ITEM 1. BUSINESS
Overview
Cardiac Science, Inc. is a leading developer, manufacturer and marketer of life-saving public access defibrillators, or Automated External Defibrillators (“AEDs”), and the largest corporate provider of comprehensive AED/CPR training and AED program management services. We also manufacture and market a unique therapeutic in-hospital patient monitor-defibrillator that instantly and automatically treats cardiac patients with life-threatening abnormal heart rhythms without human intervention. It is estimated that over 450,000 people in the United States die each year from sudden cardiac arrest (“SCA”) or what is commonly referred to as a massive heart attack. SCA is the leading cause of death in both the United States and Europe. Approximately two thirds of SCA deaths occur outside a hospital with the balance occurring while people are at work, home or play. In situations outside of a hospital where an AED in not readily available, survival rates for victims of SCA average only 5%. For victims of SCA, survival is directly linked to the amount of time between the onset of SCA and receiving a defibrillation shock, so that for every minute that goes by without a defibrillation shock, a victim’s chance of survival is reduced by approximately 10%. Additionally, the average survival rate for patients suffering an in-hospital SCA-event, is estimated to be less than 25% - a rate that has not improved since the 1960s.
Our proprietary RHYTHMx® software algorithm technology, and STAR® biphasic energy delivery system, form the technology platform for our line of Powerheart® brand AED products, and our unique therapeutic monitor-defibrillator, the Powerheart® Cardiac Rhythm Module®, or CRM®. Our products and technology are designed to easily and effectively treat victims of SCA whether outside or inside a hospital in the shortest time frame possible, thereby significantly increasing a victim’s chance of survival. Our AED products are designed to be used by lay people and provide detailed voice instructions in over 30 languages. Once the user applies the electrode pads of our Powerheart AED to a person suffering a SCA, our device instantly and accurately detects the presence of any life-threatening arrhythmias and will advise the user to deliver a shock if required. During 2004, the Company introduced a third generation AED, the Powerheart AED G-3 Automatic which detects the presence of life-threatening arrhythmias and delivers, when appropriate, defibrillation shock(s) automatically.
We are active in new product development initiatives, including expanding and enhancing our existing Powerheart AED product line, as well as integrating our RHYTHMx and STAR Biphasic technology into new cardiac resuscitation product platforms for our strategic Original Equipment Manufacturer (“OEM”) partner GE Healthcare ("GE" or "GE Healthcare"). We have a portfolio of 77 issued patents relating to our core technology and products.
In September 2001, we acquired Survivalink Corporation (“Survivalink”), a privately held Minneapolis, Minnesota-based manufacturer of AEDs. The acquisition of Survivalink enabled us to enter the rapidly growing public-access AED marketplace.
In November 2001, we acquired substantially all the outstanding shares of Artema Medical AB, (“Artema”) a Swedish based developer, manufacturer and marketer of standard hospital-based emergency defibrillators and patient monitoring equipment, which also had operations in Denmark. This acquisition provided us with a network of international distributors and the infrastructure required to establish our international headquarters in Copenhagen, Denmark.
In October 2003, we acquired substantially all the assets and certain liabilities of Complient Corporation (“Complient”), a privately held Cleveland, Ohio based provider of AED/CPR training and AED program management services. This acquisition provided us with a network of 150 certified employee-educators and sophisticated software technology that allows us to provide, initial and ongoing management of customer AED deployments.
Our corporate headquarters is located in Irvine, California, our research and development facility is located in Lake Forest, California, our manufacturing facility is located in Minneapolis, Minnesota, and our international sales offices are located in Copenhagen, Denmark and Manchester, England. Our corporate headquarters is located at 1900 Main Street, Suite 700, Irvine, California 92614 and the telephone number is (949) 797-3800.
Business Strategy
Our primary business objective is to become the market leader in the rapidly growing global AED marketplace, which according to Frost & Sullivan should grow at a rate of approximately 20% per year over the next several years. Our secondary objective is to increase the rate of adoption of our in-hospital Powerheart CRM product, and to enter the traditional hospital “crash-cart” defibrillation market, where we estimate that approximately $300 million of these types of defibrillators are purchased per year. We believe that achieving these objectives will result in consistent and significant revenue growth and allow us to attain profitability. We expect to achieve our objectives by focusing on the following core strategies:
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Increase AED market share - In 2004, our AED products and accessories revenue totaled $57 million, up 3% over 2003. A significant increase in international AED revenue, particularly in the U.K. and Japan compared to 2003, was offset by a decrease in U.S. AED revenue as a result of a strategic shift in our indirect distribution strategy and a heightened competitive environment. Based on Frost & Sullivan's estimated AED unit sales, we estimate our market share in 2004 was approximately 25%. In order for us to achieve market share growth and become the AED market leader we intend to focus on the following:
