ITEM 1. BUSINESS
Overview
We design, develop, manufacture and market advanced implantable neuromodulation devices that improve the quality of life for people suffering from chronic pain. Neuromodulation devices include implantable neurostimulation devices, which deliver electric current directly to targeted nerves, and implantable drug pumps, which deliver small, precisely controlled doses of drugs directly to targeted sites within the body. Our products utilize innovative technologies that offer advanced programming features, user-friendly interfaces and smaller implanted devices, resulting in greater patient comfort. We are leveraging our neuromodulation product platforms to develop new pain management products and to expand into new applications.
We market our products to physicians who specialize in managing chronic pain. We define chronic pain as pain that persists or recurs for more than six months, is resistant to conservative therapies and significantly restricts a patient’s normal activities. There are approximately 3,000 pain management specialists in the U.S., approximately 80% of whom are anesthesiologists and approximately 20% of whom are neurosurgeons or orthopedic surgeons, and the number of pain management specialists is growing steadily.
In 2003, we acquired certain operations of our three remaining U.S. distributors who marketed our neuromodulation products in the United States. In March 2003, we acquired certain operations of Sun Medical, Inc. (Sun Medical), our largest distributor for approximately $4.9 million. In September 2003, we acquired certain operations of Comedical, Inc. (Comedical) for approximately $1.1 million. In November 2003, we acquired certain operations of our sole remaining distributor in the U.S., State of the Art Medical Products, for approximately $4.2 million. As part of these acquisitions, substantially all of the direct sales persons who represented our products joined us as direct employees. We believe that these acquisitions will strengthen our sales capabilities and allow us to focus the sales priorities of those personnel on our products, expand sales coverage in those former distributor territories and invest in customer and market development.
We currently market three principal product lines: our Renew® radio frequency (RF) system, our Genesis® and GenesisXP™ implantable pulse generator (IPG) systems and our AccuRx® implantable drug pump. We have sold Renew in the U.S. since June 1999 for treatment of chronic pain of the trunk and limbs. Renew’s advanced features effectively manage complex and multi-extremity pain patterns and provide pain management specialists with significant programming flexibility. We began selling Genesis in Europe in the first quarter of 2001 and in the U.S. and Australia in January 2002 for treatment of chronic pain of the trunk and limbs. We believe that Genesis offers a superior size-to-function ratio, greater patient comfort, more flexibility in addressing different pain patterns and other technological advances, which provide us with a competitive advantage. Additionally, we received
approval from the U.S. Food and Drug Administration (FDA) in July 2002 to market an enhanced version of Genesis, the GenesisXP IPG system for treatment of chronic pain of the trunk and limbs, which we launched in the U.S. in the fourth quarter of 2002. The GenesisXP offers substantially more battery capacity than Genesis, resulting in enhanced longevity and/or additional power to treat more complex pain. We began selling AccuRx in certain international markets in the second quarter of 2001 and in 2003 completed all implants in a 109 patient clinical trial we conducted of AccuRx in the U.S. under an investigational device exemption (IDE) from the FDA. AccuRx is smaller than the other constant rate drug pumps currently on the market, and it incorporates a new polymeric diaphragm technology that makes it more precise under varying conditions than other constant rate drug pumps. We filed our pre-market approval (PMA) application for AccuRx with the FDA in December 2003.
Our Hi-tronics Designs, Inc. (HDI) subsidiary designs and manufactures medical devices for us, and for other companies on an O.E.M. (original equipment manufacturer) basis. HDI’s core strength is in developing highly sophisticated electromechanical devices featuring electronic circuits with very low power requirements. The acquisition of HDI allowed us to leverage its expertise in development and manufacturing and benefit from its technology platforms.
We were incorporated in the State of Texas on May 2, 1979.
The Neuromodulation Market Opportunity
When treating patients suffering from chronic pain, pain management specialists can select from several therapy options, ranging from the least invasive and lowest-cost therapies to the most aggressive and expensive therapies. Initially, patients typically try over-the-counter medications and physical therapy. If these therapies fail, patients generally try some combination of prescription medications, TENS therapy (application of electrical impulses to the skin), psychological therapy and nerve blocks (injections that provide temporary pain relief). If these therapies do not succeed in relieving pain, patients may then try narcotic and opioid drugs, neurolysis (destruction of the affected nerve) and thermal procedures. At some point during their course of treatment, patients may use neuromodulation products or undergo more invasive surgical procedures.
Patients who opt for neurostimulation or drug pumps to treat chronic pain typically range in age from 25 to 55, have suffered back or neck injuries or otherwise suffer from degenerative spine conditions, and are in constant pain that has not been alleviated by other therapies, including back surgeries. A growing number of patients are choosing neuromodulation over prolonged systemic use of narcotic or opioid drugs, which have negative side effects, or back surgeries involving vertebral fusion or nerve destruction, which are irreversible and often unsuccessful.
The use of neuromodulation devices to manage chronic pain is growing rapidly. According to an independent study, spinal cord stimulation products were forecasted to account for $357.0 million in revenues in 2003 in the United States, up from $293.2 million in 2002. Total neurostimulation revenues for all currently approved indications in the U.S. (including deep brain stimulation, sacral nerve stimulation and other applications) were forecasted to account for $553.4 million in 2003, up from $435.7 million in 2002, according to the same study. A separate study forecasted that in 2002 worldwide sales of drug pumps were approximately $270 million.
The primary factors driving this growth include the following:
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Increased physician and patient awareness of the benefits of neuromodulation. Neuromodulation can manage pain effectively, is minimally invasive, has few side effects and is generally reversible. As physicians and their patients are becoming more aware of these benefits and more accepting of this treatment option, neuromodulation is being used earlier in the process of managing chronic pain. Consequently, the number of pain management specialists worldwide
who understand and are trained to use neuromodulation products and techniques is growing steadily.
•
Expanded indications for the use of neuromodulation products. Neuromodulation products have demonstrated success in the treatment of indications outside of chronic pain. Other companies have recently received regulatory approvals to use these products to address new indications, including essential tremor, Parkinson’s Disease, and incontinence, and future approvals are expected for angina and severe headaches, which should expand the neuromodulation market.
•
Technological advances in neuromodulation products. Advances in technology have decreased the size of neuromodulation devices, increased the longevity of their power sources and enhanced programmability and other functional components of the devices, leading to better results for patients.
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Patients’ increased focus on quality of life. In the past, chronic pain sufferers were often resigned to long-term use of pain-killing drugs, often bedridden and unable to maintain a normal lifestyle. Today, many chronic pain patients hope to resume an active lifestyle following an injury or illness, and thus are more likely to consider and accept neuromodulation therapy.
Our Strategy
Our objective is to be a leading provider of a full range of innovative neuromodulation devices for the management of chronic pain and nervous system disorders. To achieve this objective, we are pursuing the following business strategies:
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Expand our presence in the chronic pain market. Through the recent launches of our IPG systems, we have entered a market that is estimated to be nearly five times larger than the RF market, and thus significantly expanded our potential market opportunity. We intend to continue increasing our penetration of the chronic pain market by enhancing our sales and marketing resources. We also intend to leverage our relationships with pain management specialists as well as our favorable track record with our RF systems to grow our market share in the IPG portion of the neurostimulation market and to further strengthen our position in the RF portion of this market.
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Pursue regulatory approvals for new treatment indications. We believe our neurostimulation technology platforms have broad applicability for multiple treatment indications beyond chronic pain conditions. We will pursue regulatory approvals for new clinical applications to treat disorders affecting large patient populations, including essential tremor, Parkinson’s Disease, pelvic pain and severe headaches, where neuromodulation has demonstrated success.
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Continue to build and expand our technology leadership. We have focused on building a corporate infrastructure and core competency in research and development, manufacturing, sales and marketing, reimbursement and regulatory affairs to provide our customers with the highest quality products and services. We believe this strategy will enable us to expand our existing product platforms into new applications and product offerings. We will continue to invest significant resources in the development of our infrastructure and technology platforms to maintain our reputation as a leader in the neuromodulation market.
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Evaluate and pursue acquisitions and strategic alliances. We will pursue acquisitions and strategic alliances that complement our existing neuromodulation business, products and technology platforms and that enhance our product development, and our technological and marketing capabilities.
Our Products
Within the neuromodulation market, there are two main categories of treatment: neurostimulation, in which an implanted device delivers electrical current directly to targeted nerve sites, and implantable drug pumps, in which an implanted pump delivers drugs directly to a targeted site. We currently market products in both of these treatment categories.
Neurostimulation Therapy Overview
Neurostimulation involves delivering small, mild electrical pulses to the spinal cord or peripheral nerves to inhibit or block the sensation of pain. This stimulation of nerves at or near the site where pain is perceived masks the sensation of pain by generating a tingling sensation or “paresthesia.” Neurostimulation is generally used to manage sharp, intense and constant pain arising from nerve damage or nervous system disorders.
A neurostimulation system typically consists of a pulse generator that produces electrical current, and an external or internal power source. The pulse generator is generally implanted under the patient’s skin in the abdominal area. Leads, which are catheters that contain electrodes and connecting wires, extend from the pulse generator to the targeted therapy site in the epidural space along the spinal cord. The electrodes are centered on the therapy site and deliver electrical current from the pulse generator to the prescribed area. An external programmer allows the physician and patient to adjust the electrical current to the electrodes to optimize the therapeutic effect.
Implant procedures are most often performed at hospitals on an outpatient basis, with a small percentage of procedures also performed at ambulatory surgery centers and at hospitals on an inpatient basis. In most cases, a patient will receive a trial device for a period of up to two weeks. Based on our experience, more than 70% of patients who undergo a trial procedure elect to receive a permanent implant. Implant procedures cost between $30,000 and $50,000, including the cost of the system. The cost of the system generally ranges from $10,000 to $20,000, depending on whether an IPG or RF system is used, the components utilized and the sophistication of the system selected.
Clinical results demonstrate that the majority of patients who are implanted with a neurostimulation system experience a substantial reduction in pain, an increase in activity level, a reduction in use of narcotics and a reduction in hospitalization. We believe these benefits translate into an overall reduction in healthcare costs as well as a significant improvement in the patient’s quality of life.
Our Neurostimulation Products
We currently have two neurostimulation product platforms that we market worldwide: our Renew RF system, which uses an external power source, and our family of totally implantable IPG systems, Genesis and GenesisXP.
Renew
Renew is the latest generation system in our RF stimulation product line, which we believe is the leading technology in the RF stimulation market. We introduced Renew in the U.S. during June 1999 and began selling it in international markets during 2000. The Renew system consists of an implanted RF receiver/pulse generator and leads, and a transmitter containing a power source that is worn externally. The system is powered with the help of an antenna that is attached to the patient’s skin with adhesive tape. Because Renew has a rechargeable, external power source, we believe it is best suited for patients with complex, changing or multi-extremity pain patterns that require higher power levels for treatment.
Genesis
In late 2000, we received regulatory approvals to begin selling our Genesis IPG system in certain international markets, and we commenced sales during the first quarter of 2001. In November 2001, we received FDA approval of Genesis for treatment of chronic pain of the trunk and limbs, and we launched Genesis in the U.S. in January 2002. Additionally, we received approval in July 2002 from the FDA to market an enhanced version of Genesis, the GenesisXP IPG system for the treatment of chronic pain of the trunk and limbs, which we launched in the U.S. in the fourth quarter of 2002. The GenesisXP offers substantially more battery capacity than Genesis, resulting in enhanced longevity and/or additional power to treat more complex pain. As a result, we now participate in the largest part of the implantable neurostimulation market, as approximately 80% of neurostimulation implantation procedures performed involve IPG systems and the remainder involves RF systems.
Like other IPGs, Genesis is totally implanted and contains a power source with a life of two to five years, depending on stimulation parameters. Generally, simple, localized pain sufferers require less power output than complex, multi-site pain sufferers. These patients and their physicians will usually select an IPG in order to benefit from the convenience of a totally implantable system.
Our Neurostimulation Technologies
Although our Renew and Genesis systems differ in certain significant respects, they share similar technology platforms and benefits, including:
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Greatest number of electrodes. Our Renew system is the only product on the market that can accommodate up to 16 electrodes. In addition, our IPG systems not only allow the use of two 4-electrode leads, but also allow the use of one 8-electrode lead. A greater number of electrodes results in more comprehensive coverage along the spine, and provides physicians with increased flexibility in accommodating a patient’s changing pain patterns. This advantage can, in some cases, also enable a physician to address the problem of lead “migration”, or lead movement along the spine after implant, noninvasively by reprogramming the patient’s stimulation, rather than using an invasive procedure to revise the placement of the lead. We estimate that lead migration occurs in 10% to 15% of cases.
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Advanced programmability. Our Renew, Genesis, and GenesisXP systems feature MultiStim technology. This technology allows clinicians to create multiple stimulation programs, which can be delivered rapidly and sequentially to cover complex pain patterns. These systems also feature PC-Stim, which enables patients to select from a number of clinician-prescribed stimulation programs to optimize treatment as their pain patterns change. Additionally, we have also developed PainDoc®, a proprietary, Windows-based computerized support system, and Rapid Programmer™, a palm-sized programming tool, which facilitate programming and therapy management.
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Innovative and patented technology. Our neurostimulation devices offer our advanced patented technology, which allows programmability of each individual electrode to a “tri-state” position, either positive, negative or neutral. This provides added flexibility in directing the flow of stimulation and is a valuable tool in addressing lead migration.
•
Reduced size of implanted device. Our Renew receiver, our Genesis IPG and GenesisXP offer smaller “size-to-power” ratios than comparable products currently on the market, which results in enhanced patient comfort.
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Ease of lead implantation. Our leads are designed for ease of implantation, which makes the procedure easier for physicians to perform and reduces the time required to complete the procedure.
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User-friendly interface. Our neurostimulation devices have easy-to-use controls and interactive displays that include a stimulation diagram for quick visual confirmation of stimulation coverage.
The following table summarizes some of the key features of the Renew and Genesis systems:
PRODUCT FEATURES
RENEW
GENESIS
Implanted Elements
Receiver/pulse
generator, leads
Pulse generator/power
supply, leads
External Elements
Programmer,
transmitter/power
supply, antenna
Programmer
Battery
External, rechargeable
and replaceable
Internal with 2-5 year
life, depending on
program settings and
system use
Programming Control
Up to 24 programs, plus some patient
control
Up to 24 programs
Lead and Electrode
Capacity
1 to 4 leads utilizing up to 16 electrodes
1 or 2 leads utilizing up
to 8 electrodes
Our Implantable Drug Pump Product - AccuRx
Implantable drug pumps deliver precise doses of medication directly to a targeted site. This direct drug delivery creates a higher drug concentration at the site, which can often provide faster relief with much lower quantities of medication. For example, the difference in intraspinal versus oral morphine dosage is approximately 1:300. These lower dosages help to minimize side effects, and are more economical for the patient and the third-party reimbursement system. Today, implantable drug pumps are used for the delivery of morphine for the treatment of pain (such as cancer pain), baclofen for spasticity and other movement disorders, and for the intra-arterial delivery of various drugs for chemotherapy.
