August 13, 2003 to August 12, 2004 to 45% from August 13, 2004 to August 12, 2005. The step-downs occur during the first quarter of each fiscal year through the remainder of the contract, which ends in August 2005. For the three-month period ended September 30, 2004, the step-down caused a $176,000 decrease in Silicone Oil revenue that the Company would have otherwise received had the step-down not occurred. The offsetting $84,000 increase in Silicone Oil revenue is due to market demand for the product. The Company does not have any further knowledge as to what factors have affected Bausch & Lomb's sales of Silicone Oil. See the Notes to Consolidated Financial Statements for a description of the step-down provisions under the contract with Bausch & Lomb. 29 The following table presents consolidated cost of goods sold by reportable business segment and as a percentage of related segment product revenues for the three-month periods ended September 30, 2004 and 2003.
Three-Month Periods Ended September 30, --------------------------------------------- Cost of goods sold: 2004 2003 -------------------------- ----------------------------- Dollars % Dollars % ------- ----- ------- ------ (in thousands) (in thousands) Drew $1,251 65.70% $ -- 0.00% Sonomed 859 52.25% 681 39.94% Vascular 320 46.04% 296 40.33% Medical/Trek/EMI 242 61.58% 236 58.71% ------ ------ ----- ------ $2,672 57.64% $1,213 42.70% ====== ====== ====== ======
Cost of goods sold totaled $2,672,000, or 57.64% of product revenue, for the three-month period ended September 30, 2004 as compared to $1,213,000, or 42.70% of product revenue, for the same period last fiscal year. The increase in cost of goods sold is primarily attributed to the acquisition of Drew on July 23, 2004. If Drew is excluded, cost of goods sold increased $208,000, to $1,421,000, or 52.01% of product revenue during the three-month period ended September 30, 2004, as compared to $1,213,000, or 42.70% of product revenue, for the same period last fiscal year. Cost of goods sold in the Sonomed business unit totaled $859,000, or 52.25% of product revenue for the three-month period ended September 30, 2004 as compared to $681,000, or 39.94% of product revenue for the same period last fiscal year. The primary factors affecting the increase in cost of goods sold as a percentage of product revenue were product mix, most notably the decrease in pachymeter sales, in addition to an increase in international sales, where the Company generally experiences lower price per unit on its products. Cost of goods sold in the Vascular business totaled $320,000, or 46.04% of revenue, for the three-month period ended September 30, 2004 as compared to $296,000, or 40.33% of revenue for the same period last fiscal year. The Company experienced increases in overtime and temporary labor during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. Cost of goods sold in the Medical/Trek/EMI business unit totaled $242,000, or 61.58%, during the three-month period ended September 30, 2004 as compared to $236,000, or 58.71% for the same period last fiscal year. Fluctuations in Medical/Trek/EMI cost of goods sold primarily emanates from product mix, which was primarily controlled by market demand. Please see the executive overview for further information regarding the operating results of Drew. The following table presents consolidated marketing, general and administrative expenses as well as identifying trends in business segment marketing, general and administrative expenses for the three-month periods ended September 30, 2004 and 2003.
