10-Q 1 a2049462z10-q.txt 10Q 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, 2001 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO COMMISSION FILE NUMBER 000-21326 ----------- Anika Therapeutics, Inc. (Exact Name of Registrant as Specified in Its Charter) MASSACHUSETTS 04-3145961 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 236 WEST CUMMINGS PARK, WOBURN, MASSACHUSETTS 01801 (Address of Principal Executive Offices) (Zip Code) ----------- REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (781) 932-6616 Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report. Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the last 90 days. Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the last practicable date. At May 7, 2001 there were issued and outstanding 9,934,280 shares of Common Stock, par value $.01 per share. PART I: FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS ANIKA THERAPEUTICS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Unaudited)
MARCH 31, DECEMBER 31, 2001 2000 ----------- ------------ ASSETS Current assets: Cash and cash equivalents $ 6,386,749 $ 8,265,936 Short term marketable securities 10,420,246 10,039,849 Accounts receivable, net of reserves of $124,000 1,251,612 1,692,457 Inventories 4,776,952 4,737,645 Prepaid expenses and other receivables 457,447 612,890 ----------- ----------- Total current assets 23,293,006 25,348,777 Property and equipment, at cost 8,755,940 8,621,579 Less: accumulated depreciation (5,722,717) (5,498,455) ----------- ----------- 3,033,223 3,123,124 Long term deposits 123,765 124,600 Notes receivable from officers 382,000 382,000 ----------- ----------- Total assets $26,831,994 $28,978,501 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 773,821 $ 870,502 Accrued expenses 1,590,917 1,395,677 ----------- ----------- Total current liabilities 2,364,738 2,266,179 Commitments and contingencies (Note 9) Stockholders' equity: Redeemable convertible preferred stock, $.01 par value authorized 750,000 shares, no shares issued and outstanding -- -- Undesignated preferred stock, $.01 par value authorized 1,250,000 shares, no shares issued and outstanding -- -- Common stock, $.01 par value: Authorized 30,000,000 shares; Issued 9,991,943 shares 99,919 99,919 Additional paid-in capital 31,735,660 31,735,660 Treasury stock (at cost, 57,663 shares) (279,756) (279,756) Deferred compensation (171,184) (244,549) Accumulated deficit (6,917,383) (4,598,952) ----------- ----------- Total stockholders' equity 24,467,256 26,712,322 ----------- ----------- Total liabilities and stockholders' equity $26,831,994 $28,978,501 =========== ===========
The accompanying notes are an integral part of these consolidated financial statements. 2 ANIKA THERAPEUTICS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, (UNAUDITED)
2001 2000 ----------- ---------- Product revenue $ 2,178,617 $2,620,833 Licensing revenue -- 100,000 ----------- ---------- Total revenue 2,178,617 2,720,833 Cost of product revenue 1,968,948 1,232,968 ----------- ---------- Gross profit 209,669 1,487,865 Operating expenses: Research & development 1,347,870 1,313,738 Selling, general & administrative 1,452,810 999,462 ----------- ---------- Total operating expenses 2,800,680 2,313,200 Loss from operations (2,591,011) (825,335) Interest income 272,580 261,248 ----------- ---------- Loss before provision for income taxes (2,318,431) (564,087) Provision for income taxes -- -- ----------- ---------- Net loss $(2,318,431) $ (564,087) =========== ========== ----------- ---------- Basic and diluted loss per share $ (0.23) $ (0.06) =========== ========== Shares used for computing basic and diluted earnings per share 9,934,280 9,804,284 =========== ==========
The accompanying notes are an integral part of these consolidated financial statements. 3 ANIKA THERAPEUTICS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED MARCH 31, (UNAUDITED)
2001 2000 --------------- ---------------- Cash flows from operating activities: Net loss $(2,318,431) $ (564,087) Adjustments to reconcile net loss to net cash used for operating activities: Depreciation and amortization 224,262 214,529 Amortization of deferred compensation 73,366 77,842 Changes in operating assets and liabilities: Accounts receivable 440,844 294,525 Inventories (39,307) (1,299,293) Prepaid expenses 155,443 246,024 Accounts payable (96,681) (207,668) Accrued expenses 195,240 202,418 Deferred revenue -- 540,735 ----------- ----------- Net cash used for operating activities (1,365,264) (494,975) ----------- ----------- Cash flows from investing activities: Proceeds of short-term marketable securities 7,039,849 3,025,324 Purchase of short term marketable securities (7,420,246) -- Purchase of property and equipment (134,361) (90,957) Notes receivable from officers -- 59,000 Deposits 835 -- Purchase of long term marketable securities -- (88,436) ----------- ----------- Net cash (used for) provided by investing activities (513,923) 2,904,931 ----------- ----------- Cash flows from financing activities: Proceeds from exercise of stock options and warrants -- 95,650 ----------- ----------- Net cash provided by financing activities -- 95,650 ----------- ----------- Increase (decrease) in cash and cash equivalents (1,879,187) 2,505,606 Cash and cash equivalents at beginning of period 8,265,936 6,440,705 ----------- ----------- Cash and cash equivalents at end of period $ 6,386,749 $ 8,946,311 =========== ===========
The accompanying notes are an integral part of these consolidated financial statements. 4 ANIKA THERAPEUTICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF BUSINESS Anika Therapeutics, Inc. ("Anika" or the "Company") develops, manufactures and commercializes therapeutic products and devices intended to promote the protection and healing of bone, cartilage and soft tissue. These products are based on hyaluronic acid ("HA"), a naturally occurring, biocompatible polymer found throughout the body. Due to its unique biophysical and biochemical properties, HA plays an important role in a number of physiological functions such as the protection and lubrication of soft tissues and joints, the maintenance of the structural integrity of tissues, and the transport of molecules to and within cells. The Company's currently marketed products consist of ORTHOVISC(R), which is an HA product used in the treatment of some forms of osteoarthritis in humans and HYVISC(R), which is an HA product used in the treatment of equine osteoarthritis. ORTHOVISC(R) is currently approved for sale and is being marketed in Canada, parts of Europe, Turkey, and Israel. In the U.S., ORTHOVISC(R) is currently limited to investigational use. The Company manufactures AMVISC(R) and AMVISC(R) Plus for Bausch & Lomb Surgical, which are HA products used as viscoelastic supplements in ophthalmic surgery. STAARVISC(R)II, an injectable ophthalmic viscoelastic is produced for STAAR Surgical Company. The Company is currently evaluating product development activities for INCERT(R)-S, which is an HA based product designed for use in the prevention of post-surgical adhesions. In collaboration with Orquest, Inc., Anika also has exclusive rights to produce OSSIGEL(R), an injectable formulation of basic fibroblast growth factor combined with HA designed to accelerate the healing of bone fractures. The accompanying financial statements and related notes should be read in conjunction with the Company's annual financial statements filed with the Annual Report on Form 10-K for the year ended December 31, 2000. The results of operations for the three months ended March 31, 2001 are not necessarily indicative of the results to be expected for the year ending December 31, 2001. (See "Risk Factors and Certain Factors Affecting Future Operating Results" below.) 2. BASIS OF PRESENTATION The accompanying financial statements have been prepared by the Company without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, these financial statements contain all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial position of the Company as of March 31, 2001, the results of operations for the three months ended March 31, 2001 and 2000 and the cash flows for the three months ended March 31, 2001 and 2000. 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles 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 revenues and expenses during the reporting period. Actual results could differ from those estimates. PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of Anika Therapeutics, Inc. and its wholly owned subsidiaries, Anika Securities Corporation and Anika Therapeutics UK, Ltd. All intercompany transactions have been eliminated in consolidation. 5 CASH AND CASH EQUIVALENTS Cash and cash equivalents consists of cash and investments with original maturities of 90 days or less. SHORT-TERM MARKETABLE SECURITIES The Company follows the provisions of Statement of Financial Accounting Standards ("SFAS") No. 115, ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES. Short-term marketable securities consist of commercial paper with maturities within twelve months of the balance sheet date. The Company classifies these short-term marketable securities as held to maturity, and accordingly they are carried at amortized costs. Aggregate fair value, amortized cost and average maturity for marketable securities held at March 31, 2001 and December 31, 2000 are as follows:
MARCH 31, 2001 ---------------------------------------------------- AMORTIZED GROSS UNREALIZED COST HOLDING GAIN FAIR VALUE ---- ------------ ---------- Commercial Paper (weighted average maturity of 3.4 months)...................................... $10,420,246 $51,069 $10,471,315 =========== ======= ===========
DECEMBER 31, 2000 ---------------------------------------------------- AMORTIZED GROSS UNREALIZED COST HOLDING GAIN FAIR VALUE ---- ------------ ---------- Commercial Paper (weighted average maturity of 3.4 months)...................................... $10,039,849 $82,384 $10,122,233 =========== ======= ===========