Implantable drug pumps consist of the pump and a catheter. The pump contains a reservoir that holds the drug and regulates the drug’s delivery rate. The pump is implanted under the skin in the abdominal area and is connected to the catheter, which is tunneled under the skin into either the epidural or intrathecal space of the spinal column. Implantation procedures are most often performed at hospitals on an outpatient basis, with a small percentage of procedures also performed at ambulatory surgery centers and at hospitals on an inpatient basis. The pump is refilled by placing a needle through the skin into an access port on the pump and injecting the drug into the reservoir.
Currently, there are two basic types of implantable drug pumps - constant rate and programmable. Constant rate pumps provide drug infusion at a single, continuous flow rate that cannot be changed once the pump has been implanted in the patient. Programmable pumps allow the rate of drug delivery to be non-invasively changed to meet the patient’s needs. According to an industry report, worldwide
sales of programmable drug pumps in 2002 were forecasted to be approximately $243 million, as compared with worldwide sales of constant rate drug pumps of $27 million.
We currently offer one drug pump product, our AccuRx constant rate drug pump. We received regulatory approvals to distribute AccuRx in certain international markets for the delivery of morphine and began selling AccuRx in those markets in the second quarter of fiscal 2001. We also received an IDE from the FDA to initiate clinical trials in the U.S. for the delivery of morphine. The clinical trials included 15 sites and 109 patients, all of whom have now been implanted with AccuRx systems. We filed our PMA application with the FDA in December 2003, and must receive approval from the FDA before we can market AccuRx within the United States. We currently expect a late 2004 or early 2005 launch of AccuRx within the United States, assuming the FDA approves our PMA application.
AccuRx is currently the only constant rate drug pump that is powered by our proprietary polymeric diaphragm, rather than by pressurized gas in a chamber surrounding the drug reservoir. The advantages of this design are that our pump is more precise under varying conditions (because its operation is not affected by changes in the body’s temperature or pressure), simpler to manufacture, smaller than other drug pumps on the market and can hold more drug for its size than competing products.
Financial Segments
We operate in two business segments. The Neuro Products segment designs, develops, manufactures and markets implantable medical devices that are used to manage chronic intractable pain and other disorders of the central nervous system through the delivery of electrical current or drugs directly to targeted nerve fibers. The HDI O.E.M. segment provides contract development and O.E.M. manufacturing of electro-mechanical devices. See Note 12 to the Consolidated Financial Statements for segment financial data for the years ended December 31, 2003, 2002 and 2001.
Sales and Marketing
General
We target our sales and marketing efforts at pain management specialists, which include anesthesiologists, neurosurgeons and orthopedic surgeons. Because most pain management specialists implant both RF and IPG devices, as well as drug pumps, we expect to leverage our relationships and experience with pain management specialists and track record with our RF systems to establish our position in the IPG portion of the neurostimulation market. Additionally, by rounding out our product offerings with our IPG systems, we are now able to target physicians who have historically implanted only IPGs.
In 2003, we derived 93% of our net revenues for neuromodulation products from domestic sales and approximately 7% from international sales.
U.S.
With our acquisitions of certain operations of our remaining three domestic distributors in 2003, we have expanded our domestic sales force. In the U.S., we currently use a hybrid sales force, which now consists of 55 direct sales employees and 37 commissioned sales agents. We typically have contracts with all of our sales agents that provide for exclusive territories and sales quotas.
Our sales agents cover defined geographic territories and focus predominantly on the pain management market. Many of our sales agents sell our products as their flagship product line. We pay
our sales agents commissions at contractual rates, and we invoice and collect revenues from end users.
We employ 26 clinical specialists, who support our direct and commissioned sales agents by providing intra-operative technical and clinical assistance and post-operative programming support.
In addition, we employ eight regional sales managers who interact with our customers and oversee our commissioned sales agents and direct sales employees, a Director of North American Sales and a Vice President of North American Sales, who both coordinate the sales efforts of our distribution network in North America.
Our domestic marketing programs include:
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medical marketing programs intended to educate physicians and their staffs about our products and their use;
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surgical training programs offered to physicians interested in improving their surgical techniques;
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education materials, such as brochures and videos, to educate patients and physicians;
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reimbursement assistance, with the help of outside consultants, to assist physicians in obtaining appropriate reimbursement for our products and their services;
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consulting relationships with opinion leaders who provide us feedback about our current and future products, diagnostic and treatment trends and other areas of interest;
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web site marketing focused on educating both physicians and patients about our product alternatives, reimbursement for our procedures and our company;
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medical journal advertisements; and
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involvement in medical device societies and conferences.
International
Internationally, we market our products through 20 independent distributors who represent us in 26 countries. We are represented by direct salespersons employed by us in Germany. Our Director of International Operations, who is based in the United Kingdom, manages our international distribution network. We are in the process of training and signing independent distributors to market our products in additional countries.
Customer Service
Our sales representatives and clinical specialists are responsible for training physicians and nurses on programming and trouble-shooting any problems with our RF and IPG systems. Both the RF and IPG systems have up to 24 different program settings, which can be programmed and saved into memory. Therefore, significant training of physicians and nurses is required for new users of our products. We typically provide a warranty against defects in workmanship and materials for one year from the date of sale of our products to end-users.
Major Customers
During 2003, we had no customer with net sales greater than 10% of net revenue for our Neuro Products segment. During 2002 and 2001, we had one customer that accounted for 10% or more of our net revenue from our Neuro Products segment. Sun Medical, a specialty distributor, accounted for $6.3 million, or 13.5% of our Neuro Products segment revenue for the year ended December 31, 2002 and $4.2 million, or 15.3% of our Neuro Products segment revenue for the year ended December 31, 2001. In March 2003, we acquired certain operations of Sun Medical and hired substantially all of the salespeople who had accounted for sales of our Neuro Products. See Note 3 to the Consolidated Financial Statements.
During the year ended December 31, 2003, we had two customers that together accounted for $9.84 million, or 88.8% of net revenue of our HDI O.E.M. segment. Medtronic, Inc. (Medtronic), our most significant competitor, accounted for $8.40 million, or 75.8%, and Arrow International, Inc. (Arrow) accounted for $1.44 million, or 13.0%. During the year ended December 31, 2002, we had two customers that together accounted for $9.52 million, or 89.3% of net revenue of our HDI O.E.M. segment. Medtronic accounted for $6.74 million, or 63.2%, and Arrow accounted for $2.78 million, or 26.1%. During the year ended December 31, 2001, we had three customers that collectively accounted for 10% or more of net revenue of our HDI O.E.M. segment. Medtronic accounted for $6.3 million, or 60.3%, Arrow accounted for $1.8 million, or 17.2%, and Transneuronix, Inc. accounted for $1.1 million, or 10.5%.
HDI currently manufactures two products for Medtronic, one of which accounts for substantially all of the revenue generated from this customer. This product is manufactured under an exclusive Supply Agreement that expires on January 1, 2005. The terms of the Supply Agreement require Medtronic to purchase its requirements for the device from us through March 31, 2004 and then at least 50% of its requirements through January 1, 2005. The device is sold in the cardiology market and is not competitive with any of our products. The Supply Agreement provides that either party may terminate the agreement prior to January 1, 2005 in the event of a material breach or nonperformance. Additionally, Medtronic can terminate the Supply Agreement prior to January 1, 2005 by paying us a termination fee. Medtronic has indicated its desire to extend the agreement and HDI and Medtronic are currently discussing the terms of a new supply agreement. Arrow engaged HDI in October 2000 to develop several products for a new cardiology system under a Product Development and Manufacturing Agreement. Development is likely to be completed during the first half of 2004. At the conclusion of the development, Arrow will likely seek PMA approval from the FDA to market and sell the system. Under the agreement with Arrow, HDI has ongoing exclusive rights to manufacture the products for clinical trials and subsequent market release if the system is approved, until Arrow meets certain purchase minimums.
Research and Development
We currently have an in-house research and development staff of 70 people. In 2003, we spent $9.53 million (10.5% of total net revenue) on research and development and clinical trials, and we expect to increase our investment in research and development and clinical trials for 2004 to approximately $12 million. In 2002 and 2001, we spent $5.84 million (10.2% of total net revenue) and $4.93 million (13.0% of total net revenue), respectively, on research and development and clinical trials.
Our current research and development efforts include work on the following:
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An IPG stimulation system to address migraine headaches. During the first quarter of 2001, we initiated a pilot clinical study in the U.S., which consisted of 10 patients at 2 sites, to evaluate the efficacy of Genesis for treating migraine headaches. We completed the pilot study during the second quarter of 2002, and the data will be used to determine the parameters for a larger pivotal
clinical study to support a PMA application for Genesis to treat migraine headaches. There are approximately one million patients in the U.S. alone who suffer from migraine headaches. We plan to initiate clinical trials in 2004 for migraine headaches upon approval of an IDE by the FDA.
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IPG stimulation systems for deep brain stimulation to address essential tremor, Parkinson’s Disease and other indications. We plan to initiate clinical trials in 2004 for deep brain stimulation to treat essential tremor and Parkinson’s Disease upon approval of an IDE by the FDA.
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Exploring new applications of our neurostimulation systems to address angina, peripheral vascular disease and sacral nerve stimulation for pelvic pain and incontinence.
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Next-generation IPG and RF neurostimulation systems.
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Next-generation drug pumps, including a prototype programmable pump that will take several years to develop, and new applications for drug pumps.
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Clinical trials that we expect to initiate on several of our new products upon IDE approval from the FDA.
Hi-tronics Designs, Inc.
Our HDI subsidiary developed and is the manufacturer of our Genesis IPG and GenesisXP IPG, and is also the manufacturer of the transmitter used with Renew. HDI’s core strength is in developing highly sophisticated electromechanical devices featuring electronic circuits with very low power requirements, utilizing both discrete and highly integrated technology. Combined with our capabilities in the design and manufacture of implantable leads, electronic device control and communication systems and implantable drug pumps, we believe this expertise allows us to develop more sophisticated products in less time.
As an O.E.M. manufacturer, HDI has developed and introduced more than 60 medical devices for leading medical device companies in the fields of cardiology, neurology and orthopedics. Through HDI, we offer our customers complete development and manufacturing services, beginning with product definition and design and continuing through validation, prototyping, regulatory approval and manufacturing. In 2003, our HDI O.E.M. operations accounted for 12.2% of our consolidated revenues. We expect revenue at HDI to grow modestly and we expect the percentage of HDI O.E.M. revenue to our total revenue to decrease further as our neuromodulation sales continue to grow and as we continue to utilize more of HDI’s manufacturing and development capabilities for our own needs. We currently use approximately 55% of HDI’s manufacturing capacity to supply products on an intercompany basis.
Manufacturing
We operate two manufacturing facilities: one in Plano, Texas and the other in Hackettstown, New Jersey. We assemble and package the majority of our neurostimulation devices and implantable drug pumps at our Plano facility. We also manufacture a variety of medical devices and products on an O.E.M. basis in our Hackettstown facility.
Our manufacturing processes largely consist of the assembly of standard and custom components that we purchase from third-party subcontractors, functional testing to ensure adherence to specifications and inspection of completed products, and the manufacture of our own leads and drug pumps. Our implantable devices are assembled and sterilized in a “clean room” environment designed and maintained to reduce product exposure to particulate matter.
We rely on third-party suppliers for most of our products’ components and on single suppliers for several critical components used in our main products, including the computer chip used in the receiver of our RF system, the computer chip used in the IPG programmer and Renew transmitter, the batteries used in our IPG systems and the medical-grade polyurethane (bionate) that we and our competitors use in our products. We have been notified by the supplier of the computer chip used in the receiver of our RF system that at some point in the future it intends to cease manufacturing and supplying the computer chip, but to date it has not determined when this will occur. This supplier has agreed to allow us to place a final one-time purchase order for the computer chip. In the interim, we are maintaining a higher than normal inventory of the computer chip and are working to develop a new product design that uses an alternative computer chip. We currently have enough of the chips in stock to meet our projected requirements through the end of 2005.
We currently have sufficient manufacturing capacity to support our business plan, and we plan to relocate our Plano facilities to our new corporate headquarters in mid-2004 which will increase our capacity. See Item 2
ITEM 2. FACILITIES
We entered a 63-month lease agreement, which became effective on June 1, 1999, for our 40,000 square foot corporate headquarters and manufacturing facility in Plano, Texas. In September 2002, we amended our lease agreement to add approximately 9,700 square feet of office space located in the same complex. The lease on the additional space as well as the corporate headquarters facility expires in August 2004. We have two five-year renewal options on the facilities. In addition, in June 2003, we entered into a sublease agreement to add approximately 9,800 square feet of office space located in the same complex. The term of the sublease expires on July 31, 2004. We expect to vacate these three spaces during mid-2004.
Because we expect our business to continue to grow at rates that will demand added office and facility space, we acquired approximately 10 acres of land in December 2002 for approximately $3.19 million. The land is located in Plano, Texas near our current corporate headquarters. We began construction of a new corporate headquarters facility on the land in April 2003 and plan to relocate to the new facility before the expiration of our principal lease in August 2004. The new facility will be approximately 143,000 square feet with an estimated construction cost of approximately $15 million. We also plan to spend approximately $1.5 million for furniture and equipment for the new facility. The new facility was designed to accommodate planned growth within a five-year horizon.
We also lease facilities in New Jersey for our HDI O.E.M. segment. One of the facilities, located in Budd Lake, New Jersey, is 10,730 square feet of office space that is used for administration, design engineering, drafting, documentation and regulatory affairs. We renewed the lease on March 1, 2004 and the lease expires on February 28, 2006. Our Budd Lake lease contains no renewal option. We also lease 18,582 square feet of space in Hackettstown, New Jersey used for our HDI O.E.M. manufacturing operations. We renewed the Hackettstown lease on December 31, 2002 and the lease expires on December 31, 2005 and is renewable for one additional three-year period.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are a party to product liability claims and other ordinary routine litigation claims arising in the ordinary course of business related to our neurostimulation devices. Our product liability insurers have assumed responsibility for defending us against product liability claims, subject to reservation of rights in certain cases. Historically, product liability claims for our neurostimulation devices have not resulted in significant monetary liability beyond our insurance coverage. We seek to maintain appropriate levels of product liability insurance with coverage that we believe is comparable to that maintained by companies similar in size and serving similar markets.
