-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, PVuQgmaIVYuG6PvGc2uske/3GMmyptI/ugmQ6EzNKu79oyaabIE7x7j9m4j9wjf5 rHXHL/RaS25DpGwpBe1k+A== 0000950147-99-000318.txt : 19990412 0000950147-99-000318.hdr.sgml : 19990412 ACCESSION NUMBER: 0000950147-99-000318 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990331 DATE AS OF CHANGE: 19990409 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ORTHOLOGIC CORP CENTRAL INDEX KEY: 0000887151 STANDARD INDUSTRIAL CLASSIFICATION: 3841 IRS NUMBER: 860585310 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-21214 FILM NUMBER: 99584542 BUSINESS ADDRESS: STREET 1: 1275 WEST WASHINGTON STREET CITY: TEMPE STATE: AZ ZIP: 85281 BUSINESS PHONE: 6024375520 MAIL ADDRESS: STREET 1: 1275 WEST WASHINGTON STREET CITY: TEMPE STATE: AZ ZIP: 85281 10-K 1 ANNUAL REPORT FOR THE YEAR ENDED 12/31/98 U.S. SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______________ to _________________ Commission file number: 0-21214 ORTHOLOGIC CORP. (Exact name of registrant as specified in its charter) Delaware 86-0585310 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) identification no.) 1275 West Washington Street, Tempe, Arizona 85281 (Address of principal executive offices) Issuer's telephone number: (602) 286-5520 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.0005 per share (TITLE OF CLASS) Rights to purchase 1/100 of a share of Series A Preferred Stock (TITLE OF CLASS) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such report(s)), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, based upon the closing bid price of the registrant's Common Stock as reported on the Nasdaq National Market on March 1, 1999 was approximately $82,742,000. Shares of Common Stock held by each officer and director and by each person who owns 10% or more of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily conclusive. The number of outstanding shares of the registrant's Common Stock on March 25, 1999 was 25,441,590. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1998 are incorporated by reference in Part II hereof and portions of the Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on May 4, 1999 are incorporated by reference in Part III hereof. ORTHOLOGIC CORP. FORM 10-K ANNUAL REPORT YEAR ENDED DECEMBER 31, 1998 TABLE OF CONTENTS PART I Item 1. Business........................................................... 1 Item 2. Properties......................................................... 10 Item 3. Legal Proceedings.................................................. 10 Item 4. Submission of Matters to a Vote of Security Holders................ 12 Executive Officers of the Registrant............................... 12 PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters........................................... 14 Item 6. Selected Financial Data............................................ 14 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations..................................... 14 Item 7A. Quantitative and Qualitative Disclosures About Market Risk..........20 Item 8. Financial Statements and Supplementary Data........................ 20 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure...................................... 20 PART III Item 10. Directors and Executive Officers of the Registrant................. 21 Item 11. Executive Compensation............................................. 21 Item 12. Security Ownership of Certain Beneficial Owners and Management..... 21 Item 13. Certain Relationships and Related Transactions..................... 21 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.... 21 SIGNATURES...................................................................S-1 PART I ITEM 1. BUSINESS GENERAL The Company was incorporated as a Delaware corporation in July 1987 as IatroMed, Inc. and changed its name to OrthoLogic Corp. in July 1991. Unless the context otherwise requires, the "Company" or "OrthoLogic" as used herein refers to OrthoLogic Corp. and its subsidiaries. The Company's executive offices are located at 1275 West Washington Street, Tempe, Arizona 85281, and its telephone number is (602) 286-5520. OrthoLogic develops, manufactures and markets proprietary, technologically advanced orthopedic products and packaged services for the orthopedic health care market including bone growth stimulation devices, continuous passive motion ("CPM") devices and ancillary orthopedic recovery products and a therapeutic injectable for relief of pain from osteoarthritis of the knee. OrthoLogic's products are designed to enhance the healing of diseased, damaged, degenerated or recently repaired musculoskeletal tissue. The Company's products focus on improving the clinical outcomes and cost-effectiveness of orthopedic procedures that are characterized by compromised healing, high-cost, potential for complication and long recuperation time. OrthoLogic periodically discusses with third parties the possible acquisition of technology, product lines and businesses in the orthopedic health care market and from time to time enters into letters of intent that provide OrthoLogic with an exclusivity period during which it considers possible acquisitions. PRODUCTS AND OTHER PRODUCT DEVELOPMENT OrthoLogic's product line includes bone growth stimulation and fracture fixation devices, CPM devices and related products and Hyalgan. The Company's product line is sold primarily through the Company's direct sales force. ORTHOLOGIC(R) 1000; OL-1000 SC. The ORTHOLOGIC 1000 is a portable, noninvasive physician prescribed magnetic field bone growth stimulator designed for home treatment of patients who have a non-healing fracture. The ORTHOLOGIC 1000 comprises two magnetic field treatment transducers (coils) and a microprocessor-controlled signal generator that delivers highly specific, low energy combined static and alternating magnetic fields. In 1989, the Company received U.S. Food and Drug Administration ("FDA") clearance of an Investigational Device Exemption ("IDE") to conduct a clinical trial of the ORTHOLOGIC 1000 for the treatment of patients with a specific variety of non-healing fracture, called a nonunion fracture, of certain long bones. A nonunion fracture was defined for the purposes of this study as a fracture that remains unhealed for at least nine months post-injury. In 1990, the Company received supplemental IDE clearance to conduct human clinical trials of the ORTHOLOGIC 1000 on patients with another type of non-healing fracture called a delayed union fracture. For purposes of this study, a delayed union fracture was defined as a non-healing fracture five to nine months post-injury. In March 1994, the FDA granted the Company's PreMarket Approval ("PMA") to market the ORTHOLOGIC 1000 for treatment of nonunion fractures. During June 1998, the Company received the approval of the FDA to change the ORTHOLOGIC 1000 label to remove references to the nine months post injury time frame. The revised label states that the ORTHOLOGIC 1000 is safe and effective for use in treating non-union fractures. In July 1997, the Company received a PMA supplement from the FDA for a single-coil model of the ORTHOLOGIC 1000. The single-coil device, the OL-1000 SC, utilizes the same magnetic fields as the ORTHOLOGIC 1000, is available in four sizes and is designed to be more comfortable for patients with fractures of some long bones, such as the upper femur or the scaphoid. The Company released this product during the first quarter of 1998. CONTINUOUS PASSIVE MOTION. CPM devices provide controlled, continuous movement to joints and limbs without requiring the patient to exert muscular effort and are intended to be applied immediately following orthopedic trauma or surgery. The products are designed to reduce swelling, increase joint range of motion, reduce the length of hospital stay and reduce the incidence of post-trauma and post-surgical complication. The primary use of CPM devices occurs in the hospital and home environments, but they are also utilized in skilled nursing facilities, sports medicine and rehabilitation centers. ANCILLARY ORTHOPEDIC PRODUCTS. The Company offers a complete line of bracing, electrotherapy, cryotherapy and dynamic splinting products. The bracing line incudes post-operative, custom and pre-sized functional and osteoarthritis models. Post-operative braces are used in the early phases of post-surgical rehabilitation while functional braces are applied as the patient returns to work or sports activities. The electrotherapy line consists of TENS, NMES, high volt pulsed current, interferential, and biofeedback units. Cryotherapy is used to cool the operative or injured site in order to prevent pain and swelling. OrthoLogic produces its own motorized cryotherapy device, the Blue Artic, which provides temperature-controlled cold therapy using a reservoir of ice water and a pump that circulates the water through a pad over the injury/surgical site. HYALGAN. The Company began marketing Hyalgan to orthopedic surgeons during July 1997 under a Co-Promotion Agreement with Sanofi Pharmaceuticals, Inc. (the "Co-Promotion Agreement"). Hyalgan is used for relief of pain from osteoarthritis of the knee for those patients who have failed to respond adequately to conservative non-pharmacological therapy and to simple analgesics, such as acetaminophen. Orthopedic surgeons administer Hyalgan in their offices, with each patient receiving five injections over a period of four weeks. Hyalgan is a preparation of highly purified sodium hyaluronate, a chemical found in the body and present in high amounts in joints and synovial fluid. The body's own hyaluronate plays a number of key roles in normal joint function, and in osteoarthritis, the quality and quantity of hyaluronate in the joint fluid and tissues may be deficient. CHRYSALIN. In January 1998 the Company made a minority equity investment in Chrysalis BioTechnology, Inc. As part of the transaction, the Company has been awarded a world-wide exclusive option to license the orthopedic applications of Chrysalin, a patented 23-amino acid peptide that has shown promise in accelerating the healing process of fractured bones. In pre-clinical animal studies, Chrysalin was shown to double the rate of fracture healing with a single injection into the fracture gap. The Company conducted pre-clinical studies during 1998, and, intends to submit an Investigational New Drug Application ("INDA") to the FDA during 1999. However, there can be no assurance that the Company will do so or that it would receive such approval if sought. ORTHOFRAME(R). ORTHOFRAme products are external fixation devices constructed of non-metallic carbon fiber-epoxy composite material. The ORTHOFRAME offers a versatile design which can be utilized for immobilization of a wide array of fracture types, including tibia, femur, ankle, elbow and pelvic fractures. The ORTHOFRAME/MAYO Wrist Fixator is a specialized device developed in cooperation with the Orthopedic Department of the Mayo Clinic, Rochester, Minnesota, for the treatment of complex wrist (Colles) fractures. The Orthopedic Department of the Mayo Clinic has agreed to provide ongoing clinical input on future design enhancements for the ORTHOFRAME/MAYO Wrist Fixator. Both products utilize non-metallic carbon fiber-epoxy materials to reduce device weight and are radiolucent (I.E., eliminate the blocking of x-rays caused by metallic devices). The Company believes that the patented fracture alignment mechanism of the ORTHOFRAME products allows for simpler application, and the radiolucency and light weight composite materials of the ORTHOFRAME products provide benefits to both surgeon and patient. ORTHOFRAME products are shipped pre-assembled in sterile packaging to increase ease-of-use for the surgeon and to reduce handling and inventory expenses for the hospital. SPINALOGIC(R) 1000. ThE SPINALOGIC 1000 is a portable, noninvasive magnetic field bone growth stimulator being developed to enhance the healing process as either an adjunct to spinal fusion surgery or as treatment for a failed spinal fusion surgery. The Company believes that the SPINALOGIC 1000 offers benefits similar to those of the ORTHOLOGIC 1000 in that it is relatively easy to use, requires a small power supply and requires only 30 minutes of treatment per day. The SPINALOGIC 1000 consists of one magnetic field treatment transducer and a microprocessor-controlled signal generator, both of which are positioned near the spine through use of an adjustable belt which the patient places around the torso. The Company received approval of an IDE from the FDA in August 1992 and commenced clinical trials for the SPINALOGIC 1000 as an adjunct to spinal fusion surgery in February 1993. The Company received approval of an IDE supplement from the FDA in September of 1995 to conduct a clinical trial of the SPINALOGIC 1000 as a noninvasive treatment for a failed spinal fusion surgery. The Company commenced this on-going clinical trial in the fourth quarter of 1995. The Company's application for a PMA Supplement was submitted to the FDA's Center for Devices and Radiological Health with a filing date of August 20, 1998. This acceptance indicates that the FDA has made a determination that the PMA application, as supplemented, is sufficiently complete to permit a substantive review. At the end of December, 1998 the Company submitted an amendment to the PMA Supplement in response to requests from the FDA. ORTHOSOUND(TM). The Company currently is conducting preclinical and a pilot clinical trial relating to the design, development and testing of diagnostic and therapeutic devices utilizing its nonthermal ultrasound technology ("ORTHOSOUND") for use in medical applications that relate to bone, cartilage, ligament or tendon diagnostics and healing. In the area of diagnostics, the ORTHOSOUND research projects address the potential use of ultrasound for the assessment of bone strength and fracture risk in osteoporotic patients and the 2 assessment of fracture healing. In therapeutic applications, the focus of the ORTHOSOUND research is on the potential use of ultrasound for the treatment of at-risk fractures to increase the healing rate and reduce the need for subsequent surgical procedures. The Company has not yet applied for FDA approval to market ORTHOSOUND based products, and there can be no assurance that the Company will do so or that it would receive such approval if sought. MARKETING AND SALES The ORTHOLOGIC 1000, OL-1000 SC, the ORTHOFRAME and the ORTHONAIL are prescribed by orthopedic surgeons and podiatrists practicing in private practices, hospitals and orthopedic and podiatric treatment centers. The Company is focusing its marketing and sales efforts on these groups, with particular emphasis on those clinicians who treat bone healing problems. CPM products are prescribed by orthopedic surgeons, hospitals, orthopedic trauma centers and allied health professionals. CPM devices are leased to the patient, typically for a period of one to three weeks. Orthopedic surgeons purchase Hyalgan from an exclusive distributor who sells Hyalgan under an agreement with Sanofi Pharmaceuticals, Inc. The Company's sales force calls on orthopedic surgeons to provide them with product information relative to Hyalgan. Additionally, the Company utilizes physician-to-physician selling via presentations and scientific and clinical articles published in medical journals. The Company's sales and marketing efforts are primarily conducted directly through the Company's own sales people. Of the Company's approximately 501 employees at December 31, 1998, approximately 309 are involved in sales and marketing. The Company employs 9 area vice presidents to manage territory sales, each of whom has responsibility for the Company's sales and marketing efforts in a designated geographic area. The Company's sales force services all product lines. Through the efforts of the Company's specialized direct sales force servicing third party payors, the Company has contracted with over 425 third party payors, including various Blue Cross/Blue Shield organizations, and the Department of Veteran Affairs. In addition, the Company is an approved Medicare provider and is also an approved Medicaid provider for a majority of states. ORTHOFRAME and ORTHOFRAME/MAYO products are sold internationally through distributors located in European and South American countries. Historically, the Company's export sales as a percentage of net sales have been less than 1%. See "Item 1 -- Business -- General." While OrthoLogic has not experienced seasonality of revenues from sales of the ORTHOLOGIC 1000 and ORTHOFRAME, revenues from leasing CPM equipment are seasonal. CPM devices are used most commonly as adjuncts to surgery and historically the strongest quarter tends to be the fourth quarter of the calendar year. The Company believes this trend may be because (i) individuals tend to put off elective surgical intervention until later in the year when their insurance deductibles have been met, and (ii) sports-related injuries tend to increase in the fall and winter months. The Company does not believe that revenues for Hyalgan will be seasonal. RESEARCH AND DEVELOPMENT The Company's research and development staff presently includes 15 individuals, of whom 4 hold doctoral (Ph.D. or D.V.M.) degrees. Individuals within the research and development organization have extensive experience in the areas of biomaterials, bioengineering, animal modeling and cell biology. Research and development efforts emphasize product engineering, activities related to the clinical trials conducted by the Company and basic research. With regard to basic research, the research and development staff conducts in-house research projects in the area of fracture healing. The staff also supports and monitors external research projects in biophysical stimulation of growth factors and the potential use of ultrasound technology in diagnostic and therapeutic applications relating to bone, cartilage, ligament or tendon. Both the in-house and external research and development projects also provide technical marketing support for the Company's products and explore the development of new products and also additional therapeutic applications for existing products. Product engineering activities are primarily related to improvements in the CPM devices. The Company also has a clinical regulatory group that initiates and monitors clinical trials. The Company's research and development expenditures totaled $2.2 million, $2.3 million and $2.9 million in the years ended December 31, 1996, 1997 and 1998, respectively. See "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations." 3 MANUFACTURING The Company assembles the ORTHOLOGIC 1000 and OL-1000 SC from parts supplied by third parties, performs tests on both the components and assembled product and calibrates the assembled product to specifications. The Company currently purchases the microprocessors used in the ORTHOLOGIC 1000 and OL-1000 SC from a sole source supplier. The ORTHOLOGIC 1000 and OL-1000 SC are not dependent on this microprocessor, and the Company believes that each could be redesigned to incorporate another microprocessor. At any point in time, the Company maintains a supply of the microprocessor on hand to meet its sales forecast for at least one year. In addition, the magnetic field sensor employed in the ORTHOLOGIC 1000 and OL-1000 SC are available from two sources. Establishment of additional or replacement suppliers for these components cannot be accomplished quickly. Other components and materials used in the manufacture and assembly of the ORTHOLOGIC 1000 and OL-1000 SC are available from multiple sources. The Company assembles CPM devices from parts that it manufactures in-house or purchases from third parties. These parts are assembled, calibrated and tested at the Company's facilities in Pickering (outside of Toronto), Canada. The Company purchases several CPM components, including microprocessors, motors and custom key panels from sole-source suppliers. The Company believes that its CPM products are not dependent on these components and could be redesigned to incorporate comparable components. The Company places orders for these components to meet sales forecast for six months. Other components and materials used in the manufacture and assembly of CPM products are available from multiple sources. Fidia S.p.A., an Italian corporation, manufactures Hyalgan under an agreement with Sanofi Pharmaceuticals, Inc. Future revenues of the Company could be adversely affected in the event Fidia S.p.A. experiences disruptions in the manufacture of Hyalgan. The Company assembles the ORTHOFRAME product from parts supplied by third parties. The composite material components of the ORTHOFRAME products are currently sourced from two vendors. Establishment of additional or replacement suppliers for these components cannot be accomplished quickly. The Company maintains a supply of these components on hand to meet its sales forecast for at least six months. Other components and materials used in the manufacture and assembly of the ORTHOFRAME products are readily available from multiple sources. See "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations -- Dependence on Key Suppliers." The Company purchases other orthopedic products fully assembled from third-party suppliers. These products are available from multiple sources. COMPETITION The orthopedic industry is characterized by rapidly evolving technology and intense competition. With respect to the treatment of bone fractures, the Company believes that patients with non-healing fractures are primarily treated with surgery, and this represents the Company's primary competition, although other manufacturers of noninvasive bone growth stimulators also represent competition for the ORTHOLOGIC 1000 and OL-1000 SC. The Company's main competitors for these products are Electro-Biology, Inc. ("EBI"), a subsidiary of Biomet, Inc., OrthoFix International N.V. ("OrthoFix") and Biolectron Inc. Exogen, Inc. markets a nonthermal ultrasound device for the acceleration of the time to a healed fracture for closed, cast immobilized, fresh fractures of the tibia and distal radius. With respect to the adjunctive treatment of spinal fusion surgery, the Company expects its primary competitors for its products to be EBI and OrthoFix. With respect to external fixation devices, the Company's primary competitors are OrthoFix, Howmedica, Inc. (a subsidiary of Pfizer, Inc.), EBI, Smith & Nephew Richards, Inc., Synthes, Inc. and ACE Orthopedic Manufacturing (a division of Depuy, Inc.). The same group of companies and Applied OsteoSystems, Inc. represent its primary competition in the internal fixation market. The Company's primary competitors in the United States for CPM devices are privately held Thera-Kinetics, Inc., many independent owners/lessors of CPM devices and suppliers of traditional orthopedic rehabilitation services including orthopedic immobilization and follow up physical therapy. The Company also believes that there are several foreign CPM device manufacturers and providers with whom the Company will compete if it increases international sales efforts or as those competitors sell in the United States. The Company's primary competitor for Hyalgan is Biomatrix, Inc. Many of the Company's competitors have substantially greater resources and experience in research and development, obtaining regulatory approvals, manufacturing, and marketing and sales of medical devices and services, and 4 therefore represent significant competition for the Company. The Company is aware that its competitors are