-----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, RJ5EMfP/NBI2Qy9ZqH2A1xXKEAT/7Er4r3Tb3a//2lkaLS9uBk/3UgBfZhukm+Mu XqtYZbNa/6GFvC2Zu6y/VA== 0001047469-99-020684.txt : 19990517 0001047469-99-020684.hdr.sgml : 19990517 ACCESSION NUMBER: 0001047469-99-020684 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990331 FILED AS OF DATE: 19990514 FILER: COMPANY DATA: COMPANY CONFORMED NAME: GENERAL SURGICAL INNOVATIONS INC CENTRAL INDEX KEY: 0000890763 STANDARD INDUSTRIAL CLASSIFICATION: SURGICAL & MEDICAL INSTRUMENTS & APPARATUS [3841] IRS NUMBER: 973170244 STATE OF INCORPORATION: CA FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-28448 FILM NUMBER: 99624371 BUSINESS ADDRESS: STREET 1: 10460 BUBB RD CITY: CUPERTINO STATE: CA ZIP: 95014 BUSINESS PHONE: 4158129740 MAIL ADDRESS: STREET 1: 3172A PORTER DRIVE CITY: PALO ALTO STATE: CA ZIP: 94304 10-Q 1 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1999. Commission file number: 0-28448 GENERAL SURGICAL INNOVATIONS, INC. (Exact name of Registrant as specified in its charter) CALIFORNIA 94-3160456 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 10460 BUBB ROAD, CUPERTINO, CALIFORNIA 95014 (Address of principal executive offices) Registrant's telephone number, including area code: (408) 863-2500 Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO There were approximately 13,480,969 shares of Registrant's Common Stock issued and outstanding as of April 30, 1999. GENERAL SURGICAL INNOVATIONS, INC. QUARTERLY REPORT ON FORM 10-Q FOR THE THREE MONTHS ENDED MARCH 31, 1999
TABLE OF CONTENTS Page PART I. FINANCIAL INFORMATION Item 1. Condensed Financial Statements (Unaudited) Condensed balance sheets at March 31, 1999 and June 30, 1998.......................................................... 3 Condensed statements of operations and comprehensive loss for the three and nine months ended March 31, 1999 and March 31, 1998...... 4 Condensed statements of cash flows for the nine months ended March 31, 1999 and March 31, 1998.......................................... 5 Notes to condensed financial statements.................................... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ................................................. 7 Item 3. Quantitative and Qualitative Disclosures About Market Risk ................ 20 PART II. OTHER INFORMATION Item 1. Legal Proceedings.......................................................... 20 Item 2. Changes in Securities and Use of Proceeds.................................. 21 Item 3. Defaults Upon Senior Securities .......................................... 22 Item 4. Submission of Matters to a Vote of Security Holders........................ 22 Item 5. Other Information ......................................................... 22 Item 6. Exhibits and Reports on Form 8-K .......................................... 22
2 GENERAL SURGICAL INNOVATIONS, INC. CONDENSED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
March 31, June 30, 1999 1998 --------- --------- ASSETS Current assets: Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,991 $ 17,954 Available-for-sale securities . . . . . . . . . . . . . . . . . . . . . . . . 10,399 10,743 Accounts receivable, net. . . . . . . . . . . . . . . . . . . . . . . . . . . 1,238 1,043 Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,041 1,284 Prepaid expenses and other current assets . . . . . . . . . . . . . . . . . . 587 733 --------- --------- Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . 25,256 31,757 Available-for-sale securities, non-current.. . . . . . . . . . . . . . . . . . . 3,670 8,772 Property and equipment, net. . . . . . . . . . . . . . . . . . . . . . . . . . . 2,828 2,101 Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347 194 --------- --------- Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 32,101 $ 42,824 --------- --------- --------- --------- LIABILITIES Current liabilities: Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,261 $ 910 Accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,172 1,316 Capital leases. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 14 Bank borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 103 --------- --------- Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . . 4,529 2,343 Other long-term liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . 56 149 Capital leases, less current portion . . . . . . . . . . . . . . . . . . . . . . 1 12 Bank borrowings, less current portion. . . . . . . . . . . . . . . . . . . . . . 21 82 --------- --------- Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,607 2,586 --------- --------- Contingencies (Note 4) SHAREHOLDERS' EQUITY Preferred stock, $.001 par value . . . . . . . . . . . . . . . . . . . . . . . . - - Common stock, $.001 par value. . . . . . . . . . . . . . . . . . . . . . . . . . 13 13 Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,383 65,290 Notes receivable from shareholders . . . . . . . . . . . . . . . . . . . . . . . (85) (87) Deferred compensation, net . . . . . . . . . . . . . . . . . . . . . . . . . . . (56) (159) Accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . 35 16 Accumulated deficit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (37,796) (24,835) --------- --------- Total shareholders' equity . . . . . . . . . . . . . . . . . . . . . . . 27,494 40,238 --------- --------- Total liabilities and shareholders' equity . . . . . . . . . . . . . . $ 32,101 $ 42,824 --------- --------- --------- ---------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONDENSED FINANCIAL STATEMENTS. 3 GENERAL SURGICAL INNOVATIONS, INC. CONDENSED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED MARCH 31, MARCH 31, ---------------------- ----------------------- 1999 1998 1999 1998 -------- -------- --------- -------- Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,123 $ 894 $ 4,070 $ 3,869 Guaranteed payments. . . . . . . . . . . . . . . . . . . . . . . . . . . . - - - 1,635 -------- -------- --------- -------- Total revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,123 894 4,070 5,504 Cost of sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,329 602 3,144 2,744 -------- -------- --------- -------- Gross profit (loss) . . . . . . . . . . . . . . . . . . . . . . . . (206) 292 926 2,760 -------- -------- --------- -------- Operating expenses: Research and development. . . . . . . . . . . . . . . . . . . . . . . . 948 651 2,626 2,074 Sales and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . 1,829 1,297 4,983 3,591 General and administrative. . . . . . . . . . . . . . . . . . . . . . . 3,214 1,906 7,524 4,990 -------- -------- --------- -------- Total operating expenses. . . . . . . . . . . . . . . . . . . . . . . 5,991 3,854 15,133 10,655 -------- -------- --------- -------- Operating loss. . . . . . . . . . . . . . . . . . . . . . . . . . . (6,197) (3,562) (14,207) (7,895) Interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345 571 1,298 1,768 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4) (8) (14) (29) Other expense, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . (30) - (38) - -------- -------- --------- -------- Net loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,886) (2,999) (12,961) (6,156) Other comprehensive income (loss): Change in unrealized gain or loss on available-for-sale securities. . . (15) 18 19 51 -------- -------- --------- -------- Comprehensive loss. . . . . . . . . . . . . . . . . . . . . . . . . $ (5,901) $ (2,981) $ (12,942) $ (6,105) -------- -------- --------- -------- -------- -------- --------- -------- Net loss per common share and per common share-assuming dilution. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (0.44) $ (0.22) $ (0.96) $ (0.46) -------- -------- --------- -------- -------- -------- --------- -------- Shares used in computing net loss per common share and per common share-assuming dilution. . . . . . . . . . . . . . . . . . . . . 13,479 13,401 13,485 13,356 -------- -------- --------- -------- -------- -------- --------- --------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONDENSED FINANCIAL STATEMENTS. 4 GENERAL SURGICAL INNOVATIONS, INC. CONDENSED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
Nine Months Ended March 31, ----------------------- 1999 1998 -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss Adjustments to reconcile net loss to net cash used in operating activities:. . . $(12,961) $ (6,156) Amortization of deferred compensation . . . . . . . . . . . . . . . . . . . . 103 103 Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . 630 820 Provision for uncollectible accounts. . . . . . . . . . . . . . . . . . . . . 131 (1) Loss on write-off/sale of fixed assets. . . . . . . . . . . . . . . . . . . . 40 - Provision for excess and obsolete inventory . . . . . . . . . . . . . . . . . 284 10 Changes in operating assets and liabilities: Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . (326) 1,453 Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,041) 650 Prepaid expenses and other current assets . . . . . . . . . . . . . . . . 146 2 Other assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (207) (4) Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,351 141 Accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 763 (132) -------- -------- Net cash used in operating activities . . . . . . . . . . . . . . . . (12,087) (3,114) -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of available-for-sale securities . . . . . . . . . . . . . . . . . . . (3,811) (18,010) Proceeds from sales and maturities of available-for-sale securities. . . . . . . 9,200 32,292 Acquisition of property and equipment . . . . . . . (1,267) (384) -------- -------- Net cash provided by investing activities acactivitiactivities. . . . 