Except for ordinary course product liability claims and other ordinary routine litigation incidental to our business, we are not currently a party to any other pending legal proceeding. We maintain general liability insurance against risks arising out of the normal course of business.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Inapplicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is currently quoted on the Nasdaq National Market under the symbol “ANSI.” On March 5, 2004, there were approximately 550 holders of record of our common stock. The following table sets forth the quarterly high and low closing sales prices for our common stock. These prices do not include adjustments for retail mark-ups, markdowns or commissions.
On July 11, 2003, we effected a 3 for 2 stock split in the form of a 50% stock dividend (one share of common stock paid for every two shares held), paid to shareholders of record on June 20, 2003. All prior period shares, share prices, and income per share figures have been restated to reflect the split.
To date, we have not declared or paid any cash dividends on our common stock and the Board of Directors does not anticipate paying cash dividends on our common stock in the foreseeable future.
Equity Compensation Plan Information
As of December 31, 2003
(1)
Executive officers and members of the Board of Directors are not eligible to receive stock option grants under non-shareholder approved plans.
(2)
Certain of the plans allow the aggregate number of shares of common stock reserved for options under the plan to be increased by the same percentage that the total number of issued and outstanding shares of common stock increased from the preceding January 1 to the following December 31 (if such percentage is positive).
Equity Compensation Plans Not Approved by Security Holders In April 2001, the Board of Directors adopted the 2001 Employee Stock Option Plan (the 2001 Plan). The purpose of the 2001 Plan is to furnish additional equity incentives to key employees of the Company, other than executive officers of the Company. Members of the Board of Directors are also ineligible to participate in the 2001 Plan. The additional equity incentives are designed to increase shareholder value and to advance the interests of the Company by furnishing incentives to attract and retain the best available personnel for positions of substantial responsibility and to provide incentives to such personnel to promote the success of the business of the Company and its subsidiaries. The total number of shares of common stock issuable under the 2001 Plan is 270,000, subject to an adjustment on January 1 of each year (commencing on January 1, 2002), when the aggregate number of shares of common stock then issuable upon the exercise of options will be increased by the same percentage that the total number of issued and outstanding shares of common stock increased from the preceding January 1 to the following December 31 (if the percentage is positive). On January 1, 2002, 2003 and 2004, 49,788 shares, 115,572 shares and 27,907 shares, respectively were added to the 2001 Plan pursuant to this provision. All options granted under the 2001 Plan will be “nonqualified stock options” under the Internal Revenue Code of 1986, as amended from time to time. All stock option grants under the 2001 Plan expire ten years from the date of grant and for the most part are exercisable one-fourth each year over a four-year period of continuous service. The exercise price of an option granted under the 2001 Plan is determined by the Stock Option Committee, but in no event can be less than the fair market value of the common stock at the time the stock option is granted.
In June 2002, the Board of Directors adopted the 2002 Stock Option Plan (the 2002 Plan). The purpose of the 2002 Plan is to furnish additional equity incentives to advisory directors, consultants and key employees of the Company, other than executive officers of the Company. Members of the Board of Directors are also ineligible to participate in the 2002 Plan. The additional equity incentives are designed to increase shareholder value and to advance the interests of the Company by furnishing incentives to attract and retain the best available advisory directors, consultants and key employees for
positions of substantial responsibility and to provide incentives to such advisory directors, consultants and key employees to promote the success of the business of the Company and its subsidiaries. The total number of shares of common stock issuable under the 2002 Plan is 337,500, subject to an adjustment on January 1 of each year (commencing on January 1, 2003), when the aggregate number of shares of common stock then issuable upon the exercise of options will be increased by the same percentage that the total number of issued and outstanding shares of common stock increased from the preceding January 1 to the following December 31 (if the percentage is positive). On January 1, 2003 and 2004, 121,973 shares and 29,452 shares, respectively, were added to the 2002 Plan pursuant to this provision. All options granted under the 2002 Plan will be “nonqualified stock options” under the Internal Revenue Code of 1986, as amended from time to time. All stock option grants under the 2002 Plan expire six years from the date of grant for advisory directors and consultants and ten years from the date of grant for key employees. For the most part, stock option grants to key employees under the 2002 Plan are exercisable one-fourth each year over a four-year period of continuous service while stock option grants to advisory directors and consultants vary from cliff vesting in eighteen months, one-half each year over a two-year period of service, one-third each year over a three-year period of service, one-fourth each year over a four-year period of service to one-fifth each year over a five-year period of service. The exercise price of an option granted under the 2002 Plan is determined by the Stock Option Committee, but in no event can be less than the fair market value of the common stock at the time the stock option is granted.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
(1) On January 2, 2001, we completed the acquisition of Hi-tronics Designs, Inc. The transaction was accounted for on a pooling of interests basis and accordingly, prior periods have been restated.
(2) Net revenue excludes contract research and development revenue in 1999 from our former agreement with Sofamor Danek.
The following is a reconciliation of previously reported amounts with restated amounts for total net revenue and net income resulting from the January 2, 2001 acquisition of Hi-tronics Designs, Inc. accounted for on a pooling of interests basis.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the Consolidated Financial Statements of the Company and the related Notes.
On July 11, 2003, we effected a 3 for 2 stock split in the form of a 50% stock dividend (one share of common stock paid for every two shares held), paid to shareholders of record on June 20, 2003. All prior period shares, share prices, and income per share figures have been restated to reflect the split.
Background
We entered the neuromodulation market in 1995 through the acquisition of a company that had developed and marketed a radio-frequency (RF) neurostimulation system. Through our initiatives, we developed and launched our next generation neurostimulation system, the Renew® RF spinal cord stimulation system, in 1999. We also recently developed our Genesis® and GenesisXP™ totally implantable pulse generator (IPG) spinal cord stimulation systems. We began selling Genesis in Europe in 2001 and in the U.S. in 2002 subsequent to the FDA’s approval of our PMA application in November 2001, and our GenesisXP IPG system following FDA approval in the fourth quarter of 2002.
In 2000, we completed development of AccuRx, our constant rate implantable drug pump, in part using proprietary technology we licensed from Implantable Devices Limited Partnership (IDP). We began selling AccuRx in certain international markets in the second quarter of 2001. In January 2001, we strengthened our position in the neuromodulation market by acquiring the assets of IDP and ESOX Technology Holdings, LLC (ESOX). This acquisition provided us with intellectual property surrounding implantable drug pump technologies in all applications, including pain and cancer therapy.
Also in January 2001, we completed the acquisition of Hi-tronics Designs, Inc. (HDI). We accounted for this acquisition using the pooling of interests method. Acquiring HDI provided us with additional in-house expertise in the design and manufacture of highly sophisticated electromechanical devices. Additionally, HDI continues to provide contract development and manufacturing services to third parties, which we report as a separate segment for financial reporting purposes (the HDI O.E.M. segment). In the future, we expect our HDI O.E.M. segment revenue to decrease as a percentage of our total revenue as we grow revenue from our proprietary neurostimulation systems and drug pumps and increasingly utilize HDI’s research and development capabilities for internal product development.
In November 2002, we completed the acquisition of MicroNet Medical, Inc. (MicroNet), a privately held developer of medical devices based on proprietary micro-lead technology. MicroNet developed a line of very thin and steerable spinal cord stimulation leads called Axxess™. These leads are the smallest neurostimulation leads on the market, which we believe offers advantages in certain applications.
In 2003, we acquired certain operations of our three remaining U.S. distributors who marketed our neuromodulation products in the United States. In March 2003, we acquired certain operations of Sun Medical, our largest U.S. distributor. In September 2003, we acquired certain operations of Comedical, our northwestern U.S. distributor and in November 2003, we acquired certain operations of our sole remaining distributor in the northeastern U.S., State of the Art Medical Products. As part of these acquisitions, substantially all of the direct sales persons that represented our products joined us as direct employees. We believe that these acquisitions will strengthen our sales capabilities and allow us to focus the sales priorities of those personnel on our products, expand sales coverage in those former distributor territories and invest in customer and market development.
Our current neuromodulation product line includes our Genesis IPG system, GenesisXP IPG system, Renew RF system and AccuRx constant rate drug pump. With the launch of our Genesis and
GenesisXP IPG systems, we compete in 100% of the implantable neurostimulation market to treat chronic pain of the trunk and limbs. The launch of the Genesis IPG and GenesisXP IPG in 2002 slowed our growth rate in sales of Renew systems from an average percentage growth rate of the mid-teens over the past several years to single-digit growth in both 2002 and 2003. Management believes this trend may continue in 2004 and has assumed similar single-digit growth in Renew sales during 2004.
Critical Accounting Policies and Estimates
General
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities and related disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to third-party reimbursement rates, bad debts, inventories, intangible assets, and contingencies and litigation. Management bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Management believes the following critical accounting policies affect its more significant judgments and estimates used in preparation of its consolidated financial statements.
Revenue Recognition
We generate revenues from product sales to end customers, product sales to international distributors, and development contracts. Until we completed the acquisition of certain operations of our remaining U.S. distributors in 2003, we also generated revenue from product sales to U.S. distributors.
We recognize revenue on product sales to end customers and distributors upon shipment, provided an arrangement with the customer or distributor exists, the fee is fixed and determinable, and collectibility is reasonably assured. Certain of our customers are third-party payors who reimburse fixed amounts for services based on a specific diagnosis. Revenue is recognized on these third-party payor sales based on the sales price less a contractual adjustment, which is based on our history of reimbursement with the third-party payor, provided all other revenue recognition criteria are met. We do not have any continuing obligation to our customers for installation or training, and there are no acceptance clauses in our customer arrangements.
We recognize revenue on development contracts at HDI using either the percentage of completion method for fixed price development contracts, or as the services are performed for development contracts that are completed on a time and materials basis. We recognize revenue using the percentage of completion method for the fixed price development agreements as the contract term can vary from 9 to 24 months, our right to receive payment depends on our performance in accordance with the agreement, and we can reasonably estimate the costs applicable to various stages of the
development arrangement. Revenue is recognized based on the ratio of costs incurred in relation to the estimated costs for the total project. If we do not accurately estimate the resources required or the scope of work to be performed under a fixed price development agreement, then future profit margins and results of operations may be negatively impacted.
Under the Company’s shipping terms, title transfers to the end customer or distributor at the point of shipment. Shipping and handling costs are included in cost of revenue. Payments received in advance of revenue recognition requirements are recorded as deferred revenue on the consolidated balance sheet.
Bad Debt
We are required to estimate the collectibility of our trade receivables. A considerable amount of judgment is required in assessing the ultimate realization of the receivables, including the current credit-worthiness of each customer, the aging of receivables and our historical experience. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances or write-offs may be required.
Inventory Reserve
Our reserve for excess and obsolete inventory is based upon forecasted demand for our products. If the demand for our products is less favorable than those projected by management, additional inventory write-downs or write-offs may be required.
Intangible Assets
Intangible assets consist of goodwill, patents, purchased technology, trademarks, customer and supplier relations and covenants not to compete, and are amortized using the straight-line method over their respective useful lives.
In assessing the recoverability of our intangible assets, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets.
Contingencies
We are subject to proceedings, lawsuits and other claims related to our products and business. We are required to assess the likelihood of any adverse judgments or outcomes to these matters as well as potential ranges of probable losses. A determination of the amount of reserves required, if any, for these contingencies are made after careful analysis of each individual issue. The required reserves may change in the future due to new developments in each matter or changes in approach, such as a change in settlement strategy, in dealing with these matters.
Currently, product liability claims and other ordinary routine litigation incidental to our business are the only litigation to which we are a party. While historically our product liability claims have not resulted in significant monetary liability beyond our insurance coverage, an adverse judgment beyond our insurance coverage could have a material adverse impact on our results of operations and financial condition.
Stock Compensation
See Note 2 to the Consolidated Financial Statements for a discussion of the application of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” and SFAS 148, “Accounting for Stock-Based Compensation - an Amendment of FASB Statement No. 123” to our stock compensation programs.
Results of Operations
Comparison of the Years Ended December 31, 2003 and 2002
Results for 2003 continue to reflect the positive impact of revenue growth from increased unit sales of our Genesis and GenesisXP IPG systems, which we launched in the United States in January 2002 and December 2002, respectively. We believe these systems will also generate most of our growth during 2004.
Net revenue. Net revenue increased $33.71 million, or 58.8%, in 2003 from 2002 due to increased sales of our neuromodulation products which increased 71.3% to a record $80.00 million in 2003 from $46.71 million in 2002 primarily due to increased sales of our Genesis family of IPG systems. Revenue from our Renew RF system grew modestly year over year. Net revenue of our HDI O.E.M. business, as planned, increased modestly to $11.08 million in 2003 from $10.66 in 2002 primarily due to higher volume of O.E.M. product sales. We continue to use more of HDI’s manufacturing and development capabilities for our own increasing needs and as such we anticipate only modest growth in our HDI O.E.M. business.
Gross profit. Gross profit increased $27.23 million, or 74.2%, in 2003 from 2002 due to the increase in net revenue discussed above and an improvement in gross profit margins. Gross profit margins increased to 70.2% in 2003, compared to 64.0% in 2002, due to higher sales of our neuromodulation products, which contribute higher margins than HDI O.E.M. product sales, higher neuromodulation product sales from direct sales and commissioned agents which contribute higher margins than distributor sales due to three acquisitions in 2003 of certain operations of our remaining U.S. distributors, and operational efficiencies gained from higher manufacturing volumes.
Operating expenses. Total operating expenses increased $18.07 million, or 65.8%, and increased as a percentage of net revenue to 50.0% in 2003 from 47.9% in 2002, primarily due to increased investments in our sales and marketing capabilities, including the additional sales personnel acquired in the three acquisitions in 2003 of certain operations of our remaining U.S. distributors, and to a lesser extent increased investments in research and development and increased amortization expense from intangibles acquired in our various acquisitions. We continued to leverage our general and administrative expense in 2003.
Sales and marketing. Sales and marketing expense, as a percentage of net revenue, increased to 29.2% in 2003 from 26.0% in 2002, and the expense increased in absolute dollars by $11.62 million principally due to higher commission expense from increased Neuro Product sales, higher salary expense from annual salary increases and staffing additions in reimbursement, direct sales and clinical support specialists, higher employee benefit costs from staffing additions, higher travel expense due to increased direct sales activities and higher expense for education and training of new implanters of Neuro Products. In 2003, we expanded our sales and marketing capabilities with the acquisitions of certain operations from our three remaining U.S. distributors and added substantially all of the salespersons of those businesses to our direct sales force. We expect to continue to add additional salespersons in the future.