Three-Month Periods Ended September 30, ------------------------------------------------- 2004 2003 % Change --------- --------- ---------- Marketing, general and administrative expenses: Drew $ 792 $ -- 100.00% Sonomed 324 259 25.10% Vascular 339 314 7.96% Medical/Trek/EMI 727 641 13.42% -------- ------- ------- $2,182 $1,214 79.74% ======== ======= ========
Marketing, general and administrative expenses increased $968,000, or 79.74%, to $2,182,000 during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. The increase in marketing, general and 30 administrative expenses was primarily attributed to incremental expenditures due to the acquisition of Drew on July 23, 2004. If Drew is excluded, marketing, general and administrative expenses increased $176,000, or 14.50%, to $1,390,000 during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. Marketing, general and administrative expenses in the Sonomed business unit increased $65,000, or 25.10%, to $324,000 as compared to the same period last fiscal year. Salaries and other personnel-related expenses increased $24,000 as a result of increased headcount. Consulting expenses increased $16,000 primarily due to increased marketing expenditures in the European market. Advertising expenses also increased $17,000. In the Vascular business unit, marketing, general and administrative expenses increased $25,000, or 7.96%, to $339,000 as compared to the same period last fiscal year. The Company agreed to pay royalties for a period of five years following the acquisition of the vascular access division of Endologix. That five-year period ended in December 2003. This resulted in a $60,000 decrease in royalty expense. Offsetting this decrease was an increase in consulting expense primarily due to increased marketing expenditures in the European market as well as a $22,000 increase in salaries and other personnel-related expenses as a result of increased headcount. In Medical/Trek/EMI, marketing, general and administrative expenses increased $86,000, or 13.42%, to $727,000 as compared to the same period last fiscal year. Salaries and other personnel-related expenses increased $42,000 due to increased headcount. Administrative travel-related expenses increased $36,000 primarily due to the Drew acquisition. Please see the executive overview for further information regarding the operating results of Drew. Research and development expenses increased $109,000, or 52.45%, to $316,000 during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. The increase in research and development expenses was attributed to incremental expenditures due to the acquisition of Drew on July 23, 2004. Please see the executive overview for further information regarding the operating results of Drew. Escalon recognized a net loss of $29,201 related to its investment in OTM. The share of OTM's loss recognized by the Company is in direct proportion to the Company's ownership equity in OTM. OTM began operations during the three-month period ended September 30, 2004. See Related Party Transactions. Interest income was $32,000 and $1,000 for the three-month periods ended September 30, 2004 and 2003, respectively. The increase relates to increased average cash balances in the current fiscal year. Interest expense was $(3,000) and $119,000 for the three-month periods ended September 30, 2004 and 2003, respectively. The Company paid off several of its debt facilities to several entities in advance of their maturity dates. Additionally, the Company reversed accrued loan commitment fees pursuant to the satisfaction of the debt and release by the lender of said fees. The fees were originally accrued based on contractual terms. 31 LIQUIDITY AND CAPITAL RESOURCES Changes in Escalon's overall liquidity and capital resources from continuing operations during the three-month period ended September 30, 2004 are reflected in the following table:
September 30, June 30, (Dollars are in thousands) 2004 2004 -------------- ------------- Current assets $ 16,301 $ 17,566 Less: Current liabilities 7,712 3,600 -------------- ------------- Working capital $ 8,589 $ 13,966 Current ratio 2.1 to 1 4.9 to 1 ------------------------------------------------------------------------------------------- Notes payable and current maturities $ 1,409 $ 1,872 Long-term debt 594 2,396 -------------- ------------- Total debt $ 2,003 $ 4,268 Total equity 30,427 23,461 -------------- ------------- Total capital $32,430 $ 27,729 Total debt to total capital 6.18% 15.39%
WORKING CAPITAL POSITION Working capital decreased $5,377,000 as of September 30, 2004 and the current ratio decreased to 2.1 to 1 when compared to June 30, 2004. The decrease in working capital was caused primarily by the pay-off of all of the Company's pre-acquisition debt. Accrued expenses, accounts payable and line of credit increased $2,681,000, $1,299,000 and $937,000, respectively. As of September 30, 2004, $2,348,000 of the accrued expenses relates to Drew, or is related to the acquisition of Drew, $1,106,000 of accounts payable relates to Drew and the entire $1,187,000 line of credit relates to Drew. CASH FLOWS USED IN OPERATING ACTIVITIES Cash flows from operating activities decreased by $2,582,000 for the three months ended September 30, 2004 as compared to the same period last fiscal year. Apart from year-over-year decreased net profitability of $507,000, the Company also put an additional $2,131,000 into working capital (related to purchase of inventory and payment of accounts payable for Drew) during the three-month period