4,122 13,898 -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock . . . . . . . . . . . . . . . . . . . . . 93 159 Proceeds from payment on notes receivable from shareholders. . . . . . . . . . . 2 - Payments on capital lease obligations. . . . . . . . . . . . . . . . . . . . . . (11) (12) Principal payments on bank borrowings. . . . . . . . . . . . . . . . . . . . . . (82) (125) -------- -------- Net cash provided by financing activities . . . . . . . . . . . . . . 2 22 -------- -------- Net increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . (7,963) 10,806 Cash and cash equivalents, beginning of period . . . . . . . . . . . . . . . . . 17,954 7,900 -------- -------- Cash and cash equivalents, end of period . . . . . . . . . . . . . . . . . . . . $ 9,991 $ 18,706 -------- -------- -------- --------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONDENSED FINANCIAL STATEMENTS. 5 GENERAL SURGICAL INNOVATIONS, INC. NOTES TO CONDENSED FINANCIAL STATEMENTS 1. Basis of Presentation: The accompanying unaudited condensed financial statements as of March 31, 1999 of General Surgical Innovations, Inc. (the "Company") have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended March 31, 1999 are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 1999, or any future interim period. These financial statements and notes should be read in conjunction with the Company's audited financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended June 30, 1998. 2. Computation of Net Loss per Common Share and per Common Share-Assuming Dilution: Net loss per common share and per common share-assuming dilution are computed using the weighted average number of shares of common stock outstanding. Common equivalent shares from stock options are excluded from the computation of net loss per common share-assuming dilution as their effect is antidilutive. Stock options to purchase 1,849,692 and 1,456,092 shares of common stock at prices ranging from $0.09 to $9.75 per share were outstanding at March 31, 1999 and March 31, 1998, respectively, but were not included in the computation of net loss per common share-assuming dilution because they were antidilutive. The aforementioned stock options could potentially dilute earnings per share in the future. 3. Inventories: Inventories comprise (IN THOUSANDS):
MARCH 31, JUNE 30, 1999 1998 ----------- ----------- (unaudited) Raw materials. . . . . . . . . . . . . . . . $ 1,731 $ 910 Work in progress . . . . . . . . . . . . . . 8 - Finished goods . . . . . . . . . . . . . . . 1,302 374 ----------- ----------- $ 3,041 $ 1,284 ----------- ----------- ----------- -----------
4. Contingencies: In May 1996, Origin Medsystems, Inc. ("Origin"), a unit of Guidant Corporation, filed suit against GSI for infringement of U.S. Patent No. 5,520,609 in the United States District Court for the Northern District of California. That suit was resolved in GSI's favor by judgment entered on May 15, 1998, finding Origin's patent unenforceable. Origin's appeal of that judgment is pending and is expected to be decided in 1999. The District Court has also awarded $990,000 in attorneys' fees to GSI and Origin has appealed that ruling as well. 6 In June 1996, GSI filed an action against Origin in the U.S. District Court for the Northern District of California alleging that the use of Origin's products infringes GSI's U.S. Patent No. 5,514,153. The court agreed with this allegation in a summary judgment ruling in GSI's favor. On February 8, 1999, a jury found the patent to be valid, that infringement was willful, and granted GSI approximately $12.9 million in damages. On April 14, 1999, the court entered judgment on the jury verdict, awarding $12.9 million in damages, and imposing a permanent injunction against sales of Origin's infringing products to take effect on November 15, 1999. Certain provisions in the injunction take place immediately. Origin has appealed the judgement, and GSI has filed a cross-appeal. These appeals are expected to be decided in 2000. A second action was filed by GSI similarly in September 1997, alleging that use of Origin's Vasoview product infringes U.S. Patent 5,667,520. Discovery is near completion in this case. GSI is also involved in an interference proceeding in the U.S. Patent Office to determine whether certain subject matter was first invented by GSI's named inventor. The priority portion of this interference has been decided in GSI's favor by an arbitrator to whom this issue was referred. The patentability portion of this interference was decided in GSI's favor by the United States Patent and Trademark Office ("PTO"). Origin has appealed the PTO's patentability decision, but could not appeal and has not appealed the arbitrator's priority decision. This appeal is also expected to be decided in 2000. In late April 1999, GSI was informed that Dr. Peter Bonutti and Bonutti Research, Inc., the assignor of several patents to GSI, had filed suit in the United States District Court for the Southern District of Illinois seeking 50% of the $12.9 million Origin damage award, rescission of the assignment agreement, and other related relief. GSI believes that the issues raised are arbitrable as provided in the assignment agreement between the parties and has filed an action in the Northern District of California in San Jose to compel arbitration. GSI intends to vigorously contest the claims made by Bonutti and Bonutti Research. From time to time the Company may be exposed to litigation arising out of its products or operations. The Company is not engaged in any legal proceedings that are expected, individually or in the aggregate, to have a material adverse effect on the Company, except for the patent interference and infringement proceedings discussed herein. No accrual for the above matters has been made in the accompanying financial statements as the ultimate outcomes of the litigation and dispute presently are not determinable. The litigation and dispute are subject to inherent uncertainties and thus, there can be no assurance that the litigation or dispute will be resolved favorably to the Company or that they will not have a material adverse effect on the Company's financial position or results of operation. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the unaudited financial statements and notes thereto included in Part I, Item I of this Quarterly Report and with Management's Discussion and Analysis of Financial Condition and Results of Operations contained in the Company's Annual Report on Form 10-K for the year ended June 30, 1998. References made in this Quarterly Report on Form 10-Q to "General Surgical Innovations, Inc.," the "Company" or the "Registrant" refer to General Surgical Innovations, Inc. The following General Surgical Innovations, Inc. trademarks are mentioned in this Quarterly Report: ENDOSAPH-Registered Trademark-, SPACEMAKER-Registered Trademark-, SAPHtrak-Registered Trademark-, registered trademarks of the Company; SPACEKEEPER-TM-, and Total Solution-TM-, trademarks of the Company. 7 OVERVIEW Since its inception in April 1992, GSI has been engaged in the development, manufacturing and marketing of balloon dissection systems and related minimally invasive surgical instruments. The Company began commercial sales of its balloon dissection systems for hernia repair in September 1993. To date, the Company has received from the FDA seven 510(k) clearances for use of the Company's technology to perform dissection of tissue planes anywhere in the body using a broad range of balloon sizes and shapes. The Company currently sells products in the United States, Europe, South America, and Australia for selected applications, such as hernia repair, subfascial endoscopic perforator surgery, saphenous vein harvesting and breast augmentation and reconstruction surgery. In December 1996, the Company entered into a five year OEM supply agreement (the "Expanded EES Agreement") with Ethicon Endo-Surgery, Inc. ("EES"), pursuant to which GSI granted EES worldwide sales and marketing rights to sell the SPACEMAKER-Registered Trademark- surgical balloon dissectors in the laparoscopic hernia repair and stress urinary incontinence ("SUI") markets. In February 1998, the Company and EES signed a non-exclusive distribution agreement for the laparoscopic hernia repair and SUI markets. This agreement supersedes the December 1996 Expanded EES Agreement. In September 1998, the Company signed two non-exclusive, three-year agreements with United States Surgical Corporation ("USSC"). Under the terms of the first agreement, USSC has obtained non-exclusive rights to market and distribute GSI's SPACEMAKER-Registered Trademark- surgical balloon dissectors worldwide for use in hernia repair and incontinence procedures. Under the terms of the second agreement, GSI has secured non-exclusive worldwide rights to market and distribute several products, including USSC's 5mm mesh fixation device, the ProTack-TM-, which is offered with GSI's balloon dissectors in the SPACEMAKER-Registered Trademark- Total Solution-TM- Hernia Repair Kit. In October 1998, GSI entered into non-exclusive agreements with seven leading surgical suppliers to distribute its SPACEMAKER-Registered Trademark- surgical balloon dissector kits used for hernia repair in the United States. In May 1999, the Company signed a distribution agreement with Dexterity Surgical, Inc. to distribute its hernia and SUI products in all or part of 28 states. Currently, domestic distribution of GSI's products is made through ten independent distributors covering 40 states for Subfascial Endoscopic Perforator Surgery ("SEPS") and saphenous vein harvest products, and ten independent distributors