During the first quarter of 2001, securities classified as held to maturity, with an amortized cost aggregating $7,039,849, including interest and realized gains of $191,788 which are included in interest income on the Consolidated Statement of Operations, matured during the year. FINANCIAL INSTRUMENTS SFAS No. 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS, requires disclosure about fair value of financial instruments. Financial instruments consist of cash equivalents, short-term marketable securities, accounts receivable, notes receivable from officers and accounts payable. The estimated fair values of the Company's other financial instruments approximate their carrying values. INVENTORIES Inventories are stated at the lower of cost or market, with cost being determined using the first-in, first-out (FIFO) method. Work-in-process and finished goods inventories include materials, labor, and manufacturing overhead. REVENUE RECOGNITION Product revenue is recognized upon shipment of commercial product and represents sales of AMVISC(R) products, HYVISC(R) and ORTHOVISC(R). ORTHOVISC(R) is sold through several distribution and logistic arrangements. Advanced payments received for products are recorded as deferred revenue and are recognized when the product is shipped. The Company adopted the provisions of SEC Staff Accounting Bulletin 101 (SAB 101) in its 1999 operating results. SAB 101 changes revenue recognition practices for non-refundable up-front payments received as part of broad supply, distribution, and marketing agreements, including $2,500,000 and $1,500,000 received from Zimmer in the fourth quarter of 1997 and the second quarter of 1998, respectively. These amounts were previously recognized in the period received. In accordance with SAB 101, issued in December 1999, the Company recorded the cumulative effect of the change in accounting principle of $3,625,000 as a charge in the first quarter of 1999. Amounts received and deferred to future periods was $3,225,000 at December 31, 1999. The Company has recognized as revenue $100,000 of the payments in each of the quarters ended from March 31, 1999 through September 30, 2000. As a result of the early termination of the Zimmer Distribution Agreement, the remaining non-refundable up-front payments in deferred revenue of $2,925,000 was recorded as revenue in the fourth quarter of 2000. 6 PROPERTY AND EQUIPMENT Property and equipment is stated at cost and depreciated using the straight-line method over the estimated useful lives of the respective assets, as follows: Machinery and equipment...................... 3-10 years Furniture and fixtures....................... 3-5 years Leasehold improvements....................... Shorter of estimated useful life or life of lease IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF The Company follows the provisions of SFAS No. 121, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF. This statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. During the three months ended March 31, 2001, the Company did not record any losses on impairment. RESEARCH AND DEVELOPMENT Research and development costs are expensed as incurred. INCOME TAXES The Company provides for income taxes in accordance with SFAS No. 109, ACCOUNTING FOR INCOME TAXES. SFAS No. 109 requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities. REPORTING COMPREHENSIVE INCOME SFAS No. 130, REPORTING COMPREHENSIVE INCOME establishes standards for reporting and display of comprehensive income and its components in the financial statements. Comprehensive income is the total of net income and all other non-owner changes in equity including such items as unrealized holding gains/losses on securities, foreign currency translation adjustments and minimum pension liability adjustments. The Company had no such items for the three months ended March 31, 2001 and 2000. DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker, or decision-making group, in making decisions regarding how to allocate resources and assess performance. The Company's chief decision-making group consists of the chief executive officer and the chief financial officer. Based on the criteria established by SFAS No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION, the Company has one reportable operating segment, the results of which are disclosed in the accompanying financial statements. Substantially all of the operations and assets of the Company have been derived from and are located in the United States. 7 Revenues by geographic location in total and as a percentage of total revenues are as follows for the three months ended March 31, 2001 and 2000, respectively:
THREE MONTHS ENDED MARCH 31, Geographic location: 2001 2000 ------------------------------------------------------------------ Percent of Percent of Revenue Revenue Revenue Revenue ------------------------------------------------------------------ United States $1,440,482 66.12% $2,201,333 80.91% Middle East 411,950 18.91% 517,500 19.02% Other/Europe 326,185 14.97% 2,000 0.07% ------------------------------------------------------------------ Total $2,178,617 100.00% $2,720,833 100.00% ==================================================================
Product revenue by significant customers is as follows:
Percent of Product Revenue Three Months ended March 31, 2001 2000 ---------------------------- AMVISC(R): Bausch & Lomb 60.1% 71.7% ORTHOVISC(R): Pharmaren AG (Formerly Biomeks) 18.2% 14.0% ---------------------------- 78.3% 85.7% ============================
4. EARNINGS PER SHARE The Company reports earnings per share in accordance with SFAS No. 128, EARNINGS PER SHARE, which establishes standards for computing and presenting earnings (loss) per share. Basic earnings per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net income (loss) by the weighted average number of common shares and dilutive potential common shares outstanding during the period. Under the treasury stock method, the dilutive unexercised options are assumed to be exercised at the beginning of the period or at issuance, if later. The assumed proceeds are then used to purchase common shares at the average market price during the period. For periods where the Company has incurred a loss, dilutive net loss per share is equal to basic net loss per share. Accordingly, diluted weighted average shares outstanding of 9,934,280 for the three months ended March 31, 2001 exclude 18,022 potential common shares related to outstanding stock options as of March 31, 2001, because to include them would have been antidilutive for the period presented. 5. INVENTORIES Inventories consist of the following:
MARCH 31, DECEMBER 31, 2001 2000 -------------------------------- Raw Materials $ 1,585,169 $ 1,386,504 Work in-process 2,971,239 3,169,358 Finished goods 220,544 181,783 -------------------------------- Total $ 4,776,952 $ 4,737,645 ================================
6. PROPERTY & EQUIPMENT Property and equipment is stated at cost and consists of the following:
MARCH 31, DECEMBER 31, 2001 2000 -------------------------------- Machinery and equipment $ 5,244,518 $ 6,071,812 Furniture and fixtures 683,314 670,923 Leasehold improvements 2,828,108 1,878,844 -------------------------------- 8,755,940 8,621,579 -------------------------------- Less accumulated depreciation (5,722,717) (5,498,455) -------------------------------- Total $ 3,033,223 $ 3,123,124 ================================
Costs of $835,000 for a clean room had previously been included in Machinery and equipment. It has been reclassified as a Leasehold improvement upon its completion in Q1 2001. 7. NOTES RECEIVABLE FROM OFFICERS Notes receivable from officers consists of loans made to three officers and one former officer. The loan amounts are generally due at the earlier of the end of five years from the date of the note or at the termination of the officers' employment. The note receivable from the former officer is secured by a mortgage on the person's primary residence. A portion of a note 8 to one officer is also secured by a mortgage on the officer's primary residence. Interest accrues at annual rates between 5.54% to 6.22% and is payable monthly over the term of the loans. 8. LICENSING AND DISTRIBUTION AGREEMENT In July 2000, the Company entered into a new seven-year supply agreement (the "BLS Agreement") with Bausch & Lomb Surgical, a unit of Bausch & Lomb. Under the terms of the BLS Agreement, effective January 1, 2001, the Company became Bausch & Lomb's exclusive provider of AMVISC(R) and AMVISC(R) Plus, ophthalmic viscoelastic products, in the U.S. and international markets. The BLS Agreement expires December 31, 2007, superceding an existing supply contract with Bausch & Lomb Surgical that was set to expire December 31, 2001. The BLS Agreement is subject to early termination and/or reversion to a non-exclusive basis under certain circumstances. The BLS Agreement lifts contractual restrictions on the Company's sales of certain ophthalmic products to other companies, subject to payment of royalties by Anika. In exchange, the Company agreed to a reduction in unit selling prices effective April 1, 2000, and the elimination of minimum unit purchase obligations by BLS. For the three months ended March 31, 2001, revenue under the BLS Agreement was $1,321,232. 9. LEGAL MATTERS SECURITIES AND EXCHANGE COMMISSION INVESTIGATION. The SEC had issued a formal order of investigation and has required the Company to provide information in connection with certain revenue recognition matters. These matters, relating to the Company's historical accounting for sales of its product under a long-term supply and distribution agreement with Zimmer, Inc., were also the subject of the Company's March 15, 2000 disclosure concerning an informal SEC inquiry and the restatement of results for 1998 and the first three quarters of 1999. The Company has been cooperating fully. However, the Company is not in a position to predict the probable outcome of this matter or its potential impact on the Company's business or operations. PUTATIVE CLASS ACTION COMPLAINTS. Three putative class action complaints have been filed against the Company, J. Melville Engle, and Sean Moran, the Company's former chief financial officer, in the United States District Court for the District of Massachusetts (the "Court") on behalf of all purchasers of the Company's shares between April 15, 1998 and May 30, 2000 (the "Class"). The first, filed on or about June 8, 2000, is captioned CASAZZA, ET AL. V. ANIKA THERAPEUTICS, INC., J. MELVILLE ENGLE AND SEAN MORAN, Civil Action No. 00-11127-WGY. The second, filed on or about June 26, 2000, is captioned NEMETH-COSLETT, ET AL. V. ANIKA THERAPEUTICS, INC., J. MELVILLE ENGLE AND SEAN MORAN, Civil Action No. 00-11257-WGY. The third, filed on or about August 2, 2000, is captioned ROCKEFELLER, ET AL. V. ANIKA THERAPEUTICS, INC., J. MELVILLE ENGLE AND SEAN MORAN, Civil Action No. 00-11540-WGY. Each of these putative class action complaints encompasses the same class period and covers almost identical allegations. On or about August 7, 2000, David and Vivian West, alleged members of the Class, filed a motion to appoint themselves lead plaintiffs, and their law firm, lead counsel; as well as a motion for consolidation of