Research and development. Research and development expense, as a percentage of net revenue, increased slightly to 10.5% in 2003 from 10.2% in 2002, and the expense increased in absolute dollars by $3.68 million principally due to higher salary and benefit expense from staffing additions and annual salary increases, higher stock-based compensation expense for certain consultants and higher prototype tooling and test materials for new products under development. Our development efforts in 2003 continued to focus on next-generation IPG stimulation systems, an IPG stimulation system for deep brain stimulation and next-generation drug pumps.
General and administrative. General and administrative expense, as a percentage of net revenue, decreased to 8.4% in 2003 from 10.0% in 2002, while the expense increased in absolute dollars by $1.89 million principally due to higher salary expense from annual salary increases and staffing additions, higher employee benefit costs, higher recruiting fee expense and higher depreciation expense.
Amortization of other intangibles. Amortization expense of intangibles increased 92.4% in 2003 from 2002, or $879,000, due to a full year of amortization expense for intangible assets we acquired in the November 2002 MicroNet acquisition, plus amortization of additional intangible assets from earn-out consideration paid in 2003 as milestones were met pursuant to the MicroNet acquisition agreement. In addition we recorded amortization expense for intangible assets we acquired in 2003 from the acquisition of certain operations of our three remaining U.S. distributors. We expect amortization expense to increase in 2004 by approximately $168,000 due to having a full year of amortization expense from the above-mentioned 2003 acquisitions, excluding additional amortization expense that may be generated as we issue additional earn-out consideration that is recorded as intangible assets under the MicroNet acquisition agreement.
Other income. Other income increased $1.05 million in 2003 from 2002 primarily due to the reversal of an accrued tax-abatement liability of $969,000 as we were legally released from our potential obligation to pay that amount in 2003.
Income tax expense. Income tax expense increased $3.67 million in 2003 from 2002 as a result of increased income before taxes and an increase in the overall effective tax rate to 35.1% in 2003 from 34.3% in 2002. Our increased effective tax rate is primarily due to our federal statutory tax rate being 35% in 2003 compared to 34% in 2002. The effective tax rates reflect a provision for state taxes, offset by tax-exempt interest income earned on our cash, cash equivalents and marketable securities.
Net income. Net income increased $6.53 million, or 97.7%, in 2003 from 2002 primarily due to the positive impact of revenue growth from increased unit sales of our Genesis and GenesisXP IPG systems, increased gross margin, and to a lesser extent from the reversal of the tax-abatement liability discussed above. Net income per diluted share increased to $.64 in 2003 from $.37 in 2002. Excluding the one-time tax-abatement reversal, net income per share increased to $.61 in 2003 from $.37 in 2002.
Comparison of the Years Ended December 31, 2002 and 2001
Net revenue. Net revenue increased $19.46 million, or 51.3%, in 2002 from 2001 due to increased sales of our neuromodulation products which increased 70.1% to $46.71 million in 2002 from $27.46 million in 2001 due to the U.S. launch of our Genesis IPG system in January 2002 and our GenesisXP IPG system in December 2002. The launch of the Genesis IPG in 2002 slowed our growth rate in sales of Renew systems from an average percentage growth rate in the mid-teens over the past several years to single-digit growth in 2002. Net revenue from our HDI O.E.M. business increased marginally to $10.66 million in 2002 from $10.46 million in 2001 as we focused more of HDI’s resources on our own manufacturing and research and development needs.
Gross profit. Gross profit increased $14.47 million, or 65.1%, in 2002 from 2001 due to the increase in net revenue discussed above and an improvement in gross profit margins. Gross profit margins increased to 64.0% in 2002, compared to 58.7% in 2001, due to higher sales of our neuromodulation products, which contribute higher margins than HDI O.E.M. product sales, higher neuromodulation product sales from direct sales and commissioned agents, which contribute higher margins than distributor sales, and operational efficiencies gained from higher manufacturing volumes.
Operating expenses. Total operating expenses increased $8.03 million in 2002 from 2001, but decreased as a percentage of net revenue to 47.9% in 2002 from 51.3% in 2001 due to leveraging of research and development expense, leveraging of general and administrative expense, and to a lesser extent, eliminating amortization expense of goodwill.
Sales and marketing. Sales and marketing expense, as a percentage of net revenue, increased to 26.0% in 2002 from 23.9% in 2001, and the expense increased in absolute dollars by $5.88 million principally due to higher salary and benefit expense from staffing additions in direct sales, reimbursement and sales support positions, higher commission expense from increased product sales, and higher sample and promotional expense in support of the Genesis and GenesisXP IPG launches.
Research and development. Research and development expense, as a percentage of net revenue, decreased to 10.2% in 2002 from 13.0% in 2001, while the expense increased in absolute dollars by $914,000 principally due to higher salary and benefit expense from staffing additions, higher test material expense and higher expense associated with our clinical trials of AccuRx.
General and administrative. General and administrative expense, as a percentage of net revenue, decreased to 10.0% in 2002 from 10.4% in 2001, while the expense increased in absolute dollars by $1.78 million principally due to higher salary expense from staffing additions (including a new executive officer position), higher employee benefit costs, higher bonus expense, higher property tax expense and higher fees for accounting and tax services.
Amortization of intangibles. No amortization expense of goodwill was recorded in 2002 due to the adoption of SFAS No. 142 on January 1, 2002. During 2001, we recorded $557,000 for amortization expense of goodwill.
Amortization expense of other intangibles increased modestly by $19,000 in 2002 from 2001 due to additional amortization expense for intangible assets acquired in November 2002 when we completed the acquisition of MicroNet.
Other income. Other income increased to $923,000 in 2002 from an expense of $26,000 in 2001 primarily due to a $451,000 increase in interest income from higher funds available for investment from our public offering during the second quarter of 2002 and the expense in 2001 of $484,000 for costs associated with the acquisition of HDI. These costs were expensed instead of capitalized because the acquisition was accounted for under the pooling of interests method.
Income tax expense. Income tax expense increased $2.22 million in 2002 from 2001, but the overall effective tax rate decreased to 34.3% in 2002 compared to 45.5% in 2001. The decrease in the effective tax rate in 2002 compared to 2001 was the result of three factors. First, our amortization of goodwill in the 2001 period was not deductible for tax purposes. Second, the HDI acquisition costs expensed in the 2001 period of $484,000 were not fully deductible for tax purposes. Finally, the 2002 period included tax-free interest income.
Net income. Net income increased $5.17 million, or 340.4%, in 2002 from 2001 reflecting the positive impact of revenue growth from increased unit sales of our Genesis and GenesisXP IPG systems, increased gross margin, and leveraging of operating expenses. Net income per diluted share increased
to $.37 in 2002 from $.10 in 2001. Results for the 2001 period reflect amortization expense for goodwill of $556,604. The 2002 results contain no similar expense since we eliminated the amortization of goodwill on January 1, 2002 when we adopted the new accounting standards for intangible assets described above. If the amortization expense for goodwill were eliminated from the 2001 period, pro forma net income would be $2.07 million and pro forma net income per diluted share would be $.14.
Liquidity and Capital Resources
At December 31, 2003 our working capital increased to $126.44 million from $114.28 million at year-end 2002. The ratio of current assets to current liabilities was 11.21:1 at December 31, 2003 compared to 13.15:1 at December 31, 2002. Cash, cash equivalents, and marketable securities totaled $94.80 million at December 31, 2003 compared to $96.77 million at December 31, 2002. In 2003, we made numerous investments discussed below which were funded to a large extent from operations.
In March, September and November 2003, we acquired certain operations of our three remaining U.S. distributors. These acquisitions expanded our direct domestic sales force. The total cost of these acquisitions was approximately $10.23 million, which we funded from our cash reserves.
In January 2003, we invested $1 million in cash in Innovative Spinal Technologies, Inc., a start-up company that develops spine technologies, products and services through intellectual property development and contract research.
We increased our investment in inventories to $22.11 million at December 31, 2003, from $13.72 million at December 31, 2002. This increase from year-end 2002 was primarily the result of three factors. First, we increased our investment in inventories held by direct and commissioned sales agents during 2003 as a result of an increased sales force. Second, we increased our investment in raw materials and finished goods for our Genesis and GenesisXP IPG systems to support our continued success of these products in the U.S. market and in anticipation of continued sales growth. Finally, we increased our overall investment in inventories in anticipation of our move to our new corporate facility in 2004 due to the new facility requiring regulatory process validation before product can be manufactured in and shipped from the facility.
Our investment in trade accounts receivable increased to $17.89 million at December 31, 2003, from $10.85 million at December 31, 2002 due to the increase in sales of our neuromodulation products resulting from the launch of the Genesis and GenesisXP IPG systems. Our days sales outstanding increased from 55 days at year-end 2002 to 64 days at year-end 2003 due to higher receivables due from insurance companies and hospitals as a result of us acquiring all of our U.S. distributors in 2003. Hospitals and insurance companies have slower payment cycles than our former U.S. distributors, who typically paid us within 10 to 30 days.
In November 2002, we completed the acquisition of MicroNet. At closing we paid the former MicroNet shareholders $500,000 in cash and 234,453 shares of our common stock with a value at the time of issuance of $4,648,421. In addition, we incurred expenses of $859,460, including an investment-banking fee of $600,000. In March 2003, we paid the former MicroNet shareholders an aggregate of 42,519 shares of our common stock with a value at the time of issuance and release from escrow of $1,020,059 upon the successful completion of half of the first product milestone, and in October 2003, we paid the former MicroNet shareholders an aggregate of 17,462 shares of our common stock with a value at the time of issuance and release from escrow of $700,182 upon the successful completion of another product sub-milestone. The former MicroNet shareholders may receive additional shares of our common stock if additional product and sales milestones are met. The aggregate value of the additional potential milestone earnout payments was $9 million as measured at the time the transaction was completed. Of this $9 million in additional shares, a fixed number of our common shares totaling 134,409 with an aggregate value at closing of $3 million were issued into an
escrow account. Shares that are released from escrow if such milestones are met will be valued at the time of release from escrow. At December 31, 2003, 100,811 shares remained in escrow. The product and sales milestones referred to above consist of three principal product milestones and a sales milestone. Each of the product milestones has three to four sub-milestones that relate to the delivery of specific products, including four separate 4-electrode leads (Milestone I), two separate 8-electrode leads (Milestone II) and three separate leads and a trial cable (Milestone III). The product sub-milestones are met if and when we are able to submit, and if and when we receive, regulatory approvals for products that have been adapted for use with our electrical stimulation devices. The sales milestone will be met if and when we and our subsidiaries generate $5 million in cumulative net sales of MicroNet lead products during the four years following the closing of the MicroNet transaction.
An important product milestone deadline occurred under the MicroNet acquisition agreement in November 2003, which was not met. We are currently in discussions with the former MicroNet shareholders regarding this product milestone. If this product milestone had been achieved by the deadline, the value of the milestone payment at December 31, 2003 was approximately $1,552,684, or 33,894 shares, which would have been allocated to certain identifiable intangible assets in accordance with the original purchase price allocation.
Excluding expenditures discussed below on our new facility, we spent $5.80 million during 2003 for capital expenditures primarily for new furniture and equipment for personnel we hired during 2003 and additional manufacturing tooling and equipment to support our current products and new products we expect to introduce in 2004.
Because we expect our business to continue to grow at rates that will demand added office and facility space, in April 2003 we began construction on a new 143,000 square foot corporate headquarters facility on the 10 acres of land we acquired in December 2002. The land is located in Plano, Texas, near our current corporate headquarters. Our current lease on our 49,700 square foot corporate headquarters expires in August 2004 and we plan to relocate to the new facility prior to the expiration of the lease. We designed the new facility to accommodate planned growth within a five-year horizon. The construction cost of the facility is approximately $15 million, and we expect to spend approximately $1.5 million on office furniture and equipment for the new facility. We have funded the interim construction costs from our cash reserves and through December 31, 2003 have spent approximately $8.8 million. While we have not yet determined the method by which we will permanently finance the facility, we believe our cash position and overall balance sheet position provides us with various financing alternatives, including financing the facility from our current cash, financing through a debt vehicle such as a mortgage or other form of note, or a sale-and-leaseback transaction.
We received $7.52 million of cash during 2003 from the exercise of employee, advisory director and director stock options to purchase 1,124,372 shares of our common stock.
Liquidity may also be enhanced based on our ability to utilize all or part of a net operating loss carryforward of $4.3 million to offset future taxable income. We acquired $3.4 million of the net operating loss carryforward in connection with the MicroNet acquisition and its utilization may be subject to a limitation under Section 382 of the Internal Revenue Code. The rules of Section 382 of the Internal Revenue Code generally apply to limit a corporation’s ability to utilize acquired net operating loss carryforwards to reduce its federal taxable income in the periods after an acquisition. The Company’s ability to use the net operating loss carryforwards acquired in the MicroNet acquisition to reduce its federal taxable income is subject to these rules. Provided the Company generates sufficient taxable income in future years, the Section 382 limitation will have the effect of deferring the utilization of the net operating loss carryforwards over several years. Without this limitation, the Company would be able to immediately use the net operating loss carryforwards to reduce taxable income in future tax periods. The total amount of net operating loss carryforwards that
the Company may use to reduce taxable income in any taxable year after the acquisition is determined with reference to its purchase price of MicroNet. Based on current estimates and assumptions, we expect to utilize at least approximately $700,000 in net operating loss carryforwards per full twelve-month tax years, assuming we generate sufficient taxable income in any given year to utilize such amount.
Additionally, liquidity may be enhanced to the extent we realize tax benefits from stock option exercises. Exercises of nonqualified stock options, and exercises of incentive stock options followed by “disqualifying dispositions” of the underlying common stock within one year following exercise generate compensation expense for tax purposes in the year of exercise or disposition, as the case may be. During 2003, we generated a $9.79 million tax benefit related to nonqualified stock option exercises and disqualifying dispositions of common stock acquired on exercise of incentive stock options.
We believe our current cash, cash equivalents, marketable securities and cash generated from operations will be sufficient to fund our current levels of operating needs and capital expenditures for the foreseeable future. We currently have no credit facilities in place. If we decide to acquire complementary businesses, product lines or technologies, or enter into joint ventures or strategic alliances that require substantial capital, we intend to finance those activities by the most attractive alternative available, which could include utilizing our current cash, bank borrowings, or the issuance of debt or equity securities.
The following table sets forth certain information concerning our contractual obligations at December 31, 2003.
(1)
In accordance with accounting principles generally accepted in the U.S., these obligations are not reflected in the consolidated balance sheets. These obligations are for operating lease payments primarily related to facilities.
(2)
Our inventory purchase commitments do not exceed our projected requirements over the related terms and are in the normal course of business.
(3)
Contractual commitments for construction of our new corporate headquarter facility of 143,000 square feet.