covering 43 states for hernia and SUI products. In addition, the Company currently has a direct sales force distributing products in the remaining portion of the United States, as well as managing distributor relationships. During the first nine months of fiscal 1999, the Company added nine direct sales personnel and realigned its regional distribution in the United States from one consisting primarily of third-party distributors to a combination of distributors and a GSI direct sales force. The Company believes this will create a more balanced approach to distribution. With respect to international sales, the Company has agreements with USSC and EES to distribute hernia repair and SUI products worldwide. GSI also sells its products in international markets through other distributors, which resell to surgeons and hospitals. At present, the Company has distribution agreements with 13 international distributors to distribute GSI's products and the Company has employees located in Europe to manage those distributors. To date, the majority of the sales to distributors and by the Company's direct sales force have been of products for use in hernia repair procedures. The Company's initial market focus was the application of its SPACEMAKER-Registered Trademark- balloon dissection technology for hernia repair. Subsequent to this, the Company has developed additional products for use in general surgery, as well as products for plastic surgery and cardiovascular applications. The Company has completed marketing-related clinical evaluations of, and has introduced products for, saphenous vein harvesting, SEPS, breast augmentation and reconstruction 8 procedures and SUI. The Company is currently conducting additional marketing-related clinical evaluations for products for use in other types of tissue dissection/expansion. While the Company has developed or is developing balloon dissection systems for stress urinary incontinence, vascular and plastic surgery, sales of products for hernia repair are expected to provide a majority of the Company's revenues at least through calendar 1999. The Company has acquired rights to a significant number of patents from third parties, including rights that apply to the Company's current balloon dissection systems. The Company has historically paid and is obligated to pay in the future to such third parties royalties equal to between one and four percent of sales of such products, which payments are expected to exceed certain minimum royalty payments due under the agreements with such parties. The payment of such royalty amounts will have an adverse impact on the Company's gross profit and results of operations. The Company has experienced significant operating losses since inception. The Company expects such operating losses to continue at least through calendar 1999. The Company's sales to date have consisted primarily of surgical balloon dissectors for hernia repair. In order to support increased levels of sales in the future and to augment its long-term competitive position, including the development of surgical balloon dissectors for other applications, the Company anticipates that it will be required to make significant additional expenditures in sales and marketing, and in research and development (including marketing-related clinical evaluations). The Company currently manufactures and ships product shortly after the receipt of orders, and anticipates that it will do so in the future. Accordingly, the Company has not developed a significant backlog and does not anticipate that it will develop a material backlog in the future. RESULTS OF OPERATIONS REVENUE. Total revenue increased by 26% to $1.1 million for the quarter ended March 31, 1999 from $894,000 million for the same period in 1998. Total revenue for the nine months ended March 31, 1999 decreased 26% to approximately $4.1 million from $5.5 million for the nine months ended March 31, 1998. Revenues for the nine months ended March 31, 1999 consisted entirely of product sales, while revenues for the nine months ended March 31, 1998 included $1.6 million in guaranteed payments from EES. The Company believes that its sales results will fluctuate from quarter to quarter during at least the next several quarters due to a number of factors including, but not limited to, the ability of the Company's distributors to effectively promote and sell the Company's products and the rate of adoption by surgeons of balloon dissection technology in markets targeted by the Company. COST OF SALES. Cost of sales increased by 121% to $1.3 million for the quarter ended March 31, 1999 from approximately $602,000 for the same period in 1998. As a percentage of product sales, cost of sales increased to 118% in the third quarter of fiscal 1999 from 67% in the third quarter of fiscal 1998. Cost of sales for the nine months ended March 31, 1999 increased as a percent of sales to 77%, or approximately $3.1 million, as compared to 50% of sales, or approximately $2.7 million, for the nine months ended March 31, 1998. This increase in cost of sales as a percentage of product sales was due to increasing sales of the SPACEMAKER-Registered Trademark- Total Solution-TM- Hernia Repair Kit, the cost of which is relatively high due to the inclusion of OEM products, as well as an increase in the reserve for obsolete inventory. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses, which include expenditures for marketing-related clinical evaluations and regulatory expenses, increased 46% to $948,000 in the quarter ended March 31, 1999 from $651,000 for the same period in 1998. R&D expenses for the nine months ended March 31, 1999 were approximately $2.6 million as compared to $2.1 million for the same period of the prior fiscal year, which represented a 27% increase. Increases were primarily related to general and vascular surgical product development expenditures. 9 SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses increased by 57% to approximately $5.0 million for the quarter ended March 31, 1999 from $3.2 million for the quarter ended March 31, 1998. For the nine months ended March 31, 1999, SG&A expenses were $12.5 million compared to $8.6 million for the same period in 1998. These increases are primarily due to increased legal expenses related to intellectual property litigation, as well as increased labor and labor related expenses as the Company expands its sales and marketing infrastructure. INTEREST INCOME, INTEREST EXPENSE, AND OTHER EXPENSE. Interest and other income (net of expense) decreased to $311,000 for the quarter ended March 31, 1999 from $563,000 for the quarter ended March 31, 1998. For the nine months ended March 31, 1999, interest and other income (net of expense) decreased to $1.2 million from $1.7 million for the same period in 1998. Decreases are due mainly to lower average cash, cash equivalents and available-for-sale securities balances. Interest earned in the future will depend on the Company's funding cycles and prevailing interest rates. LIQUIDITY AND CAPITAL RESOURCES Since inception, the Company's cash expenditures have significantly exceeded its sales, resulting in an accumulated deficit of approximately $37.8 million at March 31, 1999. The Company has funded its operations primarily through the sale of equity securities. From its inception through March 31, 1999 the Company raised approximately $15.5 million through the private placement of equity securities and approximately $46.9 million (net of underwriting discounts and commissions) in an initial public offering. As of March 31, 1999 the Company's principal source of liquidity consists of cash, cash equivalents and available-for-sale securities of $24.0 million. The Company expects to continue to incur costs over the next fiscal year, including costs related to increased sales and marketing activities, increased research and development, additional marketing-related clinical evaluations, and costs to defend its patent positions. The Company believes that its current cash balances and short-term investments along with cash generated from the future sales of products will be sufficient to meet the Company's operating and capital requirements through calendar year 2000. The Company may seek additional equity or debt financing to address its working capital needs or to provide funding for capital expenditures. There can be no assurance that additional financing, if sought, will be available on satisfactory terms or at all. YEAR 2000 COMPLIANCE The Year 2000 ("Y2K") issue arises from computer programs using two digits rather than four to define the applicable year. Such software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failures or miscalculations leading to disruptions or delays in the Company's activities and operations. If the Company, its key customers or suppliers fail to make necessary modifications to their information technology or non-information technology systems on a timely basis, the Y2K issue could have a material adverse effect on Company operations. However, the impact cannot be quantified at this time. 10 In January 1998, the Company began to evaluate and assess the Company's information technology and non-information technology systems for compliance with the Y2K issue. The Company is in the process of fixing or replacing noncompliant software and systems and intends to have this process completed by June 30, 1999, but there can be no assurance that such fixes or replacements will occur by such date. The Company is currently conducting testing and remediation activities on its systems, and intends to survey major customers and suppliers to assess their systems' compliance as well as their systems' compatibility with the Company's existing