conducting clinical trials for other medical applications of their respective technologies. In addition, other companies are developing or may develop a variety of other products and technologies to be used in CPM devices, the treatment of fractures and spinal fusions, including growth factors, bone graft substitutes combined with growth factors, nonthermal ultrasound and the treatment of pain associated with osteoarthritis of the knee. The Company believes that competition is based on, among other factors, the safety and efficacy of products in the marketplace, physician familiarity with the product, ease of patient use, product reliability, reputation, price, sales and marketing capability and reimbursement. Any product developed by the Company that gains any necessary regulatory approval will have to compete for market acceptance and market share in an intensely competitive market. An important factor in such competition may be the timing of market introduction of competitive products. Accordingly, the relative speed with which the Company can develop products, complete clinical testing as well as any necessary regulatory approval processes and supply commercial quantities of the product to the market will be critical to its competitive success. There can be no assurance the Company can successfully compete on these bases. See "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations -- Intense Competition" and "-- Rapid Technological Change." PATENTS, LICENSES AND PROPRIETARY RIGHTS The Company's practice is to require its employees, consultants and advisors to execute a confidentiality agreement upon the commencement of an employment or consulting relationship with the Company. The agreements provide that all confidential information developed by or made known to an individual during the course of the employment or consulting relationship will be kept confidential and not disclosed to third parties except in specified circumstances. In the case of employees, the agreements provide that all inventions conceived by the individual relating to the Company's business while employed by the Company shall be the exclusive property of the Company. There can be no assurance, however, that these agreements will provide meaningful protection for the Company's trade secrets in the event of unauthorized use or disclosure of such information. It is also the Company's policy to protect its owned and licensed technology by, among other things, filing patent applications for the technologies that it considers important to the development of its business. The Company uses the BIOLOGIC(R) technology in its bone growth stimulation devices through a worldwide exclusive license granted by a corporation owned by university professors who discovered the technology. With respect to the BIOLOGIC technology, the delivery of such technology to the patient and specific applications of such technology, the Company holds title to five United States patents and to patents issued in Australia and Europe (Switzerland, Germany, France, and the United Kingdom), as well as to a pending international application and pending patent applications in the United States and Japan, and holds an exclusive worldwide license to 27 United States patents, eight Australian patents, five Canadian patents, two European patents (Germany, France, the United Kingdom, Spain and Italy) and two Japanese patents. Currently there is one pending patent application in Japan and multiple pending patent applications in Canada and Germany. The Company's license for the BIOLOGIC technology extends for the life of the underlying patents (which are due to expire over a period of years beginning in 2006 and extending through 2016) and covers all improvements and applies to the use of the technology for all medical applications in man and animals. The license provides for payment of royalties by the Company from the net sales revenues of products using the BIOLOGIC technology. The license agreement can be terminated for breach of any material provision of the license. See Note 6 of Notes to Consolidated Financial Statements. The Company holds an exclusive worldwide license to four United States patents covering ORTHOFRAME products. The license, which extends for the life of the underlying patents (the earliest of which issued in 1986) and covers all improvements, provides for payment of royalties by the Company from the sales revenues of ORTHOFRAME products. The license provides for minimum royalties of $100,000 per calendar year. The license agreement can be terminated for breach of any material provision of the license and, at the Company's option, upon 60 days' notice to the licensor. See Note 6 of Notes to Consolidated Financial Statements. The Company has been assigned four United States patents covering methods for ultrasonic bone assessment by noninvasively and quantitatively evaluating the status of bone tissue IN VIVO through measurement of bone mineral density, strength and fracture risk. Additionally, patent applications are pending for this technology in the United States, Canada, Japan, and Europe as well as two pending international applications. 5 With respect to CPM technology, the Company currently owns 17 United States patents, one pending United States patent application, two Canadian patents, three Canadian patent applications, two Japanese patents, and a European patent. The issued United States patents on this technology are due to expire over a period of years beginning in the year 2001 and extending through 2016. These patents could expire at an earlier date if the patents are not maintained by paying certain fees and/or annuities to the United States Patent and Trademark Office and/or appropriate foreign patent offices at certain intervals over the life of the patents. The pending United States patents, if issued, would begin to expire over a period of time beginning around 2015, and could expire at an earlier date, if not maintained as noted in the previous sentence. ORTHOLOGIC(R), ORTHOLOGIC & DESIGN(R), ORTHOFRAME(R), BIOLOGIC(R), SPINALOGIC(R), TOMORROW'S TECHNOLOGY TODAY(R), TALON(R), CASELOG(R), ORTHOSONIC(R), LEGASUS SPORT CPM(R), LITELIFT(R), SPORTLITE(R), SUTTER(R), DANNINGER MEDICAL(R), MOBILIMB(R), WAVEFLEX(R), AND TOTALCARE(R) are federally registered trademarks of the Company. Additionally, the Company claims trademark rights in PERIOLOGICTM, OSTEOLOGICTM, ORTHONAILTM, ORTHOSOUNDTM, QUICKFIXTM, CPM 9000ATTM, LEGASUS CPMTM, SUTTER CAREPLANTM, HOME REHAB SYSTEMTM and DANNIFLEXTM. The Company has become aware of an assertion in Germany against one of its CPM patents. The Company does not believe that it will have a material effect on the Company. The Company is not aware of any other claims that have been asserted against the Company for infringement of proprietary rights of third parties. There can be no assurance, however, that third parties will not assert infringement claims against the Company in the future. GOVERNMENT REGULATION The activities of the Company are regulated by foreign, federal, state and local governments. Government regulation in the United States and other countries is a significant factor in the development and marketing of the Company's products and in the Company's ongoing manufacturing and research and development activities. The Company and its products are regulated by the FDA under a number of statutes, including the Medical Device Amendments Act of 1976 to the Federal Food, Drug and Cosmetic Act and the Safe Medical Devices Act of 1990 (collectively, the "FDC Act"). The Company's current BIOLOGIC technology-based products are classified as Class III Significant Risk Devices, which are subject to the most stringent FDA review, and are required to be tested under an IDE clinical trial and approved for marketing under a PMA. To begin human clinical studies the Company must apply to the FDA for an IDE. Generally, preclinical laboratory and animal tests are required to establish a scientific basis for granting of an IDE. Once an IDE is granted, clinical trials can commence which involve rigorous data collection as specified in the IDE protocol. After the clinical trial is completed, the data are compiled and submitted to the FDA in a PMA application. FDA approval of a PMA application occurs after the applicant has established safety and efficacy to the satisfaction of the FDA. The FDA approval process may include review by an FDA advisory panel. Approval of a PMA application includes specific requirements for labeling of the medical device with regard to appropriate indications for use. Among the conditions for PMA approval is the requirement that the prospective manufacturer's quality control and manufacturing procedures comply with the FDA regulations setting forth Good Manufacturing Practices ("GMP"). The FDA monitors compliance with these requirements by requiring manufacturers to register with the FDA, which subjects them to periodic FDA inspections of manufacturing facilities. In addition, the Company must comply with post-approval reporting requirements of the FDA. If violations of applicable regulations are noted during FDA inspections, the continued marketing of any products manufactured by the Company may be adversely affected. No significant deficiencies have been noted in FDA inspections of the Company's manufacturing facilities. The ORTHOFRAME and ORTHOFRAME/MAYO WRIST FIXATOR are Class II devices. If a medical device manufacturer can establish that a newly developed device is "substantially equivalent" to a device that was legally marketed prior to May 28, 1976, the date on which the Medical Device Amendments Act of 1976 was enacted, the manufacturer may seek marketing clearance from the FDA to market the device by filing a 510(k) pre-market notification with the agency. The Company obtained 510(k) pre-market notification clearances from the FDA for the ORTHOFRAME and ORTHONAIL products. The Company's CPM devices are Class I devices which do not require 510(k) pre-market notification. However, CPM manufacturers must comply with GMP regulations. The devices must also meet Underwriters Laboratories standards for electrical safety. For sales to the European Community, CPM devices must meet established electromechanical safety and electromagnetic emissions regulations. 6 The Company also expects that the European Community will soon require compliance with quality control standards. The Company believes that it currently complies with the new standards. Manufacturers outside the United States that export devices to the United States may be subject to FDA inspection. The FDA generally inspects companies every few years. The frequency of inspection depends upon the Company's status with respect to regulatory compliance. To date, the Company's foreign operations have not been the subject of any inspections conducted by the FDA. Under Canada's Food and Drugs Act and the rules and regulations thereunder (the "Food and Drugs Act"), the CPM devices sold by the Company do not require any Canadian regulatory approvals prior to their introduction to the market. However, the Company must provide Health and Welfare Canada with notice concerning the sale of a device. Notice for all of the CPM devices currently manufactured by the Company in Canada has been provided to Health and Welfare Canada. Subsequent to such notification, Health and Welfare Canada may request the Company to provide it with the results of the testing conducted on the device. If the results of such testing do not substantiate the nature of the benefits claimed to be obtainable from the use of the device or the performance characteristics claimed for such device to the satisfaction of Health and Welfare Canada, the sale of the device in Canada would be prohibited until appropriate results had been submitted. The Company has not been asked to provide such testing results to the Canadian authorities. CPM devices must comply with the applicable provincial regulations regarding the sale of electrical products by receiving the prior approval of either the Canadian Standards Association ("CSA") or the provincial hydro-electric authority, unless the device is otherwise exempt from such requirement. To date, the Company believes that its CPM devices have, unless otherwise exempt, obtained such necessary approvals prior to introduction to the market. The FDC Act regulates the labeling of medical devices to indicate the uses for which they are approved, both in connection with PMA approval and thereafter, including any sponsored promotional activities or marketing materials distributed by or on behalf of the manufacturer or seller. A determination by the FDA that a manufacturer or seller is engaged in marketing of a product for other than its approved use may result in administrative, civil or criminal actions against the manufacturer or seller. Regulations governing human clinical studies outside the United States vary widely from country to country. Historically, some countries have permitted human studies earlier in the product development cycle than the United States. This disparity in regulation of medical devices may result in more rapid product approvals in certain foreign countries than the United States, while approvals in countries such as Japan may require longer periods than in the United States. In addition, although certain of the Company's products have undergone clinical trials in the United States and Canada, such products have not undergone clinical studies in any other foreign country and the Company does not currently have any arrangements to begin any such foreign studies. Hyalgan is considered a Class III Significant Risk Device and is subject to the same clinical trial and GMP reviews as described for the BIOLOGIC technology-based products. The product is manufactured by Fidia S.p.A. in Italy and is imported into the United States. As a result, each shipment of the product into the United States is subject to inspections, including by the United States Department of Agriculture. The import of Hyalgan could be delayed or denied for numerous reasons, and, if this occurs, it could have a material adverse affect on sales of the product. To the Company's knowledge, no significant deficiencies have been noted in the FDA inspections of Fidia S.p.A.'s manufacturing facility. The process of obtaining necessary government approvals is time-consuming and expensive. There can be no assurance that the necessary approvals for new products or applications will be obtained by the Company or, if they are obtained, that they will be obtained on a timely basis. Furthermore, the Company or the FDA must suspend clinical trials upon a determination that the subjects or patients are being exposed to an unreasonable health risk. The FDA may also require post-approval testing and surveillance programs to monitor the effects of the Company's products. In addition to regulations enforced by the FDA, the Company is also subject to regulations under the Occupational Safety and Health Act, the Environmental Protection Act, the Toxic Substances Control Act, the Resource Conservation and Recovery Act and other present and potential future federal, state and local regulations. The ability of the Company to operate profitably will depend in part upon the Company obtaining and maintaining all necessary certificates, permits, approvals and clearances from the United States and foreign and other regulatory authorities and operating in compliance with applicable regulations. Failure to comply with regulatory requirements could have a material adverse effect on the Company's business, financial condition 7 and results of operations. Regulations regarding the manufacture and sale of the Company's current products or other products that may be developed or acquired by the Company are subject to change. The Company cannot predict what impact, if any, such changes might have on its business. See "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations -- Government Regulation" and "-- Condition of Acquired Facilities." THIRD PARTY PAYMENT Most medical procedures are reimbursed by a variety of third party payors, including Medicare and private insurers. The Company's strategy for obtaining reimbursement authorization for its products is to establish their safety, efficacy and cost effectiveness as compared to other treatments. The Company is an approved Medicare provider and is also an approved Medicaid provider for a majority of states. The Company contracts with over 425 third party payors as an approved provider for its fracture healing and orthopedic rehabilitation products, including the Department of Veterans Affairs and various Blue Cross/Blue Shield organizations. Because the process of obtaining reimbursement for products through third-party payors is longer than through direct invoicing of patients, the Company must maintain sufficient working capital to support operations during the collection cycle. In addition, third party payors as an industry have undergone consolidation, and that trend appears to be continuing. The concentration of such economic power may result in third party payors obtaining additional leverage and thus negatively affecting the Company's profitability and cash flows. As part of the Company's efforts to establish its primary products as treatments of choice among third party payors, the Company has entered into two consulting agreements with practicing physicians. These physicians were retained by the Company to increase product acceptance, respond to inquiries from other clinicians regarding the Company's products or to assist the Company in seeking third party payor endorsement of practice pattern changes. Significant uncertainty exists as to the reimbursement status of newly approved health care products, and there can be no assurance that adequate third party coverage will continue to be available for the Company's products at current levels. See "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations -- Limitations on Third Party Payment; Uncertain Effects of Managed Care." PRODUCT LIABILITY INSURANCE The business of the Company entails the risk of product liability claims. The Company maintains a product liability and general liability insurance policy and an umbrella excess liability policy. There can be no assurance that liability claims will not exceed the coverage limit of such policies or that such insurance will continue to be available on commercially reasonable terms or at all. Consequently, product liability claims could have a material adverse effect on the business, financial condition and results of operations of the Company. The Company has not experienced any product liability claims to date resulting from its Fracture Healing Products. To date, liability claims resulting from the Company's CPM Products have not had a material adverse effect on business. Additionally, the agreements by which the Company acquired its CPM businesses generally require the seller to retain liability for claims arising before the acquisition. See "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations -- Risk of Product Liability Claims." YEAR 2000 COMPLIANCE The inability of computers, software and other equipment utilizing microprocessors to recognize and properly process data fields containing a 2 digit year is commonly referred to as the Year 2000 Compliance issue. As the Year 2000 approaches, such systems may be unable to accurately process certain data-based information. STATE OF READINESS: The Company has implemented a Year 2000 Corporate Compliance Plan for coordinating and evaluating compliance activities in all business activities. The Company's Plan includes a series of initiatives to ensure that all the Company's computer equipment and software will function properly in the next millennium. "Computer equipment (or hardware) and software" includes systems generally thought of as IT dependent, as well as systems not obviously IT dependent, such as manufacturing equipment, telecopier machines, and security systems. The Company began the implementation of this plan in fiscal year 1998. All internal IT systems and non-IT systems were inventoried during the assessment phase of the plan. The first execution of the plan occurred in June 1998 when the Company converted all internal processing systems for accounting, manufacturing, third party billing, inventory and other operational processes to the Year 2000 compliant software. In addition, in the ordinary course of 8 business, as the Company periodically replaces computer equipment and software, it will acquire only Year 2000 compliant products. The Company presently believes that its software replacements and planned modifications of certain existing computer equipment and software will be completed on a timely basis so as to avoid any of the potential Year 2000 related disruptions or malfunctions of its computer equipment and software. The Company has completed its compliance review of virtually all of its products and has not learned of any products that it manufactures that will cease functioning or experience an interruption in operations as a result of the transition to the Year 2000. COSTS: The Company has used both internal and external resources to reprogram or replace, test and implement its IT and non-IT systems for Year 2000 modifications. The Company does not separately track the internal costs incurred to date on the Year 2000 compliance. Such costs are principally payroll and related costs for internal IT personnel. The costs to date have been less than $100,000. Future costs related to Year 2000 compliance are anticipated to be less than $100,000 for fiscal year 1999. External costs have been incurred for the normal system upgrades and software conversions related to other operational requirements. RISKS: The Company believes it has an effective Plan in place to anticipate and resolve any potential Year 2000 issues in a timely manner. In the event, however, that the Company does not properly identify Year 2000 issues or that compliance testing is not conducted on a timely basis, there can be no assurance that Year 2000 issues will not materially and adversely affect the Company's results of operations or relationships with third parties. In addition, disruptions in the economy generally resulting from Year 2000 issues also could materially and adversely affect the Company. The amount of potential liability and lost revenue that would be reasonably likely to result from the failure by the Company and certain key parties to achieve Year 2000 compliance on a timely basis cannot be reasonably estimated at this time. The Company currently believes that the most likely worst case scenario with respect to the Year 2000 issue is the failure of third party insurance payors to become compliant, which could result in the temporary interruption of the payments received for services and products purchased. This could interrupt cash payments received by the Company, which in turn would have a negative impact on the Company. CONTINGENCY PLAN: A contingency plan has not yet been developed for dealing with the most likely worst case scenarios. As part of its continuous assessment process, the Company is developing contingency plans as necessary. These plans could include, but are not limited to, use of alterative suppliers and vendors, substitutes for banking institutions, and the development of alternative payments solutions in dealing with third party payors. The Company currently plans to complete such contingency planning by October 1999. These plans are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ from those plans. EMPLOYEES As of December 31, 1998, the Company had 501 employees, including 309 in sales and marketing, 15 in research and development and clinical and regulatory affairs, approximately 4 in managed care, 83 in reimbursement and 90 in manufacturing, finance and administration. The managed care staff is charged with changing the practice patterns of the orthopedic community through the influence of third party payors on treatment regimes. The Company believes that the success of its business will depend, in part, on its ability to identify, attract and retain qualified personnel. In the future, the Company will need to add additional skilled personnel or retain consultants in such areas as research and development, manufacturing and marketing and sales. The Company considers its relationship with its employees to be good. See "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations -- Dependence on Key Personnel; Recent Management Changes." 