Cash Flows
Net cash provided by operating activities was $16.48 million in 2003, $7.59 million in 2002, and $3.06 million in 2001. Net cash provided by operating activities increased by $8.89 million in 2003 from 2002 principally due to a $6.53 million increase in net income and a $7.94 million increase in tax benefits from the exercise of stock options. These increases were partially offset by increases in accounts receivable and inventory. Net cash provided by operating activities increased by $4.53 million in 2002 from 2001 principally due to a $5.17 million increase in net income.
Net cash used in investing activities was $26.38 million in 2003, $91.14 million in 2002 and $3.09 million in 2001. In 2003, our primary investing activities using cash were the purchase of marketable securities ($382.65 million), the purchase of certain operations of three of our U.S. distributors ($10.23 million), funds used to finance the interim construction of our new corporate headquarters facility ($8.83 million), capital expenditures ($5.80 million), and the purchase of minority equity investments in
preferred stock of two privately-held companies ($1.10 million), while net proceeds from the sale of marketable securities provided cash of $382.22 million. In 2002, our primary investing activities using cash were the purchase of marketable securities ($188.39 million), the purchase of land ($3.19 million), capital expenditures ($2.94 million) and cash used in the purchase of MicroNet ($1.36 million), while net proceeds from the sale of marketable securities provided cash of $104.75 million. In 2001, our primary investing activities using cash were the purchase of marketable securities ($3.90 million) and capital expenditures ($3.11 million) for additional manufacturing tooling and equipment, office furniture and equipment, non-compete agreements and patents, while maturing certificates of deposit and sales of marketable securities provided cash of $3.92 million. The non-compete agreements discussed in this section for fiscal year 2001 relate to a $200,000 expenditure incurred in 2001 to purchase a non-compete agreement from a former distributor of our Neuro Products. In reference to the patents, we incurred $191,000 in cash expenditures (in addition to the stock we issued with a value of $2,426,662) related to the purchase of ESOX in January 2001, which was allocated to the patents we acquired in the transaction. Prior to the transaction, we had licensed the technology from ESOX. The patents we acquired in the ESOX transaction relate to our implantable drug pump technologies. We are currently seeking FDA approval to commercialize an implantable drug pump in the United States.
Net cash provided by financing activities was $7.52 million in 2003, $84.73 million in 2002, and $957,000 in 2001. During 2003, all of the cash provided by financing activities was the result of the exercise of stock options. During 2002, we used $190,000 to repay our entire outstanding long-term debt, while we received $83.18 million in net proceeds from a public offering and $1.75 million from the exercise of stock options. During 2001, we used $48,000 to reduce certain debt obligations, while we received $1.00 million from the exercise of stock options.
Currency Fluctuations
Substantially all of our international sales are denominated in U.S. dollars. Fluctuations in currency exchange rates in other countries could reduce the demand for our products by increasing the price of our products in the currency of the countries in which the products are sold, although we do not believe currency fluctuations have had a material effect on the Company’s results of operations to date.
Outlook and Uncertainties
The following is a “safe harbor” statement under the Private Securities Litigation Reform Act of 1995: Certain matters discussed in this Annual Report on Form 10-K contain statements that constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. The words “expect,” “estimate,” “anticipate,” “predict,” “believe,” “plan,” “will,” “should,” “intend,” “would,” “scheduled,” “new market,” “potential market applications,” and similar expressions and variations are intended to identify forward-looking statements. Such statements appear in a number of places in this Annual Report on Form 10-K and include statements regarding our intent, belief or current expectations with respect to, among other things: (i) trends affecting our financial condition or results of operations; (ii) our financing plans; and (iii) our business growth strategies. We caution our readers that any forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual results may differ materially from those projected in the forward-looking statements as a result of various factors. These risks and uncertainties include the following:
Failure of our Genesis and GenesisXP IPG systems to gain and maintain market acceptance would adversely affect our revenue growth and profitability.
We formally introduced our Genesis IPG system in the U.S. in January 2002 and our GenesisXP IPG system (offering increased battery capacity and longevity) in the U.S. in December 2002. We believe
that the size and potential for growth of the IPG portion of the neurostimulation market are greater than in the RF portion. Accordingly, our ability to generate increased revenue and profitability, and thus our general success, will depend, in large part, on the market’s acceptance of our IPG systems. As a new entrant into the IPG portion of the neurostimulation market, there are many reasons we might not achieve market acceptance on a timely basis, if at all, including the following:
•
competing products, technologies and therapies are available, and others may be introduced that gain greater and faster physician and patient acceptance than our IPG systems; and
•
our only competitor in the IPG portion of the market has had its IPG product on the market for some time and enjoys significant brand awareness and other advantages among pain management specialists.
If the IPG portion of the neurostimulation market grows at a faster rate than the RF portion, our failure to successfully market and sell our IPG systems could negatively affect our revenue growth and profitability.
Because our main competitor has significantly greater resources than we do and new competitors may enter the neuromodulation market, it may be difficult for us to compete in this market.
The medical device market is highly competitive, subject to rapid change and significantly affected by new product introductions and other market activities of industry participants. Medtronic, is one of the largest competitors in the medical device sector, and is currently our sole competitor in the neurostimulation market and our largest competitor in the implantable drug pump market. Medtronic is a large publicly-traded company and enjoys several competitive advantages over us, including:
•
substantially greater name recognition;
•
greater resources for product research and development, sales and marketing, distribution, patent protection and pursuing regulatory approvals;
•
a greater number of established relationships with health care professionals and third-party payors; and
•
multiple product lines and the ability to bundle products together or offer discounts, rebates or other incentives to secure a competitive advantage.
Medtronic will continue to develop new products that compete directly with our products, and its greater resources may allow it to respond more quickly to new technologies, new treatment indications or changes in customer requirements. Further, we generally price our products at a premium to those of Medtronic. Additionally, because the neuromodulation market is a high growth-potential market, other companies may attempt to bring new products or therapies into this market. For example, Advanced Bionics, Inc., a privately-held company that currently manufactures and markets a cochlear implant product, has publicly stated that it is developing and may be testing an IPG system for the treatment of chronic pain. For all of these reasons, we may not be able to compete successfully against Medtronic or against future competitors.
If pain management specialists do not recommend and endorse our products, our sales could be negatively impacted and we may be unable to increase our revenues and profitability.
Our products are based on evolving concepts and techniques in pain management. Acceptance of our products depends on educating the medical community as to the distinctive features, benefits, clinical
efficacy, safety and cost-effectiveness of our products compared to alternative therapies and competing products, and on training pain management specialists in the proper use of our products. To sell our products, we must successfully educate and train pain management specialists so that they will understand our products and feel comfortable recommending and endorsing them. We may not be able to accomplish this, and even if we are successful in educating and training pain management specialists, there is no guarantee that we will obtain their recommendations and endorsements.
The launch of Genesis and GenesisXP and other market factors could impede growth in or reduce sales of Renew, which would adversely affect our revenues and profitability.
Our Genesis and GenesisXP IPG systems are currently the newest neurostimulation products on the market. Although Genesis and our Renew RF system are targeted towards patients with different types of pain and Genesis is not intended to replace Renew in the neurostimulation market, some pain management specialists may recommend Genesis to their patients when they would have otherwise recommended Renew, and, consequently, Genesis may “cannibalize” or substitute for some sales of Renew. Further, we believe our principal market competitor has chosen to emphasize the IPG as the therapy of choice in the neurostimulation market. These factors could lead to a slowdown in growth, or a reduction, in sales of Renew and similar RF-based neurostimulation products. Although Renew and Genesis are targeted for different patients, sales growth of Renew has slowed since the launch of Genesis. If Renew sales growth continues to slow or sales are reduced, and we do not gain enough market share through IPG sales to compensate for these reduced sales, our revenues and profitability will be adversely affected.
If patients choose less invasive or less expensive alternatives to our products, our sales could be negatively impacted.
We sell medical devices for invasive and minimally-invasive surgical procedures. Patient acceptance of our products depends on a number of factors, including device and associated procedure costs, the failure of less invasive therapies to help the patient, the degree of invasiveness involved in the procedures used to implant our products, the rate and severity of complications from the procedures used to implant our products and any adverse side effects caused by the implanting of our products. If patients choose to use existing less invasive or less expensive alternatives to our products, or if effective new alternatives are developed, our revenues and profitability could be materially adversely affected.
Any adverse changes in coverage or reimbursement amounts by Medicare and Medicaid, private insurance companies and managed care organizations, or workers’ compensation programs could limit our ability to market and sell our products.
In the U.S., our products are generally covered by Medicare and Medicaid and other third-party payors, such as private insurance companies and managed care organizations, and workers’ compensation programs, which reimburse patients for all or part of the cost of our products and related medical procedures. The cost of our products and related procedures are significant, and third-party payors carefully scrutinize whether to cover new products and the level of reimbursement for covered products. Further, for certain types of procedures, gaps exist between the rate of reimbursement paid by Medicare and Medicaid and the rates paid by private insurers. In addition, gaps exist in reimbursement levels depending on the health care setting in which physicians perform procedures using our products. In the future, these gaps may narrow and public and private payors may reduce levels of reimbursement for neuromodulation devices in an effort to control increasing costs. If Medicare or other third-party payors decide to eliminate or reduce coverage amounts on patient reimbursements for our products, this could limit our ability to market and sell our products in the U.S., which would materially adversely affect our revenues and profitability. In November 2003, for example, the Center for Medicare and Medicaid Services issued a final ruling establishing new 2004
reimbursement rates for Medicare hospital outpatient procedures, including spinal cord stimulation procedures. Reimbursement levels for permanent implants of spinal cord stimulation devices in the hospital outpatient setting were generally reduced as a result of the ruling, which decreased the amount that hospitals would be reimbursed by Medicare for these procedures. However, because the new rates continue to provide hospitals with adequate margins to cover their facility costs and yield a fair profit to the hospitals, the new rates have not had an adverse effect on the prices we charge hospitals for our systems. If in the future CMS reduces rates to such an extent that hospitals’ ability to continue operating profitably in these procedures were at risk, then there could be price pressure on our products at that time.
International market acceptance of our products may also depend, in part, upon the availability of reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country, and include both government-sponsored health care and private insurance. We may not obtain international reimbursement approvals in a timely manner, if at all. Where reimbursement in foreign markets is available, it tends to be at levels significantly below those in the U.S. Our failure to receive international reimbursement approvals may negatively impact market acceptance of our products in the international markets in which those approvals are sought.
If we fail to protect our intellectual property rights, our competitors may take advantage of our ideas and compete directly against us.
We rely in part on patents, trade secrets and proprietary technology to remain competitive. We may not be able to obtain or maintain adequate U.S. patent protection for new products or ideas, or prevent the unauthorized disclosure or use of our technical knowledge or other trade secrets by employees. Additionally, the laws of foreign countries may not protect our intellectual property rights to the same extent as the laws of the U.S. Even if our intellectual property rights are adequately protected, litigation may be necessary to enforce them, which could result in substantial costs to us and substantial diversion of the attention of our management and key technical employees. If we are unable to adequately protect our intellectual property, our competitors could use our intellectual property to develop new products or enhance their existing products. This could harm our competitive position, decrease our market share or otherwise harm our business.
U.S. Patent No. 4,793,353 covers a non-invasive multiprogrammable tissue stimulator and method wherein only the programming data need be transmitted. The programming data may define the stimulator’s electrode selection, electrode polarity as either positive, negative or high impedence state, and simulation pulse parameter. This patent is scheduled to expire on December 27, 2005. The expiration of this patent may allow competitors to offer programmable stimulators that define electrode selection, polarity and stimulation pulse parameters, and thus could have an adverse effect on our business. A request for an extension of the term of this patent has been filed with the United States Patent Office pursuant to a federal statute that permits us to seek such an extension based on a regulatory approval delay. A final ruling on the extension request has not been made at the present time. While five other U.S. patents owned or licensed by us are due to expire prior to 2006, the expiration of these other patents would not have a material effect on our ability to protect the intellectual property rights currently utilized in our business, because the patents cover technologies that are not currently utilized in our existing products or services.
Other parties may sue us for infringing their intellectual property rights, or we may have to sue them to protect our intellectual property rights.
There has been a substantial amount of litigation in the medical technology industry regarding patents and intellectual property rights. The neuromodulation market is characterized by extensive patent and other intellectual property rights, which can create greater potential than in less-developed markets for
possible allegations of infringement, particularly with respect to newly-developed technology. We may be forced to defend ourselves against allegations that we are infringing the intellectual property rights of others. In addition, we may find it necessary, if threatened, to initiate a lawsuit seeking a declaration from a court that we are not infringing the intellectual property rights of others or that these rights are invalid or unenforceable, or to protect our own intellectual property rights. Intellectual property litigation is expensive and complex and its outcome is difficult to predict. If we do not prevail in any litigation, in addition to any damages we might have to pay, we would be required to stop the infringing activity, obtain a license, or concede intellectual property rights. Any required license may not be available to us on acceptable terms, if at all. In addition, some licenses may be nonexclusive, and, therefore, our competitors may have access to the same technology licensed to us. If we fail to obtain a required license or are unable to design around a patent, we may be unable to sell some of our products, which could adversely affect our revenues and profitability.
Failure to obtain necessary government approvals for new products or for new applications for existing products would mean we could not sell those new products, or sell our existing products for those new applications.
Our products are medical devices, which are subject to extensive government regulation in the U.S. and in foreign countries where we do business. Unless an exemption applies, each medical device that we wish to market in the U.S. must first receive either a PMA or a 510(k) clearance from the FDA with respect to each application for which we intend to market it. Either process can be lengthy and expensive. According to the FDA, the average 510(k) review period was 96 days in 2003, but reviews may take longer and approvals may be revoked if safety or effectiveness problems develop. The PMA process is much more costly, lengthy and uncertain. According to the FDA, the average PMA submission-to-decision period was 359 days in 2003; however, reviews may take much longer and completing a PMA application can require numerous clinical trials and require the filing of amendments over time. The result of these lengthy approval processes is that a new product, or a new application for an existing product, often cannot be brought to market for a number of years after it is developed. Additionally, we anticipate that many of the products we bring to market in the future will require us to seek PMA approvals rather than 510(k) clearances. If we fail to obtain or maintain necessary government approvals of our new products or new applications for existing products on a timely and cost-effective basis, we will be unable to market the affected products for their intended applications.
Modification of any marketed device could require a new 510(k) clearance or PMA or require us to cease marketing or recall the modified device until we obtain this clearance or approval.
Any modification we want to make to an FDA-cleared or approved device that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, would require a new 510(k) clearance, or possibly a new or supplemental PMA. Under FDA procedures, we would make the initial determination of whether to seek a new 510(k) clearance or PMA, but the FDA could review our decision. If the FDA disagrees with our decision not to seek a new 510(k) clearance or PMA and requires us to seek either 510(k) clearance or PMA for modifications we have already made to a previously-cleared product, we might be required to cease marketing or recall the modified device until we obtain this clearance or approval. We could also be subject to significant regulatory fines or penalties.