or projected compliant systems. There can be no assurance that there will not be an adverse material effect on the Company's business, financial condition or results of operations if the Company or its suppliers or customers do not convert or replace their systems in a timely manner to comply with the Y2K issue. The Company's costs related to the Y2K issue are funded through operating cash flows. Through March 31, 1999, the Company has expended approximately $20,000 in evaluating, planning and upgrading equipment. The Company estimates total costs to be between $25,000 and $35,000 for fixing and replacing noncompliant systems, including the cost of new software and modifying the applicable code of existing software. The Company currently believes that the total cost of achieving Y2K compliant systems will not be material to its business, financial condition or results of operations. In the event that the Company will be unable to achieve Y2K compliance in a timely manner with existing personnel, as a contingency the Company expects to hire outside Y2K solution providers to assist in achieving such compliance. There can be no assurance that such contingency plan will adequately address the Company's Y2K compliance issues. Time and cost estimates are based on currently available information. Factors that could affect these estimates include, but are not limited to, the availability and cost of trained personnel to evaluate and implement the changes, the ability to locate and correct all noncompliant systems, and the ability of the Company's customers and suppliers to successfully implement Y2K compliant systems or fixes. FACTORS AFFECTING FUTURE RESULTS The following discussion should be read in conjunction with the condensed financial statements and notes thereto included herein. The Company desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. Specifically, the Company wishes to alert readers that, except for the historical information contained in this Quarterly Report on Form 10-Q, the matters discussed herein are forward-looking statements that are subject to certain risks and uncertainties that could cause the actual results to differ materially from those projected. Factors that could cause actual results to differ materially include, but are not limited to, outcomes in litigation proceedings, market demand for the Company's products, the timing of orders and shipments, the timely development and market acceptance of new products and surgical procedures, the impact of performance of the Company's distributors, the Company's ability to further expand into international markets, public policy relating to health care reform in the United States and other countries, approval of its products by government agencies such as the United States Food and Drug Administration, and other risks detailed below and included from time to time in the Company's other SEC reports and press releases, copies of which are available from the Company upon request. The Company assumes no obligation to update any forward-looking statements contained herein. The factors listed below under "Factors Affecting Future Results," as well as other factors, have in the past affected, and could in the future affect, the Company's actual results and could cause the Company's results for future periods to differ materially from those expressed in any forward-looking statements contained in the following discussion. 11 HISTORY OF LOSSES AND ANTICIPATED FUTURE LOSSES. The Company has experienced significant operating losses since inception and as of March 31, 1999, the Company had an accumulated deficit of $37.8 million. The Company's net operating losses for the quarters ended March 31, 1999, December 31, 1998 and September 30, 1998 were $5.9 million, $4.5 million and $2.6 million, respectively. The Company expects to continue to incur operating losses on a quarterly and annual basis through at least calendar year 1999. There can be no assurance that the Company will ever generate substantial revenue or achieve profitability. Failure by the Company to generate substantial revenues would have a material adverse effect on the Company's business, financial condition and results of operations. DEPENDENCE UPON BALLOON DISSECTION PRODUCTS; RISK OF TECHNOLOGICAL OBSOLESCENCE. Nearly all of the Company's sales since inception have been derived from sales of its balloon dissection products, with a substantial portion derived from sales for hernia repair procedures. The success of the Company's products depends on the market acceptance of and demand for the Company's products and related procedures, the nature of the technological advances inherent in the product designs, reduction in patient trauma or other benefits provided by such products, continued adoption of minimally invasive surgery ("MIS") procedures by surgeons, reimbursement for the Company's products by health care payors and the Company's receipt of regulatory approvals. There can be no assurance that the Company's products will have the required technical characteristics, that the Company's products will provide adequate patient benefits, that marketing-related clinical evaluations results will be favorable, that surgeons will continue to adopt MIS procedures, that recently-introduced products or future products of the Company or related procedures will gain market acceptance, or that required regulatory approvals will be obtained. The failure to achieve any of the foregoing could have a material adverse effect on the Company's business, financial condition and results of operations. To the extent demand for the Company's surgical balloon dissectors for hernia repair declines and the Company's newly-introduced products are not commercially accepted or its existing products are not developed for new procedures, there could be a material adverse effect on the Company's business, financial condition and results of operations. DEPENDENCE ON KEY DISTRIBUTORS. In February 1998, the Company replaced its five-year OEM supply agreement with EES with a non-exclusive distribution agreement which granted EES worldwide sales and marketing rights to sell the SPACEMAKER-Registered Trademark- surgical balloon dissectors in the laparoscopic hernia repair and stress urinary incontinence ("SUI") markets. Unlike the prior EES OEM Agreement, this new EES non-exclusive agreement does not provide for any minimum payments from EES to the Company. In December 1997, the Company entered into a four-year distribution agreement with Genzyme Surgical Products Corporation ("Genzyme"). Under the agreement, Genzyme has exclusive rights to market and distribute GSI's surgical balloon dissectors worldwide for use in reconstructive and cosmetic plastic surgery procedures. In September 1998, the Company signed a non-exclusive, three-year agreement with United States Surgical Corporation ("USSC"). Under the terms of the agreement, USSC has obtained non-exclusive rights to market and distribute GSI's SPACEMAKER-Registered Trademark- surgical balloon dissectors worldwide for use in hernia repair and incontinence procedures. 12 LIMITED MARKETING AND DIRECT SALES EXPERIENCE. The Company has limited experience marketing and selling its products through its direct sales force, and has sold its products in commercial quantities through its direct sales force only to the hernia market and, to a lesser degree, to the vascular surgery markets. The Company intends to establish relationships with additional distribution partners, and there can be no assurance that the Company will be successful in establishing such relationships on commercially reasonable terms, if at all. The failure to establish and maintain an effective distribution channel for the Company's products, or establish and retain qualified and effective sales personnel to support commercial sales of the Company's products, could have a material adverse effect on the Company's business, financial condition and results of operations. UNCERTAINTY OF MARKET ACCEPTANCE; NO ASSURANCE OF CLINICAL ADVANTAGE. The Company's success is substantially dependent upon the success of its SPACEMAKER-Registered Trademark- balloon dissection products. The Company believes that market acceptance of the Company's products will depend on the adoption of laparoscopic techniques generally and the conversion of non-balloon dissection surgical techniques and treatments to balloon dissection techniques specifically. To date, the Company has limited long-term outcomes data regarding successful balloon dissection procedures. If the Company is not able to demonstrate consistent clinical benefits resulting from the use of its products (including reduced procedure time, reduced patient trauma and lower costs), the Company's business, financial condition and results of operations could be materially and adversely affected. The Company further believes that the ability of health care providers to obtain adequate reimbursement for procedures using the Company's SPACEMAKER-Registered Trademark- balloon dissection products and related instruments will be critical to market acceptance of the Company's products. Although the Company believes that procedures using its balloon dissection products currently may be reimbursed in the United States under certain existing procedure codes, there can be no assurance that such procedure codes will remain available or that reimbursement under these codes will be adequate. The Company has limited experience in obtaining third-party reimbursement, and the failure to obtain reimbursement for some or all of its products could have a material adverse effect on the Company's business, financial condition and results of operations. The Company introduced its surgical balloon