the above cases. On or about September 13, 2000, the Court granted David and Vivian West's motions, consolidated the cases and recaptioned the case IN RE ANIKA THERAPEUTICS, INC. SECURITIES LITIGATION, Civil Action No. 00-11127-WGY. On or about October 30, 2000, lead plaintiffs filed a consolidated amended complaint. The complaint alleges that the Company and the individual defendants violated the federal securities laws by, INTER ALIA, making material misrepresentations and omissions in certain public disclosures during the period between April 15, 1998 and May 30, 2000. The alleged misrepresentations and omissions relate to the Company's historical revenue recognition policies and its restatement of revenues for 1998 and the first three quarters of 1999. The complaint seeks an unspecified amount of monetary damages, costs and expenses, and equitable and/or injunctive relief to restrict the defendants from disposing of various assets in order to assure adequate funds are available for the claimed damages. On December 14, 2000, the Company, Mr. Engle and Mr. Moran each filed motions to dismiss the consolidated amended complaint. On January 29, 2001, plaintiffs' counsel filed oppositions to defendants' motions to dismiss. The Defendants filed reply briefs on February 12, 2001. The parties have negotiated and entered into an agreement in principle to settle the action (the "Memorandum of Understanding"), which sets forth the terms of the proposed settlement, subject to approval by the Court. As part of the proposed settlement, defendants would pay a total of $1.25 million into a settlement fund, which would, among other things, be used to pay authorized members of the Class. The Memorandum of Understanding and the proposed settlement will be contingent upon, among other things, (i) the parties execution of an appropriate Stipulation of Settlement which is acceptable to the parties; (ii) conditional certification of the Class for purposes of the Settlement, (iii) Court approval of the Settlement; and (iv) dismissal of the Action with prejudice. The Company is not able to provide any assurances that (i) the proposed settlement will be consummated or (ii) the terms of any final settlement will not differ from the terms of the Memorandum of Understanding. Accordingly, the Company has not recorded a liability for the proposed settlement. 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED FINANCIAL STATEMENTS OF ANIKA THERAPEUTICS, INC. AND THE NOTES THERETO AS WELL AS THE "RISK FACTORS AND CERTAIN FACTORS AFFECTING FUTURE OPERATING RESULTS" HEREIN. The Company receives a substantial portion of its revenue from the sale of AMVISC(R) and AMVISC(R)Plus to Bausch & Lomb Surgical. For the three months ended March 31, 2001 and 2000, AMVISC sales accounted for 60.1% and 71.7% of product revenue, respectively. RESULTS OF OPERATIONS PRODUCT REVENUE. Product revenue for the three months ended March 31, 2001 decreased by $442,216 or 16.9%, compared with the first quarter of 2000. Sales of AMVISC products to Bausch & Lomb are the principal element of this decrease due primarily to a reduction in unit prices beginning April 1, 2000 in connection with a new long-term distribution agreement with Bausch & Lomb. ORTHOVISC sales in Europe and Canada through third party logistics agents totaled approximately $300,000 in the first quarter of 2001. These sales channels were established following the termination of the ORTHOVISC distribution agreement with Zimmer Corporation in the fourth quarter of 2000. LICENSING FEES. There were no licensing fees for the three months ended March 31, 2001 due to the termination of the Zimmer Distribution Agreement on November 10, 2000. For the three months ended March 31, 2000, licensing fees of $100,000 represented the annual amortization of amounts received in 1997 and 1998. GROSS PROFIT. Gross profit for the three months ended March 31, 2001 was $209,669, a decrease of $1,278,196 or 86% from $1,487,865 recorded in the corresponding quarter of 2000. Gross profit as a percentage of product sales for the three months ended March 31, 2001 was 9.6% compared to 53% in the prior year corresponding quarter, as a result of reduced unit selling prices to Bausch and Lomb and reduced manufacturing cost performance. Costs of sales includes approximately $700,000 in the first quarter of 2001 attributable to underutilization of manufacturing capacity resulting from the Company's efforts to reduce work-in-process and other inventory that had been produced through mid-2000 in anticipation of ORTHOVISC product launch in the U.S. market. The Company expects to continue to experience the impacts of this underutilization through mid-2001. RESEARCH AND DEVELOPMENT. Research and development expenses for the three months ended March 31, 2001 increased by $34,132 to $1,347,870 from $1,313,738 in the prior year corresponding quarter. The increase in research and development during 2001 was primarily due to approximately $700,000 in startup costs associated with the new ORTHOVISC(R) Phase III clinical trials and development costs for INCERT. Research and development expenses during 2001 are expected to be approximately twice the level of spending in 2000 due to clinical trial costs, as well as expected additions to headcount. SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expenses for the three months ended March 31, 2001 increased by $453,348 or 45.4% to $1,452,810 from $999,462 in the prior year corresponding quarter. The increase was primarily attributable to higher professional fees associated with the putative class action suit described in Note 9--"Legal Matters" and certain corporate matters. Selling, general and administrative expenses for the first quarter of 2001 also included approximately $200,000 to support the sales and marketing of ORTHOVISC(R) in Europe and Canada. INTEREST INCOME. The Company's interest income increased by $11,332 to $272,580 for the three months ended March 31, 2001 from $261,248 in the prior year corresponding quarter. The increase is attributable to slightly higher average balances in marketable securities in 2001 versus 2000 and higher average interest rates. 10 LIQUIDITY AND CAPITAL RESOURCES At March 31, 2001, the Company had cash, cash equivalents and short term marketable securities of $16.8 million and working capital of $20.9 million versus cash, cash equivalents and short-term marketable securities of $18.3 million and working capital of $23.1 million at December 31, 2000. During the first quarter of 2001, the Company utilized $1,365,264 in operations, primarily as a result of the net loss, partially offset by the reductions of accounts receivable and certain other working capital items. Capital expenditures were $134,361 during the quarter. As previously disclosed, the company is planning certain pilot laboratory projects amounting to approximately $500,000 that would result in additional capital spending during the remainder of 2001. Aggregate capital investments for 2001 are expected to be approximately $1 million. As described in financial statement Note 9 - "Legal Matters", the Company is a defendant in a putative class action lawsuit. The parties have negotiated and entered into a Memorandum of Understanding, which sets forth the terms of the proposed settlement, subject to approval by the Court. As part of the proposed settlement, defendants would pay a total of $1.25 million into a settlement fund, which would, among other things, be used to pay authorized members of the Class. The Memorandum of Understanding and the proposed settlement will be contingent upon, among other things, (i) the parties execution of an appropriate Stipulation of Settlement which is acceptable to the parties; (ii) conditional certification of the Class for purposes of the Settlement, (iii) Court approval of the Settlement; and (iv) dismissal of the Action with prejudice. The Company is not able to provide any assurances that (i) the proposed settlement will be consummated or (ii) the terms of any final settlement will not differ from the terms of the Memorandum of Understanding. Accordingly, the Company has not recorded a liability for the proposed settlement. The Company's future capital requirements and the adequacy of available funds will depend on numerous factors, including market acceptance of its existing and future products; the successful commercialization of products in development; progress in its product development efforts; the magnitude and scope of such efforts; progress with preclinical studies; clinical trials and product clearances by the FDA and other agencies; the cost, and timing requirements of its efforts to expand its manufacturing capabilities; the cost of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights; defending, negotiating, and settling legal matters; competing technological and market developments; and the development of strategic alliances for the marketing of certain of its products. There can be no assurance that the company will record profits in future periods. See "Risk Factors and Certain Other Factors Affecting Future Operating Results - History of Losses; Uncertainty of Future Profitability." 