We will be unable to sell our products if we fail to comply with manufacturing regulations.
To commercially manufacture our products, we must comply with government manufacturing regulations that govern design controls, quality systems and documentation policies and procedures. The FDA and equivalent foreign governmental authorities periodically inspect our manufacturing facilities. Our failure to comply with these manufacturing regulations may prevent or delay our marketing or distribution of our products, which would negatively impact our business.
Our products are subject to product recalls even after receiving FDA clearance or approval, which would negatively affect our financial performance and could harm our reputation.
Any of our products may be found to have significant deficiencies or defects in design or manufacture. The FDA and similar governmental authorities in other countries have the authority to require the recall of any such defective product. A government-mandated or voluntary recall could occur as a result of component failures, manufacturing errors or design defects. We do not maintain insurance to cover losses incurred as a result of product recalls. Any product recall would divert managerial and financial resources and negatively affect our financial performance, and could harm our reputation with customers.
We are subject to potential product liability and other claims and we may not have the insurance or other resources to cover the cost of any successful claim.
Defects in our implantable medical devices could subject us to potential product liability claims that our devices were ineffective or caused some harm to the human body. Our current product liability litigation involves assertions that our products did not perform as intended and, in some cases, that they caused discomfort or harm to the patient. Our product liability insurance may not be adequate to cover current or future claims. Product liability insurance is expensive and, in the future, may not be available on terms that are acceptable to us, if it is available to us at all. Plaintiffs may also advance other legal theories supporting their claims that our products or actions resulted in some harm. A successful claim brought against us in excess of our insurance coverage could significantly harm our business and financial condition.
We are subject to substantial government regulation and our failure to comply with all applicable government regulations could subject us to numerous penalties, any of which could adversely affect our business.
We are subject to numerous government regulations relating to, among other things, our ability to sell our products, third-party reimbursement, fraud and abuse of Medicare or Medicaid and patient privacy. If we do not comply with all applicable government regulations, government authorities could do any of the following:
•
impose fines and penalties on us;
•
prevent us from manufacturing our products;
•
bring civil or criminal charges against us;
•
delay the introduction of our new products into the market;
•
recall or seize our products;
•
disrupt the manufacture or distribution of our products; or
•
withdraw or deny approvals for our products.
Any one of these results could materially adversely affect our revenues and profitability and harm our reputation.
Our reliance on single suppliers for critical components used in our main products could adversely affect our ability to deliver products on time.
We continue to rely upon sole source suppliers for certain materials and services used in manufacturing our products, including the custom chip used in the receiver of our RF system, the computer chip used in the IPG programmer and Renew transmitter, the batteries used in our IPG system and the medical-grade polyurethane (bionate) that we use in all of our products, for reasons of quality assurance, component availability or cost effectiveness. We work closely with our vendors to assure continuity of supply while maintaining high quality and reliability. With the exception of the custom chip used in our RF receiver, which we discuss below, we believe that alternative suppliers exist for the other components used to manufacture our products. FDA requirements regarding the design and manufacture of our products require an investment in time and money to establish additional or replacement sources for certain components or materials. We believe that in some cases, the cost of pursuing and qualifying alternative sources and/or redesigning specific components of our products would significantly outweigh the benefits of doing so and consume significant resources that are better devoted to other aspects of our business. Similarly, qualifying alternative sources or product designs require costly and time-consuming regulatory submissions and approvals that again may not be justified from a cost-benefit standpoint for all components used in our products. The reduction or interruption in supply, or our inability to develop alternative sources of supply, could adversely affect our operations.
Although there are currently no alternative suppliers for the custom chip used in our RF system, we have sufficient chips in stock to meet our near-term requirements and we believe we will be able to order more chips to meet our future needs. In the meantime, we are designing and developing our own replacement chip. The sole supplier of this chip first indicated its desire to cease manufacturing and supplying the RF system chip several years ago. The supplier has continued to supply the chip, however, and to date has not determined if and when it will cease to supply the chip. The supplier has agreed to notify us when it does decide to cease supplying the chip and has promised to permit us to place a final one-time purchase order for the chip. In the interim, we have maintained and will continue to maintain a higher than normal inventory of the chip. We currently have enough of the chips in stock to meet our requirements through the end of 2005. Our engineers are developing a new chip to be used with our next-generation RF receiver. Our engineers estimate that this new chip and the next-generation RF receiver would be completed and have received the appropriate regulatory approvals by the second half of 2005. Consequently, under the circumstances, we do not believe that a single source of supply for the RF system chip poses a serious risk to our business. Our RF system sales accounted for approximately 37% of our total Neuro Product segment sales in 2003, and approximately 33% of our total sales.
Our major competitor in the neuromodulation market currently accounts for a significant percentage of our revenue from our HDI O.E.M. segment.
During 2003, we had two major customers that together accounted for $9.84 million, or 88.8%, of our net revenue from our HDI O.E.M. segment. Medtronic, our most significant competitor, accounted for $8.40 million, or 75.8% and Arrow accounted for $1.44 million, or 13.0%. Either of these customers could cease doing business with us at any time. If this were to occur, our revenues and profitability could be materially adversely affected, at least in the short term.
We are dependent upon the success of neuromodulation technology. Our inability to continue to develop innovative neuromodulation products, or the failure of the neuromodulation market to develop as we anticipate, would adversely affect our business.
Our current products focus on the treatment of chronic pain using neuromodulation. Our development efforts focus on leveraging our neuromodulation expertise. The neuromodulation market is subject to
rapid technological change and product innovation. Our competitors may succeed in developing or marketing products, using neuromodulation technology or other technologies that may be superior to ours. If we are unable to compete successfully in the development of new neuromodulation products, or if new and effective therapies not based on neuromodulation are developed, our products could be rendered obsolete or non-competitive. This would materially adversely affect our business.
Our success will depend on our ability to attract and retain key personnel and scientific staff.
We believe our future success will depend on our ability to manage our growth successfully, including attracting and retaining scientists, engineers and other highly skilled personnel. Our key employees are subject to confidentiality, trade secret and non-competition agreements, but may terminate their employment with us at any time. Hiring qualified management and technical personnel is difficult due to the limited number of qualified professionals. Competition for these types of employees is intense in the medical device field. If we fail to attract and retain personnel, particularly management and technical personnel, we may not be able to continue to succeed in the neuromodulation market.
If we choose to acquire complementary businesses, products or technologies instead of developing them ourselves, we may be unable to complete these acquisitions or to successfully integrate an acquired business, product or technology in a cost-effective and non-disruptive manner.
Our success depends on our ability to continually enhance and broaden our product offerings in response to changing technologies, customer demands and competitive pressures. Accordingly, we may, as we have in the past, acquire complementary businesses, products or technologies instead of developing them ourselves. We do not know if we will be able to identify prospective acquisition targets or complete any future acquisitions, or whether we will be able to successfully integrate any acquired business, operate it profitably or retain its key employees. Integrating any business, product or technology we acquire could be expensive and time-consuming, disrupt our ongoing business and distract our management and key technical personnel. If we are unable to integrate any acquired entities, products or technologies effectively, our business will suffer. In addition, any impairment of goodwill or other intangible assets or charges resulting from the costs of acquisitions could harm our business and operating results.
We are subject to additional risks associated with international operations.
Internationally, we market our products through 20 independent distributors who represent us in 26 countries, except in Germany where we are represented by direct salespersons. In 2003, 7% of our sales revenue from our neuromodulation products segment came from international sales. International sales are subject to a number of additional risks, including the following:
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establishment by foreign regulatory agencies of requirements different from those in place in the U.S.;
•
fluctuations in exchange rates of the U.S. dollar against foreign currencies that may affect demand for our products overseas;
•
export license requirements, changes in tariffs, and other general trade restrictions;
•
difficulties in staffing and managing international operations;
•
political or economic instability; and
•
lower and more restrictive third-party reimbursement for our products.
Any of these risks could make it difficult or impossible for us to continue to expand our overseas operations, which could have an adverse effect on our revenues.
Our operations are conducted at three locations, and a disaster at any of these facilities could result in a prolonged interruption of our business.
We currently conduct all of our development, manufacturing and management activities at our facilities in Plano, Texas and Budd Lake and Hackettstown, New Jersey. However, a natural disaster, such as a tornado, fire or flood, or a man-made disaster, could cause substantial delays in our operations, damage or destroy our manufacturing equipment or inventory and cause us to incur significant additional expenses. A disaster could seriously harm our business and affect our reputation with customers. The insurance we maintain may not be adequate to cover our losses in any particular case.
We may be obligated to issue shares of our common stock in the future and the number of shares could increase if our stock price decreases.
In connection with the acquisition of MicroNet in November 2002, as part of the purchase price, we agreed to pay the former MicroNet shareholders additional shares of our common stock if certain product, regulatory approval and sales milestones are met. The aggregate value of the additional potential milestone earnout payments payable in shares of our common stock was $9 million as measured at the time the transaction was completed. Of this $9 million in additional shares, we issued a fixed number of shares totaling 134,409 with an aggregate value at closing of $3 million into an escrow account. If and when specified product and regulatory milestones are achieved, we will release a specified and fixed number of shares of common stock from escrow to the former MicroNet shareholders. In addition, if and when those same product and regulatory milestones are achieved, we will also issue at that time a number of shares of our common stock with an aggregate value of up to $3 million. Finally, if and when we generate $5 million in cumulative net sales of MicroNet lead products during the four years following the closing, we will issue at that time a number of shares of our common stock with an aggregate value of $3 million. Thus, we agreed to issue shares of our common stock with an aggregate value of up to $6 million in the future upon the achievement of specific milestones, the number of shares of which will depend on the average trading price of our common stock. The average trading price for this purpose is the per share average closing price of our common stock on the Nasdaq National Market for the 30 consecutive trading days immediately prior to two business days before the applicable milestone payment date. Because the number of shares we could be required to issue depends on the average trading price at the time of payment, if the average trading price of our common stock declines significantly, we could be required to issue more shares of our common stock. For example, if our stock price were $40 per share and we were required to issue $3 million of our common stock on satisfaction of the sales milestone, we would be required to issue 75,000 shares of our common stock to the former MicroNet shareholders. If our stock price declined 50% from that level to $20 per share, however, we would be required to issue twice as many shares, or 150,000 shares.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We invest our cash reserves in high quality short-term liquid money market instruments with major financial institutions, a high quality short-term municipal bond fund with a major financial institution and certificates of deposit. At December 31, 2003, we had $71,695 invested in money market funds, $1,677,894 in certificates of deposit with maturities less than 90 days from the purchase date and $3,735,875 in a tax-free municipal bond fund with daily liquidity. The rate of interest earned on these investments will vary with overall market rates. A hypothetical 100-basis point change in the interest rates earned on these investments would not have a material effect on our income or cash flows.
We also have certain investments in available-for-sale securities. These investments primarily consist of investment grade municipal bonds with maturities less than one year from the date of purchase, 7-day and 35-day AAA municipal bond floaters and Freddie Mac Notes with maturities less than one-year from the date of purchase. The cost of these investments is $86,243,780 and the fair value at December 31, 2003 was $86,213,841. The investments are subject to overall bond market and interest rate risk, however the Company believes the risk to be limited since a large portion of the investments, $82,747,000, are in 7-day and 35-day municipal floaters which have no principal risk. The investment grade municipal bonds and Freddie Mac Notes may have risk of principal depending on the overall bond market. A hypothetical 10% decrease in the value of these investments from their prices at December 31, 2003 would decrease the fair value by $346,628.
We do not use derivative financial instruments to manage the impact of interest rate changes on our investments or debt instruments.
At December 31, 2003, we had no interest bearing debt.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item is set forth in Appendices A, B and C.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures designed to ensure that we are able to collect the information we are required to disclose in the reports we file with the SEC and to process, summarize and disclose this information within the time periods specified in the rules of the SEC. Based on their evaluation of our disclosure controls and procedures which took place as of the end of the period covered by this report, the Chief Executive and Chief Financial Officers believe that these controls and procedures are effective to ensure that we are able to collect, process and disclose the information we are required to disclose in the reports we file with the SEC within the required time periods.
No changes in our internal controls over financial reporting have occurred during our most recently completed fiscal quarter that have materially affected or are reasonably likely to materially affect our internal controls over financial reporting.
PART III
ITEM 10.
ITEM 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item is contained in our definitive proxy statement to be filed in connection with our 2004 annual meeting of shareholders, which information is incorporated herein by reference.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
The information required by this item is contained in our definitive proxy statement to be filed in connection with our 2004 annual meeting of shareholders, which information is incorporated herein by reference. Information under the captions “Compensation Committee Report” and “Performance Graph” are not incorporated herein by reference.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item is contained in our definitive proxy statement to be filed in connection with our 2004 annual meeting of shareholders, which information is incorporated herein by reference.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Inapplicable.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is contained in our definitive proxy statement to be filed in connection with our 2004 annual meeting of shareholders, which information is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)
Documents filed as part of this report.
1.
Financial Statements:
See Index to Financial Statements on the second page of Appendix A.
See Appendix C.
2.
Financial Statement Schedules:*
Schedule II - Valuation and Qualifying Accounts.
See Appendix B.
* Those schedules not listed above are omitted as not applicable or not required.
3.
Exhibits: See (c) below.
(b)
Reports on Form 8-K.
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Company and in the capacities and on the dates indicated:
Appendix A
Consolidated Financial Statements
Independent Auditors’ Report
Three Years Ended December 31, 2003
Forming a Part of the Annual Report on
Form 10-K
Item 8
of
ADVANCED NEUROMODULATION SYSTEMS, INC.
(Name of issuer)
Filed with the
Securities and Exchange Commission
Washington, D.C. 20549
under
The Securities Exchange Act of 1934
Advanced Neuromodulation Systems, Inc. and Subsidiaries
to
Consolidated Financial Statements
Form 10-K - Item 8
Report of Ernst & Young LLP, Independent Auditors
Consolidated Financial Statements:
Consolidated Balance Sheets - December 31, 2003 and 2002
Consolidated Statements of Income - Years ended December 31, 2003, 2002 and 2001
Consolidated Statements of Cash Flows - Years ended December 31, 2003, 2002 and 2001
Consolidated Statements of Stockholders’ Equity - Three years ended December 31, 2003
Notes to Consolidated Financial Statements
Report of Ernst & Young LLP, Independent Auditors
The Board of Directors Advanced Neuromodulation Systems, Inc.