9 ITEM 2. PROPERTIES The Company leases facilities in Tempe, Arizona and Pickering, Ontario, Canada. These facilities are designed and constructed for industrial purposes and are located in industrial districts. Each facility is suitable for the Company's purposes and is effectively utilized. The table below sets forth certain information about the Company's principal facilities. Approx. Location Square Feet Lease Expires Description Principal Activity - - -------- ----------- ------------- ----------- ------------------ Tempe 80,000 11/07 2-story, in industrial Assembly, park Administration Pickering 28,500 2/99 1-story, in CPM assembly industrial park The Company believes that each facility is well maintained. In 1997, the Company consolidated all CPM manufacturing in its Toronto facility and all CPM administrative and service functions in Phoenix. The Company has ceased operations at facilities in San Diego, California in connection with the consolidation. See "Item 7 -- Management's Discussion and Analysis of Financial Condition Results of Operations -- Condition of Acquired Facilities." ITEM 3. LEGAL PROCEEDINGS On June 24, 1996, and on several days thereafter, lawsuits were filed in the United States District Court for the District of Arizona against the Company and certain officers and directors alleging violations of Sections 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") and SEC Rule 10b-5 promulgated thereunder, and, as to other defendants, Section 20(a) of the Exchange Act. See "Item 7 -- Management's Discussion and Analysis of Financial Condition Results of Operations -- Potential Adverse Outcome of Litigation." These lawsuits are: Mark Silveria v. Allan M. Weinstein, Allen R. Dunaway, David E. Derminio and OrthoLogic Corporation, Cause No. CIV 96-1563 PHX EHC, filed in the United States District Court for the District of Arizona (Phoenix Division) on July 1, 1996. Derric C. Chan and Anna Chan as attorney in fact for Moon-Yung Chow, on behalf of themselves and all others similarly situated v. OrthoLogic Corporation, Allan M. Weinstein, Frank P. Magee and David E. Derminio, Cause No. CIV 96-1514 PHX RCB, filed in the United States District Court for the District of Arizona (Phoenix Division) on June 21, 1996. Jeffrey M. Boren and Charles E. Peterson, Jr., on behalf of themselves and all others similarly situated v. Allan M. Weinstein and OrthoLogic Corp., Cause No. CIV 96-1520 PHX RCB, filed in the United States District Court for the District of Arizona on June 24, 1996. Jeffrey Draker, on behalf of himself and all others similarly situated v. Allan M. Weinstein and OrthoLogic Corp., Cause No. CIV 96-1667 PHX RCB, filed in the United States District Court for the District of Arizona (Phoenix Division) on July 16, 1996. Edward and Eleanor Katz v. OrthoLogic Corp. and Allan M. Weinstein, Cause No. CIV 96-1668 PHX RGS, filed in the United States District Court for the District of Arizona (Phoenix Division) on July 17, 1996. Mark J. Rutkin, Paul A. Wallace, Malcolm E. Brathwaite, Elaine K. Davies and David G. Davies, Larry E. Carder and Carl Hust, on behalf of themselves and all others similarly situated v. Allan M. Weinstein, Allen R. Dunaway, David E. Derminio and OrthoLogic Corp., Cause No. CIV 96-1678 PHX EHC, filed in the United States District Court for the District of Arizona (Phoenix Division), on July 17, 1996. Frank J. DeFelice, on behalf of himself and all others similarly situated v. OrthoLogic Corp. and Allan M. Weinstein, Cause No. CIV 96-1713 PHX EHC, filed in the United States District Court for the District of Arizona (Phoenix Division), on July 23, 1996. 10 Scott Longacre, Joseph E. Sheedy, Trustee, Rickie Trainor, W. Preston Battle, III, Taylor D. Shepherd, Dianna Lynn Shepherd, Gordon H. Hogan, Trustee, and Dallas Warehouse Corp., Inc., on behalf of themselves and all others similarly situated v. Allan M. Weinstein, Allen R. Dunaway, David E. Derminio, Frank P. Magee and OrthoLogic Corp., Cause No. CIV 96-1891 PHX PGR, filed in the United States District Court for the District of Arizona (Phoenix Division) on August 16, 1996. Jeffrey D. Bailey, Milton Berg, Bryan Boatwright, Charles R. Campbell, Mark and Cathy Daniel, Tom Drotar, Rudy Gonnella, David Gross, Janet Gustafson, Willa P. Koretz, Dr. Richard Lewis, John Maynard, Margaret Milosh, Michelle Milosh, Theresa L. Onn, Ward B. Perry, William Schillings, Darwin and Merle Sen, Nestor Serrano and Larry E. and Gloria M. Swanson v. Allan M. Weinstein, Allen R. Dunaway, David E. Derminio and OrthoLogic Corporation, Cause No. CIV 96-1910 PHX PGR, filed in the United States District Court for the District of Arizona (Phoenix Division) on August 19, 1996. Nancy Z. Kyser and Mark L. Nichols, on behalf of themselves and all others similarly situated v. OrthoLogic Corporation, Allan M. Weinstein, Frank P. Magee and David E. Derminio, Cause No. CIV 96-1937 PHX ROS, filed in the United States District Court for the District of Arizona (Phoenix Division) on August 22, 1996. Plaintiffs in these actions allege generally that information concerning the May 31, 1996 letter received by the Company from the FDA regarding the Company's OrthoLogic 1000 Bone Growth Stimulator, and the matters set forth therein, was material and undisclosed, leading to an artificially inflated stock price. Plaintiffs further allege that the Company's non-disclosure of the FDA correspondence and of the alleged practices referenced in that correspondence operated as a fraud against plaintiffs, in that the Company allegedly made untrue statements of material facts or omitted to state material facts necessary in order to make the statements not misleading. Plaintiffs further allege that once the FDA letter became known, a material decline in the stock price of the Company occurred, causing damage to plaintiffs. All plaintiffs seek class action status, unspecified compensatory damages, fees and costs. Plaintiffs also seek extraordinary, equitable and/or injunctive relief as permitted by law. Pursuant to court orders dated December 17, 1996 and January 19, 1997, the preceding actions were consolidated for all purposes before Judge Broomfield in Arizona federal district court, and lead plaintiffs and counsel were appointed. Thereafter, the Company and its officers and directors moved to dismiss the consolidated amended complaint for failure to state a claim. On February 5, 1998, Judge Broomfield dismissed the consolidated amended complaint in its entirety against the Company and its officers and directors, giving plaintiffs leave to amend all claims to cure all deficiencies. Plaintiffs have filed an amended complaint, and the cases are pending. On or about June 20, 1996, a lawsuit entitled Norman Cooper, et al. v. OrthoLogic Corp., et al., Cause No. CV 96- 10799, was filed in the Superior Court, Maricopa County, Arizona. The plaintiffs allege violations of Arizona Revised Statutes Sections 44-1991 (state securities fraud) and 44-1522 (consumer fraud) and common law fraud based upon factual allegations substantially similar to those alleged in the federal court class action complaints. Plaintiffs also seek class action status, unspecified compensatory and punitive damages, fees and costs. Plaintiffs also seek injunctive and/or equitable relief. By agreement of the parties, that action has been stayed while the federal actions proceed. On or about July 16, 1996, Jacob B. Rapoport filed a Shareholder Derivative Complaint for Breach of Fiduciary Duty and Misappropriation of Confidential Corporation Information (based on similar factual issues underlying the above lawsuits) in the Superior Court of the State of Arizona, Maricopa County, No. CV 96-12406 against Allan M. Weinstein, John M. Holliman, Augustus A. White, Fredric J. Feldman, Elwood D. Howse, George A. Oram, Frank P. Magee and David E. Derminio, Defendants and OrthoLogic Corp., Nominal Defendant. On October 29, 1996 the defendants removed the case to the United States District Court for the District of Arizona (Phoenix Division) No. CIV 96-2451 PHX RCB on grounds of diversity pursuant to 28 U.S.C. ss. 1332. Defendants filed a motion to dismiss the complaint. By agreement of the parties, the case had been stayed pending a decision on defendants' motion to dismiss the consolidated amended class action complaint. The case continues to be stayed pending plaintiffs' amendment of their consolidated amended class action complaint in compliance with the Court's Order of Dismissal. The Company continues to deny the substantive allegations in the aforesaid lawsuits and will continue to defend the action vigorously. In February 1997, the Company received a letter from the California Department of Industrial Relations Division of Occupational Safety and Health regarding an informal complaint involving certain physical problems with one of the facilities leased by Sutter prior to its acquisition by the Company. The Company responded to the letter in March 1997 11 and believes that it has addressed the issues raised in that letter. See "Item 2 - - -- Properties" and "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations -- Condition of Acquired Facilities." ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth information regarding the executive officers of the Company: Name Age Title - - ---- --- ----- Thomas R. Trotter 51 Chief Executive Officer, President and Director Frank P. Magee, D.V.M. 42 Executive Vice President, Research and Development Terry D. Meier 60 Senior Vice President, Chief Financial Officer William C. Rieger 49 Vice President, Marketing Worldwide David K. Floyd 38 Vice President, Sales Ruben Chairez, Ph.D. 56 Vice President, Medical Regulatory and Clinical Affairs MaryAnn G. Miller 41 Vice President, Human Resources Kevin Lunau 41 Vice President, Manufacturing Thomas R. Trotter joined the Company as President and Chief Executive Officer and a Director in October 1997. From 1988 to October 1997, Mr. Trotter held various positions at Mallinckrodt, Inc. in St. Louis, Missouri, most recently as President of the Critical Care Division and a member of the Corporate Management Committee. From 1984 to 1988, he was President and Chief Executive Officer of Diamond Sensor Systems, a medical device company in Ann Arbor, Michigan. From 1976 to 1984, he held various senior management positions at Shiley, Inc. (a division of Pfizer, Inc.) in Irvine, California. Frank P. Magee, D.V.M. joined the Company as a Vice President in November 1989 and became Executive Vice President, Research and Development in 1991. Mr. Magee served as President between August 1997 and October 1997. From 1984 to 1989, Dr. Magee was head of Experimental Surgery at Harrington Arthritis Research Center, a not-for-profit independent research and development organization. Terry D. Meier joined the Company in March 1998 as Senior Vice President and on April 1, 1998, began serving as its Chief Financial Officer. From 1974 to 1997, Mr. Meier held several positions at Mallinckrodt, Inc., a healthcare and specialty chemicals company. Most recently, he served as their Vice President and Corporate Controller and from 1989 to 1996, as the Senior Vice President and Chief Financial Officer. William C. Rieger joined the Company in January 1998 as Vice President, Marketing and Sales. From 1994 to 1997, Mr. Rieger held the position of Vice President of Sales and Marketing at Hollister Inc., a privately held manufacturer of medical products. From 1985-1994, he held several positions as Vice President at Miles Inc. Diagnostic Division, a manufacturer of diagnostic products. David K. Floyd joined the Company in May 1998 as Vice President, Sales. From September 1994 through April 1998, Mr. Floyd was associated with Sulzer Orthopedics, most recently as Vice President of Sales with responsibility for sales activity in North America and South America. From May 1987 through August 1994. Mr. Floyd held positions in sales and marketing with Zimmer Inc., a Bristol-Myers Squibb Company and a manufacturer of medical devices. Ruben Chairez, Ph.D., joined the Company in May 1998 as Vice President, Medical Regulatory and Clinical Affairs. From November, 1993 through April 1998, Dr. Chairez served as Vice President, Regulatory Affairs/Quality Assurance of SenDx Medical, Inc., a manufacturer of blood gas analyzer systems. From July 1990 to November 1993, Mr. Chairez was the Director of Regulatory Affairs with Glen - Probe Incorporated, an in retro diagnostic device manufacturer. 12 MaryAnn G. Miller joined the Company as Vice President of Human Resources in October 1996. From November 1995 to June 1996, Ms. Miller was Human Resources Director for Southwestco Wireless, Inc. doing business as CellularOne, a subsidiary of Bell Atlantic Nynex Mobile, a provider of wireless telecommunications services in the Southwest. From October 1992 to July 1995, Ms. Miller was a human resources officer with Firstar Corporation, a Wisconsin-based bank holding company. She was previously First Vice President and Regional Human Resources Director of Firstar from January 1994 to July 1995. Kevin Lunau joined the Company as Vice President of Manufacturing on March 17, 1999. From 1991 to 1999, Mr. Lunau held management positions at Orthologic Canada (previously Toronto Medical Corp.), a subsidiary of OrthoLogic. Most recently, he served as Orthologic Canada's Executive Vice President and General Manager. 13 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information under the heading "Stockholder Information" on page 18 of the Company's Annual Report to Stockholders for the year ended December 31, 1998 (the "Annual Report") is incorporated herein by reference. ITEM 6. SELECTED FINANCIAL DATA The information on pages 17 and 31 of the Annual Report under the heading "Selected Financial Data" is incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information on pages 13 through 16 of the Annual Report under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" is incorporated herein by reference. The Company may from time to time make written or oral forward-looking statements, including statements contained in the Company's filings with the Securities and Exchange Commission and its reports to stockholders. This Report contains forward-looking statements made pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. In connection with these "safe harbor" provisions, the Company identifies important factors that could cause actual results to differ materially from those contained in any forward-looking statements made by or on behalf of the Company. Any such forward-looking statement is qualified by reference to the following cautionary statements. LIMITED HISTORY OF PROFITABILITY; QUARTERLY FLUCTUATIONS IN OPERATING RESULTS. The Company was founded in 1987 and only began generating revenues from the sale of its primary product in 1994. The Company has experienced significant operating losses since its inception and had an accumulated deficit of approximately $51.4 million at December 31, 1998. There can be no assurance that the Company will ever generate sufficient revenues to attain operating profitability or retain net profitability on an on-going annual basis. In addition, the Company may experience fluctuations in revenues and operating results based on such factors as demand for the Company's products, the timing, cost and acceptance of product introductions and enhancements made by the Company or others, levels of third party payment, alternative treatments which currently exist or may be introduced in the future, completion of acquisitions, changes in practice patterns, competitive conditions, regulatory announcements and changes affecting the Company's products in the industry and general economic conditions. The development and commercialization by the Company of additional products will require substantial product development and regulatory, clinical and other expenditures. See "Item 1 -- Business -- Competition." POTENTIAL ADVERSE OUTCOME OF LITIGATION. The Company is a defendant in a number of investor lawsuits relating generally to correspondence received by the Company from the FDA in mid-1996 regarding the promotion and configuration of the ORTHOLOGIC 1000. See "Item 1 -- Business -- Governmental Regulation" and "Item 3 -- Legal Proceedings." The Company intends to defend these lawsuits vigorously. However, an adverse litigation outcome could have a material adverse effect on the Company's business, financial condition and results of operations. DEPENDENCE ON SALES FORCE. A substantial portion of the Company's sales are generated through the Company's internal sales force of approximately 282 employees. During 1996, the Company shifted its primary focus from sales through independent orthopedic specialty dealers to an internal sales force. In January 1998 the sales management was restructured so that territories are determined based only on geography and not on geography and devices. As a result, certain members of sales management were now responsible during 1998 for devices not previously within their area of responsibility. There can be no assurance that these individuals will be able to manage their new responsibilities successfully. See "Item 1 -- Business -- Marketing and Sales." DEPENDENCE ON KEY PERSONNEL; RECENT MANAGEMENT CHANGES. The success of the Company is dependent in large part on the ability of the Company to attract and retain its key management, operating, technical, marketing and sales personnel as well as clinical investigators who are not employees of the Company. Such individuals are in high demand, and the identification, attraction and retention of such personnel could be lengthy, difficult and costly. The Company competes for its employees and clinical investigators with other companies in the orthopedic industry and research and 14 academic institutions. There can be no assurance that the Company will be able to attract and retain the qualified personnel necessary for the expansion of its business. A loss of the services of one or more members of the senior management group, or the Company's inability to hire additional personnel as necessary, could have an adverse effect on the Company's business, financial condition and results of operations. See "Item 1 -- Business -- Employees." HISTORICAL DEPENDENCE ON PRIMARY PRODUCT; FUTURE PRODUCTS. During 1997 and 1998 revenues from CPM devices and Hyalgan reduced the Company's dependence on revenues from the ORTHOLOGIC 1000. However, the Company believes that, to sustain long-term growth, it must develop and introduce additional products and expand approved indications for its existing products. The development and commercialization by the Company of additional products will require substantial product development, regulatory, clinical and other expenditures. There can be no assurance that the Company's technologies will allow it to develop new products or expand indications for existing products in the future or that the Company will be able to manufacture or market such products successfully. Any failure by the Company to develop new products or expand indications could have a material adverse effect on the Company's business, financial condition and results of operations. See "Item 1 -- Business -- Products" and "Item 1 -- Business -- Competition." UNCERTAINTY OF MARKET ACCEPTANCE. The Company believes that the demand for bone growth stimulators is still developing and the Company's success will depend in part upon the growth of this demand. There can be no assurance that this demand will develop. The long-term commercial success of the ORTHOLOGIC 1000 will also depend in significant part upon its widespread acceptance by a significant portion of the medical community as a safe, efficacious and cost-effective alternative to invasive procedures. The Company is unable to predict how quickly, if at all, its products may be accepted by members of the orthopedic medical community. The widespread acceptance of the Company's primary products represents a significant change in practice patterns for the orthopaedic medical community and in reimbursement policy for third party payors. Historically, some orthopedic medical professionals have indicated hesitancy in prescribing bone growth stimulator products such as those manufactured by the Company. The use of CPM is more widely accepted, however the Company must continue to prove that the products are safe, efficacious and cost-effective in order to maintain and grow its market share. Hyalgan is a new therapeutic treatment for relief of pain from osteoarthritis of the knee. The long-term commercial success of the product will depend upon its widespread acceptance by a significant portion of the medical community and third party payors as a safe, efficacious and cost-effective alternative to other treatment options such as simple analgesics. Failure of the Company's products to achieve widespread market acceptance by the orthopedic medical community and third party payors would have a material adverse effect on the Company's business, financial condition and results of operations. See "Item 1 -- Business -- Third Party Payment." INTEGRATION OF ACQUISITIONS. The Company acquired three businesses in 1996 and 1997. In the first quarter of 1997, the Company commenced the consolidation of the recent acquisitions. The administrative operations, manufacturing and servicing operations were consolidated by the end of 1997. The sales force management was consolidated in early 1998 and computer hardware and software systems were consolidated during 1998. Successful integration of such acquisitions is critical to the future financial performance of the combined Company. CONDITION OF ACQUIRED FACILITIES. The Company has determined that the facilities acquired in the acquisition of Sutter Corporation ("Sutter") had several physical problems, primarily resulting from excessive moisture and water leaks. Two Sutter employees have filed related worker's compensation claims, and these two claims are being processed by Sutter's worker's compensation carrier. In addition, the lack of maintenance has allegedly caused some structural problems at one facility, and employee complaints based upon these problems have led to two informal complaints by the California Department of Industrial Relations and Division of Occupational Safety and Health. Sutter has responded to both complaints and continues to work with its landlord to correct the problems. In addition, Sutter has notified the prior owners of Sutter of the problems because the prior owners may be the responsible party under the acquisition agreement for any required remedies. Sutter has vacated the leasehold premises of both Sutter facilities. Sutter vacated a manufacturing facility in conjunction with a negotiated lease termination. Sutter also vacated a mixed use facility and notified that landlord of its termination of the lease due to acts and omissions of the landlord. That landlord claims that rent remains unpaid but has not yet responded to Sutter's claim that the lease has been terminated. Damages, claims and future discoveries regarding the maintenance of the facilities by prior occupants could have a material adverse effect on the Company's business, financial condition and results of operations. See "Item 3 -- Legal Proceedings" and "Item 2 -- Properties." 