11 RISK FACTORS AND CERTAIN FACTORS AFFECTING FUTURE OPERATING RESULTS THIS QUARTERLY REPORT FORM 10-Q CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934. THE WORDS "BELIEVE," "EXPECT," "ANTICIPATE," "INTEND," "ESTIMATE," "PLAN," "SEEK," "HOPE," "WILL" AND OTHER EXPRESSIONS, WHICH ARE PREDICTIONS OF, OR INDICATE FUTURE EVENTS AND TRENDS AND WHICH DO NOT RELATE TO HISTORICAL MATTERS, IDENTIFY FORWARD-LOOKING STATEMENTS. FORWARD-LOOKING STATEMENTS INVOLVE KNOWN AND UNKNOWN RISKS, UNCERTAINTIES AND OTHER FACTORS, INCLUDING BUT NOT LIMITED TO STATEMENTS REGARDING: FUTURE SALE AND PRODUCT REVENUES, NEGOTIATIONS WITH POTENTIAL AND EXISTING CUSTOMERS, POSSIBLE DEVELOPMENT OF NEW PRODUCTS, POSSIBLE STRATEGIC INVESTMENTS, POSSIBLE REGULATORY APPROVAL OF NEW OR POTENTIAL PRODUCTS, THE IMPACT OF THE TERMINATION OF THE ZIMMER DISTRIBUTION AGREEMENT, ACQUISITION OF NEW DISTRIBUTION AND COLLABORATION PARTNERS, PERFORMANCE UNDER THE BLS AGREEMENT AND THE OUTCOME AND IMPACT OF THE SEC INVESTIGATION AND PUTATIVE CLASS ACTION COMPLAINT. THE COMPANY'S ACTUAL RESULTS, PERFORMANCE OR ACHIEVEMENT COULD DIFFER MATERIALLY FROM ANTICIPATED RESULTS, PERFORMANCE OR ACHIEVEMENT, EXPRESSED OR IMPLIED IN SUCH FORWARD-LOOKING STATEMENTS. IN PARTICULAR, THERE CAN BE NO ASSURANCE THAT THE COMPANY WILL: (i) BEGIN CLINICAL TRIALS OF INCERT(R)-S; (ii) SUCCESSFULLY COMPLETE CLINICAL TRIALS OF ORTHOVISC(R) OR INCERT(R)-S; (iii) OBTAIN CLINICAL DATA TO SUPPORT A PRE-MARKET APPROVAL APPLICATION AND/OR FDA APPROVAL; (iv) RECEIVE FDA OR OTHER REGULATORY APPROVALS OF ORTHOVISC(R) OR THAT SUCH APPROVALS WILL BE OBTAINED IN A TIMELY MANNERS OR WITHOUT THE NEED FOR ADDITIONAL CLINICAL TRIALS. THERE CAN BE NO ASSURANCE THAT THE TERMINATION OF THE DISTRIBUTION AGREEMENT WITH ZIMMER WILL NOT HAVE A MATERIAL ADVERSE IMPACT ON SALES OR DISTRIBUTION OF ORTHOVISC(R) OR THAT THE COMPANY WILL BE ABLE TO IDENTIFY OR ENGAGE APPROPRIATE DISTRIBUTION OR COLLABORATION PARTNERS FOR SALES OF ORTHOVISC(R) OR INCERT(R)-S OR EFFECTIVELY TRANSITION THE DISTRIBUTION OF ORTHOVISC(R) OR INCERT(R)-S TO SUCH DISTRIBUTORS, ONCE ENGAGED. IN ADDITION, THERE CAN BE NOT ASSURANCE THAT ANY DELAY IN RECEIVING ANY SUCH APPROVALS WILL NOT ADVERSELY EFFECT THE COMPANY'S COMPETITIVE POSITION OR, IF COMPLETED, MEANINGFUL SALES OF THE PRODUCTS WILL BE ACHIEVED. THERE CAN BE NO ASSURANCE THAT THE COMPANY'S INVENTORY REDUCTION OR OTHER EFFORTS WILL RESULT IN IMPROVED GROSS MARGINS BY MID - 2001 OR EVER. THERE CAN BE NOT ASSURANCES THAT: (i) THE COMPANY WILL ACHIEVE INCREMENTAL SALES OF THIS OPHTHALMIC PRODUCTS TO BAUSCH & LOMB SURGICAL AND/OR OTHER COMPANIES SUFFICIENT TO OFFSET THE EFFECTS OF THE PRICE REDUCTION AND ROYALTIES TO BE PAID TO BAUSCH & LOMB SURGICAL (ii) BAUSCH & LOMB SURGICAL WILL MAKE PURCHASES IN ACCORDANCE WITH ITS FORECASTS. FURTHERMORE, THE COMPANY CANNOT MAKE ANY ASSURANCE THAT THE CURRENT LEVELS OF SELLING, GENERAL AND ADMINISTRATIVE EXPENSES WILL NOT CONTINUE. ADDITIONAL FACTORS THAT MIGHT CAUSE SUCH A DIFFERENCE ARE SET FORTH HEREIN AND IN THE "MANAGEMENT'S DISCUSSIONS AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" BEGINNING ON PAGE 10 OF THIS QUARTERLY REPORT ON FORM 10-Q AS WELL AS THOSE DESCRIBED IN THE COMPANY'S ANNUAL REPORT ON FORM 10-K AND THE COMPANY'S PRESS RELEASES AND OTHER FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION. THE COMPANY UNDERTAKES NO OBLIGATION TO PUBLICLY UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENT WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OF OTHERWISE. COMPREHENSIVE GOVERNMENT REGULATION; NO ASSURANCE OF FDA APPROVAL. The Company's products, product development activities, manufacturing processes, and current and future sales and marketing are subject to extensive and rigorous regulation by the Food & Drug Administration (FDA) and comparable agencies in foreign countries. In the United States, the FDA regulates the marketing, advertising, promotion, and distribution of medical devices, drugs, and biologics, as well as testing, safety, effectiveness, clearance, approval, manufacturing, labeling, packing, storage, record keeping, and reporting activities for such products. Medical products regulated by the FDA are generally classified as medical devices and/or drugs and/or biologics. Product development and approval within the FDA framework takes a number of years and involves the expenditure of substantial resources. There can be no assurance that the FDA will grant approval for the Company's new products on a timely basis if at all, or that FDA review will not involve delays that will adversely affect the Company's ability to commercialize additional products or expand permitted uses of existing products, or that the regulatory framework will not change, or that additional regulation will not arise at any stage of the Company's product development process which may adversely affect approval of or delay an application or require additional expenditures by the Company. In the event the Company's future products are regulated as human drugs or biologics, the FDA's review process typically would be substantially longer and more expensive than the review process to which they are currently subject as devices. The Company's ORTHOVISC(R) product will have to meet regulatory requirements of a Class III device by the FDA. Class III devices are those that generally must receive pre-market approval (PMA) by the FDA (e.g. life-sustaining, life-supporting and implantable or new devices which have not been found to be substantially equivalent to legally marketed devices) and require clinical testing to ensure safety and effectiveness and FDA approval prior to marketing and 12 distribution. In order for the Company to commercially distribute ORTHOVISC(R) in the U.S., it must obtain a PMA. The PMA process can be expensive, uncertain and lengthy. A number of devices for which PMAs have been sought have never been approved for marketing. The review of an application often occurs over a protracted time period and may take two years or more from the filing date to complete. The Company submitted a PMA application for ORTHOVISC(R) in December 1997. In October 1998, the Company was notified by the FDA that the Company's PMA application for ORTHOVISC(R) was not approvable and that additional clinical data would be required to demonstrate the effectiveness of ORTHOVISC(R). The Company submitted an Investigational Device Exemption (IDE) to the FDA in February 1999 and received approval in late March 1999 to commence a second Phase III clinical study. The Company received initial results from the Phase III clinical trial in late May 2000 that the Company determined did not show sufficient efficacy to support the filing of a PMA application. The Company has evaluated available information and announced its intention to pursue further clinical trials. In February 2001, the Company commenced another Phase III clinical trial of ORTHOVISC(R). The trial is being conducted in up to 20 centers in the U.S. and Canada, with 360 patients expected to be enrolled, and with evaluation over a six-month period following treatment. There can be no assurance that (i) any additional clinical data will support the efficacy of ORTHOVISC(R), (ii) the Company will complete any additional clinical trials of ORTHOVISC(R), (iii) the Company will be able to successfully complete the FDA approval process, or (iv) additional clinical trials will support a PMA application and/or FDA approval in a timely manner or at all. There also can be no assurance that any delay in receiving FDA approvals will not adversely affect the Company's competitive position. Furthermore, even if the Company were to receive a PMA approval, (i) the approval may include significant limitations on the indications and other claims sought for use for which the product may be marketed; (ii) the approval may include other significant conditions to approval such as post-market testing, tracking, or surveillance requirements; and (iii) the Company may not be able to achieve meaningful sales in the U.S. The Company's HA product under development, INCERT(R)-S, has not obtained regulatory approval in the U.S. for commercial marketing and sale. The Company believes that INCERT(R)-S will be regulated as a Class III medical device and will require a PMA prior to marketing. The Company has received IDE approval from the FDA and is evaluating product development activities, including the prospects for conducting clinical trials for INCERT(R)-S. There can be no assurance that (i) the Company will begin or successfully complete clinical trials oF INCERT(R)-S; (ii) the clinical data will support the efficacy of INCERT(R)-S; (iii) it will be able to successfuLlY complete the FDA approval process; or (iv) additional clinical trials will support a PMA application and/or FDA approval in a timely manner or at all. There also can be no assurance that any delay in receiving FDA approvals will not adversely affect our competitive position. Furthermore, even if we received FDA approval, (i) the approval may include significant limitations on the indications and other claims sought for use for which the product may be marketed, (ii) the approval may include other significant conditions of approval such as post-market testing, tracking, or surveillance requirements; and /or (iii) meaningful sales of INCERT(R)-S may never be achieved. Orquest has not received regulatory approval in the U.S. for the commercial marketing and sale of OSSIGEL(R). The Company believes that OSSIGEL(R) will be regulated as a Class III medical device with the FDA's Center of Biologics Research and Review as the lead review center and will require a PMA prior to marketing. There can be no assurance that clinical trials of OSSIGEL(R) will demonstrate that OSSIGEL(R) is safe and effective or otherwise satisfies FDA requirements. Once obtained, marketing approval can be withdrawn by the FDA for a number of reasons, including, among other things, the failure to comply with regulatory standards, or the occurrence of unforeseen problems following initial approval. The Company may be required to make further filings with the FDA under certain circumstances. The FDA's regulations require a PMA supplement for certain changes if they affect the safety and effectiveness of an approved device, including, but not limited to, new indications for use, labeling changes, the use of a different facility to manufacture, process or package the device, and changes in performance or design specifications. Changes in manufacturing that effect safety and effectiveness, may be deemed approved after a 30-day notice unless the FDA requests a supplement. Failure by the Company to receive approval of a PMA supplement regarding the use of a different manufacturing facility or any other change affecting the safety or effectiveness of an approved device on a timely basis, or at all, may have a material adverse effect on the Company's business, financial condition, and results of operations. The FDA could also limit or prevent the manufacture or distribution of the Company's products and has the power to require the recall of such products. Significant delay or cost in obtaining, or failure to obtain FDA approval to market products, any FDA limitations on the use of the Company's products, or any withdrawal or suspension of approval or rescission of approval by the FDA could have a material adverse effect on the Company's business, financial condition, and results of operations. 