dissectors in late 1993. To the extent that laparoscopic techniques are adopted slowly, that surgical balloon dissectors are not incorporated into laparoscopic techniques or that surgeons are unwilling or unable to develop the skills necessary to utilize surgical balloon dissectors, the Company's business, financial condition and results of operations could be materially adversely affected. FLUCTUATIONS IN QUARTERLY RESULTS. Results of the Company's operations may fluctuate significantly from quarter to quarter and will depend on numerous factors, including (i) fluctuations in purchases of the Company's products by its distributors, (ii) the ability of the Company's distributors to effectively promote and sell the Company's products, (iii) the rate of adoption by surgeons of balloon dissection technology in markets targeted by the Company, (iv) the mix of sales among distributors and the Company's direct sales force, (v) new product introductions by the Company and its competitors, (vi) fluctuations in revenues among different product lines and markets, (vii) timing of patent and regulatory approvals, if any, (viii) intellectual property litigation, (ix) timing and growth of operating expenses and (x) general market conditions. In December 1996, the Company entered into the Expanded Ethicon Agreement, pursuant to which EES made approximately $4.9 million in guaranteed payments to the Company in fiscal year 1997, which 13 constituted 54% of revenues for fiscal year 1997, and payments by mutual consent of $775,000 in the first quarter of fiscal year 1998 and $860,000 in the second quarter of fiscal 1998. The Company and EES entered into a nonexclusive distribution agreement for the laparoscopic hernia repair and stress urinary incontinence markets in February 1998, which supersedes the Expanded Ethicon Agreement and which does not include a provision for minimum quarterly payments. Sales to EES in the first nine months of fiscal year 1999 have decreased compared to sales for the similar period in fiscal year 1998, and the Company anticipates that sales to EES may decrease in the future. Failure by EES to achieve certain levels of sales growth or purchases could adversely affect the Company's operating results. In addition, in September 1998 the Company signed two non-exclusive, three-year distribution agreements with United States Surgical Corporation. Failure by the Company or USSC to achieve certain levels of sales growth or purchases could adversely affect the Company's operating results. In addition, announcements or expected announcements by the Company, its competitors or its distributors of new products, new technologies or pricing changes could cause existing or potential customers of the Company to defer purchases of the Company's existing products and could alter the mix of products purchased from the Company, which could have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that future products or product enhancements will be successfully introduced or that such introductions will not adversely affect the demand for existing products. As a result of these and other factors, the Company's quarterly operating results have fluctuated in the past, and the Company expects that such results may fluctuate in the future. Due to such quarterly fluctuations in operating results, quarter-to-quarter comparisons of the Company's operating results are not necessarily meaningful and should not be relied upon as indicators of likely future performance or annual operating results. RELIANCE ON PATENTS AND PROPRIETARY TECHNOLOGY. The Company's success will depend on its ability to obtain patent protection for its products and processes, to preserve its trade secrets and proprietary technology and to operate without infringing upon the patents or proprietary rights of third parties. In May 1996, Origin Medsystems, Inc. ("Origin"), a unit of Guidant Corporation, filed suit against GSI for infringement of U.S. Patent No. 5,520,609 in the United States District Court for the Northern District of California. That suit was resolved in GSI's favor by judgment entered on May 15, 1998, finding Origin's patent unenforceable. Origin's appeal of that judgment is pending and is expected to be decided in 1999. The District Court has also awarded $990,000 in attorneys' fees to GSI and Origin has appealed that ruling as well. In June 1996, GSI filed an action against Origin in the U.S. District Court for the Northern District of California alleging that the use of Origin's products infringes GSI's U.S. Patent No. 5,514,153. The court agreed with this allegation in a summary judgment ruling in GSI's favor. On February 8, 1999, a jury found the patent to be valid, that infringement was willful, and granted GSI approximately $12.9 million in damages. On April 14, 1999, the court entered judgment on the jury verdict, awarding $12.9 million in damages, and imposing a permanent injunction against sales of Origin's infringing products to take effect on November 15, 1999. Certain provisions in the injunction take place immediately. Origin has appealed the judgement, and GSI has filed a cross-appeal. These appeals are expected to be decided in 2000. A second action was filed by GSI similarly in September 1997, alleging that use of Origin's Vasoview product infringes U.S. Patent 5,667,520. Discovery is near completion in this case. GSI is also involved in an interference proceeding in the U.S. Patent Office to determine whether certain subject matter was first invented by GSI's named inventor. The priority portion of this interference has been decided in GSI's favor by an arbitrator to whom this issue was referred. The patentability portion of this interference was decided in GSI's favor by the United States Patent and Trademark Office ("PTO"). Origin has appealed the PTO's patentability decision, but could not appeal and has not appealed the arbitrator's priority decision. This appeal is also expected to be decided in 2000. 14 In late April 1999, GSI was informed that Dr. Peter Bonutti and Bonutti Research, Inc., the assignor of several patents to GSI, had filed suit in the United States District Court for the Southern District of Illinois seeking 50% of the $12.9 million Origin damage award, rescission of the assignment agreement, and other related relief. GSI believes that the issues raised are arbitrable as provided in the assignment agreement between the parties and has filed an action in the Northern District of California in San Jose to compel arbitration. GSI intends to vigorously contest the claims made by Bonutti and Bonutti Research. From time to time the Company may be exposed to litigation arising out of its products or operations. The Company is not engaged in any legal proceedings that are expected, individually or in the aggregate, to have a material adverse effect on the Company, except for the patent interference and infringement proceedings discussed herein. Patent interference or infringement involves complex legal and factual issues and is highly uncertain, and there can be no assurance that any conclusion reached by the Company regarding patent interference or infringement will be consistent with the resolution of such issue by a court. In the event the Company's products are found to infringe patents held by competitors, there can be no assurance that the Company will be able to modify successfully its products to avoid infringement, or that any modified products will be commercially successful. Failure in such event to either develop a commercially successful alternative or obtain a license to such patent on commercially reasonable terms would have a material adverse effect on the Company's business, financial condition and results of operations. As discussed above, the Company is defending itself, and may in the future have to defend itself, in court against allegations of infringement of third-party patents. Patent litigation is expensive, requires extensive management time, and could subject the Company to significant liabilities, require disputed rights to be licensed from third parties or require the Company to cease selling its products. The validity and breadth of claims in medical technology patents involve complex legal and factual questions and, therefore, may be highly uncertain. No assurance can be given that any patents based on pending patent applications or any future patent applications will be issued, that the scope of any patent protection will exclude competitors or provide competitive advantages to the Company, that any of the Company's patents or patents to which it has licensed rights will be held valid under current challenges or if subsequently challenged or that persons or entities in addition to Origin will not claim rights in or ownership of the patents and other proprietary rights held or licensed by the Company or that the Company's existing patents will cover the Company's future products. Furthermore, there can be no assurance that others have not developed or will not develop similar products, duplicate any of the Company's products or design around any patents issued to or licensed by the Company or that may be issued in the future to the Company. Since patent applications in the United States are maintained in secrecy until patents issue, the Company also cannot be certain that others did not first file applications for inventions covered by the Company's pending patent applications, nor can the Company be certain that it will not infringe any patents that may issue to others on such applications. The patent laws of European and certain other foreign countries generally do not allow for the issuance of patents for methods of surgery on the human body. Accordingly, the ability of the Company to gain patent protection for its methods of tissue dissection will be significantly limited. As a result, there can be no assurance that the Company will be able to develop a patent portfolio in Europe or that the scope of any patent protection will provide competitive advantages to the Company. 