15 MANAGEMENT OF GROWTH. The Company experienced a period of rapid growth during 1996 and 1997. This growth has placed, and could continue to place, a significant strain on the Company's financial, management and other resources. The Company's future performance will depend in part on its ability to manage change in its operations, including integration of acquired businesses. In addition, the Company's ability to manage its growth effectively will require it to continue to improve its manufacturing, operational and financial control systems and infrastructure and management information systems, and to attract, train, motivate, manage and retain key employees. If the Company's management were to become unable to manage growth effectively, the Company's business, financial condition, and results of operations could be adversely affected. LIMITATIONS ON THIRD PARTY PAYMENT; UNCERTAIN EFFECTS OF MANAGED CARE. The Company's ability to commercialize its products successfully in the United States and in other countries will depend in part on the extent to which acceptance of payment for such products and related treatment will continue to be available from government health administration authorities, private health insurers and other payors. Cost control measures adopted by third party payors in recent years have had and may continue to have a significant effect on the purchasing and practice patterns of many health care providers, generally causing them to be more selective in the purchase of medical products. In addition, payors are increasingly challenging the prices and clinical efficacy of medical products and services. Payors may deny reimbursement if they determine that the product used in a procedure was experimental, was used for a nonapproved indication or was unnecessary, inappropriate, not cost-effective, unsafe, or ineffective. The Company's products are reimbursed by most payors, however there are generally specific product usage requirements or documentation requirements in order for the Company to receive reimbursement. In certain circumstances the Company is successful in appealing reimbursement coverage for those applications which are not in compliance with the payor requirements. Medicare has very strict guidelines for reimbursement, and until the second quarter 1997, the Company had some success in appealing claims for applications of the ORTHOLOGIC 1000 which were outside the coverage guidelines. During the second quarter of 1997 the Company determined that Medicare would no longer reimburse for such cases, and the Company wrote off all Medicare receivables which did not meet Medicare's guidelines. Significant uncertainty exists as to the reimbursement status of newly approved health care products, and there can be no assurance that adequate third party coverage will continue to be available to the Company at current levels. See "Item 1 - Business Third Party Payment." UNCERTAINTY AND POTENTIAL NEGATIVE EFFECTS OF HEALTH CARE REFORM. The health care industry is undergoing fundamental changes resulting from political, economic and regulatory influences. In the United States, comprehensive programs have been proposed that seek to (i) increase access to health care for the uninsured, (ii) control the escalation of health care expenditures within the economy and (iii) use health care reimbursement policies to help control the federal deficit. The Company anticipates that Congress and state legislatures will continue to review and assess alternative health care delivery systems and methods of payment, and public debate of these issues will likely continue. Due to uncertainties regarding the outcome of reform initiatives and their enactment and implementation, the Company cannot predict which, if any, of such reform proposals will be adopted and when they might be adopted. Other countries also are considering health care reform. The Company's plans for increased international sales are largely dependent upon other countries' adoption of managed care systems and their acceptance of the potential benefits of the Company's products and the belief that managed care plans will have a positive effect on sales. For the reasons identified in this and in the preceding paragraph, however, those assumptions may be incorrect. Significant changes in health care systems are likely to have a substantial impact over time on the manner in which the Company conducts its business and could have a material adverse effect on the Company's business, financial condition and results of operations and ability to market its products as currently contemplated. INTENSE COMPETITION. The orthopedic industry is characterized by intense competition. Currently, there are three major competitors other than the Company selling electromagnetic bone growth stimulation products approved by the FDA for the treatment of nonunion fractures, one large domestic and several foreign manufacturers of CPM devices and one competitor selling a therapeutic injectable for treatment of osteoarthritis of the knee. The Company also competes with many independent owners/lessors of CPM devices in addition to the providers of traditional orthopedic immobilization products and rehabilitation services. The Company estimates that one of its competitors has a dominant share of the market for electromagnetic bone growth stimulation products for non-healing fractures in the United States, and another has a dominant share of the market for use of their device as an adjunct to spinal fusion surgery. In addition, there are several large, well-established companies that sell fracture fixation devices similar in function to those sold by the Company. Many participants in the medical technology industry, including the Company's competitors, have substantially greater capital resources, research and development staffs and facilities than the Company. Such participants have developed or are developing products that may be competitive with the products that have been or are 16 being developed or researched by the Company. Other companies are developing a variety of other products and technologies to be used in CPM devices, the treatment of fractures and spinal fusions, including growth factors, bone graft substitutes combined with growth factors, and nonthermal ultrasound. One company has received FDA approval for a nonthermal ultrasound device to treat nonsevere fresh fractures of the lower leg and lower forearm. There can be no assurance that products marketed by these or other companies will not be sold for use in treating non-healing fractures or spinal fusions, even in the absence of regulatory approval to do so. Any such sales could have a material adverse effect on the Company. Many of the Company's competitors have substantially greater experience than the Company in conducting research and development, obtaining regulatory approvals, manufacturing and marketing and selling medical devices. Any failure by the Company to develop products that compete favorably in the marketplace would have a material adverse effect on the Company's business, financial condition and results of operations. See "Item 1 -- Business - - -- Research and Development" and "Item 1 -- Business -- Competition." RAPID TECHNOLOGICAL CHANGE. The medical device industry is characterized by rapid and significant technological change. There can be no assurance that the Company's competitors will not succeed in developing or marketing products or technologies that are more effective or less costly, or both, and which render the Company's products obsolete or noncompetitive. In addition, new technologies, procedures and medications could be developed that replace or reduce the value of the Company's products. The Company's success will depend in part on its ability to respond quickly to medical and technological changes through the development and introduction of new products. There can be no assurance that the Company's new product development efforts will result in any commercially successful products. A failure to develop new products could have a material adverse effect on the company's business, financial condition and results of operations. See "Item 1 -- Business -- Research and Development." GOVERNMENT REGULATION. The Company's current and future products and manufacturing activities are and will be regulated under the Medical Device Amendments Act of 1976 to the Food, Drug and Cosmetic Act and the 1990 Safe Medical Devices Act. The Company's current BIOLOGIC technology-based products and Hyalgan are classified as Class III Significant Risk Devices, which are subject to the most stringent level of FDA review for medical devices and are required to be tested under IDE clinical trials and approved for marketing under a PMA. The Company's fracture fixation devices are Class II devices that are marketed pursuant to 510(k) clearance from the FDA. The Company received approval of an IDE for the SPINALOGIC 1000 for use as an adjunct to spinal fusion surgery in August 1992 and commenced clinical trials for this product in February 1993. The Company is in the process of evaluating the results of the clinical trial for use of the SPINALOGIC 1000 as an adjunct to spinal fusion surgery. In September 1995, the Company received an approval of an IDE supplement for the SPINALOGIC 1000 for treatment of failed spinal fusions. The Company commenced this study in the fourth quarter of 1995. The Company submitted a PMA (pre-market approval) Supplement to the FDA for SPINALOGIC 1000 on August 20, 1998, starting the FDA's 180 day review period. The supplement was based on the original PMA approved for the ORTHOLOGIC 1000. However, on December 30, 1998 the Company submitted an amendment to the SpinaLogic PMA Supplement, providing more analysis of the clinical data. The Company believes the submission of the amendment may restart the 180 day review period. There can be no assurance that the Company will receive regulatory approval of the SPINALOGIC 1000 or any other products. Any significant delay in receiving or failure to receive regulatory approval of the Company's products could have a material adverse effect on the Company's business, financial condition and results of operations. See "Item 1 -- Business -- Products" and "Item 1 -- Business -- Government Regulation." The FDA and comparable agencies in many foreign countries and in state and local governments impose substantial limitations on the introduction of medical devices through costly and time-consuming laboratory and clinical testing and other procedures. The process of obtaining FDA and other required regulatory approvals is lengthy, expensive and uncertain. Moreover, regulatory approvals, if granted, typically include significant limitations on the indicated uses for which a product may be marketed. In addition, approved products may be subject to additional testing and surveillance programs required by regulatory agencies, and product approvals could be withdrawn and labeling restrictions may be imposed for failure to comply with regulatory standards or upon the occurrence of unforeseen problems following initial marketing. The Company is also required to adhere to applicable requirements for FDA Good Manufacturing Practices, to engage in extensive record keeping and reporting and to make available its manufacturing facilities for periodic inspections by governmental agencies, including the FDA and comparable agencies in other countries. Failure to comply with these and other applicable regulatory requirements could result in, among other things, significant fines, suspension of approvals, seizures or recalls of products, or operating restrictions and 17 criminal prosecutions. From time to time, the Company receives letters from the FDA regarding regulatory compliance. The Company has responded to all such letters and believes all outstanding issues raised in such letters have been resolved. See "Item 1 -- Business -- Government Regulation." Changes in existing regulations or interpretations of existing regulations or adoption of new or additional restrictive regulations could prevent the Company from obtaining, or affect the timing of, future regulatory approvals. If the Company experiences a delay in receiving or fails to obtain any governmental approval for any of its current or future products or fails to comply with any regulatory requirements, the Company's business, financial condition and results of operations could be materially adversely affected. See "Item 1 -- Business -- Products" and "Item 1 -- Business -- Government Regulation." DEPENDENCE ON KEY SUPPLIERS. The Company purchases the microprocessor used in the ORTHOLOGIC 1000 and OL- 1000 SC from a sole source supplier, Phillips N.V. In addition, there are two suppliers for another component used in the ORTHOLOGIC 1000 and OL-1000 SC and two suppliers for the composite material components of the ORTHOFRAME products. Establishment of additional or replacement suppliers for the components cannot be accomplished quickly. In addition, Hyalgan is manufactured by a single company, Fidia S.p.A. Fidia has been manufacturing Hyalgan for sale in Europe since 1987. The Company purchases several CPM components, including microprocessors, motors and custom key panels from sole-source suppliers. The Company believes that its CPM products are not dependent on these components and could be redesigned to incorporate comparable components. While the Company maintains a supply of certain ORTHOLOGIC 1000 and OL-1000 SC components to meet sales forecasts for one year and ORTHOFRAME components to meet sales forecasts for three months and the distributor of Hyalgan maintains a supply of product to last several months, any delay or interruption in supply of these components or products could significantly impair the Company's ability to deliver its products in sufficient quantities, and therefore, could have a material adverse effect on its business, financial condition and results of operations. See "Item 1 -- Business -- Manufacturing." DEPENDENCE ON PATENTS, LICENSES AND PROPRIETARY RIGHTS. The Company's success will depend in significant part on its ability to obtain and maintain patent protection for products and processes, to preserve its trade secrets and proprietary know-how and to operate without infringing the proprietary rights of third parties. While the Company holds title to numerous United States and foreign patents and patent applications, as well as licenses to numerous United States and foreign patents (see "Item 1 -- Business -- Patents, Licenses and Proprietary Rights"), no assurance can be given that any additional patents will be issued or that the scope of any patent protection will exclude competitors or that any of the patents held by or licensed to the Company will be held valid if subsequently challenged. The validity and breadth of claims covered in medical technology patents involves complex legal and factual questions and therefore may be highly uncertain. In addition, although the Company holds or licenses patents for certain of its technologies, others may hold or receive patents which contain claims having a scope that covers products developed by the Company. There can be no assurance that licensing rights to the patents of others, if required for the Company's products, will be available at all or at a cost acceptable to the Company. The Company's licenses covering the BIOLOGIC and ORTHOFRAME technologies provide for payment by the Company of royalties. A Co-Promotion Agreement with Sanofi provides the Company with exclusive marketing rights for Hyalgan to orthopedic surgeons in the United States. The Company is paid a fee which is based upon the number of units sold at the wholesale acquisition cost less amounts for distribution costs, discounts, rebates, returns, product transfer price, overhead factor and a royalty factor. Each license may be terminated if the Company breaches any material provision of such license. The termination of any license would have a material adverse effect on the Company's business, financial condition and results of operations. See Note 15 of Notes to Consolidated Financial Statements. The Company also relies on unpatented trade secrets and know-how. The Company generally requires its employees, consultants, advisors and investigators to enter into confidentiality agreements which include, among other things, an agreement to assign to the Company all inventions that were developed by the employee while employed by the Company that are related to its business. There can be no assurance, however, that these agreements will protect the Company's proprietary information or that others will not gain access to, or independently develop similar trade secrets or know-how. There has been substantial litigation regarding patent and other intellectual property rights in the orthopedic industry. Litigation, which could result in substantial cost to, and diversion of effort by the Company may be necessary to enforce patents issued or licensed to the Company, to protect trade 18 secrets or know-how owned by the Company or to defend the Company against claimed infringement of the rights of others and to determine the scope and validity of the proprietary rights of others. There can be no assurance that the results of such litigation would be favorable to the Company. In addition, competitors may employ litigation to gain a competitive advantage. Adverse determinations in litigation could subject the Company to significant liabilities, and could require the Company to seek licenses from third parties or prevent the Company from manufacturing, selling or using its products, any of which determinations could have a material adverse effect on the Company's business, financial condition and results of operations. See "Item 1 -- Business - - -- Patents, Licenses and Proprietary Rights." RISK OF PRODUCT LIABILITY CLAIMS. The Company faces an inherent business risk of exposure to product liability claims in the event that the use of its technology or products is alleged to have resulted in adverse effects. To date, no product liability claims have been asserted against the Company for its fracture healing and Hyalgan products and only limited claims for its CPM products. The Company maintains a product liability and general liability insurance policy with coverage of an annual aggregate maximum of $2.0 million per occurrence. The Company's product liability and general liability policy is provided on an occurrence basis. The policy is subject to annual renewal. In addition, the Company maintains an umbrella excess liability policy which covers product and general liability with coverage of an additional annual aggregate maximum of $25.0 million. There can be no assurance that liability claims will not exceed the coverage limits of such policies or that such insurance will continue to be available on commercially reasonable terms or at all. If the Company does not or cannot maintain sufficient liability insurance, its ability to market its products may be significantly impaired. In addition, product liability claims could have a material adverse effect on the business, financial condition and results of operations of the Company. See "Item 1 -- Business -- Product Liability Insurance." POSSIBLE VOLATILITY OF STOCK PRICE. Factors such as fluctuations in the Company's operating results, developments in litigation to which the Company is subject, announcements and timing of potential acquisitions, conversion of preferred stock, announcements of technological innovations or new products by the Company or its competitors, FDA and international regulatory actions, actions with respect to reimbursement matters, developments with respect to patents or proprietary rights, public concern as to the safety of products developed by the Company or others, changes in health care policy in the United States and internationally, changes in stock market analyst recommendations regarding the Company, other medical device companies or the medical device industry generally and general market conditions may have a significant effect on the market price of the Common Stock. In addition, the stock market has from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the market price of the Company's Common Stock. Developments in any of these areas, which are more fully described elsewhere in "Item 1 -- Business," "Item 3 -- Legal Proceedings," and "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 13 through 16 of the Company's Annual Report to stockholders, each of which is incorporated into this section by reference, could cause the Company's results to differ materially from results that have been or may be projected by or on behalf of the Company. The Company cautions that the foregoing list of important factors is not exclusive. The Company does not undertake to update any forward-looking statement that may be made from time to time by or on behalf of the Company. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is not currently vulnerable to a material extent to fluctuations in interest rates, commodity prices, or foreign currency exchange rates. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information on pages 17 through 31 of the Annual Report is incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. 19 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information in response to this Item is incorporated by reference to (i) the biographical information relating to the Company's directors under the caption "Election of Directors" and the information relating to Section 16 compliance under the caption, "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive Proxy Statement for its Annual Meeting of Stockholders to be held May 15, 1999 (the "Proxy Statement"), and (ii) the information under the caption "Executive Officers of the Registrant" in Part I hereof. The Company anticipates filing the Proxy Statement within 120 days after December 31, 1998. ITEM 11. EXECUTIVE COMPENSATION The information under the heading "Executive Compensation" and "Compensation of Directors" in the Proxy Statement is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the heading "Voting Securities and Principal Holders Thereof - Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information under the heading "Certain Transactions" in the Proxy Statement is incorporated herein by reference. 20 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. Financial Statements The following financial statements of OrthoLogic Corp. and Independent Auditors' Report are incorporated by reference from pages 19 through 31 of the Annual Report: Balance Sheets - December 31, 1998 and 1997. Statements of Operations - Each of the three years in the period ended December 31, 1998. Statements of Comprehensive Income - Each of the three years in the period ended December 31, 1998. Statements of Stockholders' Equity - Each of the three years in the period ended December 31, 1998. Statements of Cash Flows - Each of the three years in the period ended December 31, 1998. Notes to Financial Statements 2. Financial Statement Schedules Valuation and Qualifying Accounts. Allowance for doubtful accounts Balance December 31, 1995 $ (1,480,000) 1996 Additions charged to expense (10,151,117) 1996 Deductions to allowance 3,036,117 Balance December 31, 1996 (8,595,000) 1997 Additions charged to expense (11,246,229) 1997 Deductions to allowance 8,470,705 Balance December 31, 1997 (11,370,524) 1998 Additions charged to expense (19,529,547) 1998 Deductions to allowance 11,582,247 Balance December 31, 1998 $(19,317,824) Allowance for inventory reserves Balance December 31, 1995 $ 0 1996 Additions charged to expense (260,602) 1996 Deductions to allowance Balance December 31, 1996 (260,602) 1997 Additions charged to expense (944,313) 1997 Deductions to allowance 843,277 Balance December 31, 1997 (361,638) 1998 Additions charged to expense (1,239,181) 1998 Deductions to allowance 852,421 Balance December 31, 1998 $ (748,398) 21 3. Exhibits and Management Contracts, and Compensatory Plans and Arrangements All management contracts and compensatory plans and arrangements are identified by footnote after the Exhibit Descriptions on the attached Exhibit Index. (b) Reports on Form 8-K. None. (c) Exhibits See the Exhibit Index immediately following the signature page of this report, which Index is incorporated herein by reference. (d) Financial Statements and Schedules See Item 14(a)(1) and (2) above. 22 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ORTHOLOGIC CORP. Date: March 31, 1999 By /s/ Thomas R. Trotter ------------------------------------- Thomas R. Trotter President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date - - --------- ----- ---- /s/ Thomas R. Trotter President, Chief Executive March 31, 1999 - - --------------------------- Officer and Director Thomas R. Trotter (Principal Executive Officer) /s/ John M. Holliman III Chairman of the Board of March 31, 1999 - - --------------------------- Directors and Director John M. Holliman III /s/ Fredric J. Feldman Director March 31, 1999 - - --------------------------- Fredric J. Feldman /s/ Elwood D. Howse, Jr. Director March 31, 1999 - - --------------------------- Elwood D. Howse, Jr. /s/ Stuart H. Altman Director March 31, 1999 - - --------------------------- Stuart H. Altman, Ph.D. /s/ Augustus A. White III Director March 31, 1999 - - --------------------------- Augustus A. White III, M.D. /s/ Terry D. Meier Senior Vice President and March 31, 1999 - - --------------------------- Chief Financial Officer Terry D. Meier (Principal Financial and Accounting Officer) S-1 ORTHOLOGIC CORP. EXHIBIT INDEX TO REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998 (FILE NO. 0-21214)