13 In addition, all FDA approved or cleared products manufactured by the Company must be manufactured in compliance with FDA's Good Manufacturing Practices (GMP) regulations and, for medical devices, FDA's Good Manufacturing Practices/Quality System Regulations (GMP/QSR). Ongoing compliance with GMP/QSR and other applicable regulatory requirements is enforced through periodic inspection by state and federal agencies, including the FDA. The FDA may inspect the Company and its facilities from time to time to determine whether the Company is in compliance with regulations relating to medical device and manufacturing companies, including regulations concerning manufacturing, testing, quality control and product labeling practices. There can be no assurance that the Company will be able to comply with current or future FDA requirements applicable to the manufacture of products. FDA regulations depend heavily on administrative interpretation and there can be no assurance that the future interpretations made by the FDA or other regulatory bodies, with possible retroactive effect, will not adversely affect the Company. In addition, changes in the existing regulations or adoption of new governmental regulations or policies could prevent or delay regulatory approval of the Company's products. Failure to comply with applicable regulatory requirements could result in, among other things, warning letters, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, refusal of the FDA to grant pre-market clearance or pre-market approval for devices, withdrawal of approvals and criminal prosecution. In addition to regulations enforced by the FDA, the Company is subject to other existing and potential future federal, state, local and foreign regulations. International regulatory bodies often establish regulations governing product standards, packing requirements, labeling requirements, import restrictions, tariff regulations, duties and tax requirements. To enable the Company to market ORTHOVISC(R) in Europe, the Company was required to receive a "CE" marking certification, an international symbol of quality and compliance with the applicable European medical device directive. In October 1996, the Company received an EC Design Examination and an EC Quality System Certificate from a European Notified Body, which entitled the Company to affix a CE marking for ORTHOVISC(R) as a viscoelastic supplement or a replacement for synovial fluid in human joints. There can be no assurance that the Company will be able to achieve and/or maintain compliance required for CE marking or other foreign regulatory approvals for any or all of its products or that it will be able to produce its products in a timely and profitable manner while complying with applicable requirements. Federal, state, local and foreign regulations regarding the manufacture and sale of medical products are subject to change. The Company cannot predict what impact, if any, such changes might have on its business. The requirements relating to the conduct of clinical trials, product licensing, pricing and reimbursement also vary widely from country to country. The process of obtaining approvals from the FDA and other regulatory authorities can be costly, time consuming, and subject to unanticipated delays. There can be no assurance that approvals or clearances of the Company's products will be granted or that the Company will have the necessary funds to develop certain of such products. Any failure to obtain, or delay in obtaining such approvals or clearances could adversely affect the ability of the Company to market its products. HISTORY OF LOSSES; UNCERTAINTY OF FUTURE PROFITABILITY. From its inception, up until December 31, 1996 and in 1999 and 2000, the Company had incurred annual operating losses. As of March 31, 2001, the Company had an accumulated deficit of approximately $6,917,000. The continued development of the Company's products will require the commitment of substantial resources to conduct research and preclinical and clinical development programs, and to establish sales and marketing capabilities or distribution arrangements. The ability of the Company to reach sustained profitability is highly uncertain. To achieve sustained profitability the Company must, among other things, successfully complete development of certain of its products, obtain regulatory approvals and establish sales and marketing capabilities or distribution arrangements for certain of its products. COMPETITION. The Company competes with many companies, including, among others, large pharmaceutical companies and specialized medical products companies. Many of these companies have substantially greater financial and other resources, larger research and development staffs, more extensive marketing and manufacturing organizations and more experience in the regulatory process than the Company. The Company also competes with academic institutions, governmental agencies and other research organizations which may be involved in research, development and commercialization of products. Because a number of companies are developing HA products for similar applications, the successful commercialization of a particular product will depend in part upon the ability of the Company to complete clinical 14 studies and obtain FDA marketing and foreign regulatory approvals prior to its competitors. There can be no assurance that the Company will be able to compete against current or future competitors or that competition will not have a material adverse effect on the Company's business, financial condition and results of operations. The Company is currently experiencing pricing pressures in the Turkish market from increased competition which may hinder its ability to effectively compete in that market. As a result, prices to our Turkish distribution have decreased. UNCERTAINTY REGARDING SUCCESS OF CLINICAL TRIALS. Several of the Company's products, including ORTHOVISC(R), as well as the products of the Company's collaborative partners, including OSSIGEL(R), will require clinical trials to determine their safety and efficacy for U.S. and international marketing approval by regulatory bodies, including the FDA. In late May 2000, the Company's initial analysis of the results of its second Phase III clinical trial of ORTHOVISC(R) did not show sufficient efficacy to support the filing of a PMA application to obtain FDA approval. The Company has evaluated available information and announced the commencement of further clinical trials. The Company has received Investigational Device Exemption (IDE) approval from the FDA. There can be no assurance that (i) any additional clinical data will support the efficacy of ORTHOVISC(R), (ii) the Company will begin clinical trials of INCERT(R)- S or complete any additional clinical trials of ORTHOVISC(R) or INCERT(R)- S, (iii) it will be able to successfully complete the FDA approval process FoR either ORTHOVISC(R) or INCERT(R)- S, or (iv) additional ORTHOVISC(R) or INCERT(R)- S clinical trials will support a PMA application and/or FDA approval in a timely manner or at all. There can be no assurance that the Company or its collaborative partners will not encounter problems that will cause it to delay, suspend or terminate clinical trials. In addition, the Company cannot provide any assurance that such clinical trials, if completed, will ultimately demonstrate these products to be safe and efficacious. DEPENDENCE UPON MARKETING AND DISTRIBUTION PARTNERS. The Company's success will be dependent upon the efforts of its marketing partners and the terms and conditions of the Company's relationships with such marketing partners. In addition, there can be no assurances that such marketing partners will not seek to renegotiate their current agreements on terms less favorable to the Company. Under the terms of the BLS Agreement, effective January 1, 2001, the Company became Bausch & Lomb Surgical's exclusive provider of AMVISC(R) and AMVISC(R) Plus, ophthalmic viscoelastic products, in the U.S. and international markets. The BLS Agreement expires December 31, 2007, superseding an existing supply contract with Bausch & Lomb Surgical that was set to expire December 31, 2001. The BLS Agreement is subject to early termination and/or reversion to a non-exclusive basis under certain circumstances. The BLS Agreement lifts contractual restrictions on the Company's sales of certain ophthalmic products to other companies, subject to payment of royalties by the Company. In exchange, the Company agreed to a reduction in unit selling prices retroactively effective to April 1, 2000 and the elimination of minimum unit purchase obligations by BLS. The Company has not achieved incremental sales of its ophthalmic products to Bausch & Lomb Surgical and/or other companies sufficient to offset the effects of the price reduction to Bausch & Lomb Surgical and there can be no assurances that the Company will be able to do so in the future. The Company expects that, at least through 2001, the reduction in unit prices will result in a decrease in the Company's revenue and gross margin from Bausch & Lomb Surgical. In addition, under certain circumstances, (i) Bausch & Lomb Surgical may have the right to terminate the agreement and/or (ii) the agreement may revert to a non-exclusive basis; in each case, the Company cannot make any assurances that such circumstances will not occur. For the three months ended March 31, 2001 and 2000, sales of AMVISC(R) products to Bausch & Lomb Surgical accounted for 60.1% and 71.7% of product revenues, respectively. Although the Company intends to continue to seek new opthalmic product customers, there can be no assurances that the Company will be successful in obtaining new customers or to achieve meaningful sales to such new customers. The Zimmer Distribution Agreement provided Zimmer with exclusive marketing and distribution rights to ORTHOVISC(R) in the United States, Canada, Latin America, Asia and most of Europe. On November 10, 2000, the Company reached an agreement with Zimmer, Inc. for an early termination of its marketing and distribution agreement for ORTHOVISC(R). The termination may have a material adverse effect on the Company's ability to market ORTHOVISC(R), which may have a material adverse effect on the Company's future operating results. The Company has relationships with logistics service providers in order to distribute ORTHOVISC(R) to customers in Canada and European countries previously served by Zimmer. The Company is seeking to establish long-term relationships with new distribution partners in these countries where Zimmer previously sold the product. There can be no assurance that the Company will be able to identify or engage appropriate distribution or collaboration partners or effectively transition to any such partners. There 15 can be no assurance that the Company will obtain European or other reimbursement approvals or, if such approvals are obtained, they will be obtained on a timely basis or at a satisfactory level of reimbursement. Furthermore, the Company may experience some difficulties or delays in the transfer of existing business relationships and reimbursement approvals from Zimmer. The Company will need to obtain the assistance of additional marketing partners for new products, which are