We have audited the accompanying consolidated balance sheets of Advanced Neuromodulation Systems, Inc. and subsidiaries (the Company) as of December 31, 2003 and 2002, and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These consolidated financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Advanced Neuromodulation Systems, Inc. and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for goodwill as of January 1, 2002, as required by Statement of Financial Accounting Standards No. 142, “Accounting for Goodwill and Other Intangible Assets.”
/s/ Ernst & Young LLP
Ernst & Young LLP
Dallas, Texas
March 8, 2004
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Consolidated Balance Sheets
December 31, 2003 and 2002
See accompanying notes to consolidated financial statements.
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Consolidated Balance Sheets (continued)
December 31, 2003 and 2002
See accompanying notes to consolidated financial statements.
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Consolidated Statements of Income
Years Ended December 31
See accompanying notes to consolidated financial statements.
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
Years Ended December 31
See accompanying notes to consolidated financial statements.
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity
Three Years Ended December 31, 2003
See accompanying notes to consolidated financial statements.
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(1) Business
Advanced Neuromodulation Systems, Inc. (the Company or ANS) designs, develops, manufactures and markets implantable neuromodulation devices. ANS devices are used primarily to manage chronic severe pain. ANS revenues are derived primarily from sales throughout the United States, Europe and Australia.
On July 11, 2003, the Company effected a 3 for 2 stock split in the form of a 50% stock dividend (one share of common stock paid for every two shares held), paid to shareholders of record on June 20, 2003. All prior period shares, share prices, and income per share figures have been restated to reflect the split.
The research and development, manufacture, sale and distribution of medical devices is subject to extensive regulation by various public agencies, principally the Food and Drug Administration and corresponding state, local and foreign agencies. Product approvals and clearances can be delayed or withdrawn for failure to comply with regulatory requirements or the occurrence of unforeseen problems following initial marketing.
In addition, ANS neuromodulation products are purchased primarily by hospitals and other users who then bill various third-party payors including Medicare, Medicaid, private insurance companies and managed care organizations. These third-party payors reimburse fixed amounts for services based on a specific diagnosis. The impact of changes in third-party payor reimbursement policies and any amendments to existing reimbursement rules and regulations that restrict or terminate the eligibility of ANS products could have an adverse impact on the Company’s financial condition and results of operations.
(2) Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of Advanced Neuromodulation Systems, Inc. and all of its subsidiaries. All significant intercompany transactions and accounts have been eliminated in consolidation.
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 amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Reclassification
Certain amounts in the prior years financial statements have been reclassified to conform to the Company’s 2003 presentation.
Cash Equivalents
The Company considers all highly liquid investments with maturities of three months or less at the time of purchase to be cash equivalents.
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
Revenue Recognition
The Company generates revenues from product sales to end customers, product sales to distributors, and development contracts. The Company recognizes revenue from neuro product sales when the goods are shipped to its customers or distributors, provided an arrangement exists, the fee is fixed and determinable, and collectibility is reasonably assured. Certain of the Company’s customers are third-party payors who reimburse fixed amounts for services based on a specific diagnosis. Revenue is recognized on these third-party payor sales based on the sales price less a contractual adjustment, which is based on the Company’s history of reimbursement with the third-party payor, provided all other revenue recognition criteria are met. The Company also records, as a reduction in revenue, a provision for estimated sales returns and adjustments on product sales in the same period as the related revenue is recorded. These estimates are based on historical sales returns, analysis of credit memo data, and other known factors. Payments received in advance of revenue recognition requirements are recorded as deferred revenue on the consolidated balance sheets. In the second quarter of 2003, the Company received a payment of $1,200,000 related to a distribution agreement under which the Company has granted the exclusive rights to market certain of its neuromodulation products in Japan. Of such payment, $1,100,000 was recorded as deferred revenue and is being amortized into revenue over the length of the distribution agreement, which at the date of payment was 9.25 years. At December 31, 2003, the balance of the deferred revenue under this agreement was $1,010,811.
The Company recognizes revenue from custom manufactured products at HDI when the goods are shipped to the customer. HDI also develops products for certain customers under fixed price research and development contracts. The Company recognizes revenue and profit under the development agreements using the percentage-of-completion method, which relies on estimates of total expected revenue and costs. The Company follows this method since reasonably dependable estimates of revenue and costs applicable to various stages of a development agreement can be made. If the Company does not accurately estimate the resources required or the scope of work to be performed under a development agreement, then future profit margins and results of operations may be negatively impacted. In certain cases, HDI will undertake a development project on a cost plus basis. In these cases, the Company invoices and recognizes revenue for actual time and material expended on the project at contractual hourly billing rates and markups.
Under the Company’s shipping terms, title transfers to the end customer or distributor at the point of shipment. Shipping and handling costs are included in cost of revenue.
Investments
The Company’s investments in marketable and debt securities are classified as available-for-sale and are carried at fair value with the unrealized gains and losses, net of tax, reported in a separate component of stockholders’ equity entitled “Accumulated Other Comprehensive Income (losses).” The cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in investment income. Realized gains and losses and declines in value judged to be other than temporary are included in other income. The cost of securities sold is based on the specific identification method. Interest and dividends are included in investment income. The Company acquires marketable and debt securities having contractual terms less than one year, and as such all of the Company’s marketable and debt securities are classified as short-term marketable investments.
The Company holds minority investments in preferred stock, which are stated at cost given the ownership percentage is less than 10%, and represents a long-term investment in two private companies made for business purposes. Consistent with the Company’s policies for other long-lived assets, the carrying value of these long-term strategic investments is periodically reviewed for
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
impairment whenever triggering events occur that may indicate the fair value of the investment is less than the carrying value.
Accounts Receivable
The Company estimates the collectibility of its trade receivables. A considerable amount of judgment is required in assessing the ultimate realization of the receivables, including the current credit-worthiness of each customer. The Company’s historical bad debt experience has been within management’s expectations.
Inventories
Inventories are recorded at the lower of standard cost or market. Standard cost approximates actual cost determined on the first-in, first-out (FIFO) basis. Cost includes the acquisition cost of raw materials and components, direct labor and overhead. The Company reserves for excess and obsolete inventory based upon forecasted demand for its products.
Property, Equipment and Fixtures
Equipment and fixtures are stated at cost. Additions and improvements extending asset lives are capitalized while maintenance and repairs are expensed as incurred. The cost and accumulated depreciation of assets sold or retired are removed from the accounts and any gain or loss is reflected in the Statement of Income.
Depreciation is provided using the straight-line method over the estimated useful lives of the various assets as follows:
Leasehold improvements
The lesser of 3 to 5 years or the term of the lease
Furniture and fixtures
2 to 10 years
Machinery and equipment
3 to 10 years
Construction in process represents costs incurred to fund the Company’s new headquarters facility. Depreciation of the facility will begin upon completion of construction.
Goodwill and Other Intangible Assets
Goodwill represents the excess of the purchase price over the fair value of net assets of acquired businesses. Effective January 1, 2002 the Company adopted Statement of Financial Accounting Standards No. 142 (SFAS 142), “Goodwill and Other Intangible Assets.” Under the provision of SFAS 142, goodwill and intangible assets deemed to have indefinite lives are no longer amortized but are subject to annual impairment tests in accordance with the statement.
During the first quarter of 2004, the Company performed its annual review for impairment of goodwill as of December 31, 2003 and, based on this review, no impairment was recorded. The Company must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets in assessing the recoverability of its goodwill. If these estimates or the related assumptions change, the Company may be required to record impairment charges for these assets in the future.
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
Prior to the adoption of SFAS 142, amortization expense was recorded for goodwill. Had SFAS 142 been effective January 1, 2001, net income and income per share for fiscal 2001 would have been reported as follows:
The Company’s definite-lived intangible assets are reviewed for impairment whenever events indicate that their carrying amount may not be recoverable. In such reviews, the related undiscounted cash flows expected are compared with their carrying values to determine if a write-down to fair value is required. At December 31, 2003, the Company does not believe there has been any impairment of its intangible assets. The cost of purchased intangibles related to acquisitions is amortized on a straight-line basis over the following estimated useful life:
Purchased technology
15 years
Tradenames
15-20 years
Patents
15-17 years
Customer and supplier relations
4-7 years
Non-compete agreements (included in Other assets)
Term of agreement
The cost of certain licensed patents is amortized on a straight-line basis over the estimated useful life (20 years) of such patents. Costs of patents that are the result of internal development are charged to current operations.
The Company expects to record annual amortization expense of approximately $1,999,000 in 2004, $1,950,000 in 2005, $1,947,000 in 2006, $1,874,000 in 2007 and $1,657,000 in 2008 related to its intangible assets as of December 31, 2003.
Warranty Obligations
The Company’s products are generally covered by a one-year warranty. The Company accrues a warranty reserve for estimated costs to provide warranty services. The estimated costs to service the Company’s warranty obligations are based on historical experience and expectation of future conditions.
Research and Development
Product development costs including start-up and research and development are charged to operations in the year in which such costs are incurred.
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
Advertising
Advertising expense is charged to operations in the year in which such costs are incurred. Total advertising expense, included in sales and marketing expense was $108,333, $74,673, and $20,592 at December 31, 2003, 2002 and 2001, respectively.
Deferred Taxes
The Company accounts for income taxes using the liability method as required by Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (SFAS 109). Under the liability method, deferred taxes are determined based on differences between financial reporting and tax basis of assets and liabilities and are measured using the enacted tax laws that will be in effect when the differences are expected to reverse.
Stock-Based Compensation
The Company accounts for its stock-based employee compensation plans in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related interpretations. Under APB 25, no compensation expense is recognized for stock option grants to employees if the exercise price of the Company’s stock option grants is at or above fair market value of the underlying stock on the date of the grant. Stock-based compensation to non-employees is measured at fair market value over the service period and recorded as compensation expense in the Statement of Income. The Company recorded $845,480, $123,492 and $0 of compensation expense for stock compensation to non-employees in 2003, 2002 and 2001, respectively. The Company has adopted the pro-forma disclosure-only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.” The following table illustrates the effect on net income and net income per share amounts if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation:
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
For purposes of the pro-forma disclosures above, the weighted average fair value per stock option granted in fiscal 2003, 2002, and 2001 was $11.54, $8.78, and $4.16, respectively. The fair value was estimated using the Black-Scholes option-pricing model with the following assumptions:
Earnings Per Share
Basic earnings per share is computed based only on the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed using the additional dilutive effect, if any, of stock options using the treasury stock method based on the average market price of the stock during the period. The following table presents the reconciliation of basic and diluted shares:
(1) See Note 7 for a description of these instruments.
For 2003, 2002 and 2001 the incremental shares used for dilutive earnings per share relate to stock options whose exercise price was less than the average market price in the underlying quarterly computations. Options to purchase 29,781 shares at an average price of $30.63 per share were outstanding in 2003 and options to purchase 37,125 shares at an average price of $13.19 per share were outstanding in 2001, but were not included in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive. In 2002, all options were included in the computation of diluted earnings per share.
Following is the Company’s computation of basic and diluted income per share for the years ended December 31:
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
Comprehensive Income
Comprehensive income is the total of net income and all other non-owner changes in equity, and consists of net income, unrealized gains or losses on the Company’s available for sale securities, and, for 2001, the effect of the change in fiscal year end of a company acquired (see Note 3).
(3) Business Combinations and Asset Acquisitions
During 2003, the Company completed the following three acquisitions of certain operations of the Company’s existing Neuro distributors:
These transactions enable the Company to focus sales priorities on the Company’s products, expand sales coverage and invest in customer and market development. The assets and operations acquired are part of the Neuro Products segment. The purchase price of these acquisitions was recorded as follows:
On November 26, 2002, the Company completed the acquisition of MicroNet Medical, Inc. (MicroNet), a privately held developer of medical devices based on proprietary micro-lead technology. Under the terms of the transaction, which was structured as a merger, the Company acquired only MicroNet’s proprietary technology and certain associated tangible assets, which are part of the Neuro Products segment. MicroNet’s operations, other tangible assets, certain liabilities and certain employees became part of a separate, unaffiliated company. ANS assumed no material debt, liabilities, or overhead in the transaction. At closing, the Company paid the former MicroNet shareholders $500,000 in cash and 234,453 shares of ANS common stock valued at $4,648,421. The Company also paid acquisition related costs of $859,460, including an investment-banking fee of $600,000. In addition to the initial purchase price paid at closing, the Company agreed to pay the former MicroNet shareholders additional shares of ANS common stock if certain product, regulatory approval, and sales milestones are met. These milestones consist of three principal product milestones and a sales milestone. Each of the product milestones has four to six sub-milestones that relate to the delivery of specific products, and are met if and when the Company is able to submit, and when the Company receives regulatory approvals for products that have been adapted for use directly with the Company's devices. The sales milestone will be met if
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
and when $5 million in cumulative net sales are generated of MicroNet lead products during the four-year following the closing of the MicroNet transaction.
The aggregate value of the additional potential milestone earn out payments payable in shares of ANS common stock was $9 million as measured at the closing of the MicroNet transaction. Of this $9 million in additional shares, a fixed number of ANS common shares totaling 134,409 with an aggregate value at closing of $3 million were issued into an escrow account. If and when the product and regulatory milestones are met, a specified and fixed number of ANS common shares will be released from the escrow (which for purchase price accounting will be valued at the time of release from escrow). In addition, if and when those same product and regulatory milestones are achieved, at that time a number of ANS common shares will be issued with an aggregate value of up to $3 million. Finally, if and when $5 million in cumulative net sales are generated of MicroNet lead products during the four years after closing, at that time a number of ANS common shares will be issued with an aggregate value of up to $3 million.
The initial purchase price of the MicroNet acquisition was recorded in 2002 as follows:
As the MicroNet acquisition was effected through a stock-for-stock exchange, and therefore not tax deductible beyond MicroNet’s existing tax basis, the Company recorded a deferred tax liability of $2,651,720 for the identified intangible assets related to the initial purchase price. The recording of the deferred tax liability resulted in additional basis in purchased technology of $1,396,224 and in additional tradenames of $74,410. In addition, the Company acquired MicroNet’s net operating loss carryforward of approximately $3.4 million, which was recorded as a deferred tax asset of $1,181,086 (see Note 6).
In March 2003, two parts of the first major product milestone were satisfied, and 42,519 of ANS common shares were issued (of which 22,401 shares were released from escrow) with a value at the time of issuance and release from escrow of $1,020,059. In October 2003, an additional product milestone was satisfied, and 17,462 shares of ANS common shares were issued (of which 11,197 shares were released from escrow) with a value at the time of issuance and release from escrow of $700,182. The value of ANS common shares issued and released from escrow during 2003 was allocated to certain identifiable intangible assets in accordance with the original purchase price allocation, and resulted in the following additions to identifiable intangible assets:
As indicated above, the Company recorded a deferred tax liability for the identified intangible assets related to the additional earn-out consideration issued. The deferred tax liability was allocated in accordance with the original purchase price allocation resulting in an additional $449,190 and $21,305 of purchased technology and tradenames, respectively.