Exhibit Filed No. Description Incorporated by Reference To: Herewith --- ----------- ----------------------------- -------- 2.1 Stock Purchase Agreement dated August Exhibit 2.1 to the Company's Current 30, 1996 by and among the Company, Report on Form 8-K filed on Sutter Corporation and Smith September 13, 1996 Laboratories, Inc. 2.2 Purchase and Sale Agreement dated as of Exhibit 2.1 to the Company's Current December 30, 1996 by and among the Report on Form 8-K filed on March 18, Company and Toronto Medical Corp., an 1997 ("March 18, 1997 8-K") Ontario corporation 2.3 Amendment to Purchase and Sale Exhibit 2.2 to March 18, 1997 8-K Agreement dated as of January 13, 1997 by and among the Company and Toronto Medical Corp., an Ontario corporation 2.4 Second Amendment to Purchase and Exhibit 2.3 to March 18, 1997 8-K Sale Agreement dated as of March 1, 1997 by and among the Company and Toronto Medical Corp., an Ontario corporation 2.5 Assignment of Purchase and Sale Exhibit 2.4 to March 1997 8-K Agreement dated as of March 1, 1997 by and among the Company, Toronto Medical Orthopaedics Ltd., a Canada corporation and Toronto Medical Corp., an Ontario corporation 2.6 Asset Purchase Agreement dated March Exhibit 2.1 to the Company's Current 12, 1997 by and among the Company, Report on Form 8-K filed on March 27, Danninger Medical Technology, Inc., a 1997 Delaware corporation, and Danninger Health care, Inc., an Ohio corporation 3.1 Composite Certificate of Incorporation Exhibit 3.1 to Company's Form 10-Q of the Company, as amended, including for the quarter ended March 31, 1997 Certificate of Designation in respect of ("March 1997 10-Q") Series A Preferred Stock 3.2 Bylaws of the Company Exhibit 3.4 to Company's Amendment No. 2 to Registration Statement on Form S-1 (No. 33-47569) filed with the SEC on January 25, 1993 ("January 1993 S-1") 4.1 Articles 5, 9 and 11 of the Certificate of Exhibit 3.1 to March 1997 10-Q Incorporation of the Company 4.2 Articles II and III.2(c)(ii) of Bylaws of Exhibit 3.4 to January 1993 S-1 the Company 4.3 Specimen Common Stock Certificate Exhibit 4.1 to January 1993 S-1 4.4 Stock Purchase Warrant, dated August Exhibit 4.6 to the Company's Form 10- 18, 1993, issued to CyberLogic, Inc. K for the fiscal year ended December 31, 1994 ("1994 10-K") 4.5 Stock Purchase Warrant, dated Exhibit 4.6 to Company's Registration September 20, 1995, issued to Statement on Form S-1 (No. 33-97438) Registered Consulting Group, Inc. filed with the SEC on September 27, 1995 ("1995 S-1") 4.6 Stock Purchase Warrant, dated October Exhibit 4.7 to the Company's Annual 15, 1996, issued to Registered Report on Form 10-K for the year Consulting Group, Inc. ended December 31, 1996 ("1996 10-K") 4.7 Rights Agreement dated as of March 4, Exhibit 4.1 to the Company's 1997 between the Company and Bank of Registration Statement on Form 8-A New York, and Exhibits A, B and C filed with the SEC on March 6, 1997 thereto 4.8 1987 Stock Option Plan of the Company, Exhibit 4.4 to the Company's Form as amended and approved by 10-Q for the quarter ended June 30, stockholders (1) 1997 ("June 1997 10-Q") 4.9 1997 Stock Option Plan of the Company(1) Exhibit 4.5 to the Company's June 1997 10-Q 4.10 Stock Purchase Warrant dated March Exhibit 4.10 to the Company's 1997 10-K 2, 1998 issued to Silicon Valley Bank
EX-1
Exhibit Filed No. Description Incorporated by Reference To: Herewith --- ----------- ----------------------------- -------- 4.11 Antidilution Agreement dated March 2, Exhibit 4.11 to the Company's 1997 10-K 1998 by and between the Company and Silicon Valley Bank 4.12 Amendment to Stock Purchase Warrant Exhibit 4.1 to the Company's form 10-Q dated May 12, 1998 issued to Silicon for the quarter ended September 30, 1998 Valley Bank ("September 1998 10-Q") 4.13 Form of Warrant Exhibit 4.1 to the Company's Form 8-K filed on July 13, 1998 4.14 Registration Rights Agreement Exhibit 4.2 to the Company's Form 8-K filed on July 13, 1998 5.1 Form of Opinion Letter of Quarles & Brady Exhibit 5.1 to the Company's S-3 filed on August 24, 1998. 10.1 License Agreement dated September 3, Exhibit 10.6 to January 1993 S-1 1987 between the Company and Life Resonances, Inc. 10.2 Invention, Confidential Information and Exhibit 10.7 to January 1993 S-1 Non-Competition Agreement dated September 18, 1987 between the Company and Weinstein 10.3 Fifth Amendment to Lease, dated Exhibit 10.10 to the Company's September 14, 1993 between the September 30, 1994 10-Q Company and Cook Inlet Region, Incorporated 10.4 Invention, Confidential Information and Exhibit 10.11 to January 1993 S-1 Non-Competition Agreement dated January 10, 1989 between the Company and Frank P. Magee 10.5 Addendum to Lease between the Exhibit 10.8.1 to the Registration Company and Cook Inlet Region, Inc. Statement on Form S-3 (No. 333-3082) commencing April 1, 1996 filed with the SEC on April 2, 1996 ("April 1996 S-3") 10.6 1995 Officer Bonus Plan(1) Exhibit 10.10 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995 ("1995 10- K") 10.9 Form of Indemnification Agreement* Exhibit 10.16 to January 1993 S-1 10.10 License Agreement dated December 2, Exhibit 10.22 to January 1993 S-1 1992 between Orthotic Limited Partnership and Company 10.11 Consulting Agreement dated May 1, Exhibit 10.11 to the Company's 1990 between Augustus A. White III and September 30, 1994 Form 10-Q the Company(1) 10.12 Loan Modification Agreement dated Exhibit 10.22 to 1995 S-1 March 23, 1995 between Company and Silicon Valley Bank 10.13 Renewal of Employment Agreement of Exhibit 10.23 to 1994 10-K Frank P. Magee dated March 28, 1995(1) 10.14 [Intentionally omitted] 10.15 Amendment to Employment Agreement Exhibit 10.25 to 1995 10-K between the Company and Allen R. Dunaway dated February 14, 1996(1) 10.16 Underwriting Agreement between the Exhibit 1.1 to 1995 S-1 Company and Volpe, Welty & Co. and Dain Bosworth, Inc., as Representatives of the Underwriters 10.17 Underwriting Agreement between the Exhibit 1.1 to April 1996 S-3 Company and Volpe, Welty & Company Hambrecht & Quist and Dain Bosworth, Inc., as Representatives of the Underwriters 10.18 Maturity Modification Letter dated Exhibit 10.21 to April 1996 S-3 March 29, 1996, by Silicon Valley Bank
EX-2
Exhibit Filed No. Description Incorporated by Reference To: Herewith --- ----------- ----------------------------- -------- 10.19 Lease made March 1997 between Exhibit 10.34 to the Company's 1996 Toronto Medical Corp. and Toronto 10-K Medical Orthopaedics Ltd. 10.20 Lease dated September 4, 1991 by and Exhibit 10.35 to the Company's between Greystone Realty Corporation Annual Report on Form 10-K/A and Sutter Corporation (Amendment No. 1) for the year ended December 31, 1996 ("1996 10-K/A") 10.21 Lease dated February 10, 1988 between Exhibit 10.36 to 1996 10-K/A MIC Four Points and Sutter Biomedical, Inc. 10.22 First Addendum to Lease dated February Exhibit 10.37 to 1996 10-K/A 15, 1988 by and between MIC Four Points and Sutter Biomedical, Inc. 10.23 October 7, 1988 Second Addendum to Exhibit 10.38 to 1996 10-K/A Lease dated February 10, 1988 between MIC Four Points and Sutter Biomedical, Inc. 10.24 Severance Agreement dated February Exhibit 10.39 to the Company's 1996 18, 1997 by and between George A. 10-K Oram, Jr. and the Company (1) 10.25 Promissory Note dated November 15, Exhibit 10.40 to the Company's 1996 1996 made by George A. Oram, Jr. in 10-K favor of the Company (1) 10.26 [Intentionally Omitted.] 10.27 Employment Agreement by and between Exhibit 10.4 to the Company's March Allan M. Weinstein and the Company 1997 10-Q effective as of December 1, 1996 (1) 10.28 Employment Agreement by and between Exhibit 10.5 to the Company's March Frank P. Magee and the Company 1997 10-Q effective as of December 1, 1996 (1) 10.29 [intentionally omitted] 10.30 Employment Agreement by and between Exhibit 10.7 to the Company's March James B. Koeneman and the Company 1997 10-Q effective as of December 1, 1996 (1) 10.31 Employment Agreement by and between Exhibit 10.8 to the Company's March MaryAnn G. Miller and the Company 1997 10-Q effective as of December 1, 1996 (1) 10.32 Employment Agreement by and between Exhibit 10.9 to the Company's March Nicholas A. Skaff and the Company 1997 10-Q effective as of December 1, 1996 (1) 10.33 Co-promotion Agreement dated June 23, Exhibit 10.1 to the Company's June 1997 by and between the Company and 1997 10-Q Sanofi Pharmaceuticals, Inc. 10.34 Single-tenant Lease-net dated June 12, Exhibit 10.2 to the Company's Form 1997 by and between the Company and 10-Q for the quarter ended Chamberlain Development, L.L.C. September 30, 1997 ("September 1997 10-Q") 10.35 Employment Agreement dated October Exhibit 10.3 to the Company's 20, 1997 by and between the Company September 1997 10-Q and Thomas R. Trotter, including Letter of Incentive Option Grant, OrthoLogic Corp. 1987 Stock Option Plan (1) 10.36 Employment Agreement dated October Exhibit 10.4 to the Company's 17, 1997 by and between the Company September 1997 10-Q and Frank P. Magee (1) 10.37 Employment Agreement dated Exhibit 10.5 to the Company's October 17, 1997 by and between the September 1997 10-Q Company and Allan M. Weinstein (1) 10.38 Severance Agreement dated May 21, Exhibit 10.6 to the Company's 1997 by and between the Company and September 1997 10-Q David E. Derminio (1) 10.39 Severance Agreement dated September Exhibit 10.7 to the Company's 19, 1997 by and between the Company September 1997 10-Q and Nicholas A. Skaff (1)
EX-3
Exhibit Filed No. Description Incorporated by Reference To: Herewith --- ----------- ----------------------------- -------- 10.40 Employment Agreement effective as of Exhibit 10.7 to the Company's September December 15, 1997 by and between the 1997 10-Q Company and William C. Rieger (1) 10.41 Transitional Employment Agreement Exhibit 10.40 to the Company's 1997 dated February 2, 1998 by and between 10-K the Company and Allen R. Dunaway (1) 10.42 Employment Agreement effective as of Exhibit 10.42 to the Company's 1997 March 16, 1998 by and between the 10-K Company and Terry D. Meier (1) 10.43 Revised and Restated Employment Exhibit 10.43 to the Company's 1997 Agreement effective as of March 16, 10-K 1998 by and between the Company and Allan M. Weinstein(1) 10.44 Loan and Security Agreement dated Exhibit 10.44 to the Company's 1997 March 2, 1998 by and between the 10-K Company and Silicon Valley Bank 10.45 Registration Rights Agreement dated Exhibit 10.45 to the Company's 1997 March 2, 1998 by and between the 10-K Company and Silicon Valley Bank 10.46 Licensing Agreement with Chrysalis Exhibit 10.1 to the Company's September Biotechnolgoy, Inc. 1998 10-Q 10.47 1998 Management Bonus Program Exhibit 10.2 to the Company's September 1998 10-Q 10.48 Loan Modification Agreement dated Exhibit 10.3 to the Company's September May 12, 1998 by and between the 1998 10-Q Company and Silicon Valley Bank 10.49 Securities Purchase Agreement Exhibit 10.1 to the Company's Form 8-K filed on July 13, 1998 11.1 Statement of Computation of Net Income X (Loss) per Weighted Average Number of Common Shares Outstanding 13.1 Portions of 1998 Annual Report to X Stockholders 21.1 Subsidiaries of Registrant Exhibit 21.1 to the Company's 1997 10-K 23.1 Consent of Deloitte & Touche LLP X 27 Financial Data Schedule X
- - ---------- (1) Management contract or compensatory plan or arrangement * The Company has entered into a separate indemnification agreement with each of its current direct and executive officers that differ only in party names and dates. Pursuant to the instructions accompanying Item 601 of Regulation S-K, the Company has filed the form of such indemnification agreement. EX-4 EX-13.1 2 PORTIONS OF ANNUAL REPORT TO SHAREHOLDERS EXHIBIT 13.1 PORTIONS OF THE 1998 ANNUAL REPORT TO STOCKHOLDERS SPECIAL NOTES REGARDING FORWARD-LOOKING STATEMENTS This Annual Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including projections of results of operations and financial condition, statements of future economic performance, and general or specific statements of future expectations and beliefs. The matters covered by such forward-looking statements are subject to known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company to differ materially from those contemplated or implied by such forward-looking statements. Important factors which may cause actual results to differ include, but are not limited to, the following matters, which are discussed in more detail in the Company's Form 10-K for the 1998 fiscal year: The Company's lack of experience with respect to newly acquired technologies and products may reduce the Company's ability to exploit the opportunities offered by the acquisitions discussed in this report. Potential difficulties in integrating the operations of newly acquired businesses may impact negatively on the Company's ability to realize benefits from the acquisitions. As discussed herein, the Company intends to pursue sales in international markets. The Company, however, has had little experience in such markets. Expanded efforts at pursuing new markets necessarily involves expenditures to develop such markets and there can be no assurance that the results of those efforts will be profitable. There can be no assurance that the Company's estimates of the market opportunity are accurate, or that changes in that market will not cause the nature and extent of that market to deviate materially from the Company's expectations. To the extent that the Company presently enjoys perceived technological advantages over competitors, technological innovation by present or future competitors may erode the Company's position in the market. To sustain long-term growth, the Company must develop and introduce new products and expand applications of existing products; however, there can be no assurance that the Company will be able to do so or that the market will accept any such new products or applications. The Company operates in a highly regulated environment and cannot predict the actions of regulatory authorities. The action or non-action of regulatory authorities may impede the development and introduction of new products and new applications for existing products, and may have temporary or permanent effects on the Company's marketing of its existing or planned products. There can be no assurance that the influence of managed care will continue to grow either in the United States or abroad, or that any such growth will result in greater acceptance or sales of the Company's products. In particular, there can be no assurance that existing or future decision makers and third party payors within the medical community will be receptive to the use of the Company's products or replace or supplement existing or future treatments. Moreover, the transition to managed care and the increasing consolidation underway in the managed care industry may concentrate economic power among buyers of the Company's products, which concentration could foreseeably adversely affect the price third party payors are willing to pay, and thus adversely affect the Company's margins. Although the Company believes that existing litigation initiated against the Company is without merit and the Company intends to defend such litigation vigorously, an adverse outcome of such litigation could have a material adverse effect on the on the Company's business, financial condition and results of operation. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL OrthoLogic (the "Company") was founded in July 1987. Through August 1996, the Company was engaged primarily in the commercialization of the Company's proprietary BioLogic(TM) technology in order to develop products that stimulate the healing of bone fractures and spinal fusions. The Company expanded its product base to include continuous passive motion ("CPM") products on August 30, 1996 by acquiring Sutter Corporation ("Sutter"). In March 1997, the Company acquired certain assets and assumed certain liabilities of Toronto Medical Corp. ("Toronto") and Danninger Medical Technology, Inc. ("DMTI"). These acquisitions allowed the Company to develop, manufacture and market orthopedic rehabilitation products and services. During the first 1 quarter of 1998, the Company completed the integration of all the CPM administrative and service related operations from these acquisitions into one Phoenix based headquarters. OrthoLogic develops, manufactures and markets proprietary products and services for the orthopedic health care market. The Company's product lines includes bone growth stimulation devices, CPM devices and ancillary orthopedic recovery products, and Hyalgan, a therapeutic injectable. All the Company's products focus on improving the clinical outcomes and cost-effectiveness of orthopedic procedures. OrthoLogic periodically discusses with third parties the possible acquisition of technology, product lines, and businesses in the orthopedic health care market. It has previously entered into letters of intent that provides the Company with an exclusivity period during which it considers possible acquisitions. BONE GROWTH STIMULATION AND FRACTURE FIXATION DEVICES The Company's bone growth stimulation products consist of the OrthoLogic 1000 and the OL-1000 SC (single coil) portable, which are noninvasive physician prescribed magnetic field bone growth stimulators designed for home treatment of patients with a non-healing fracture, called a nonunion fracture, of certain long bones. In March 1994, the FDA granted the Company Pre-Market Approval (PMA) to market the OrthoLogic 1000 for treatment of nonunion fractures. Initially, a nonunion fracture was defined as a fracture that remains unhealed for at least nine months post injury. During June 1998, the Company received the approval of the FDA to change the OrthoLogic 1000 label to remove reference to the nine-month post injury time frame. The revised label states that the OrthoLogic 1000 is safe and effective to use in treating nonunion fractures. The SpinaLogic 1000 is a portable, noninvasive magnetic field bone growth stimulator being developed to enhance the healing process as either an adjunct to spinal fusion surgery or as a treatment for failed spinal fusion surgery. The Company's application for a PMA supplement was accepted by the FDA's Center for Devices and Radiological Health with a filing date of August 20, 1998. This acceptance indicates that the FDA has made a determination that the PMA application is sufficiently complete to permit a substantive review. At the end of December 1998, the Company submitted an amendment to the PMA supplement in response to requests from the FDA. In July 1997, the Company received a PMA supplement from the FDA for a single coil model of the OrthoLogic 1000. The single coil device, the OL-1000 SC, utilizes the same combined magnetic fields as the OrthoLogic 1000. The Company released this product during the first quarter of 1998. The OrthoFrame(R) and the OrthoFrame/Mayo products are external fixation devices used in conjunction with surgical procedures. The OrthoLogic 1000 and the OL-1000 SC are sold to patients upon receipt of a written prescription. The Company submits a bill to the patient's insurance carrier for reimbursement. The Company recognizes revenue at the time the product is placed on the patient. The OrthoFrame(R) and the OrthoFrame/Mayo products are sold to hospitals. The revenue is recognized on these products at the point a purchase order is received and the bill is sent to the hospital. CONTINUOUS PASSIVE MOTION CPM devices provide controlled, continuous movement to joints and limbs without requiring the patient to exert muscular effort and are intended to be applied immediately following the orthopedic trauma or surgery. The products are designed to reduce swelling, increase joint range of motion, reduce the length of hospital stay and reduce the incidence of post-trauma and post surgical complication. The Company offers a complete line of ancillary orthopedic products, including bracing, electrotherapy, cryotherapy and dynamic splinting products. The Company maintains a fleet of CPM devices that are rented to patients upon receipt of a written prescription. The Company recognizes rental revenue daily during the period of usage. Revenue on ancillary products is recognized at the time of billing. A bill is sent to the patient's insurance carrier for reimbursement. 