brought to market for the replacement of certain marketing partners, such as Zimmer, and for existing products brought to new markets. There can be no assurance that such additional partners will be available or that such partners will agree to market the Company's products on acceptable terms. The failure to establish strategic partnerships for the marketing and distribution of the Company's products on acceptable terms would have a material adverse effect on the Company's business, financial condition, and results of operations. UNCERTAINTY OF MARKET ACCEPTANCE OF FUTURE PRODUCTS. The Company's success will depend in part upon the acceptance of the Company's future products by the medical community, hospitals and physicians and other health care providers, and third-party payors. Such acceptance may depend upon the extent to which the medical community perceives the Company's products as safer, more effective or cost-competitive than other similar products. Ultimately, for the Company's new products to gain general market acceptance, it will also be necessary for the Company to develop marketing partners for the distribution of its products. There can be no assurance that the Company's new products will achieve significant market acceptance on a timely basis, or at all. Failure of some or all of the Company's future products to achieve significant market acceptance could have a material adverse effect on the Company's business, financial condition and results of operations. DEPENDENCE ON PATENTS AND PROPRIETARY TECHNOLOGY. The Company's success will depend, in part, on its ability to obtain and enforce patents, protect trade secrets, obtain licenses to technology owned by third parties when necessary, and conduct its business without infringing on the proprietary rights of others. The patent positions of pharmaceutical, medical products and biotechnology firms, including the Company, can be uncertain and involve complex legal and factual questions. There can be no assurance that any patent applications will result in the issuance of patents or, if any patents are issued, whether they will provide significant proprietary protection or commercial advantage, or will not be circumvented by others. In the event a third party has also filed one or more patent applications for any of its inventions, the Company may have to participate in interference proceedings declared by the U.S. Patent and Trademark Office ("PTO") to determine priority of invention (see below), which could result in failure to obtain or the loss of patent protection for the inventions and the loss of any right to use the inventions. Even if the eventual outcome is favorable to the Company, such interference proceedings could result in substantial cost to the Company. Filing and prosecution of patent applications, litigation to establish the validity and scope of patents, assertion of patent infringement claims against others and the defense of patent infringement claims by others can be expensive and time consuming. There can be no assurance that in the event that any claims with respect to any of the Company's patents, if issued, are challenged by one or more third parties, that any court or patent authority ruling on such challenge will determine that such patent claims are valid and enforceable. An adverse outcome in such litigation could cause the Company to lose exclusivity covered by the disputed rights. If a third party is found to have rights covering products or processes used by the Company, the Company could be forced to cease using the technologies or marketing the products covered by such rights, could be subject to significant liabilities to such third party, and could be required to license technologies from such third party. Furthermore, even if the Company's patents are determined to be valid, enforceable, and broad in scope, there can be no assurance that competitors will not be able to design around such patents and compete with the Company using the resulting alternative technology. The Company has a policy of seeking patent protection for patentable aspects of its proprietary technology. It filed five (5) patent applications in the first quarter of 2001. The Company co-owns certain United States patents with claims relating to the chemical modification of HA and certain adhesion prevention and drug delivery uses of HA. Two patents in this portfolio were issued in the year 2000. The Company also solely owns patents directed to certain manufacturing processes. The Company holds an exclusive license from Tufts University to use technologies claimed in a United States patent application which has been granted a Notice of Allowance from the U.S. Patent Office for the anti-metastasis applications of HA oligosaccharides. The Company's patents expire between 2007 and 2015 and the license expires upon expiration of all related patents. The Company intends to seek patent protection with respect to products and processes developed in the course of its activities when it believes such protection is in its best interest and when the cost of seeking such protection is not inordinate. However, no assurance can be given that any patent application will be filed, that any filed applications will result in issued patents or that any issued patents will provide the Company with a competitive advantage or will not be successfully challenged by third parties. The protections afforded by patents will 16 depend upon their scope and validity, and others may be able to design around the Company's patents. The Company's issued patents and any licensed patents would provide competitive protection, if at all, only in the United States. The Company has not, to date, pursued foreign patents equivalent to those issued or applied for in the United States. Other entities have filed patent applications for or have been issued patents concerning various aspects of HA-related products or processes. There can be no assurance that the products or processes developed by the Company will not infringe on the patent rights of others in the future. Any such infringement may have a material adverse effect on the Company's business, financial condition, and results of operations. In particular, the Company received notice from the PTO in 1995 that a third party was attempting to provoke a patent interference with respect to one of the Company's co-owned patents covering the use of INCERT(R) for post-surgical adhesion prevention. It is unclear whether an interference will be declared. If an interference is declared it is not possible at this time to determine the merits of the interference or the effect, if any, the interference will have on the Company's marketing of INCERT(R) for this use. The existence of the interference proceeding may have a negative impact on the marketing of the INCERT(R) product, and no assurance can be given that the Company would be successful in any such interference proceeding. If the third-party interference were to be decided adversely to the Company, involved claims of the Company's patent would be cancelled, the Company's marketing of the INCERT(R) product may be materially and adversely affected and the third party may enforce patent rights against the Company which could prohibit the sale and use of INCERT(R) products, which could have a material adverse effect on the Company's future operating results. The Company also relies upon trade secrets and proprietary know-how for certain non-patented aspects of its technology. To protect such information, the Company requires all employees, consultants and licensees to enter into confidentiality agreements limiting the disclosure and use of such information. There can be no assurance that these agreements provide meaningful protection or that they will not be breached, that the Company would have adequate remedies for any such breach, or that the Company's trade secrets, proprietary know-how, and technological advances will not otherwise become known to others. In addition, there can be no assurance that, despite precautions taken by the Company, others have not and will not obtain access to the Company's proprietary technology. Further, there can be no assurance that third parties will not independently develop substantially equivalent or better technology. Pursuant to the BLS Agreement, the Company has agreed to transfer to Bausch & Lomb Surgical, upon expiration of the term of the agreement on December 31, 2007, or in connection with earlier termination in certain circumstances, the Company's manufacturing process, know-how and technical information, which relate to AMVISC(R) products. Upon expiration of the BLS Agreement, there can be no assurance that Bausch & Lomb Surgical will continue to use the Company to manufacture AMVISC(R) and AMVISC(R) Plus. If Bausch & Lomb Surgical discontinues the use of the Company as a manufacturer after such time, the Company's business, financial condition, and results of operations would likely be materially and adversely affected. RISKS ASSOCIATED WITH MANUFACTURING. The Company's results of operations are dependent upon the continued operation of its manufacturing facility in Woburn, Massachusetts. The operation of biomedical manufacturing plants involves many risks, including the breakdown, failure or substandard performance of equipment, natural and other disasters, and the need to comply with the requirements of directives of government agencies, including the FDA. In addition, the Company relies on a single supplier for syringes and a small number of suppliers for a number of other materials required for the manufacturing and delivery of its HA products. Furthermore, manufacturing processes and research and development efforts of the Company involve animals and products derived from animals. The utilization of animals in research and development and product commercialization is subject to increasing focus by animal rights activists. The activities of animal rights groups and other organizations that have protested animal based research and development programs or boycotted the products resulting from such programs could cause an interruption in the Company's manufacturing processes and research and development efforts. The occurrence of material operational problems, including but not limited to the events described above, could have a material adverse effect on the Company's business, financial condition and results of operations during the period of such operational difficulties. NO ASSURANCE OF GROWTH OR ABILITY TO MANAGE GROWTH. The Company's future success depends on substantial growth in product sales. There can be no assurance that such growth