ended September 30, 2004 as compared to the same period last fiscal year. CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES Cash flows from investing activities relate to net cash received from the acquisition of Drew offset by the Company's $130,000 investment in OTM and the purchase of fixed assets. Any necessary capital expenditures have generally been funded out of cash from operations, and the Company is not aware of any factors that would cause historical capital expenditure levels not to be indicative of capital expenditures in the future and, accordingly, does not believe that it will have to commit material resources to capital investment for the foreseeable future. Cash flows used in financing activities were $4,928,000 during the three-month period ended September 30, 2004. The Company paid off all of the pre-acquisition term debt it had outstanding prior to the Drew acquisition as well as the line of credit it had outstanding prior to the acquisition. The outstanding balance of these debt facilities was a combined $4,268,000. 32 FORWARD-LOOKING STATEMENT ABOUT SIGNIFICANT ITEMS LIKELY TO AFFECT LIQUIDITY On July 23, 2004, Escalon acquired approximately 67% of the outstanding ordinary shares of Drew, pursuant to the Company's exchange offer for all of the outstanding ordinary shares of Drew, and since that date has acquired substantially all of the Drew shares. As of September 30, 2004, the Company has acquired approximately 94% of the outstanding ordinary shares of Drew. During the remainder of fiscal 2005, Escalon expects to compel Drew shareholders to tender all of the remaining outstanding Drew shares pursuant to procedures under United Kingdom laws and regulations. Drew does not have a history of producing positive operating cash flows and, as a result, at the time of acquisition, was operating under financial constraints and was under-capitalized. As of November 9, 2004, as Drew is not yet wholly owned, Escalon loaned $3,253,000 to Drew. The funds have been primarily used to procure components to build up inventory to support the manufacturing process as well as to pay off accounts payable of Drew. As Drew is integrated into the Company, management will be working to reverse the situation, while at the same time strengthening Drew's market position. Escalon anticipates that further working capital will be required by Drew. In October 1997, Escalon licensed its intellectual laser properties to IntraLase in exchange for an equity interest of 252,535 shares of common stock (as adjusted after splits), as well as royalties on future product sales. On October 7, 2004, IntraLase announced the initial public offering of shares of its common stock at a price of $13.00 per share. The shares of common stock are restricted for a period of less than one year and may be sold after April 4, 2005 pursuant to a certain Fourth Amended Registration Rights Agreement between the Company and IntraLase. The shares have been classified as available-for-sale-securities. The Company's net proceeds will be the market price of the shares, multiplied by the number of shares sold, less any broker commissions. As of November 9, 2004, IntraLase's common stock closed at $18.32 per share on the Nasdaq National Market. At that price, Escalon's shares of IntraLase were valued at $4,626,441. The Company cannot assure that it will be able to liquidate its shares of IntraLase at the current market price. Escalon realized 7.88% and 14.91% of its net revenue during the three-month period ended September 30, 2004 and 2003, respectively, from Bausch & Lomb's sale of Silicone Oil. Silicone Oil revenue is based on sales of the product by Bausch & Lomb multiplied by a contractual factor that reduces on an annual basis due to a contractual step-down provision. While the Company does not expect total Silicone Oil revenue to decline rapidly during the remainder of the contract, any such decrease would have an impact on the Company's financial position, results of operations and cash flows and the Company's stock price could be negatively impacted. The Company is entitled to receive this revenue from Bausch & Lomb, in varying amounts, through August 2005, when all revenues will cease. See the Notes to Consolidated Financial Statements for a description of the step-down provisions under the contract with Bausch & Lomb. The Company issued 120,000 common stock purchase warrants in connection with the private placement on March 17, 2004. The warrants are exercisable at $15.60 per share and expire in five years from the placement date. If all 120,000 warrants were to be exercised, it would provide gross proceeds to the Company of $1,872,000. Escalon cannot assure, however, that the warrant exercise price will be less than the market price of the Company's common stock or that even if the exercise price is less than the market price that any of the warrants will be exercised. These warrants are not currently in the money and will not be exercised, and the Company will not receive any proceeds as long as the exercise price is greater than the market price. See the Notes to Condensed Consolidated Financial Statements for a description of the private placement of the Company's common stock and common stock purchase warrants. Additionally, the Company issued 60,000 common stock purchase warrants in connection with the renegotiation of the Company's term debt in November 2001. The warrants are exercisable at $3.66 per share and expire in November 2006. If all 60,000 warrants were to be exercised, it would provide gross proceeds to the Company of $219,600. Escalon cannot assure, however, that the warrant exercise price will be less than the market price of the Company's common stock or that even if the exercise price is less than the market price that any of the warrants will be exercised. 33 BALANCE SHEET The components of the balance sheet of the Company were increased as of July 23, 2004 by the acquisition of Drew as follows: Cash $ 295,373 Accounts receivable 1,433,324 Inventory 2,562,848 Other current assets 577,140 Furniture and equipment 868,839 Goodwill 8,622,303 Patents 461,779 Other long-term assets 264,530 Line of credit 1,617,208 Current liabilities 4,548,746 Liability for shares reserved for future exchange 597,019 Long-term debt 767,165 Exchange of common stock 6,833,420