2 HYALGAN The Company began marketing Hyalgan to orthopedic surgeons during July 1997 under a Co-Promotion Agreement (the "Co-Promotion Agreement") with Sanofi Pharmaceuticals, Inc. Hyalgan is used for relief of pain from osteoarthritis of the knee for those patients who have failed to respond adequately to simple analgesics. The Company recognizes fee revenue when the product is shipped from the distributor to the orthopedic surgeon under a purchase order. The fee revenue is based upon the number of units sold at the wholesale acquisition cost less amounts for distribution costs, discounts, rebates, returns, product transfer price, overhead factor and a royalty factor. OTHER The Company reported a net loss of $16.6 million during 1998 with an accumulated deficit as of December 31, 1998, of $51.4 million. As of December 31, 1998, the Company had approximately $28.4 million in net operating loss carryforwards for federal tax purposes. The Company's ability to utilize its net operating loss carryforwards may be subject to annual limitations in future years pursuant to the "change in ownership rules" under Section 382 of the Internal Revenue Code of 1986, as amended, and are dependent on the Company's future profitability. Future operating results will depend on numerous factors including, but not limited to, demand for the Company's products, the timing, cost and acceptance of product introductions and enhancements made by the Company or others, level of third party payment, alternate treatments which currently exist or may be introduced in the future, practice patterns, competitive conditions in the industry, general economic conditions and other factors influencing the orthopedic market in the United States or other countries in which the Company operates or expands. In addition, efforts to reform the health care systems and contain health care expenditures in the United States could adversely affect the Company's revenues and results of operations. Furthermore, the Company's products are subject to regulation by the FDA, and FDA regulations may adversely affect the marketing and sales of the Company's products. The Company cannot determine the effect such trends and regulations will have on its operations, if any. RESULTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998 Revenues. The Company's revenues increased 84% from $41.9 million in 1996 to $77.0 million in 1997. The increase of revenues is attributed to a full year of revenues from the acquisition of Sutter, the addition of DMTI and Toronto product lines in March 1997 and fee income for Hyalgan which started in July 1997. Sales of OrthoLogic 1000 declined in 1997 compared to 1996. Revenues decreased 2% from $77.0 million in 1997 to $75.4 million in 1998. The decrease in revenues is primarily attributable to lower sales of the OrthoLogic 1000. The fee income for Hyalgan represented a full twelve months of revenue. Gross Profit. Gross profit increased 75% from $33.6 million in 1996 to $58.7 million in 1997. The gross profit percentage declined from 80.2% in 1996 to 76.2% in 1997 primarily as a result of the CPM operations which have a lower gross profit percentage than the company's fracture healing products. Gross profit decreased to $57.7 million in 1998, a decrease of 1.7%. Gross profit as a percent of sales increased to 76.5% in 1998. The gross profit improvement is due primarily to the sale of Hyalgan. Selling, General and Administrative ("SG&A") Expenses. SG&A expenses increased 93% from $31.9 million in 1996 to $61.5 million in 1997 and increased 17% to $72 million in 1998. The increase from 1996 to 1997 is primarily due to a full year of fixed costs and variable costs associated with the 1996 acquisition of Sutter and the acquisition of the CPM business of Toronto and DMTI in the first quarter of 1997. The increase from 1997 to 1998 is primarily due to an increase in bad debt expense of approximately $9.3 million during the first quarter 3 of 1998. The increase was a result of management's decision to focus resources on the collection of current sales and on re-engineering the overall process of billing and collections. Research and Development Expenses. Research and development expenses increased from $2.2 million in 1996 to $2.3 million in 1997. Research and development expenses increased to $2.9 million in 1998. The increase in 1998 is primarily due to the $750,000 initial license fee cost for Chrysalin. Restructuring and Other Charges. During the third quarter of 1997, the Company restructured its sales, marketing and managed care groups. As a result of their restructuring and a second consecutive quarter of declining sales of the OrthoLogic 1000 in the third quarter of 1997, the Company determined that certain dealer intangibles acquired in the transition to a direct sales force had been impaired. The Company recorded a restructuring charge of $13.8 million in the third quarter, composed of a $10.0 million write-off of its dealer intangibles and $3.8 million in severance, facility closing and related costs. In the first quarter of 1998, $399,000 of the restructuring reserves were reversed. Net Income (Loss). Net loss during 1998 consists of an operating loss of $16.9 million offset by other income of $354,000. Net loss during 1997 is composed of an operating loss of $19 million offset by other income of $1.5 million, consisting primarily of interest income of $1.4 million. Net income during 1996 is composed of an operating loss of $485,000 offset by other income of $3.0 million, consisting predominantly of interest income of $2.8 million. LIQUIDITY AND CAPITAL RESOURCES The Company has financed its operations through the public and private sales of equity securities and product revenues. In July 1998, the Company completed a private placement with two investors, an affiliate of Credit Suisse First Boston Corp. and Capital Ventures International. Under the terms of the Purchase Agreement, the Company sold 15,000 shares of Series B convertible Preferred Stock for $15 million (prior to costs). The Series B Convertible Preferred Stock is convertible into shares of Common Stock 300 days after issuance and will automatically convert, to the extent not previously converted, into Common Stock four years following the date of issuance. Each share of Series B Convertible Preferred Stock is convertible into Common Stock at a per share price equal to the lesser of the average of the 10 lowest closing bids during the 30 days prior to conversion, or 103% of the average of the closing bids for the 10 days prior to the 300th day following the issuance. The Series B Convertible Preferred Stock is convertible into Common Stock prior to the 300th day after issuance upon the occurrence of certain events (in which case the conversion price will be the average of the 10 lowest closing bids during the 30 days prior to conversion). In the event of certain Mandatory Redemption Events, each holder of Series B Preferred Shares will have the right to require the Company to redeem those shares for cash at the Mandatory Redemption Price. Mandatory Redemption Events include, but are not limited to: the failure of the Company to timely deliver Common Shares as required under the terms of the Series B Preferred Shares or Warrants; the Company's failure to satisfy registration requirements applicable to such securities; the failure by the Company's stockholders to approve the transactions contemplated by the Securities Purchase Agreement relating to the issuance of the Series B Preferred Shares; the failure by the Company to maintain the listing of its Common Stock on Nasdaq or another national securities exchange; and certain transactions involving the sale of assets or business combinations involving the Company. In the event of any liquidation, dissolution or winding up of the Company, holders of the Series B Preferred Shares are entitled to receive, prior and in preference to any distribution of any assets of the Company to the holders of Common Stock, the Stated Value for each Series B Preferred Share outstanding at that time. The Purchase Agreement contains strict covenants that protect against hedging and short-selling of the Company's Common Stock while the purchasers hold shares of the Series B Convertible Preferred Stock. In connection with the private placement of the Series B Convertible Preferred Stock, OrthoLogic issued to the purchasers warrants to purchase 40 shares of Common Stock for each share of Series B Convertible Preferred Stock, exercisable at $5.50. The warrants are valued at $1,093,980. Additional costs of the private placement were approximately $966,000. Both the value of the warrants and the cost of the private placement will be 4 recognized over the 10 month conversion period as an "accretion of non-cash Preferred Stock Dividends" at the amount of $617,994 per quarter. From the inception of the Company through December 31, 1998, equity financing has resulted in net proceeds of $134.4 million. At December 31, 1998, the Company had cash and cash equivalents of $1.7 million and short term investments of $6.1 million. Working capital decreased 13% from $44.4 million at December 31, 1997 to $38.8 million at December 31, 1998. The decrease of $5.6 million is primarily the result of a decrease in accounts receivable and cash. The Company has secured a $7.5 million accounts receivable revolving line of credit and a $2.5 million revolving term loan from a bank. The maximum amount that may be borrowed under this agreement is $10 million. The Company may borrow up to 80% of eligible accounts receivable under the accounts receivable revolving line of credit and 50% of the net book value of CPM rental fleet under the revolving term loan. The accounts receivable revolving line of credit matures May 1, 2000, and the revolving term loan on November 30, 1999. Interest is payable monthly on the accounts receivable revolving line of credit and amortized principal and interest are due monthly on the revolving term loan. The interest rate is prime plus 1.05% for the accounts receivable line of credit, and prime plus .65% for the revolving term loan. There are certain financial covenants and reporting requirements associated with the loans. In connection with these loans the Company issued a warrant to purchase 10,000 shares of Common Stock at a price equal to the average fair market value for five days prior to the closing of the loans. The Company anticipates that its cash and short-term investments on hand, cash from operations, and the funds available from the line of credit and revolving term loan will be sufficient to meet the Company's presently projected cash and working capital requirements for the next 12 months. There can be no assurance, however, that this will prove to be the case. The timing and amounts of cash used will depend on many factors, including the Company's ability to continue to increase revenues, reduce and control its expenditures, become profitable and collect amounts due from third party payors. Additional funds may be required if the Company is not successful in any of these areas. The Company's ability to continue funding its planned operations beyond the next 12 months is dependent upon its ability to generate sufficient cash flow to meet its obligations on a timely basis, or to obtain additional funds through equity or debt financing, or from other sources of financing, as may be required. Net cash used by operations decreased 30.2% from $6.9 million in 1996 to $4.8 million in 1997. The 1997 amount was primarily due to (1) a net loss of $17.7 million, (2) an increase in accounts receivable of $2.8 million, and (3) an increase in inventories of $1.5 million, which was offset by a non-cash restructuring charge of $13.8 million and depreciation/amortization of $5.5 million. Net cash used in operations during 1998 rose to $10 million, an increase of 108% over the $4.8 million. The 1998 amount was primarily due to (1) a net loss of $16.6 million, (2) a decrease in accrued and other current liabilities of $4.5 million, and (3) an increase in inventories of $1.4 million, which was offset by a decrease in accounts receivable of $5.7 million and depreciation/amortization of $6.5 million. As discussed in greater detail in Note 13 to the Consolidated Financial Statements the Company has been named as a defendant in certain lawsuits. Management believes that the allegations are without merit and will vigorously defend them. No costs related to the potential outcome of these actions have been accrued. Under the terms of the Hyalgan Co-Promotion Agreement (Note 15), the Company is obligated to pay a total of $4 million during the first eighteen months of the agreement payable at $1 million every six months. The first $1 million was paid in 1997. During the first and third quarters of 1998, the Company paid $2.0 million under the Co-Promotion Agreement. The final payment of $1.0 million is payable during the first quarter of 1999. YEAR 2000 COMPLIANCE The inability of computers, software and other equipment utilizing microprocessors to recognize and properly process data fields containing a 2 digit year is commonly referred to as the Year 2000 Compliance issue. As the Year 2000 approaches, such systems may be unable to accurately process certain date-based information. 5 State of Readiness. The Company has implemented a Year 2000 Corporate Compliance Plan for coordinating and evaluating compliance actions in all business activities. The Company's Plan includes a series of initiatives to ensure that all the Company's computer equipment and software will function properly in the next millennium. "Computer equipment (or hardware) and software" includes systems generally thought of as IT dependent, as well as systems not obviously IT dependent, such as manufacturing equipment, telecopier machines, and security systems. The Company began the implementation of this plan in fiscal year 1998. All internal IT systems and non-IT systems were inventoried during the assessment phase of the plan. The first execution of the plan occurred in June 1998 when the Company converted all internal processing systems for accounting, manufacturing, third party billing, inventory and other operational processes to Year 2000 compliant software. In addition, in the ordinary course of business, as the Company periodically replaces computer equipment and software, it will acquire only Year 2000 compliant products. The Company presently believes that its software replacements and planned modifications of certain existing computer equipment and software will be completed on a timely basis so as to avoid any of the potential Year 2000 related disruptions or malfunctions of its computer equipment and software. The Company has completed its compliance review of virtually all of its products and has not learned of any products that it manufactures that will cease functioning or experience an interruption in operations as a result of the transition to the Year 2000. Costs. The Company has used both internal and external resources to reprogram or replace, test and implement its IT and non-IT systems for Year 2000 modifications. The Company does not separately track the internal costs incurred to date on the Year 2000 compliance. Such costs are principally payroll and related costs for internal IT personnel. The costs to date have been less than $100,000. Future costs related to Year 2000 compliance is anticipated to be less than $100,000 for fiscal year 1999. External costs have been incurred for the system upgrades and software conversions related to other operational requirements. Risks. The Company believes it has an effective Plan in place to anticipate and resolve any potential Year 2000 issues in a timely manner. In the event, however, that the Company does not properly identify Year 2000 issues or that compliance testing is not conducted on a timely basis, there can be no assurance that Year 2000 issues will not materially and adversely affect the Company's results of operations or relationships with third parties. In addition, disruptions in the economy generally resulting from Year 2000 issues also could materially and adversely affect the Company. The amount of potential liability and lost revenue that would be reasonably likely to result from the failure by the Company and certain key parties to achieve Year 2000 compliance on a timely basis cannot be reasonably estimated at this time. The Company currently believes that the most likely worst case scenario with respect to the Year 2000 issue is the failure of third party insurance payors to become compliant, which could result in the temporary interruption of the payments received for services and products sold. This could interrupt cash payments received by the Company, which in turn would have a negative impact on the Company. Contingency Plan. A contingency plan has not yet been developed for dealing with the most likely worst case scenarios. As part of its continuous assessment process, the Company is developing contingency plans as necessary. These plans could include, but are not limited to, use of alternative suppliers and vendors, substitutes for banking institutions, and the development of alternative payments solutions in dealing with third party payors. The Company currently plans to complete such contingency planning by October 1999. These plans are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ from those plans. 6 MARKET RISKS The Company is not currently vulnerable to a material extent to fluctuations in interest rates, commodity prices, or foreign currency exchange rates. 7 SELECTED FINANCIAL DATA The selected financial data for each of the five years in the period ended December 31, 1998 are derived from audited financial statements of the Company. The selected financial data should be read in conjunction with the Financial Statements and related Notes thereto and other financial information appearing elsewhere herein and the discussion in "Management's Discussion and Analysis of Financial Condition and Results of Operations." As discussed in Note 2 of the notes to the Company's financial statements, the Company completed two acquisitions in March 1997 and one in August 1996.
Years Ending December 31, Statements of Operations Data: 1998 1997 1996 1995 1994 (in thousands, except per share data) ---- ---- ---- ---- ---- Total revenues $ 75,369 $ 77,049 $ 41,884 $ 14,678 $ 4,953 Total cost of revenues 17,693 18,369 8,299 3,065 1,314 Operating expenses: Selling, general, and administrative 72,011 61,484 31,901 11,304 5,611 Research and development 2,920 2,320 2,169 2,132 2,787 Restructuring and other charges [Note 1] (399) 13,844 -- -- -- -------- -------- -------- -------- -------- Total operating expenses 74,532 77,648 34,070 13,436 8,398 -------- -------- -------- -------- -------- Operating loss (16,856) (18,968) (485) (1,823) (4,760) Other income/expense 354 1,466 3,023 471 288 Income taxes (100) (212) -- -- -- -------- -------- -------- -------- -------- Net income (loss) $(16,602) $(17,714) $ 2,538 $ (1,352) $ (4,472) Accretion of non-cash preferred stock dividend $ (1,236) -- -- -- -- -------- -------- -------- -------- -------- Net income (loss) applicable to common stockholders $(17,838) $(17,714) $ 2,538 $ (1,352) $ (4,472) ======== ======== ======== ======== ======== Net income (loss) per common share Basic [Note 1] $ (0.71) $ (0.71) $ 0.11 $ (0.09) $ (0.33) ======== ======== ======== ======== ======== Net income (loss) per common share Diluted [Note 1] $ (0.71) $ (0.71) $ 0.11 $ (0.09) $ (0.33) ======== ======== ======== ======== ======== Weighted Average-- Basic shares outstanding 25,291 25,116 23,275 15,549 13,791 Weighted Average-- Equivalent shares and stock options -- -- 869 -- -- -------- -------- -------- -------- -------- Diluted shares outstanding 25,291 25,116 24,144 15,549 13,791 ======== ======== ======== ======== ========
1. Net income was affected in 1997 by a one-time charge for restructuring and other costs, applicable to the impairment of dealer intangibles acquired in the transition to a direct sales force and expenses related to severance, facility closing and related costs. The effect on earnings per share from the restructuring and other changes is a loss of .55 cents per share. 8 BALANCE SHEET DATA December 31 -------------------------------------------------- Balance Sheet Data: 1998 1997 1996 1995 1994 (in thousands) ---- ---- ---- ---- ---- Working capital $38,817 $ 44,418 $ 74,985 $23,518 $4,968 Total assets 93,980 103,103 113,026 27,490 7,576 Long-term obligations, less current maturities 196 1,631 280 -- -- Stockholders' equity 68,225 84,737 101,927 24,437 6,052 STOCKHOLDER INFORMATION Market Information. The Company's Common Stock commenced trading on the Nasdaq National Market on January 28, 1993 under the symbol "OLGC." The bid price information [adjusted for a 2-for-1 stock split effected as a stock dividend in June 1996] included herein is derived from the Nasdaq Monthly Statistical Report, represents quotations by dealers, may not reflect applicable markups, markdowns or commissions and does not necessarily represent actual transactions. 1998 1997 ----------------- ----------------- High Low High Low ---- --- ---- --- First Quarter 7 9/16 5 1/2 7 4 1/2 Second Quarter 7 1/2 4 3/4 6 9/16 4 1/4 Third Quarter 5 2 1/2 7 4 9/16 Fourth Quarter 4 3/8 2 15/16 6 3/16 4 5/8 As of January 29, 1999, there were 25,304,590 shares outstanding of the Common Stock of the Company held by approximately 306 stockholders of record. Dividends. The Company has never paid a cash dividend on its Common Stock. The Board of Directors currently anticipates that all the Company's earnings, if any, will be retained for use in its business and does not intend to pay any cash dividends on its Common Stock in the foreseeable future. 9 CONSOLIDATED BALANCE SHEETS
December 31 1998 1997 ---- ---- Assets Current assets: Cash and cash equivalents $ 1,713,966 $ 7,783,349 Short-term investments [Note 7] 6,052,469 4,568,526 Accounts receivable, less allowance for doubtful accounts of $19,317,823 and $11,370,524 27,030,755 34,530,294 Inventories, net [Note 8] 11,960,071 10,548,173 Prepaids and other current assets 799,350 1,126,075 Deferred income taxes [Note 10] 2,642,909 2,596,386 Total current assets 50,199,520 61,152,803 Furniture, rental fleet & equipment, net [Note 9] 12,867,391 11,459,035 Deposits and other assets 344,915 593,239 Goodwill, net of accumulated amortization of $2,918,116 and $1,207,707 [Note 2] 26,195,846 26,008,805 Intangibles, net [Notes 3, 15, and 16] 4,372,238 3,888,889 Total assets $ 93,979,910 $ 103,102,771 Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 3,038,684 $ 2,896,056 Loan payable 500,000 500,000 Accrued compensation 1,458,849 3,844,359 Deferred credits 1,542,393 1,683,321 Accrued royalties [Note 6] 166,457 447,380 Accrued restructuring and other charges [Note 3] 762,151 2,408,476 Obligations under co-promotion agreement [Note 15] 1,000,000 2,000,000 Accrued expenses 2,914,397 2,955,010 Total current liabilities 11,382,931 16,734,602 Deferred rent and capital leases 196,192 130,708 Loan payable-- long term -- 500,000 Obligations under co-promotion agreement [Note 15] -- 1,000,000 Total liabilities 11,579,123 18,365,310 Commitments and contingencies [Notes 6,12,13,15 and 16] Series B Convertible Preferred Stock, $1,000 par value; 15,000 shares issued and outstanding; liquidation preference, $15,000,000 [Note 11] 14,176,008 -- Stockholders' Equity [Note 11] Common Stock, $.0005 par value; 40,000,000 shares authorized; 25,302,190 and 25,255,190 shares issued and outstanding 12,649 12,626 Additional paid in capital 119,658,836 119,413,210 Deficit (51,405,989) (34,665,794) Comprehensive income (loss) (40,717) (22,581) Total stockholders' equity 68,224,779 84,737,461 Total liabilities and stockholders' equity $ 93,979,910 $ 103,102,771
See notes to consolidated financial statements. 10 CONSOLIDATED STATEMENTS OF OPERATIONS AND OF COMPREHENSIVE INCOME