15 ROYALTY PAYMENT OBLIGATIONS. The Company has acquired rights to patents from third parties, including rights that apply to the Company's current surgical balloon dissectors. The Company has historically paid and is obligated to pay in the future to such third parties royalties equal to between one and four percent of sales of such products, which payments are expected to exceed minimum royalty payments due under agreements with such parties. The payment of such royalty amounts will have an adverse impact on the Company's gross profit and other results of operations. There can be no assurance that the Company will be able to continue to satisfy such royalty payment obligations in the future, and a failure to do so could have a material adverse effect on the Company's business, financial condition and results of operations. COMPETITION; UNCERTAINTY OF TECHNOLOGICAL CHANGE. Competition in the market for medical devices used in tissue dissection surgical procedures is intense and is expected to increase. The Company competes primarily with other producers of MIS tissue dissection instruments. Origin, a subsidiary of Guidant Corporation, currently competes with the Company in the marketing of MIS tissue dissection instruments and will continue to do so through at least November 15, 1999 pending the outcome of current litigation. Other companies currently compete against the Company in the development, production and marketing of MIS tissue dissection instruments and technology. To the extent that surgeons elect to use open surgical procedures rather than MIS, the Company also competes with producers of tissue dissection instruments used in open surgical procedures, such as blunt dissectors or graspers. A number of companies currently compete against the Company in the development, production and marketing of tissue dissection instruments and technology for open surgical procedures. In addition, the Company indirectly competes with producers of therapeutic drugs, when such drugs are used as an alternative to surgery. Many of the Company's competitors have substantially greater capital resources, name recognition, expertise in research and development, manufacturing and marketing and obtaining regulatory approvals. There can be no assurance that the Company's competitors will not succeed in developing surgical balloon dissectors or competing technologies that are more effective than products marketed by the Company or that render the Company's technology obsolete. Additionally, even if the Company's products provide performance comparable to competing products or procedures, there can be no assurance that the Company will be able to obtain necessary regulatory approvals or compete against competitors in terms of price, manufacturing, marketing and sales. Many of the alternative treatments for medical indications that can be treated by surgical balloon dissectors and laparoscopic surgery are widely accepted in the medical community and have a long history of use. In addition, technological advances with other therapies could make such other therapies more effective or cost-effective than surgical balloon dissectors and minimally invasive surgery, and could render the Company's technology non-competitive or obsolete. There can be no assurance that surgeons will use MIS to replace or supplement established treatments or that MIS will remain competitive with current or future treatments. The failure of surgeons to adopt MIS could have a material adverse effect on the Company's business, financial condition and results of operations. In addition to the Company's development of its surgical balloon dissectors, the Company has also developed surgical instruments for use in MIS. There can be no assurance that the Company's surgical instruments will successfully compete with those manufactured by other producers of such surgical instruments. The failure to achieve commercial market acceptance of such surgical instruments could have a material adverse effect on the Company's business, financial condition and results of operations. UNCERTAIN AVAILABILITY OF THIRD-PARTY REIMBURSEMENT. The Company's success will depend upon the ability of surgeons to obtain satisfactory reimbursement from healthcare payors for the Company's products. In the United States, hospitals, physicians and other healthcare providers that purchase medical devices generally rely on third-party payors, such as private health insurance plans, to reimburse all or part of the costs associated with the treatment of patients. Reimbursement in the United States for the Company's balloon dissection products is currently available from most third-party payors, including most major private health care insurance plans and Medicaid, under existing surgical procedure codes. The Company does not expect that third-party 16 reimbursement in the United States will be available for use of some of its other products unless and until clearance or approval is received from the federal Food and Drug Administration (the "FDA"). If FDA clearance or approval is received, third-party reimbursement for these products will depend upon decisions by individual health maintenance organizations, private insurers and other payors. Many payors, including the federal Medicare program, pay a preset amount for the surgical facility component of a surgical procedure. This amount typically includes medical devices such as the Company's. Thus, the surgical facility or surgeon may not recover the added cost of the Company's products. In addition, managed care payors often limit coverage to surgical devices on a preapproved list or obtained from an exclusive source. If the Company's products are not on the list or are not available from the exclusive source, the facility or surgeon will need to obtain an exception from the payor or the patient will be required to pay for some or all of the cost of the Company's product. The Company believes that procedures using its balloon dissection products currently may be reimbursed in the United States under certain existing procedure codes. However, there can be no assurance that such procedure codes will remain available or that the reimbursement under these codes will be adequate. Given the efforts to control and decrease health care costs in recent years, there can be no assurance that any reimbursement will be sufficient to permit the Company to increase revenues or achieve or maintain profitability. The unavailability of third-party or other adequate reimbursement could have a material adverse effect on the Company's business, financial condition and results of operations. Reimbursement systems in international markets vary significantly by country, and by region within some countries, and reimbursement approvals must be obtained on a country-by-country basis. Many international markets have government-managed health care systems that govern reimbursement for new devices and procedures. In most markets, there are private insurance systems as well as government-managed systems. Large-scale market acceptance of the Company's surgical balloon dissectors and other products will depend on the availability and level of reimbursement in international markets targeted by the Company. Currently, the Company has been informed by its international distributors that the surgical balloon dissectors have been approved for reimbursement in many of the countries in which the Company markets its products. Obtaining reimbursement approvals can require 12 to 18 months or longer. There can be no assurance that the Company will obtain reimbursement in any country within a particular time, for a particular amount, or at all. Failure to obtain such approvals could have a material adverse effect on the Company's business, financial condition and results of operations. Regardless of the type of reimbursement system, the Company believes that surgeon advocacy of its products will be required to obtain reimbursement. Availability of reimbursement will depend on the clinical efficacy of the procedure and the utility and cost of the Company's products. There can be no assurance that surgeons will support and advocate reimbursement for use of the Company's systems for all applications intended by the Company. Failure by surgeons, hospitals and other users of the Company's products to obtain sufficient reimbursement from health care payors or adverse changes in government and private third-party payors' policies toward reimbursement for procedures employing the Company's products could have a material adverse effect on the Company's business, financial condition and results of operations. GOVERNMENT REGULATION. The Company's SPACEMAKER-Registered Trademark- surgical balloon dissectors and other products are subject to extensive and rigorous regulation by the FDA and, to varying degrees, by state and foreign regulatory agencies. Under the federal Food, Drug, and Cosmetic Act, the FDA regulates the clinical testing, manufacture, labeling, packaging, marketing, distribution and record keeping for medical devices, in order to ensure that medical devices distributed in the United States are safe and effective for their intended use. Prior to commercialization, a medical device generally must receive FDA and foreign regulatory clearance or approval, which can be an expensive, lengthy and uncertain process. The Company is also subject to routine inspection by the FDA and state