can be achieved or, if achieved, can be sustained. There can be no assurance that even if substantial growth in product sales and the demand for the Company's products is achieved, the Company will be able to (i) develop the necessary manufacturing capabilities; (ii) obtain the assistance of additional marketing partners; (iii) attract, retain and integrate the required key personnel; or (iv) implement the financial, accounting and management systems needed to manage growing demand for its products, should it occur. Failure of the Company to 17 successfully manage future growth could have a material adverse effect on the Company's business, financial condition and results of operations. THIRD PARTY REIMBURSEMENT AND HEALTH CARE COST CONTAINMENT INITIATIVES. In the U.S. and other markets, health care providers, such as hospitals and physicians, that purchase health care products, such as the Company's products, generally rely on third party payors, including Medicare, Medicaid and other health insurance and managed care plans, to reimburse all or part of the cost of the health care product. The Company depends upon the distributors for its products to secure reimbursement. Reimbursement by a third party payor may depend on a number of factors, including the payor's determination that the use of the Company's products are clinically useful and cost-effective, medically necessary and not experimental or investigational. Since reimbursement approval is required from each payor individually, seeking such approvals can be a time consuming and costly process which, in the future, could require the Company or its marketing partners to provide supporting scientific, clinical and cost-effectiveness data for the use of the Company's products to each payor separately. Significant uncertainty exists as to the reimbursement status of newly approved health care products, and third party payors are increasingly attempting to contain the costs of health care products and services by limiting both coverage and the level of reimbursement for new therapeutic products and by refusing in some cases to provide coverage for uses of approved products for disease indications for which the FDA has not granted marketing approval. In addition, Congress and certain state legislatures have considered reforms that may affect current reimbursement practices, including controls on health care spending through limitations on the growth of Medicare and Medicaid spending. There can be no assurance that third party reimbursement coverage will be available or adequate for any products or services developed by the Company. Outside the U.S., the success of the Company's products is also dependent in part upon the availability of reimbursement and health care payment systems. Lack of adequate coverage and reimbursement provided by governments and other third party payors for the Company' products and services could have a material adverse effect on the Company's business, financial condition and results of operations. NEED FOR ADDITIONAL FUNDS; LIQUIDITY. The Company had cash, cash equivalents and short-term marketable securities of $16.8 million as of March 31, 2001. The Company's future capital requirements and the adequacy of available funds will depend, however, on numerous factors, including market acceptance of its existing and future products; the successful commercialization of products in development; progress in its product development efforts; the magnitude and scope of such efforts, progress with preclinical studies, clinical trials and product clearances by the FDA and other agencies; the cost and timing of its efforts to expand its manufacturing capabilities; the cost of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights; competing technological and market developments; and the development of strategic alliances for the marketing of certain of its products. To the extent that funds generated from the Company's operations, together with the Company's existing capital resources and are insufficient to meet future requirements, the Company will be required to obtain additional funds through equity or debt financings, strategic alliances with corporate partners and others, or through other sources. The terms of any future equity financings may be dilutive to the Company's stockholders and the terms of any debt financings may contain restrictive covenants, which limit the Company's ability to pursue certain courses of action. The ability of the Company to obtain financing is dependent on the status of the Company's future business prospects as well as conditions prevailing in the relevant capital markets. No assurance can be given that any additional financing will be made available to the Company or will be available on acceptable terms should such a need arise. EXPOSURE TO PRODUCT LIABILITY CLAIMS. The testing, marketing and sale of human health care products entail an inherent risk of allegations of product liability, and there can be no assurance that substantial product liability claims will not be asserted against the Company. Although the Company has not received any material product liability claims to date and has an insurance policy of $5,000,000 per occurrence and $5,000,000 in the aggregate to cover such claims should they arise, there can be no assurance that material claims will not arise in the future or that the Company's insurance will be adequate to cover all situations. Moreover, there can be no assurance that such insurance, or additional insurance, if required, will be available in the future or, if available, will be available on commercially reasonable terms. Any product liability claim, if successful, could have a material adverse effect on the Company's business, financial condition and results of operations. DEPENDENCE UPON KEY PERSONNEL. The Company is highly dependent on the members of its management and scientific staff, the loss of one or more of whom could have a material adverse effect on the Company. In addition, the Company believes that its future success will depend in large part upon its ability to attract and retain highly skilled, scientific, managerial and manufacturing personnel. The Company faces significant competition for such personnel from other companies, research and academic institutions, government entities and other organizations. There can be no assurance 18 that the Company will be successful in hiring or retaining the personnel it requires. The failure to hire and retain such personnel could have a material adverse effect on the Company's business, financial condition and results of operations. ENVIRONMENTAL REGULATION. The Company is subject to a variety of local, state and federal government regulations relating to the storage, discharge, handling, emission, generation, manufacture and disposal of toxic, or other hazardous substances used in the manufacture of the Company's products. Any failure by the Company to control the use, disposal, removal or storage of hazardous chemicals or toxic substances could subject the Company to significant liabilities, which could have a material adverse effect on the Company's business, financial condition and results of operations. RISKS RELATING TO INTERNATIONAL OPERATIONS. During the three months ended March 31, 2001 and 2000, approximately, 33.9% and 19.7%, respectively, of the Company's product sales were generated in international markets through marketing partners. The Company's representatives, agents and distributors who sell products in international markets are subject to the laws and regulations of the foreign jurisdictions in which they operate and in which the Company's products are sold. A number of risks are inherent in international sales and operations. For example, the volume of international sales may be limited by the imposition of government controls, export license requirements, political instability, trade restrictions, changes in tariffs, difficulties in managing international operations, import restrictions and fluctuations in foreign currency exchange rates. Such changes in the volume of sales may have an adverse effect on the Company's business, financial condition and results of operations. POTENTIAL VOLATILITY OF STOCK PRICE; NO CONTROL OVER MARKET MAKING. The market price of shares of the Company's common stock may be highly volatile. Factors such as announcements of new commercial products or technological innovations by the Company or its competitors, disclosure of results of clinical testing or regulatory proceedings, governmental regulation and approvals, developments in patent or other proprietary rights, public concern as to the safety of products developed by the Company and general market conditions may have a significant effect on the market price of the Company's common stock. In particular, the Company's stock price declined significantly in October 1998 following the Company's announcement that the FDA had notified the Company that its PMA for ORTHOVISC(R) was not approvable and that additional clinical data would be required to demonstrate the effectiveness of ORTHOVISC(R). The stock price declined again in May 2000 following the Company'S announcements that initial analysis of results from the Phase III clinical trial of ORTHOVISC(R) did not show sufficient efficacy to support the filing of a PMA application to obtain FDA approval, and that the SEC had issued a formal order of investigation and required the Company to provide information in connection with certain revenue recognition matters. The trading price of the Company's common stock could be subject to wide fluctuations in response to quarter-to-quarter variations in the Company's operating results, material announcements by the Company or its competitors, governmental regulatory action, conditions in the health care industry generally or in the medical products industry specifically, or other events or factors, many of which are beyond the Company's control. In addition, the stock market has experienced extreme price and volume fluctuations which have particularly affected the market prices of many medical products companies and which often have been unrelated to the operating performance of such companies. The Company's operating results in future quarters may be below the expectations of equity research analysts and investors. In such event, the price of the common stock would likely decline, perhaps substantially. No person is under any obligation to make a market in the common stock or publish research reports on the Company, and any person making a market in the common stock or publishing research reports on the Company may discontinue market