Years Ending December 31, ------------------------------------------- 1998 1997 1996 ---- ---- ---- Revenues Net sales $ 29,491,932 $ 36,043,169 $ 31,031,451 Net rentals 37,138,960 37,362,446 10,852,788 Fee revenue from co-promotion agreement [Note 15] 8,737,325 3,643,618 -- ------------ ------------ ------------ Total revenues 75,368,217 77,049,233 41,884,239 ------------ ------------ ------------ Cost of Revenues Cost of goods sold 10,591,924 10,224,397 5,714,510 Cost of rentals 7,100,706 8,144,806 2,584,530 ------------ ------------ ------------ Total cost of revenues 17,692,630 18,369,203 8,299,040 ------------ ------------ ------------ Gross profit 57,675,587 58,680,030 33,585,199 Operating Expenses Selling, general and administrative 72,010,982 61,484,418 31,900,966 Research and development 2,919,857 2,319,640 2,169,090 Restructuring and other charges [Note 3] (398,943) 13,843,591 -- ------------ ------------ ------------ Total operating expenses 74,531,896 77,647,649 34,070,056 ------------ ------------ ------------ Operating loss (16,856,309) (18,967,619) (484,857) Other Income (Expense) Grant/other revenue 103,861 147,263 182,658 Interest income 350,858 1,384,133 2,840,588 Interest expense (101,100) (65,884) -- ------------ ------------ ------------ Total other income 353,619 1,465,512 3,023,246 ------------ ------------ ------------ Income (loss) before taxes (16,502,690) (17,502,107) 2,538,389 Provision for income taxes [Note 10] (99,804) (211,560) -- ------------ ------------ ------------ Net income (loss) (16,602,494) (17,713,667) 2,538,389 Accretion of non-cash preferred stock dividend [Note 11] (1,235,988) -- -- ------------ ------------ ------------ Net income (loss) applicable to common stockholders $(17,838,482) $(17,713,667) $ 2,538,389 ============ ============ ============ Net income (loss) per common share-- basic $ (0.71) $ (0.71) $ 0.11 ============ ============ ============ Net income (loss) per common share-- diluted $ (0.71) $ (0.71) $ 0.11 ============ ============ ============ Weighted average-- Basic shares outstanding 25,290,784 25,116,164 23,274,763 Equivalent shares and stock options -- -- 869,000 ------------ ------------ ------------ Weighted average-- Diluted shares outstanding 25,290,784 25,116,164 24,143,763 ============ ============ ============ CONSOLIDATED STATEMENTS OF COMPREHENSIVE-INCOME Net income (loss) applicable to common stockholders $(17,838,482) $(17,713,667) $ 2,538,389 Foreign translation adjustment (18,136) (22,581) -- ------------ ------------ ------------ Comprehensive income (loss) applicable to common stockholders $(17,856,618) $(17,736,248) $ 2,538,389 ============ ============ ============
See notes to consolidated financial statements. 11 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Additional Paid in Comprehensive Shares Amount Capital Income Deficit Total ------ ------ ------- ------ ------- ----- Balance, January 1, 1996 9,625,864 4,813 43,887,804 -- (19,456,005) 24,436,612 Sale of common stock 2,530,000 1,265 73,949,643 -- -- 73,950,908 Exercise of common options at prices ranging from $.325 to $14.625 per share 324,318 162 852,051 -- -- 852,213 Exercise of common stock warrant 10,241 5 (5) -- -- -- Stock option compensation -- -- 64,307 -- -- 64,307 Two for one stock split [Note 11] 12,490,423 6,245 (6,245) -- -- -- Exercise of common options at prices ranging from $1.844 to $7.313 per share 41,500 20 84,485 -- -- 84,505 Net income -- -- -- -- 2,538,389 2,538,389 ---------- ------- ----------- -------- ------------ ------------ Balance, December 31, 1996 25,022,346 12,510 118,832,040 -- (16,917,616) 101,926,934 Exercise of common stock options at prices ranging from $.16 to $4.78 per share 232,844 116 496,593 -- -- 496,709 Stock option compensation -- -- 84,577 -- -- 84,577 Other -- -- -- (22,581) (34,511) (57,092) Net loss -- -- -- -- (17,713,667) (17,713,667) ---------- ------- ----------- -------- ------------ ------------ Balance, December 31, 1997 25,255,190 12,626 119,413,210 (22,581) (34,665,794) 84,737,461 Exercise of common options at prices ranging from $.50 to $4.55 per share 47,000 23 158,754 -- -- 158,777 Stock option compensation -- -- 25,622 -- -- 25,622 Issuance of warrants in connection with preferred stock -- -- 1,093,980 -- 1,093,980 Accretion of non-cash preferred stock dividend -- -- (1,093,980) -- (142,008) (1,235,988) Other warrants issued and other -- -- 61,250 -- 4,307 65,557 Foreign exchange -- -- -- (18,136) -- (18,136) Net loss -- -- -- -- (16,602,494) (16,602,494) ---------- ------- ----------- -------- ------------ ------------ Balance, December 31, 1998 25,302,190 12,649 119,658,836 (40,717) (51,405,989) 68,224,779 ========== ======= =========== ======== ============ ============
See notes to consolidated financial statements. 12 CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ending December 31, --------------------------------------- 1998 1997 1996 ---- ---- ---- Operating Activities Net income (loss) (16,602,494) (17,713,667) 2,538,389 Adjustments to reconcile net income (loss) to net cash used in operating activities: Depreciation and amortization 6,473,000 5,510,251 1,926,056 Restructuring and other charges (399,000) 13,843,591 -- Other -- (438,504) -- Change in operating assets and liabilities, excluding effects of business acquisitions: Accounts receivable 5,682,834 (2,759,187) (9,062,119) Inventories (1,411,898) (1,494,096) (3,171,448) Prepaids and other current assets 280,065 (23,215) (819,623) Deposits and other assets 186,870 (438,447) 4,636 Accounts payable 242,628 (871,546) (708,136) Accrued and other current liabilities (4,466,299) (437,934) 2,377,410 ----------- ----------- --------- Net cash used in operating activities (10,014,294) (4,822,754) (6,914,835) ----------- ----------- --------- Investing Activities Expenditures for furniture and equipment, net (5,423,652) (5,128,159) (1,389,309) Intangibles from dealer transactions -- (704,966) (10,752,116) Officer note receivable, net -- 200,000 (75,000) Acquisitions, net of cash acquired -- (24,886,134) (24,907,442) Investments in Chrysalin (750,000) -- (Purchase) sale of short-term investments (1,484,943) 30,738,463 (26,157,629) ----------- ----------- --------- Net cash (used) provided in investing activities (7,658,595) 219,204 (63,281,496) ----------- ----------- --------- Financing Activities Payments under long-term debt and capital lease obligations (157,984) (233,756) (27,956) Payments on loan payable (500,000) (420,084) -- Payments under co-promotion agreement (2,000,000) (1,000,000) -- Net proceeds from stock options exercised and other 227,490 546,886 700,700 Net proceeds from issuance of convertible preferred stock and warrants 14,034,000 -- Net proceeds from issuance of common stock -- -- 74,186,926 ----------- ----------- --------- Net cash (used in) provided by financing activities 11,603,506 (1,106,954) 74,859,670 ----------- ----------- --------- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (6,069,383) (5,710,504) 4,663,339 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 7,783,349 13,493,853 8,830,514 ----------- ----------- --------- CASH AND CASH EQUIVALENTS, END OF YEAR 1,713,966 7,783,349 13,493,853 =========== =========== ========= Supplemental schedule of non-cash investing and financing activities: Stock option compensation 25,622 84,577 64,307 Supplemental Disclosure of Cash Flow Information Acquisition of intangible asset through obligation for product distribution rights [Note 15] 4,000,000 Accretion of non-cash preferred stock dividend 1,235,988 Purchase of property and equipment with capital leases 493,289 -- -- Purchase price adjustment related to preacquisition contingencies 1,816,362 -- -- Cash paid during the year for interest 101,100 65,844 -- Cash paid during the year for income taxes 350,000 400,000 --
See notes to consolidated financial statements. 13 NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION. OrthoLogic Corp. ("the Company") was incorporated on July 30, 1987 (date of inception) and commenced operations in September 1987. On August 30, 1996 OrthoLogic Corp. acquired all of the outstanding capital stock of Sutter Corporation ("Sutter") which became a wholly-owned subsidiary of the Company. On March 9, 1997 and March 12, 1997, the Company acquired certain assets and assumed certain liabilities of Toronto Medical Corp. ("Toronto") and Danninger Medical Technology, Inc. ("DMTI "). Concurrent with the acquisition of Toronto the Company formed a wholly-owned Canadian subsidiary, now known as OrthoLogic Canada Ltd. DESCRIPTION OF THE BUSINESS. OrthoLogic develops, manufactures and markets proprietary, technologically advanced orthopedic products and packaged services for the orthopedic health care market including bone growth stimulation, continuous passive motion ("CPM") devices and ancillary orthopedic recovery products primarily in the United States. OrthoLogic's products are designed to enhance the healing of diseased, damaged, degenerated or recently repaired muscular skeletal tissue. The Company's products focus on improving the clinical outcomes and cost-effectiveness of orthopedic procedures that are characterized by compromised healing, high-cost, potential for complication and long recuperation time. In June 1997, the Company further extended its product line by entering into a co-promotion agreement (the "Co-Promotion Agreement") with Sanofi Pharmaceuticals, Inc. of New York (Note 15). The Co-Promotion Agreement allows the Company to market Hyalgan (sodium hyaluronate) to orthopedic surgeons in the United States for the relief of pain from osteoarthritis of the knee. The Company commenced marketing of Hyalgan in July 1997. On January 14, 1999 the Company exercised its option to license the United States development, marketing, and distribution rights for the fresh fracture indications for Chrysalin, a new tissue repair synthetic peptide. The Company will pursue commercialization of Chrysalin, initially seeking Food and Drug Administration (FDA) approval for the human clinical trials for the fracture healing indication. The Company projects that Chrysalin could receive all the necessary FDA approvals and be introduced in the market during 2003. There can be no assurance, however, that the clinical trials will result in favorable data or that FDA approvals if sought will be obtained. During the year ended December 31, 1998 and 1997 the Company incurred losses of $16.6 million and $17.7 million, respectively. In addition, the Company used cash in operating activities of $10.0 million and $4.8 million for the years ended December 31, 1998 and 1997, respectively. The Company anticipates that its cash and short-term investments on hand, cash from operations and the funds available from the line of credit and revolving term loan (Note 12) will be sufficient to meet the Company's presently projected cash and working capital requirements for the next 12 months. There can be no assurance, however, that this will prove to be the case. The timing and amounts of cash used will depend on many factors, including the Company's ability to continue to increase revenues, reduce and control its expenditures, become profitable and collect amounts due from third party payors. Additional funds may be required if the Company is not successful in any of these areas. The Company's ability to continue funding its planned operations beyond the next 12 months is dependent on its ability to generate sufficient cash flow to meet its obligations on a timely basis, or to obtain additional funds through equity or debt financing, or from other sources of financing, as may be required. PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the accounts of OrthoLogic Corp. since its inception, Sutter since its acquisition on August 30, 1996 and the operations of Toronto and DMTI since their acquisition in March 1997. All material intercompany accounts and transactions have been eliminated. 14 The following briefly describes the significant accounting policies used in the preparation of the financial statement of the Company: A. INVENTORIES are stated at the lower of cost (first in, first out method) or market. B. FURNITURE, RENTAL FLEET, AND EQUIPMENT are stated at cost or, in the case of leased assets under capital leases, at the present value of future lease payments at inception of the lease. Depreciation is calculated on a straight-line basis over the estimated useful lives of the various assets, which range from three to seven years. Leasehold improvements and leased assets under capital leases are amortized over the life of the asset or the period of the respective lease using the straight-line method, whichever is the shortest. C. REVENUE recognition for the OrthoLogic 1000 and the OL-1000 SC is at the time the product is placed on the patient. The OrthoFrame(R) and the OrthoFrame/Mayo are typically held on consignment at hospitals and revenue is recognized at the point a purchase order is received from the hospital. Rental revenue for CPM products is recorded daily during the period of usage. Revenue on CPM ancillary products is generally recognized at the time of shipment. Fee revenue for Hylagan is based upon the number of units sold at the wholesale acquisition cost less amounts for distribution costs, discounts, rebates, returns, product transfer price, overhead factor and a royalty factor. Grant revenue is recorded as earned in accordance with the terms of the grant contracts. D. RESEARCH AND DEVELOPMENT represent both costs incurred internally for research and development activities, as well as costs incurred by the Company to fund the activities of the various research groups which the Company has contracted. All research and development costs are expensed when incurred. E. CASH AND CASH EQUIVALENTS consist of cash on hand and cash deposited with financial institutions, including money market accounts, and commercial paper purchased with an original maturity of three months or less. F. INCOME (LOSS) PER COMMON SHARES is computed on the weighted average number of common or common and common equivalent shares outstanding during each year. Basic EPS is computed as net income (loss) applicable to common stockholders divided by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur from common shares issuable through stock options, warrants, and other convertible securities when the effect would be dilutive. The Board of Directors approved a 2-for-1 stock split in the form of a 100% common share dividend which was paid on June 25, 1996. The accompanying Financial Statements have been restated to give effect of the split. G. CERTAIN RECLASSIFICATIONS have been made to the 1997 and 1996 financial statements to conform to the 1998 presentation. H. INTANGIBLE ASSETS. Goodwill from the acquisition of Sutter, Toronto and DMTI is capitalized and amortized on a straight-line basis over the estimated useful life of the related asset (15-20 years). The intangible relating to the product distribution rights for Hyalgan acquired in the co-promotion agreement is being amortized over 15 years. I. LONG-LIVED ASSETS. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 121, the Company reviews the carrying values of its long lived assets and identifiable intangibles for possible impairment whenever events or changes in circumstances indicate that the carrying amount of assets to be held and used may not be recoverable. J. STOCK BASED COMPENSATION. The Company accounts for its stock based compensation plan based on accounting Principles Board ("APB") Opinion No. 25. In October 1995, the Financial Accounting Standards Board issued SFAS No. 123, Accounting for Stock-Based Compensation. The Company has 15 determined that it will not change to the fair value method and will continue to use APB Opinion No. 25 for measurement and recognition of any expense related to employee stock based transactions (Note 11). K. USE OF ESTIMATES. The preparation of the financial statements in conformity with generally accepted accounting principles necessarily requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Significant estimates include the allowance for doubtful accounts ($19,317,823 and $11,370,524 at December 31, 1998 and 1997, respectively), which is based primarily on trends in historical collection statistics, consideration of current events, payer mix and other considerations. The Company derives a significant amount of its revenues in the United States from third-party health insurance plans, including Medicare. Amounts paid under these plans are generally based on fixed or allowable reimbursement rates. Revenues are recorded at the expected or preauthorized reimbursement rates when billed. Some billings are subject to review by such third party payors and may be subject to adjustments. In the opinion of management, adequate allowances have been provided for doubtful accounts and contractual adjustments. Any differences between estimated reimbursement and final determinations are reflected in the year finalized. L. NEW ACCOUNTING PRONOUNCEMENTS. In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 requires that an enterprise recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The statement is effective for the Company's fiscal year ending December 31, 2000. The Company has not completed evaluating the impact of implementing the provisions of SFAS No. 133. The FASB issued SFAS No. 131 on "Disclosures about Segments of an Enterprise and Related Information" effective in 1998. The Company evaluated SFAS No. 131 and determined that the Company operates in only one segment. 2. ACQUISITIONS On August 30, 1996, the Company acquired all of the outstanding capital stock of Sutter for $24.5 million in cash and assumption of $11.7 million of liabilities. The acquisition was accounted for as a purchase, resulting in goodwill of $13.2 million which is being amortized over 15 years. On March 3, 1997 and March 12, 1997, the Company acquired certain assets and assumed certain liabilities of Toronto and DMTI. After paying certain of the assumed liabilities, the net cash outlay was approximately $7.5 million for Toronto and $10.7 million for DMTI. In March 1998, the Company recorded an increase of approximately $1.8 million to goodwill representing the settlement of a preacquisition contingency and representations and warranties relating to the 1997 acquisitions. Both acquisitions were accounted for as purchases under the purchase method of accounting, which resulted in goodwill of $5.5 million for Toronto and $10.6 million for DMTI. The goodwill is being amortized over 20 years. The Company has substantially completed its integration of operations related to these acquisitions. The following unaudited pro forma summary combines the consolidated results of operations of the Company as if the acquisitions of Toronto and DMTI had occurred January 1, 1997 after giving effect to certain adjustments including amortization of goodwill, interest income and income taxes. This pro forma summary is not necessarily indicative of the results of operations that would have occurred if OrthoLogic, Toronto, and DMTI had been combined for all of 1997. Year Ending December 31, 1997 ------------------------------------- (in thousands, except per share data) Net revenues $ 80,332 Income (loss) from continuing operations (17,725) Net income (loss) per common share $ (.71) 16 3. RESTRUCTURING AND OTHER CHARGES During the third quarter of 1997, the Company restructured its sales, marketing and managed care groups. As a result of their restructuring and a second consecutive quarter of declining sales of the OrthoLogic 1000 bone growth stimulator, the Company determined that certain dealer intangibles acquired in the transition to a direct sales force in 1996 have been impaired. The Company recorded a restructuring charge of $13.8 million in the third quarter, composed of a $10.0 million write-off of its dealer intangibles, $2.3 million in severance, $1.2 million in facility closing and $300,000 of related costs. There was a reversal of 1997 restructuring expenses of $399,000 during the first quarter of 1998. The remaining balance of the restructuring reserve of $762,000 on December 31, 1998 primarily relates to severance. 4. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES During the first quarter of 1998, the Company recorded a charge of approximately $9.3 million for additional bad debt expense. The charge was a result of a management decision during the first quarter of 1998 to focus proportionately more resources on collection of current sales and on re-engineering the overall process of billing and collections. Management determined it was no longer considered to be cost effective to expend significant resources on the collection of the older receivables as had been done in the past. 5. LEGAL SETTLEMENT The Company settled a false claims matter with the U.S. Department of Justice in a case that was filed in December 1996 under qui tam provisions of the Federal False Claims Act. The allegations included the submission of claims for reimbursement for a small number of custom medical devices to various federal care programs including Medicare, TRICARE (formerly known as CHAMPUS) and various state Medicaid programs. OrthoLogic denies any wrongdoing or liability with respect to the allegations in this matter. Nevertheless, in an effort to avoid the expense, burden and uncertainty of litigation in this case as well as the potential distraction this case could have on the Company's management, the Company agreed to settle this matter. Under the terms of the definitive settlement agreement, OrthoLogic paid and expensed in 1998 $1.0 million to the U.S. Department of Justice, on behalf of several federal health care programs including Medicare, TRICARE, and various state Medicaid programs. In return, the U.S. Department of Justice released the Company's officers, employees, and directors from any causes of actions for civil damages or civil penalties for the various allegations being settled in this matter. The original complaint was dismissed with prejudice. 6. RESEARCH, PRODUCT DEVELOPMENT AND LICENSE AGREEMENTS The Company has committed to pay royalties on the sale of products or components of products developed under certain product development and licensing agreements. The royalty percentages vary but generally range from 7% to 0.5 % of the sales amount for licensed products. The royalty percentage under the different agreements decrease when either a certain sales dollar amount is reached or royalty amount is paid. Royalty expense under these agreements totaled $258,456, $360,110 and $621,597 in 1998, 1997 and 1996, respectively. 