DEBT HISTORY On December 23, 2002, a lender acquired the Company's bank debt, which consisted of term debt of $5,850,000 and $1,475,000 outstanding on a $2,000,000 available line of credit. On February 13, 2003, the Company entered into an amended agreement with the lender. The primary amendments of the amended loan agreement were to reduce quarterly principal payments, extend the term of the repayments and to alter the covenants of the original bank agreement. On September 30, 2004, the Company paid off and terminated both the remaining term debt and the outstanding balance on this line of credit. In November 2001, the Company issued the lender 60,000 warrants to purchase the Company's common stock at $3.66 per share in connection with this debt. The warrants will expire in November 2006. On January 21, 1999, the Company's Vascular subsidiary and Endologix entered into an Assets Sale and Purchase Agreement. Pursuant to this agreement, the Company acquired for cash the assets of Endologix's vascular access business in exchange for cash and also agreed to pay royalties to Endologix based on future sales of the vascular access business for a period of five years following the closing of the sale, with a guaranteed minimum royalty of $300,000 per year. On February 1, 2001, the parties amended the agreement to eliminate any future royalty payments to Endologix. Pursuant to this amendment, the Company paid $17,558 in cash to Endologix, delivered a short-term note in the amount of $64,884 that was satisfied in January 2002, a note in the amount of $717,558 payable in 11 quarterly installments that commenced on April 15, 2002, and the Company issued 50,000 shares of its common stock to Endologix. On September 30, 2004, the Company paid off the balance of the term debt. As of September 30, 2004, Drew has an overdraft line of credit with a United Kingdom financial institution. The amount available on the line is $651,344. The interest rate is 2.00% over the United Kingdom prime rate (4.75% at September 30, 2004). The line is secured by Drew's assets and is personally guaranteed by certain of Drew's current and former directors. The balance as of September 30, 2004 is $655,791. Drew also has long-term debt facilities through the Texas Mezzanine Fund and through Symbiotics, Inc. The Texas Mezzanine Fund term debt is payable in monthly installments of $14,200, which includes interest at a fixed rate of 8.00%. The note is due in April 2008 and is secured by certain assets of Drew. The outstanding balance at September 30, 2004 is $515,880. The Symbiotics, Inc. term debt, which originated from the acquisition of a product line from Symbiotics, Inc., is payable in monthly installments of $8,333 with interest at a fixed rate of 5.00%. The outstanding balance at September 30, 34 2004 is $300,002. Drew has a line of credit with a U.S. financial institution secured by certain assets of Drew. The amount available on the line of credit is $2,000,000. Interest is at the prime rate plus 4.00% (8.75% as of September 30, 2004). The outstanding balance as of September 30, 2004 was $531,236. OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS Escalon was not a party to any off-balance sheet arrangements as of and for the three-month periods ending September 30, 2004 and 2003. The following table presents the Company's contractual obligations as of September 30, 2004:
Less than More than Total 1 Year 1-3 Years 3-5 Years 5 Years ---------- ----------- ----------- ------------ ------------ Long-term debt $ 815,882 $ 221,668 $ 499,548 $ 94,666 $ -- Line of credit 1,187,027 1,187,027 -- -- -- Operating lease agreements 3,272,022 773,154 1,332,717 582,770 583,381 OTM commitment 126,000 126,000 -- -- -- Purchase obligations 700,000 700,000 -- -- -- ---------- ----------- ----------- ------------ ------------ $6,100,931 $3,007,849 $1,832,265 $ 677,435 $ 583,381 ========== =========== =========== ============ ============
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The table below provides information about the Company's financial instruments, consisting primarily of debt obligations that are sensitive to changes in interest rates. For debt obligations, the table represents principal cash flows and related interest rates by expected maturity dates. Interest rates at September 30, 2004 are fixed at 8.00% on the Texas Mezzanine Fund term debt, fixed at 5.00% on the Symbiotics, Inc. term debt, 4.00% over the Federal prime rate (4.75% at September 30, 2004) on the U.S. line of credit and 2.00% over the United Kingdom prime rate (4.75% at September 30, 2004) on the overdraft line of credit. See the Notes to Condensed Consolidated Financial Statements for further information regarding the Company's debt obligations.