making or publishing such reports at any time without notice. There can be no assurance that an active public market in the common stock will be sustained. POSSIBLE ADVERSE EFFECT OF CERTAIN ANTI-TAKEOVER PROVISIONS. Certain provisions of the Company's Restated Articles of Organization and Amended and Restated By-laws could have the effect of discouraging a third party from pursuing a non-negotiated takeover of the Company and preventing certain changes in control. These provisions include a classified Board of Directors, advance notice to the Board of Directors of stockholder proposals, limitations on the ability of stockholders to remove directors and to call stockholder meetings, the provision that vacancies on the Board of Directors be filled by a majority of the remaining directors. In addition, the Board of Directors adopted a Shareholders Rights Plan in April 1998. The Company also is subject to Chapter 110F of the Massachusetts General Laws which, subject to certain exceptions, prohibits a Massachusetts corporation from engaging in any of a broad range of business combinations with any "interested stockholder" for a period of three years following the date that such stockholder became an interested stockholder. These provisions could discourage a third party from pursuing a takeover of the Company at a price considered attractive by many 19 stockholders, since such provisions could have the effect of preventing or delaying a potential acquiror from acquiring control of the Company and its Board of Directors. SEC INVESTIGATION AND SECURITIES CLASS ACTION LITIGATION. The SEC had issued a formal order of investigation and has required the Company to provide information in connection with certain revenue recognition matters. These matters, relating to the Company's historical accounting for sales of its product under a long-term supply and distribution agreement with Zimmer, Inc., were also the subject of the Company's March 15, 2000 disclosure concerning an informal SEC inquiry and the restatement of results for 1998 and the first three quarters of 1999. The Company has been cooperating fully. However, the Company is not in a position to predict the probable outcome of this matter or its potential impact on the Company's business or operations. Three putative class action lawsuits were filed against the Company. These lawsuits have been consolidated. The parties have negotiated and entered into an agreement in principle to settle the Action (the "Memorandum of Understanding"), which sets forth the terms of the proposed settlement, subject to approval by the Court. As part of the proposed settlement, defendants will pay a total of $1.25 million into a settlement fund, which will, among other things, be used to pay authorized members of the class comprised of all purchasers of the Company's shares between April 15, 1998 and May 30, 2000 (the "Class"). The Memorandum of Understanding and the proposed settlement will be contingent upon, among other things, (i) the parties execution of an appropriate Stipulation of Settlement which is acceptable to the parties; (ii) conditional certification of the Class for purposes of the Settlement, (iii) Court approval of the Settlement; and (iv) dismissal of the Action with prejudice. The Company is not able to provide any assurances that (i) the proposed settlement will be consummated or (ii) the terms of any final settlement will not differ from the terms of the Memorandum of Understanding. Accordingly, the Company has not recorded a liability for the proposed settlement. The consolidated lawsuit is described more fully in Note 9 - "Legal Matters" to the financial statements. RELIANCE ON A SMALL NUMBER OF CUSTOMERS. The Company has historically derived the majority of its revenues from a small number of customers, most of who resell its products to end users and most of who are significantly larger companies. The Company's failure to generate as much revenue as expected from these customers or the failure of these customers to purchase Anika's products would seriously harm Anika's business. For the three months ended March 31, 2001, Bausch & Lomb Surgical accounted for 60.1% of product revenues and 73.95% of the accounts receivable balance and Pharmaren (formerly Biomeks), Anika's distributor in Turkey, accounted for 18.2% of product revenues and none of the accounts receivable balance. Accordingly, if present and future customers terminate their purchasing arrangements with the Company, significantly reduce or delay their orders or seek to renegotiate their agreements on terms less favorable to the Company, the Company will be adversely affected. If the Company accepts terms less favorable than the terms of the current agreement, such renegotiations may have a material adverse affect on Anika's business, financial condition, and/or results of operations. Furthermore, the Company may be subject to the perceived or actual leverage the customers may have given their relative size and importance to the Company in any future negotiations. Any termination, change, reduction or delay in orders could seriously harm the Company's business, financial condition, and results of operations. Accordingly, unless and until the Company diversifies and expands its customer base, Anika's future success will significantly depend upon the timing and size of future purchases by its largest customers and the financial and operational success of these customers. Product revenue in the future may continue to be impacted by economic uncertainties associated with the Turkish market. Furthermore, 2001 sales to our Turkish distributor are at lowered prices and negotiations are ongoing to establish a new long-term distribution agreement for this territory. The loss of any one of the Company's major customers or the delay of significant orders from such customers, even if only temporary, could reduce or delay the Company's recognition of revenues, harm its reputation in the industry, and reduce its ability to accurately predict cash flow, and, as a consequence, could seriously harm the Company's business, financial condition, and results of operations. The Company distributes ORTHOVISC(R) in territories such as Spain, Portugal, Turkey, and Israel. Due to the result of the unfavorable results of the U.S. ORTHOVISC(R) Phase III clinical trial announced on May 31, 2000, marketing efforts in these countries may be negatively affected. There can be no assurance that past ORTHOVISC(R) sales levels will be maintained or that sales will occur at all in these countries. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK As of March 31, 2001, the Company did not participate in any derivative financial instruments or other financial and commodity instruments for which fair value disclosure would be required under SFAS No. 107. All of the Company's 20 investments consist of money market funds and commercial paper that are carried on the Company's books at amortized cost, which approximates fair market value. Accordingly, the Company has no quantitative information concerning the market risk of participating in such investments. PRIMARY MARKET RISK EXPOSURES The Company's primary market risk exposures are in the areas of interest rate risk and foreign currency exchange rate risk. The Company's investment portfolio of cash equivalent and short-term investments is subject to interest rate fluctuations, but the Company believes this risk is immaterial due to the short-term nature of these investments. The Company's exposure to currency exchange rate fluctuations is specific to certain sales to a foreign customer and is expected to continue to be modest. The impact of currency exchange rate movements on sales to this foreign customer was immaterial for the quarter ended March 31, 2001. Currently, the Company does not engage in foreign currency hedging activities. 21 PART II: OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS See Note 9, "Legal Matters" of the financial statements incorporated herein by reference to such financial statements. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBIT NO. DESCRIPTION (3) Articles of Incorporation and Bylaws: 3.1 The Amended and Restated Articles of Organization of the Company, incorporated herein by reference to Exhibit 3.1 to the Company's Registration Statement on Form 10 (File no. 000-21326), filed with the Securities and Exchange Commission on March 5, 1993. 3.2 Certificate of Vote of Directors Establishing a Series of Convertible Preferred Stock, incorporated herein by reference to Exhibits to the Company's Registration Statement on Form 10 (File no. 000-21326), filed with the Securities and Exchange Commission on March 5, 1993. 3.3 Amendment to the Amended and Restated Articles of Organization of the Company, incorporated herein by reference to Exhibit 3.1 to the Company's quarterly report on Form 10-QSB for the period ended November 30, 1996, (File no. 000-21326), filed with the Securities and Exchange Commission on January 14, 1997. 3.4 Certificate of Vote of Directors Establishing a Series of a Class of Stock, incorporated herein by reference to Exhibit 3.1 of the Company's Current Report on Form 8-AB12 (File no. 001-14027), filed with the Securities and Exchange Commission on April 7, 1998. 3.5 Amendment to the Amended and Restated Articles of Organization of the Company, incorporated herein by reference to the Company's quarterly report on Form 10-QSB for the quarterly period ending June 30, 1998 (File no. 001-14027), filed with the Securities and Exchange Commission on August 14, 1998. 3.6 The Amended and Restated Bylaws of the Company, incorporated herein by reference to Exhibit 3.4 to the Company's quarterly report on Form 10-QSB for the period ended November 30, 1996 (File no. 000-21326), filed with the Securities and Exchange Commission on January 14, 1997. (4) Instruments Defining the Rights of Security Holders 4.1 Shareholder Rights Agreement dated as of April 6, 1998 between the Company and Firstar Trust Company, incorporated herein by reference to Exhibit 4.1 to the Company's Current Report on Form 8-A12B (File no. 001-14027), filed with the Securities and Exchange Commission on April 7, 1998. (11) Statement Regarding the Computation of Per Share Earnings 11.1 See Note 4 to the Financial Statements included herewith. (b) Reports on Form 8-K: None 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 in Woburn, Massachusetts on May 14, 2001. ANIKA THERAPEUTICS, INC. May 14, 2000 By: /s/ Douglas R. Potter ---------------------------------------------------- Douglas R. Potter CHIEF FINANCIAL OFFICER (Principal Financial Officer and Authorized Officer) 23