17 7. INVESTMENTS The Company has implemented SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities." At December 31, 1998, short term investments were composed of corporate debt securities and direct obligations of the United States Government and its agencies and were managed as part of the Company's cash management program and were classified as held-to-maturity securities. All such securities were purchased with original maturities less than one year. Such classification requires these securities to be reported at amortized cost. A summary of the fair market value and unrealized gains and losses on these securities is as follows: Years Ending December 31, ------------------------- 1998 1997 ---- ---- Amortized cost $6,052,469 $4,568,526 Gross unrealized gains 665 11,250 Gross unrealized losses (17,205) (73,947) ---------- ---------- Fair value $6,035,929 $4,505,829 ========== ========== 8. INVENTORIES Inventories consisted of the following: December 31 -------------------------- 1998 1997 ---- ---- Raw materials $8,484,773 $5,812,861 Work-in-process 122,371 3,463,197 Finished goods 4,101,325 1,633,753 ----------- ----------- 12,708,469 10,909,811 Less allowance for obsolescence (748,398) (361,638) ----------- ----------- Total $11,960,071 $10,548,173 ============ =========== 9. FURNITURE, RENTAL FLEET AND EQUIPMENT Furniture, rental fleet and equipment consisted of the following: December 31 -------------------------- 1998 1997 ---- ---- Rental fleet 14,373,674 10,843,842 Machinery and equipment 2,383,562 2,007,544 Computer equipment 3,708,812 2,574,896 Furniture and fixtures 767,661 780,039 Leasehold and improvements 727,996 186,431 ----------- ----------- 21,961,705 16,392,752 Less accumulated depreciation and amortization (9,094,314) (4,933,717) ----------- ----------- Total $12,867,391 $11,459,035 =========== =========== 18 10. INCOME TAXES At December 31,1998, the Company has approximately $28.4 million in net operating loss carryforwards expiring from 2002 through 2017 for federal income tax purposes. Stock issuances, as discussed in Note 11, may cause a change in ownership under the provisions of Internal Revenue Code Section 382; accordingly, the utilization of the Company's net operating loss carryforwards may be subject to annual limitations. Management has evaluated the available evidence about future taxable income and other possible sources of realization of deferred tax assets. The valuation allowance reduces deferred tax assets to an amount that management believes will more likely than not be realized. The components of deferred income taxes at December 31 are as follows: 1998 1997 ---- ---- Allowance for bad debts $ 7,779,000 $ 4,560,000 Other accruals and reserves 1,263,909 672,386 Valuation allowance (6,400,000) (2,636,000) ------------ ------------ Total current 2,642,909 2,596,386 ------------ ------------ Net operating loss carryforwards 12,207,000 6,971,000 Difference in basis of fixed assets (1,100,000) (978,000) Nondeductible accruals and reserves 159,000 340,000 Amortization of intangibles and other 90,000 2,075,000 Difference in basis of dealer intangible 3,889,000 4,198,000 Valuation allowance (15,245,000) (12,606,000) ------------ ------------ Total noncurrent -- -- ------------ ------------ Total deferred income taxes $ 2,642,909 $ 2,596,386 The provision for income taxes are as follows: 1998 1997 ---- ---- Current $ 146,327 $ 407,000 Deferred (46,523) (195,440) ------------ ------------ Income Tax Provisions $ 99,804 $ 211,560 ============ ============ A reconciliation of the difference between the provision for income taxes and income taxes at the statutory U.S. federal income tax rate is as follows for the years ended December 31: 1998 1997 1996 ---- ---- ---- Income taxes at statutory rate $(5,611,000) $(5,950,000) $ 863,000 Net operating losses used -- -- (930,000) State income taxes (990,000) (1,024,000) 200,000 Change in valuation allowance 6,403,000 6,558,000 -- Other 297,804 627,560 (133,000) ----------- ----------- ----------- Net provision $ 99,804 $ 211,560 $ 0 =========== =========== =========== 19 11. STOCKHOLDERS' EQUITY AND SERIES B CONVERTIBLE PREFERRED STOCK In October 1987, the stockholders adopted a Stock Option Plan (the "1987 Option Plan") which was amended in September 1996, and approved by shareholders in May 1997, to increase the number of common shares reserved for issuance under the 1987 Option Plan to 4,160,000 shares. This plan expired during October 1997. In May 1997, the Stockholders adopted a new Stock Option Plan (the "1997 Option Plan") which replaced the 1987 Option Plan. The 1997 Option Plan reserved for issuance 1,040,000 shares of common stock and was amended in 1998 to increase the number of shares of common stock by 275,000 shares. Two types of options may be granted under the 1997 Option Plan: options intended to qualify as incentive stock options under Section 422 of the Internal Revenue Code ("Code") and other options not specifically authorized or qualified for favorable income tax treatment by the Code. All eligible employees may receive more than one type of option. Any director or consultant who is not an employee of the Company shall be eligible to receive only nonqualified stock options under the 1997 Option Plan. In October 1989, the Board of Directors (the "Board") approved that in the event of a takeover or merger of the company in which 100% of the equity of the company is purchased, 75% of all unvested employee options will vest, with the balance vesting equally over the ensuing 12 months, or according to the individual's vesting schedule, whichever is earlier. If an employee or holder of stock options is terminated as a result of or subsequent to the acquisition, 100% of that individual's stock option will vest immediately upon employment termination. These provisions are also included in the 1997 Option Plan. Options are granted at prices which are equal to the current fair value of the Company's common stock at the date of grant. The vesting period is generally related to length of employment and all vested options lapse upon termination of employment if not exercised within a 90-day period (or one year after death or disability or the date of termination if terminated for cause). A summary of the status of the Option Plans as of December 31, 1998, 1997 and 1996, and changes during the years then ended is:
1998 1997 1996 ------------------- ------------------- --------------------- Weighted- Weighted- Weighted- Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price ------ ----- ------ ----- ------ ----- Fixed options outstanding at beginning of year 2,535,450 $6.07 2,509,644 $7.31 2,356,034 $ 3.33 Granted 1,024,000 4.79 1,132,150 5.54 903,746 13.15 Exercised (47,000) 3.92 (232,844) 2.37 (690,136) 1.60 Forfeited (127,625) 7.48 (873,500) 9.59 (60,000) 6.23 Outstanding at end of year 3,384,825 5.66 2,535,450 6.07 2,509,644 7.31 Options exercisable at year-end 1,744,357 1,072,975 613,737 Weighted-average fair value price of options granted during the year $2.26 $3.02 $ 7.50
20 The following table summarizes information about fixed stock options outstanding at December 31, 1998:
Outstanding Exercisable Number Weighted- Weighted- Number Weighted- Range of Outstanding Average Remaining Average Exercisable Average Exercise Prices as of 12/31/98 Contractual Life Exercise Price as of 12/31/98 Exercise Price - - --------------- -------------- ---------------- -------------- -------------- -------------- $1.8100-2.4400 351,800 5.11 $ 2.0551 348,049 $ 2.0554 2.5000-3.2500 406,600 6.92 2.8192 234,934 2.7315 3.3440-5.0000 375,000 9.03 4.7423 155,000 4.9810 5.0630-5.4380 436,250 8.90 5.3680 229,838 5.3348 5.5000-5.5310 352,900 9.33 5.5018 7,000 5.5000 5.5630-5.5630 100,000 9.01 5.5630 0 0.0000 5.6250-5.6250 381,000 8.76 5.6250 112,833 5.6250 5.8125-6.5625 177,575 8.68 6.2934 54,794 6.3118 6.7800-6.7800 470,000 6.95 6.7800 362,292 6.7800 7.3100-17.3800 333,700 7.48 12.7001 239,617 13.4350 - - --------------- --------- -------- -------- --------- -------- $1.8100 -17.3800 3,384,825 7.89 $ 5.6643 1,744,357 $ 5.7614 ================ ========= ======== ======== ========= ========
The Company applies APB Opinion No. 25 and related interpretations in accounting for its Option Plans. Had compensation costs been computed based on the fair value of awards on the date of grant, utilizing the Black-Scholes option-pricing model, consistent with the method stipulated by SFAS No. 123, the Company's net earnings and earnings per share for the years ended December 31, 1998, 1997 and 1996 would have been reduced to the pro forma amounts indicated below, followed by the model assumptions used:
1998 1997 1996 ---- ---- ---- Net income (loss) attributable to common stockholders; As reported (in thousands) $(17,838) $(17,714) $ 2,538 Pro forma (in thousands) $(20,351) $(20,371) $ 679 Basic and Diluted Net income (loss) per-share: As reported $ (0.71) $ (0.71) $ 0.11 Pro forma $ (0.80) $ (0.81) $ 0.03 Black-scholes model assumptions: Risk free interest rate 6.00% 6.00% 6.00% Expected volatility 0.4 0.6 0.6 Expected term 5 Years 5 Years 5 Years Dividend yield 0% 0% 0%
In July 1998, the Company completed a private placement with two investors, an affiliate of Credit Suisse First Boston Corp. and Capital Ventures International. Under the terms of the Purchase Agreement, OrthoLogic sold 15,000 shares of Series B Convertible Preferred Stock for $15 million (prior to costs). The Series B Convertible Preferred Stock is convertible into shares of Common Stock 300 days after issuance and will automatically convert, to the extent not previously converted, into Common Stock four years following the date of issuance. Each share of Series B Convertible Preferred Stock is convertible into Common Stock at a per share price equal to the lesser of the average of the 10 lowest closing bids during the 30 days prior to conversion, or 103% of the average of the closing bids for the 10 days prior to the 300th day following the issuance. The Series B Convertible Preferred Stock is convertible into Common Stock prior to the 300th day after issuance upon the occurrence of certain events (in which case the conversion price will be the average of the 10 lowest closing bids during the 30 days prior to conversion). In the event of certain Mandatory Redemption Events, each holder of Series B Preferred Shares will have the right to require the Company to redeem those shares for cash at the Mandatory Redemption Price. Mandatory Redemption Events include, but are not limited to: the failure of the 21 Company to timely deliver Common Shares as required under the terms of the Series B Preferred Shares or Warrants; the Company's failure to satisfy registration requirements applicable to such securities; the failure by the Company's stockholders to approve the transactions contemplated by the Securities Purchase Agreement relating to the issuance of the Series B Preferred Shares; the failure by the Company to maintain the listing of its Common Stock on Nasdaq or another national securities exchange; and certain transactions involving the sale of assets or business combinations involving the Company. In the event of any liquidation, dissolution or winding up of the Company, holders of the Series B Preferred Shares are entitled to receive, prior and in preference to any distribution of any assets of the Company to the holders of Common Stock, the Stated Value for each Series B Preferred Share outstanding at that time. The Purchase Agreement contains strict covenants that protect against hedging and short-selling of OrthoLogic Common Stock while the purchasers hold shares of the Series B Convertible Preferred Stock. In connection with the private placement of the Series B Convertible Preferred Stock, OrthoLogic issued to the purchasers warrants to purchase 40 shares of Common Stock for each share of Series B Convertible Preferred Stock, exercisable at $5.50 per share. These warrants expire in 2008. The warrants are valued at $1,093,980. Additional costs of the private placement were approximately $966,000. Both the value of the warrants and the cost of the private placement will be recognized over the 10 month conversion period as an "accretion of non-cash Preferred Stock Dividends" for the amount of $617,994 per quarter. The Company filed a registration statement covering the underlying Common Stock. Proceeds from the private placement will be used to fund new product opportunities, including SpinaLogic, Chrysalin and Hyalgan, as well as to complete the re-engineering of the Company's key business processes. At the closing of the Company's IPO on January 28, 1993 all convertible Series D Preferred Stock, totaling 4,173,002 shares, was converted into an equal amount of common stock. At December 31, 1998, there were 2,000,000 shares of preferred stock authorized. In 1993, the Company issued a warrant to purchase 20,000 shares of common stock, at an exercise price of $1.813 per share, to another company for an ownership interest of that company. In 1996, the Company issued a warrant to purchase 5,000 shares of common stock, at an exercise price of $2.41 per share, to a consultant as partial payment for services. On April 30, 1996, the Company issued 5,060,000 shares of common stock upon closing of a public offering of its common stock. Gross proceeds to the Company were $78.4 million. The net proceeds to the Company after deducting costs of the offering were approximately $74.0 million. The common stock was sold at $15.50 per share. During the first quarter of 1996 the Company amended its Certificate of Incorporation to authorize 40,000,000 shares of common stock, $.0005 par value. In addition, the Board of Directors approved a 2-for-1 stock split in the form of a 100% common share dividend which was paid on June 25, 1996. The accompanying financial statements and footnotes have been restated to give effect to the split. 12. COMMITMENTS The Company is obligated under non-cancelable operating lease agreements for its office, manufacturing and research facilities. Rent expense for the years ended December 31, 1998, 1997 and 1996 was $1,716,000, $594,000 and $482,000, respectively. Future lease payments for fiscal years 1999, 2000, 2001, 2002 and beyond 2002 are $1,781,000, $1,198,000, $985,000, $963,000 and $5,537,000, respectively. 22 The Company has secured a $7.5 million accounts receivable revolving line of credit and a $2.5 million revolving term loan from a bank. The maximum amount that may be borrowed under this agreement is $10 million. The Company may borrow up to 80% of eligible accounts receivable under the accounts receivable revolving line of credit and 50% of the net book value of CPM rental fleet under the revolving term loan. The accounts receivable revolving line of credit matures May 1, 2000, and the revolving term loan on November 31, 1999. Interest is payable monthly on the accounts receivable revolving line of credit and amortized principal and interest are due monthly on the revolving term loan. The interest rate is prime plus 1.05% for the accounts receivable line of credit, and prime plus .65% for the revolving term loan. There are certain financial covenants and reporting requirements associated with the loans. In connection with these loans the Company issued a warrant to purchase 10,000 shares of Common Stock at a price of $6.13. These warrants expire in 2003. 13. LITIGATION During 1996 certain lawsuits were filed in the United States District Court for the District of Arizona against the Company and certain officers and directors alleging violations of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-6 promulgated thereunder. Plaintiffs in these actions allege that correspondence received by the Company from the U.S. Food and Drug Administration (the "FDA") pertaining principally to the promotion of the Company's OrthoLogic 1000 Bone Growth Stimulator was material and undisclosed, leading to an artificially inflated stock price. Plaintiffs further allege practices referenced in that correspondence operated as a fraud against plaintiffs. Plaintiffs further allege that once the FDA letter became known, a material decline in the stock price of the Company occurred, causing damage to the plaintiffs. All plaintiffs seek class action status, unspecified compensatory damages, fees, and costs. Plaintiffs also seek extraordinary, equitable and/or injunctive relief as permitted by law. The actions were consolidated for all purposes in the United States District Court for the District of Arizona and lead plaintiffs and counsel were appointed. The Company and its officers and directors moved to dismiss the consolidated amended complaint for failure to state a claim. The Court dismissed the consolidated amended complaint in its entirety against the Company and its officers and directors but gave plaintiffs leave to amend all claims to cure all deficiencies. Plaintiffs have filed an amended complaint, and the cases are pending. If any claim deficiencies are not cured, that claim will be dismissed with prejudice as against the Company and its officers and directors. In addition, the Company has been served with a substantially similar action filed in Arizona state court alleging state law causes of action grounded in the same set of facts. By agreement between the parties this action has been stayed while the federal actions proceed. In addition to the foregoing, a shareholder derivative complaint alleging, among other things, breach of fiduciary duty in connection with the conduct alleged in the aforesaid federal and state court class actions have also been filed in Arizona state court. That action is stayed pending action on plaintiffs' amended complaint. Management believes that the allegations are without merit and will vigorously defend them. At December 31, 1998, in addition to the matters disclosed above, the Company is involved in various other legal proceedings that arose in the ordinary course of business. The costs associated with defending the above allegations and the potential outcome cannot be determined at this time and accordingly, no estimate for such costs have been included in the accompanying Financial Statements. In management's opinion, the ultimate resolution of the above legal proceedings will not have a material effect on the financial position, results of operations, or cash flow of the Company. 23 14. 401(k) PLAN The Company adopted a 401(k) plan (the "Plan") for its employees on July 1, 1993. The Company may make matching contributions to the Plan on behalf of all Plan participants, the amount of which is determined by the Board of Directors. The Company did not make any matching contributions to the Plan in 1998, 1997, and 1996. 15. CO-PROMOTION AGREEMENT The Company entered into an exclusive co-promotion agreement (the "Agreement") with Sanofi Pharmaceuticals Inc. ("Sanofi") at a cost of $4 million on June 23, 1997 for purpose of marketing Hyalgan, a hyaluronic acid sodium salt, to orthopedic surgeons in the United States for the treatment of pain in patients with osteoarthtitis of the knee. During 1997 and 1998 the Company paid $3.0 million of this amount. At December 31, 1998 the Company has recorded the remaining $1.0 million as a liability in its financial statements. The initial term of the agreement ends on December 31, 2002. Upon the expiration of the initial term, Sanofi may terminate the agreement, extend the agreement for up to ten additional one year periods, or enter into a revised agreement with the Company. Management believes it is mutually beneficial for both parties to extend the agreement beyond the initial period. Upon termination of the agreement, Sanofi must pay the Company the amount equal to 50% of the gross compensation paid to the Company, pursuant to the Agreement, for the immediately preceding year. The Company's sales force began to promote Hyalgan in the third quarter of 1997. Fee revenue of $8.7 and $3.6 million was recognized during 1998 and 1997, respectively. 16. LICENSING AGREEMENT The Company announced in January 1998 that it had acquired a minority equity interest in a biotech firm, Chrysalis Bio Technology, Inc. for $750,000. As part of the transaction, the Company was awarded a nine-month world-wide exclusive option to license the orthopedic applications of Chysalin, a patented 23-amino acid peptide that has shown promise in accelerating the healing process and has completed an extensive pre-clinical safety and efficacy profile of the product. In pre-clinical animal studies, Chrysalin was also shown to double the rate of fracture healing with a single injection into the fresh fracture gap. The Company's agreement with Chrysalis contains provisions for the Company to continue and expand its option to license Chrysalin contingent upon regulatory approvals, successful pre-clinical trials, and certain milestone payments to Chrysalis by the Company. An additional $750,000 for the initial license was expensed in the third quarter. The agreement was extended to January 1999 to complete the evaluation of the Technology (Note 17). The Company will pursue commercialization of Chrysalis, initially seeking Food and Drug Administration (FDA) approval for the human clinical trials for the fracture-healing indication. The Company projects that Chrysalis could receive all the necessary FDA approvals and be introduced in the market during 2003. There can be no assurance, however, that the clinical trials will result in favorable data or that FDA approvals, if sought, will be obtained. Significant additional costs will be necessary to complete development of this product. 17.SUBSEQUENT EVENTS In January 1999, the Company exercised its option to license the U.S. development, marketing and distribution rights for Chrysalin, for fresh fracture indications. As part of the equity investment (Note 16), OrthoLogic acquired options to license Chrysalin for orthopedic applications. On February 9, 1999, the Company loaned $157,800 to an Officer of the Company. The note plus accrued interest is payable on June 15, 1999. Subsequent to the year-end, the Company settled a lawsuit related to the acquisition of DMTI and received approximately $100,000 of the amounts escrowed at the time of the acquisition. 24 Independent Auditors' Report BOARD OF DIRECTORS AND STOCKHOLDERS OrthoLogic Corp., Phoenix, Arizona We have audited the accompanying consolidated balance sheets of OrthoLogic Corp. and subsidiaries (the "Company") as of December 31, 1998 and 1997, and the related consolidated statements of operations, comprehensive income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 1998 and 1997, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. Deloitte & Touche LLP Phoenix, Arizona February 9, 1999 EX-11.1 3 COMPUTATION OF NET INCOME LOSS PER SHARE ORTHOLOGIC CORP. STATEMENT OF COMPUTATION OF NET INCOME (LOSS) PER WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING* (In thousands, except per share amounts)
Years Ended December 31, ------------------------ 1998 1997 1996 ---- ---- ---- Net income (loss) ............................... ($17,838) ($17,714) $ 2,538 ======== ======= ======= Common shares outstanding at end of period....... 25,302 25,255 25,022 Adjustment to reflect weighted average for shares issued during the period.................. (11) (139) (878) -------- -------- ------- Weighted average number of common shares outstanding...................................... 25,291 25,116 24,144 ======== ======= ======= Net income (loss) per weighted average number of common shares outstanding..................... ($.71) ($.71) $.11 ======== ======= =======
* Adjusted to reflect the Company's 2-for-1 stock split effected in the form of a 100% stock dividend in June 1996. EX-23.1 4 CONSENT OF DELOITTE & TOUCHE LLP EXHIBIT 23.1 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statements No. 33-79010, No. 333-1268, No. 333-09785, No. 333-35507 and No. 333-35505 of OrthoLogic Corp. on Form S-8 and Registration Statements No. 33-82050, No. 333-1558 and No. 333-62321 of OrthoLogic Corp. on Form S-3 of our reports dated February 9, 1999, appearing in and incorporated by reference in the Annual Report on Form 10-K of OrthoLogic Corp. for the year dated December 31, 1998. DELOITTE & TOUCHE LLP Phoenix, Arizona March 26, 1999 EX-27 5 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE FINANCIAL STATEMENTS IN ORTHOLOGIC CORP.'S REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1 U.S. DOLLAR 12-MOS DEC-31-1998 JAN-01-1998 DEC-31-1998 1 1713966 6052469 46348578 19317823 11960071 50199520 21961705 9094314 93979910 11382931 0 0 14176008 12649 68212130 93979910 66630892 75368217 17692630 74531896 0 0 101100 (16502690) 99804 0 0 0 0 (17838482) (0.71) (0.71)
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