agencies, such as the California Department of Health Services ("CDHS"), for 17 compliance with Good Manufacturing Practice requirements, Medical Device Reporting requirements and other applicable regulations. Noncompliance with applicable requirements can result in warning letters, import detentions, fines, civil penalties, injunctions, suspensions or losses of regulatory approvals, recall or seizure of products, operating restrictions, refusal of the government to approve product export applications or allow the Company to enter into supply contracts, and criminal prosecution. Delays in receipt of, or failure to obtain, regulatory clearances and approvals, if obtained, or any failure to comply with regulatory requirements could have a material adverse effect on the Company's business, financial condition and results of operations. Labeling and promotional activities are subject to scrutiny by the FDA and, in certain circumstances, by the Federal Trade Commission. Current FDA enforcement policy prohibits the marketing of approved medical devices for unapproved uses. The SPACEMAKER-Registered Trademark- I platform, SPACEMAKER-Registered Trademark- II platform, SPACEMAKER-Registered Trademark- Plastics platform, SPACEMAKER-Registered Trademark- SAPHtrak-Registered Trademark- platform and KnotMaker-TM- product each have received 510(k) clearance for use during general, endoscopic, laparoscopic or cosmetic and reconstructive surgery, and certain vascular surgery (including saphenous vein procedures) when tissue dissection is required. The Company has promoted these products for surgical applications (E.G., hernia repair, subfascial endoscopic perforator surgery, breast augmentation and reconstruction, treatment of stress urinary incontinence and saphenous vein harvesting), and may in the future promote these products for the dissection required for additional selected applications (E.G. tissue dissection/expansion and a variety of orthopedic procedures such as anterior spinal fusion and long-bone plating). For any medical device cleared through the 510(k) process, modifications or enhancements that could significantly affect the safety or effectiveness of the device or that constitute a major change to the intended use of the device will require a new 510(k) submission. The Company has made modifications to its products which the Company believes do not affect the safety or effectiveness of the device or constitute a major change to the intended use and therefore do not require the submission of new 510(k) notices. There can be no assurance, however, that the FDA will agree with any of the Company's determinations not to submit a new 510(k) notice for any of these changes or will not require the Company to submit a new 510(k) notice for any of the changes made to the product. If such additional 510(k) clearances are required, there can be no assurance that the Company will obtain them on a timely basis, if at all, and delays in receipt of or failure to receive such approvals could have a material adverse effect on the Company's business, financial condition and results of operations. If the FDA requires the Company to submit a new 510(k) notice for any product modification, the Company may be prohibited from marketing the modified product until the 510(k) notice is cleared by the FDA. Sales of medical devices outside of the United States are subject to foreign regulatory requirements that vary widely from country to country. The Company currently relies on its international distributors for the receipt of premarket approvals and compliance with clinical trial requirements in those countries that require them, and it expects to continue to rely on distributors in those countries where the Company continues to use distributors. In the event that the Company's international distributors fail to obtain or maintain premarket approvals or compliance in foreign countries where such approvals or compliance are required, the Company may be required to cause the applicable distributor to file revised governmental notifications, cease commercial sales of its products in the applicable countries or otherwise act so as to stop any ongoing noncompliance in such countries. Any enforcement action by regulatory authorities with respect to past or any future regulatory noncompliance could have a material adverse effect on the Company's business, financial condition and results of operations. LIMITED COMMERCIAL MANUFACTURING EXPERIENCE. The Company has only limited experience in manufacturing its products in commercial quantities. Manufacturers often encounter difficulties in scaling up for commercial production of new products, including problems involving production yields, quality control and assurance, component supply and shortages of qualified personnel. Difficulties experienced by the 18 Company in manufacturing scale-up and manufacturing difficulties could have a material adverse effect on its business, financial condition and results of operations. There can be no assurance that the Company will be successful in scaling up or that it will not experience manufacturing difficulties or product recalls in the future. DEPENDENCE ON SINGLE SOURCE SUPPLIERS; LACK OF CONTRACTUAL ARRANGEMENTS. The Company currently relies upon single source suppliers for several components of its balloon dissection products, and in most cases there are no formal contracts with such suppliers. There can be no assurance that the component materials obtained from single source suppliers will continue to be available in adequate quantities or, if required, that the Company will be able to locate alternative sources of such component materials on a timely basis to market its products, if at all. In addition, there can be no assurance that the single source suppliers will meet the Company's future requirements for timely delivery of products of sufficient quality and quantity. The failure to obtain sufficient quantities and qualities of such component materials, or the loss of any of the Company's single source suppliers, could cause a delay in GSI's ability to fulfill orders while it attempts to identify and certify a replacement supplier, if any, and could have a material adverse effect on the Company's business, financial condition and results of operations. PRODUCT LIABILITY RISK AND PRODUCT RECALL; LIMITED INSURANCE COVERAGE. The Company's business exposes it to potential product liability risks or product recalls that are inherent in the design, development, manufacture and marketing of medical devices, in the event the use of the Company's products cause or are alleged to have caused adverse effects on a patient or such products are believed to be defective. The Company's products are designed to be used in certain procedures where there is a high risk of serious injury or death. Such risks will exist even with respect to those products that have received, or may in the future receive, regulatory clearance for commercial sale. As a result, there can be no assurance that the Company's product liability insurance is adequate or that such insurance coverage will continue to be available on commercially reasonable terms or at all. Particularly given the lack of data regarding the long-term results of the use of balloon dissection products, there can be no assurance the Company will avoid significant product liability claims. Consequently, a product liability claim or other claim with respect to uninsured or underinsured liabilities could have a material adverse effect on the Company's business, financial condition and results of operations. DEPENDENCE ON MANAGEMENT AND OTHER KEY PERSONNEL. The Company is dependent upon a limited number of key management and technical personnel. The loss of the services of one or more of such key employees could have a material adverse effect on the Company's business, financial condition, and results of operations. In addition, the Company's success will be dependent upon its ability to attract and retain additional highly qualified sales, management, manufacturing and research and development personnel. The Company faces intense competition in its recruiting activities and there can be no assurance that the Company will be able to attract and/or retain qualified personnel. POTENTIAL VOLATILITY OF STOCK PRICE. The market prices of the Company's common stock and the stock of many other publicly held medical device companies have in the past been, and can in the future be expected to be, especially volatile. Announcements regarding competitive developments, product sales, clinical marketing trial results, release of reports by securities analysts, developments or disputes concerning patents or proprietary rights, regulatory developments, changes in regulatory or medical reimbursement policies, economic and other external factors, as well as period-to-period fluctuations in the Company's financial results, may have a significant impact on the market price of the common stock. In addition, the securities markets have from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. 