2004 2005 2006 Thereafter Total ------------ ---------- --------- ---------- ---------- Texas Mezzanine Fund Note $ 121,672 $ 143,721 $ 155,821 $ 94,666 $ 515,880 Interest rate 8.00% 8.00% 8.00% 8.00% Symbiotics, Inc. Note 99,996 99,996 100,010 -- 300,002 Interest rate 5.00% 5.00% 5.00% -- U.S. Line of Credit 531,236 -- -- -- 531,236 Interest rate 8.75% -- -- -- Overdraft Line of Credit 655,791 -- -- -- 655,791 Interest rate 6.75% -- -- -- ------------ ---------- --------- ---------- ---------- $ 1,408,695 $ 243,717 $ 255,832 $ 94,665 $2,002,909 ============ ========== ========== ========== ==========
EXCHANGE RATE RISK During the three-month periods ended September 30, 2004 and 2003, approximately 35.90% and 15.80%, respectively, of Escalon's consolidated net revenue was derived from international sales. Prior to the acquisition of Drew, the price of all product sold overseas was denominated in United States Dollars and consequently the Company incurred no exchange rate risk on revenue. However, a portion of Drew's product revenue is denominated in United Kingdom pounds. During the period from July 24 through September 30, 2004, Drew recorded $518,000 of product revenue denominated in United Kingdom Pounds. Additionally, Drew incurs a portion of its expenses denominated in United Kingdom Pounds. During the 35 period from July 24 through September 30, Drew incurred $632,000 of expense denominated in United Kingdom Pounds. The Company's Sonomed business unit incurs a portion of its marketing expenses in the European market that are transacted in Euros. These expenses totaled $41,000 and $27,000 for the three-month periods ended September 30, 2004 and 2003, respectively. The Company's Vascular business unit began incurring marketing expenses in the European market during the second quarter of fiscal 2004, the majority of which are transacted in Euros. These expenses were $45,000 for the three-month period ended September 30, 2004. The Company may begin to experience fluctuations, beneficial or adverse, in the valuation of the currencies in which the Company transacts its business, namely the United States Dollar, the United Kingdom Pound and the Euro. ITEM 4. CONTROLS AND PROCEDURES (A) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES The Company's management, with the participation of the Company's Chief Executive Officer and Senior Vice President of Finance, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rule 13a-15(e) and 15(d)-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, the Company's Chief Executive Officer and Senior Vice President of Finance have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act. (B) INTERNAL CONTROLS OVER FINANCIAL REPORTING There have been changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the Company's first fiscal quarter ended September 30, 2004 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. The Company's management notes that there have not been any changes in the Company's internal control over financial reporting in the Company's historical business; however, the Company's recent acquisition of Drew did cause a change in the Company's internal control as it relates to that business. The improvement of internal controls surrounding the acquired Drew business is a continuing focus of Company management. In connection with their review of the Company's September 30, 2004 interim financial statements the Company's independent registered public accounting firm identified certain material weaknesses and other deficiencies in our internal control related to the Drew business that was acquired during the quarter. The Public Company Accounting Oversight Board, Standard No. 2 states a material weakness is "a significant deficiency, or a combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected." The Company's independent registered public accounting firm identified the following material weaknesses in the Company's acquired Drew businesses related to: 1. the Company's financial reporting closing and review process; 2. inadequate documentation, untimely account reconciliations and account analysis of certain balance sheet accounts; and 3. untimely and inadequate communication of Escalon policies and procedures to personnel of newly acquired business. 36 In connection with the non-negotiated acquisition of Drew on July 23, 2004 and the related material control weaknesses discussed above, we have or expect to take the following actions: 1. The Company's in the process of remediating the specific material control weaknesses identified above, 2. shortly after the acquisition of Drew, Escalon began relocating and consolidating the financial accounting and reporting function of Drew to Dallas, Texas from the United Kingdom, 3. the accounting personnel in the United Kingdom have all been replaced with employees that will remain until the final transition of the financial and reporting function to Dallas, Texas, 4. we are currently undertaking a detailed review of the internal control requirements under the newly organized financial accounting and reporting function of Drew and will implement changes as deemed necessary, 5. we have instituted temporary controls that require the direct involvement of the Company's corporate financial management team and, accounting consultants that actively engaged in integrating Escalon policies and procedures with all of Drew's operating entities. 