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
An important product milestone deadline occurred under the MicroNet acquisition agreement in November 2003, which was not met. The Company is currently in discussions with the former MicroNet shareholders regarding this product milestone. If this product milestone had been achieved by the deadline, the value of the milestone payment at December 31, 2003 was approximately $1,552,684, or 33,894 shares, which would have been allocated to certain identifiable intangible assets in accordance with the original purchase price allocation.
Another important product milestone deadline will occur in May 2004, while other milestones depend on the receipt of regulatory approvals and meeting the aggregate sales milestone referred to above. All milestones must be met by November 2006 or November 2007, depending on the milestone.
On January 1, 2001, the Company acquired the assets (primarily intellectual property consisting of patents) of Implantable Devices Limited Partnership (IDP) and ESOX Technology Holdings, LLC (ESOX), two privately-held companies, for 178,650 shares of the Company’s common stock. Based on the closing price of ANS common stock on December 29, 2000, the value of the stock issued to acquire the assets was $2,426,662. The assets purchased consisted primarily of intellectual property and developed technology, and are part of the Neuro Products segment. The purchase price of these acquisitions was recorded to patents, and is being amortized over a 15-year period.
Also on January 1, 2001, the Company completed the acquisition of Hi-tronics Designs, Inc. (HDI), a privately held contract developer and original equipment manufacturer (O.E.M) of electro-mechanical devices with headquarters in Budd Lake, New Jersey. The Company acquired all of HDI’s outstanding stock through a merger in exchange for 1,657,088 shares of ANS common stock. The transaction was accounted for on a pooling of interest basis and accordingly, prior periods were restated. Prior to the Company’s acquisition of HDI, HDI’s fiscal year ended on November 30. The Consolidated Balance Sheet at December 31, 2000 combined the balance sheet of HDI at November 30, 2000 with the Balance Sheet of the Company at December 31, 2000. Beginning in 2001, the fiscal year-ends were conformed to December 31. As a result, the results of operations of HDI for the one-month period ending December 31, 2000 have been recorded directly to retained earnings in the Consolidated Statement of Stockholders’ Equity for the period ended December 31, 2001 and are not reflected in the Consolidated Statements of Income. Summary operating results of HDI for this one-month period ending December 31, 2000, were as follows:
For the one-month period ended December 31, 2000, cash flows for HDI were as follows:
The results of operations for the acquisitions above have been included in the Company’s consolidated Statements of Income after the date of the acquisition, with the exception of the HDI acquisition accounted for as a pooling of interest, for which prior periods have been restated.
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(4) Marketable Securities
The following is a summary of the Company’s marketable and debt securities classified as available-for-sale securities at December 31, 2003:
Estimated fair value for the investment grade municipal bonds, 7-day and 35-day municipal bond floaters and Freddie Mac notes is provided by the brokerage firms holding such bonds and notes at each reporting period by utilizing a standard pricing service.
At December 31, 2003, no individual security represented more than 7.5% of the total portfolio or 3.25% of total assets. The Company did not have any investments in derivative financial instruments at December 31, 2003.
The following is a summary of the Company’s marketable and debt securities classified as available-for-sale securities at December 31, 2002:
At December 31, 2002, no individual security represented more than 6.5% of the total portfolio or 3.5% of total assets. The Company did not have any investments in derivative financial instruments at December 31, 2002.
(5) Minority Investments in Preferred Stock
In January 2003, the Company invested $1 million in cash to purchase preferred stock for a minority equity position in Innovative Spinal Technologies, Inc., a privately held start-up company that develops spine technologies, products and services through intellectual property development and contract research. This investment is accounted for under the cost method of accounting due to the Company’s minimal ownership percentage. The Company periodically reviews the valuation of this investment using available financial information from Innovative Spine Technologies, Inc. As of December 31, 2003, there were no indicators that the fair value of the investment is less than the carrying value.
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(6) Federal Income Taxes
The significant components of the net deferred tax liability at December 31, were as follows:
As of December 31, 2003, the Company had a net operating loss carry forward of approximately $4.3 million which expires in years through 2021. Of the $4.3 million net operating loss carry forward approximately $3.4 million was acquired by the Company in connection with the MicroNet acquisition and its utilization in any future year may be subject to a limitation under Section 382 of the Internal Revenue Code or other provisions which may limit the use of the net operating loss carry forward in any tax year.
The provision (benefit) for income taxes for the years ended December 31 consists of the following:
A reconciliation of the provision for income taxes to the expense calculated at the U.S. statutory rate follows:
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(7) Stockholders’ Equity
The Company has a Shareholder’s Rights Plan, adopted in 1996 and amended in 2002, which permits shareholders to purchase shares of the Company’s common stock at significant discounts in the event a person or group acquires more than 15% of the Company’s common stock or announces a tender or exchange offer for more than 20% of the Company’s common stock.
At December 31, 2000, the Company had 178,650 treasury shares. These shares were reissued on January 2, 2001 in connection with the acquisition of IDP and ESOX (see Note 3).
The Company issued 4,312,500 shares of common stock during May 2002 in an underwritten public offering. The Company received net proceeds from the offering of approximately $83.2 million.
The Company has various stock option plans (the Plans) pursuant to which stock options may be granted to key employees, officers, directors and advisory directors of the Company. In accordance with the Plans, on January 1 of each year the aggregate number of shares of common stock reserved for options under the Plans is increased by the same percentage that the total number of issued and outstanding shares of common stock increased from the preceding January 1 to the following December 31 (if such percentage is positive). On January 1, 2003 and 2004, options to purchase 1,374,353 shares and 331,859 shares of common stock, respectively, were added to the Plans.
Several of the Plans allow for the grant of incentive stock options to key employees and officers intended to qualify for preferential tax treatment under Section 422 of the Internal Revenue Code of 1986. Under all of the Company’s Plans, the exercise price of options granted must equal or exceed the fair market value of the common stock at the time of the grant. Options granted to employees and officers expire ten years from the date of grant and for the most part are exercisable one-fourth each year over a four-year period of continuous service. Options granted to directors and advisory directors expire six years from the date of grant and for the most part are exercisable one-fourth each year over a four-year period of continuous service. Certain options, however, have an eighteen-month, two-year, three-year, four year or five year vesting schedule.
At December 31, 2003, under all of the Company’s Plans, 3,290,265 shares had been granted and were outstanding, 4,852,623 shares of common stock had been issued upon exercise, and 44,562 shares were reserved for future grants.
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
Data with respect to stock option plans of the Company are as follows:
(8) Commitments and Contingencies
The Company leases offices, manufacturing and research facilities, as well as office equipment under operating leases. Future minimum rental payments related to these operating leases at December 31, 2003 are as follows:
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
Total rent expense for offices, manufacturing and research facilities, and office equipment for the years ended December 31, 2003, 2002 and 2001 was $1,190,319, $1,063,097 and $858,761, respectively.
In connection with the construction of a new corporate headquarters and manufacturing facility of 143,000 square feet located in Plano, Texas, the Company entered into various agreements in 2003 for architectural and construction services. The total amount of the agreements at inception totaled approximately $15 million. At December 31, 2003, the remaining commitment under these agreements was approximately $6.1 million. The construction on the new facility commenced in April 2003 and the Company anticipates moving its operations to the new facility before its currently leased facilities in Plano, Texas expire in August 2004.
The Company is a party to product liability claims related to ANS neurostimulation devices. Product liability insurers have assumed responsibility for defending the Company against these claims. The Company seeks to maintain appropriate levels of product liability insurance with coverage comparable to that maintained by companies similar in size and serving similar markets. While historically product liability claims for ANS neurostimulation devices have not resulted in significant monetary liability for the Company beyond its insurance coverage, there can be no assurances that the Company will not incur significant monetary liability to the claimants if such insurance is inadequate, and there can be no assurance that the Company’s neurostimulation business and future ANS product lines will not be adversely affected by these product liability claims.
Except for such product liability claims and other ordinary routine litigation incidental or immaterial to its business, the Company is not currently a party to any other pending legal proceeding. The Company maintains general liability insurance against risks arising out of the normal course of business.
Under the Company’s sales agreements with its independent sales agents, the Company can terminate those agreements without cause by paying an early termination fee equal to 100% of the commissions that would otherwise be payable on sales in the territory for the 90 days after termination and 50% of the commission that would otherwise be payable on sales in the territory for the 90 day period after the first 90 day period.
In addition, under its distributor agreements, sales agent agreements and certain other ordinary course commercial contracts with third parties, the Company typically agrees to indemnify the other contracting party from damages and costs that may arise from product liability claims. The terms of the agreements and contracts vary and the potential exposure under these indemnities cannot reasonably be estimated or determined.
(9) Financial Instruments, Risk Concentration and Major Customers
In the United States, the Company’s accounts receivable from its Neuro Products segment are due primarily from hospitals, insurance companies and Medicare. Internationally, the Company’s accounts receivable from its Neuro Products segment are due primarily from distributors located in Europe and Australia. For the HDI O.E.M segment, all of the accounts receivable are due from privately held and publicly traded medical device companies based in the United States. The Company generally does not require collateral for trade receivables. The Company maintains an allowance for doubtful accounts based upon expected collectibility. Any losses from bad debts have historically been within management’s expectations.
In 2003, the Company had no customer with net sales greater than 10% of net revenue for its Neuro Products segment as a result of the March 2003 acquisition of the pain management business of Sun Medical, Inc. (Sun Medical), the Company’s largest distributor. Net sales of implantable neurostimulation systems to
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
one major customer, Sun Medical for each of the years ended December 31, as a percentage of net revenue from the Neuro Products segment, were as follows: 2002- 14% and 2001- 15%.
Net sales of HDI O.E.M. products and services to two major customers for the year ended December 31, 2003, as a percentage of net revenue from the HDI O.E.M. segment were 76% and 13%, respectively. Net sales of HDI O.E.M. products and services to two major customers for the year ended December 31, 2002, as a percentage of net revenue from the HDI O.E.M. segment were 63% and 26%, respectively. Net sales of HDI O.E.M products and services to three major customers for the year ended December 31, 2001, as a percentage of net revenue from the HDI O.E.M. segment were 60%, 17% and 11%, respectively.
Foreign sales, primarily Europe and Australia, for the years ended December 31, 2003, 2002 and 2001 were approximately 7%, 8% and 10% of net revenue from the Neuro Products segment, respectively. The HDI O.E.M. segment had no foreign sales for the years ended December 31, 2003, 2002 and 2001, respectively.
(10) Employee Benefit Plans
The Company has a defined contribution retirement savings plan (the Plan) available to substantially all employees of its Neuro Products segment. The Plan permits employees to elect salary deferral contributions of up to 15% of their compensation and requires the Company to make matching contributions equal to 50% of the participants’ contributions to a maximum of 6% of the participants’ compensation. The Company also has a defined contribution retirement savings plan (the HDI Plan) available to substantially all employees of HDI. The HDI Plan permits employees to elect salary deferral contributions of up to 15% of their eligible compensation, subject to statutory limitations, and requires the Company to make matching contributions equal to 100% of the participants’ contributions to a maximum of 5% of the participants’ eligible compensation. The Board of Directors may change the percentage of matching contribution under either of the plans at their discretion. The expense of the Company’s contribution for the years ended December 31 was $475,012 in 2003, $346,125 in 2002 and $305,091 in 2001.
(11) Accrued Tax Abatement Liability
In January 1998, the Company sold its cardiovascular operations to Atrion Corporation, and granted Atrion a nine-month option to acquire the Company’s principal office and manufacturing facility in Allen, Texas for $6.5 million. During October 1998, Atrion exercised its option to acquire the facility. When the facility was built in 1993, the Company entered a ten-year agreement with the City of Allen granting tax abatements to the Company if a minimum job base and personal property base were maintained in the City of Allen. The agreement provided for the repayment of abated taxes if the Company defaulted under the agreement. During 1998 the Company recorded a pretax expense of $969,204 in connection with the abated taxes. In April 1999, the Company was successful in petitioning the City of Allen to assign the abatement agreement to Atrion. In July 1999, the Company, Atrion and the City of Allen executed an assignment agreement under which Atrion (as successor in interest to the Company) must continue to meet the conditions of the original tax abatement agreement until August 2003. Atrion met the minimum requirements under the agreement through 2003, and as such the Company was absolved from any liability. Accordingly, the Company reversed the accrual of $969,204 in September 2003 to other income in the Consolidated Statements of Income.
Advanced Neuromodulation Systems, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(12) Segment Information
The Company operates in two business segments. The Neuro Products segment designs, develops, manufactures and markets implantable medical devices that are used to manage chronic intractable pain and other disorders of the central nervous system through the delivery of electrical current or drugs directly to targeted nerve fibers. The HDI O.E.M. segment provides contract development and O.E.M. manufacturing of electro-mechanical devices. Intersegment revenue from HDI is billed at cost with no intercompany mark-up.
Segment data as of and for the year ended December 31, 2003 is as follows:
Segment data as of and for the year ended December 31, 2002 is as follows:
Segment data as of and for the year ended December 31, 2001 is as follows:
(13) Subsequent Event
In March 2004, the Company agreed to acquire microHelix, Inc.’s (microHelix) cable and wire division, which is operated out of Portland, Oregon, for approximately $2 million in cash and assumed liabilities. The transaction is subject to customary terms and conditions, including shareholder approval by microHelix shareholders. The acquisition is expected to close in April 2004. The acquisition of microHelix represents a vertical integration of a component supplier to the Company and other third parties, and provides the Company with additional research and development resources and intellectual property for the design and development of existing and new products.
Appendix B
Schedule II - Valuation and Qualifying Accounts
Forming a Part of the Annual Report
Form 10-K
Item 14
of
ADVANCED NEUROMODULATION SYSTEMS, INC.
(Name of issuer)
Filed with the
Securities and Exchange Commission
Washington, D.C. 20549
under
The Securities Exchange Act of 1934
Schedule II - Valuation and Qualifying Accounts
Advanced Neuromodulation Systems, Inc. and Subsidiaries
December 31, 2003
Appendix C
Quarterly Financial Data
(unaudited)
Forming a Part of the Annual Report
Form 10-K
Item 8
of
ADVANCED NEUROMODULATION SYSTEMS, INC.
(Name of issuer)
Filed with the
Securities and Exchange Commission
Washington, D.C. 20549
under
The Securities Exchange Act of 1934
(1) Q3 2003 includes other income of $969,204 from the reversal of an accrued tax abatement liability.
INDEX TO EXHIBITS