19 YEAR 2000 COMPLIANCE. The Year 2000 ("Y2K") issue arises from computer programs using two digits rather than four to define the applicable year. Such software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failures or miscalculations leading to disruptions or delays in the Company's activities and operations. If the Company, its key customers or suppliers fail to make necessary modifications to their information technology or non-information technology systems on a timely basis, the Y2K issue could have a material adverse effect on Company operations. However, the impact cannot be quantified at this time. In January 1998 the Company began to evaluate and assess the Company's information technology and non-information technology systems for compliance with the Y2K issue. The Company is in the process of fixing or replacing noncompliant software and systems and intends to have this process completed by June 30, 1999, but there can be no assurance that such fixes or replacements will occur by such date. The Company is currently conducting testing and remediation activities on its systems, and intends to survey major customers and suppliers to assess their systems' compliance as well as their systems' compatibility with the Company's existing or projected compliant systems. There can be no assurance that there will not be an adverse material effect on the Company's business, financial condition or results of operations if the Company or its suppliers or customers do not convert or replace their systems in a timely manner to comply with the Y2K issue. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Year 2000 Compliance." RECENT PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131 ("SFAS 131"), "Disclosures about Segments of an Enterprise and Related Information." This statement establishes standards for disclosure about operating segments in annual financial statements and selected information in interim financial reports. It also establishes standards for related disclosures about products and services, geographic areas and major customers. This statement supersedes Statement of Financial Accounting Standards No. 14, "Financial Reporting for Segments of a Business Enterprise." The new standard becomes effective for fiscal years beginning after December 15, 1997, and requires that comparative information from earlier years be restated to conform to the requirements of this standard. The Company is evaluating the requirements of SFAS 131 and the effects, if any, on the Company's current reporting and disclosures. In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which establishes accounting and reporting standards for derivative instruments and hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. To date, the Company has not engaged in derivative and hedging activities. The Company will adopt SFAS No. 133 as required for fiscal year 2000. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's exposure to market risk for changes in interest rates relates primarily to its investment portfolio and bank borrowings. The Company does not use derivative financial instruments in its investment portfolio, and its investment portfolio only includes highly liquid instruments with original maturity dates ranging between April 30, 1999 and October 30, 2000. The Company has primarily entered into debt obligations for capital expenditures. The Company is subject to fluctuating interest rates that may impact, adversely or otherwise, its results of operations or cash flows for our variable rate bank borrowings, available-for-sale securities and cash and cash equivalents. The table below presents principal amounts and related weighted average interest rates by period of maturity for our investment portfolio and debt obligations:
Three Months Twelve Months Twelve Months Ending Ending Ending June 30, 1999 June 30, 2000 June 30, 2001 Total ------------- ------------- ------------- ---------- Assets Cash and cash equivalents $ 9,991 - - $ 9,991 Average interest rate 4.91% - - 4.91% Available-for-sale securities $ 4,307 $ 8,751 $ 1,011 $14,069 Average interest rate 5.97% 6.05% 5.46% 5.98% Liabilities Bank borrowings (including current portion) $ 20 $ 83 - $ 103 Average interest rate 9.0% 9.0% - 9.0%
The estimated fair value of the Company's cash and cash equivalents approximates the principal amounts reflected above based on the short maturities of these financial instruments. The estimated fair value of the Company's debt obligations approximates the principal amounts reflected above based on rates currently available for debt with similar terms and remaining maturities. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS 20 In May 1996, Origin Medsystems, Inc. ("Origin"), a unit of Guidant Corporation, filed suit against GSI for infringement of U.S. Patent No. 5,520,609 in the United States District Court for the Northern District of California. That suit was resolved in GSI's favor by judgment entered on May 15, 1998, finding Origin's patent unenforceable. Origin's appeal of that judgment is pending and is expected to be decided in 1999. The District Court has also awarded $990,000 in attorneys' fees to GSI and Origin has appealed that ruling as well. In June 1996, GSI filed an action against Origin in the U.S. District Court for the Northern District of California alleging that the use of Origin's products infringes GSI's U.S. Patent No. 5,514,153. The court agreed with this allegation in a summary judgment ruling in GSI's favor. On February 8, 1999, a jury found the patent to be valid, that infringement was willful, and granted GSI approximately $12.9 million in damages. On April 14, 1999, the court entered judgment on the jury verdict, awarding $12.9 million in damages, and imposing a permanent injunction against sales of Origin's infringing products to take effect on November 15, 1999. Certain provisions in the injunction take place immediately. Origin has appealed the judgement, and GSI has filed a cross-appeal. These appeals are expected to be decided in 2000. A second action was filed by GSI similarly in September 1997, alleging that use of Origin's Vasoview product infringes U.S. Patent 5,667,520. Discovery is near completion in this case. GSI is also involved in an interference proceeding in the U.S. Patent Office to determine whether certain subject matter was first invented by GSI's named inventor. The priority portion of this interference has been decided in GSI's favor by an arbitrator to whom this issue was referred. The patentability portion of this interference was decided in GSI's favor by the United States Patent and Trademark Office ("PTO"). Origin is expected to appeal the PTO's decision, but could not appeal and has not appealed the arbitrator's priority decision. This appeal is also expected to be decided in 2000. In late April 1999, GSI was informed that Dr. Peter Bonutti and Bonutti Research, Inc., the assignor of several patents to GSI, has filed suit in the United States Dsitrict Court for the Southern District of Illinois seeking 50% of the $12.9 million Origin damage award, rescission of the assignment agreement, and other related relief. GSI believes that the issues raised are arbitrable as provided in the assignment agreement between the parties and has filed an action in the Northern District of California in San Jose to compel arbitration. GSI intends to vigorously contest the claims made by Bonutti and Bonutti Research. From time to time the Company may be exposed to litigation arising out of its products or operations. The Company is not engaged in any legal proceedings that are expected, individually or in the aggregate, to have a material adverse effect on the Company, except for the patent interference and infringement proceedings discussed herein. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS In connection with its initial public offering in 1996, the Company filed a Registration Statement on Form S-1, SEC File No. 333-2774 (the "REGISTRATION STATEMENT"), which was declared effective by the Commission on May 9, 1996. Pursuant to the Registration Statement, the Company registered and sold 3,450,000 shares of its Common Stock, $0.001 par value per share, for its own account. The offering commenced on May 10, 1996 and terminated when all of the registered shares had been sold. The aggregate offering price of the registered shares was $51,750,000. The managing underwriters of the offering were Cowen & Company and UBS Securities LLC. 21 From May 10, 1996 to March 31, 1999, the Company incurred the following expenses in connection with the offering: Underwriting discounts and commissions..... $3,622,500 Other expenses............................. $1,187,025 ---------- Total Expenses........................ $4,809,525
All of such expenses were direct or indirect payments to others. The net offering proceeds to the Company after deducting the total expenses above were $46,940,475. From May 10, 1996 to March 31, 1999, the Company used such net offering proceeds, in direct or indirect payments to others, as follows: Construction of plant, building and facilities.......... $ 1,232,949 Purchase and installment of machinery and equipment..... $ 2,542,634 Repayment of indebtedness............................... $ 922,742 Working capital......................................... $ 36,521,864 ------------ Total......................................... $ 41,220,189
This use of proceeds does not represent a material change in the use of proceeds described in the prospectus of the Registration Statement. ITEM 3. DEFUALTS IN SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits EXHIBIT DESCRIPTION 27.1 Financial Data Schedule. (b) Reports on Form 8-K The Company filed no reports on Form 8-K during the quarter ended March 31, 1999. 22 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. GENERAL SURGICAL INNOVATIONS, INC. By: /s/ STEPHEN J. BONELLI ------------------------------- Stephen J. Bonelli Chief Financial Officer, Vice President of Finance and Administration, Treasurer Date: May 14, 1999 23 EX-27.1 2 EX-27.1
5 0000890763 GENERAL SURGICAL INNOVATIONS, INC. 9-MOS JUN-30-1999 JUL-01-1998 MAR-31-1999 9,991 14,069 1,609 371 3,041 25,256 4,551 1,723 32,101 4,529 0 0 0 13 27,481 32,101 4,070 4,070 (3,144) (3,144) (15,133) 0 (14) (12,961) 0 (12,961) 0 0 0 (12,961) (.96) (.96)
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