6. During the quarter an independent accounting firm performed an investigation on the Drew UK operations to determine if there had been any fraudulent activity related to cash receipts on disbursements. The accounting firm did not find any evidence of fraud. Our analysis is continuing and we will attempt to have it completed by the end of the current fiscal year. This additional work and testing may identify other deficiencies in our internal control over financial reporting for Drew. After completing our full analysis, we may conclude that any additional deficiencies rise to the level of significant deficiencies or material weaknesses in internal control over financial reporting. The Company has performed additional procedures to evaluate the extent to which the internal control weaknesses discussed above could have led to material misstatements in the Company's consolidated financial statements. Based on this evaluation, the Company do not believe that the control weaknesses and deficiencies noted above led to any material misstatements in the consolidated financial statements included in this report. A control system, no matter how well-designed and operated, cannot provide absolute assurance that the objectives of the control systems are met, and no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On June 10, 2004, Escalon provided notice to Intralase of the Company's intention to terminate the license agreement with Intralase due to Intralase's failure to pay certain royalties that the Company believes are due under the license agreement. On June 21, 2004, Intralase sought a preliminary injunction and a temporary restraining order with the United States District Court for the Central District of California, Southern District against Escalon to prevent the termination of the license agreement with Intralase. The parties subsequently agreed to stipulate to the temporary restraining order to prevent a termination of the license agreement and, on July 6, 2004, as mutually agreed by Intralase and Escalon, the same district court entered a stipulation and order to remove from the trial list the hearing on the preliminary injunction. The litigation will continue in accordance with the court order. The Company does not believe that this matter has had or is likely to have a material adverse effect on the Company's business, financial condition or future results of operations. Escalon is aware of three lawsuits involving Drew. The first lawsuit involves the principal shareholders of an entity previously acquired by Drew for the collection of unpaid expenses. A counterclaim was filed by Drew for breach of intellectual property rights and for breach of the principal 37 shareholders' covenants not to compete. This action was filed in the state courts of Connecticut. The second lawsuit was filed in the state court of Minnesota, but transferred to the Federal District Court of Minnesota. This action was brought by a distributor against an entity previously acquired by Drew claiming a breach of a marketing and distribution agreement. The parties have reached a tentative settlement of this matter. The third action involves a suit instituted in California in connection with a dispute from a customer claiming a refund for a product purchase. The Company does not believe that these matters have had or are likely to have a material adverse effect on the Company's business, financial condition or future results of operations. Escalon, from time to time is involved in various legal proceedings and disputes that arise in the normal course of business. These matters have included intellectual property disputes, contract disputes, employment disputes and other matters. The Company does not believe that the resolution of any of these matters have had or are likely to have a material adverse effect on the Company's business, financial condition or results of operations. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS On July 23, 2004, Escalon acquired approximately 67% of the outstanding ordinary shares of Drew, a United Kingdom company, pursuant to the Company's exchange offer for all of the outstanding ordinary shares of Drew, and since that date has acquired substantially all of the Drew shares. During the remainder of fiscal 2005, Escalon expects to compel Drew shareholders to tender all of the remaining outstanding Drew shares pursuant to procedures under United Kingdom laws and regulations. During the quarter ended September 30, 2004, the Company has issued 841,686 shares of its common stock and reserved 58,314 shares for future issuance pursuant to the exchange offer. The issuances of shares of Escalon common stock in the exchange offer for the acquisition of Drew were made in accordance with Rule 802 under the Securities Act of 1933, as an exchange offer for a class of securities of a foreign private issuer in which the conditions regarding the limitation on United States ownership of Drew, the equal treatment of any United States holders and Form CB filings were satisfied. The Company did not effect any repurchases of its common stock during the quarter ended September 30, 2004. ITEM 5. OTHER INFORMATION In October 1997, Escalon licensed its intellectual laser properties to IntraLase in exchange for an equity interest of 252,535 shares of common stock (as adjusted after splits), as well as royalties on future product sales. On October 7, 2004, IntraLase announced the initial public offering of shares of its common stock at a price of $13.00 per share. The shares of common stock are restricted for a period of less than one year an may be sold after April 4, 2005 pursuant to a certain Fourth Amended Registration Rights Agreement between the Company and IntraLase. The shares have been classified as available-for-sale-securities. The Company has historically accounted for these shares at $0 basis because a readily determinable market value was not available. The Company cannot assume that it will be able to Liquidate its shares of Intralase at the current market price. ITEM 6. EXHIBITS EXHIBITS Exhibit No. Exhibit ----------- ------- Exhibits 10.34 Nat West Multi Currency Overdraft Facility dated February 12, 2003 between Drew Scientific and Nat West.. 10.35 Security Agreement between Danam Acquisition Corp and Symbiotics Corporation dated August 31, 2002. 10.36 Secured Promissory Note between Danam Acquisition Corp and Symbiotics Corporation dated August 31, 2002. 10.37 Sixth Amendment to Amended and Restated Loan Agreement - Dated November 30, 2003 - between Drew Scientific, Inc. and Bank of America. 10.38 Eight Amended and Restated Revolving Promissory Note - Date November 30, 2003 - between Bank of America and Drew Scientific, Inc. 10.39 Ratification of Guaranty - November 30, 2003 - between Bank of America and Drew Scientific, Inc. 10.40 Ratification of Guaranty - November 30, 2003 - between CDC Acquisition Corp and Bank of America 10.41 Post Closing Agreement - Dated November 30, 2003 - between Drew Scientific, Inc. and Danam Electronics 10.42 Second Amendment to Intercreditor Agreement - Dated November 20, 2003 - between Texas Mezzanine and Bank of America 10.43 Loan Agreement - Dated June 1, 2000 - by the Bank of America and MWI, Inc d/b/a Danam Electronics 10.44 Guaranty - June 1, 2000 - borrower MWI, Inc d/b/a Danam Electronics to Bank of America - Grantor Jerry West 10.45 Guaranty - June 1, 2000 - borrower MWI, Inc d/b/a Danam Electronics to Bank of America - Grantor - Infolab Inc. 10.46 Revolving Promissory Note - June 1, 2000 - Bank of America and MWI, Inc d/b/a Danam Electronics 10.47 Intercreditor Agreement - June 1, 2000 - between Texas Community Bank and Trust, The Texas Mezzanine Fund, Inc. and Bank of America 10.48 Promissory Note - November 20, 2003 - between Drew Scientific, Inc. and Texas Mezzanine Fund, Inc. 10.49 Revenue Participation Agreement - - November 20, 2003 - between Drew Scientific, Inc. and Texas Mezzanine Fund, Inc. 10.50 Security Agreement - - November 20, 2003 - between Drew Scientific, Inc. and Texas Mezzanine Fund, Inc. 10.51 Loan Agreement - November 20, 2003 - between Drew Scientific, Inc. and Texas Mezzanine Fund, Inc 10.52 Guaranty Agreement - November 20, 2003 - between Drew Scientific, Inc. and Texas Mezzanine Fund, Inc. 10.53 Guaranty Agreement - November 20, 2003 - between Keith Raymond Drew Scientific, Inc. and Texas Mezzanine. 10.54 Subornation Agreement - November 20, 2003 - between Drew Scientific, Inc. and Texas Mezzanine Fund, Inc. 10.55 Post Closing Agreement - November 20, 2003 - between Drew Scientific, Inc., Drew Scientific, plc, Keith Drew. and Texas Mezzanine Fund, Inc. 10.56 First Amendment to Post Closing Agreement dated December 20, 2003 between Drew Scientific, Inc. Drew Scientific, plc, Keith Drew and Texas Mezzanine Fund, Inc. 31.1 Certificate of Chief Executive Officer under Rule 13a-14(a) 31.2 Certificate of Senior Vice President of Finance under Rule 13a-14(a) 32.1 Certificate of Chief Executive Officer under Section 1350 of Title 18 of the United States Code 32.2 Certificate of Senior Vice President of Finance under Section 1350 of Title 18 of the United States Code
* All the above Filed herewith. 38 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ESCALON MEDICAL CORP. (Registrant) Date: November 22, 2004 By: /s/ Richard J. DePiano ----------------------- Richard J. DePiano Chairman and Chief Executive Officer Date: November 22, 2004 By: /s/ Harry M. Rimmer -------------------- Harry M. Rimmer Senior Vice President - Finance
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