• Expanding our AED distribution channels - We currently sell our AEDs through direct, indirect and OEM channels in the U.S. and internationally. During 2004, we rationalized our direct selling efforts and ended the year with a direct U.S. sales force of 50 persons, compared to 62 persons at the end of 2003. We have direct operations in the U.K. with a 6- person sales team and another 7 area managers who work with our international distributors in over 50 countries worldwide. Our U.S. direct sales force is primarily focused on selling our AEDs and training services in the corporate and government workplace markets, and secondarily on the schools and first responder (police/fire/ambulance) markets, and is supported by direct marketing lead generation efforts in these market segments. In 2005, we intend to expand our direct sales force in order to maximize the revenue potential of our direct marketing efforts, and to leverage the large national distribution relationships we established in the second half of 2004. During 2004, we made a strategic shift in our indirect distribution channel from the smaller, local distributors we had focused on in 2003, to establishing relationships with large, national distribution organizations such as Airgas Safety, Hagemeyer North America, Concentra Health Services and Fisher Safety. Unlike a traditional distributor model, our relationship with these national companies allow us to combine the efforts of the hundreds of dedicated sales representatives they have in the field with our direct sales force, and provides us access to their existing customer base for direct marketing activities. In 2005, our indirect channel focus will be on maximizing the potential revenue from the national distribution relationships we established last year. Internationally, we continue to sell primarily through country specific distributors, except in the U.K. where we established a direct operation in 2003, and in Japan, where we entered into an OEM relationship with Nihon Kohden in 2002. In 2005, in addition to expanding our direct efforts in the U.K. in order to leverage the sole source British Heart Foundation contract we were awarded in 2004, and we intend to increase the number of distributors worldwide by identifying and signing additional distributors in non-medical market segments, particularly in Europe. In addition to the OEM relationships we have established with Nihon Kohden for Japan, Criticare Systems, Inc. for the dental market and Quinton Cardiology Systems, Inc. for the U.S. physician’s office market, in 2003, we entered into a multi-dimensional agreement with GE Healthcare, the medical arm of General Electric Company, which included providing GE-branded AEDs and CRMs for sale by GE Healthcare outside the U.S. We recently expanded this relationship when GE Healthcare agreed to sell our Cardiac Science branded Powerheart AED and CRM product line in U.S. hospitals beginning in the first quarter of 2005.
• Enhancing our AED product line - We plan to continue to enhance our core Powerheart AED product line as we did in 2003 with the launch of the Powerheart G3 and FirstSave G3 products in the second half of the year, and the introductions in the second half of 2004 of the Powerheart G3 Automatic and the Powerheart G3 Pro. During 2005, we expect to file for clearance from the U.S. Food and Drug Administration (“FDA”) and offer for sale a consumer version AED that can be purchased without the need of a physician prescription. Future product improvements will be driven by the requirements of certain specific market segments and continued efforts to reduce product costs.
• Leveraging our AED services - Our October 2003 purchase of Complient’s assets allows us to provide a unique, single source, turnkey AED deployment solution to purchasers of AEDs. Through our nationwide network of 200 certified employee-educators, we now provide the AED/CPR training required by most states to deploy AEDs. In addition to providing certified training services, we provide the medical direction and information management necessary for AED users to be in compliance with various state laws and regulations. We believe that the ability to offer a turnkey solution differentiates us from other AED manufacturers and provides us with a competitive advantage at point of sale particularly with multi-unit, multi-facility transactions with larger customers in the corporate and government workplace sectors.
• Increasing the rate of adoption of our Powerheart CRM - Our therapeutic monitoring product, the Powerheart CRM, is the only hospital bedside monitor defibrillator cleared by the FDA for prophylactic attachment and continuous monitoring of patients at risk of life-threatening arrhythmias that can deliver a potentially lifesaving shock without human intervention. It has the potential to become a new “standard of care” in the treatment of in-hospital SCA. However, despite clinical evidence which demonstrates the positive impact the CRM may have on the survival rate of SCA victims, adoption of the technology has been much slower than we expected. We believe that the adoption of the product has been hindered by a lack of (a) peer reviewed clinical evidence demonstrating the cost/benefit of the technology; and (b) distribution capability. We intend to address these issues by:
• Conducting several clinical studies at recognized hospitals, for publication in peer-reviewed medical journals, to further support improved patient outcomes and cost effectiveness of our Powerheart CRM.
• Supporting GE in its efforts to market the Powerheart CRM in the U.S. and internationally.
• Developing new product embodiments for our existing technology - In 2003, we entered into a strategic relationship with GE. In addition to OEM distribution of our Powerheart AED and CRM products, we agreed to develop and manufacture for GE a traditional “crash cart” hospital defibrillator utilizing our core RHYTHMx and STAR Biphasic technology. We anticipate that this development project will be completed in the second quarter of 2005. This development arrangement allows us to enter what we estimate to be a $300 million hospital defibrillator market by leveraging the distribution strength of GE Healthcare. We have identified and have had preliminary discussions regarding other product development projects where GE technology and our RHYTHMx and STAR Biphasic core technology could be brought together to create a new line of hospital based patient monitor and defibrillation products. We believe that continued collaboration with GE Healthcare will allow us to develop additional hospital based products which incorporate our core technology, ultimately allowing increased adoption of our technology through the marketing strength and hospital presence of GE Healthcare.
Sudden Cardiac Arrest
SCA is the leading cause of death of Americans and accounts for over 450,000 deaths annually. Factors contributing to the onset of SCA include coronary heart disease, drug abuse, respiratory arrest, electrocution, drowning, choking and trauma. Death from SCA is sudden and unexpected, occurring without warning or immediately after the onset of symptoms. The American Heart Association (“AHA”) estimates that 50% of SCA victims have no prior indication of heart disease-their first symptom is SCA. And for those with a known history of heart attacks, the chance of sudden cardiac death is four to six times greater than that of the general population.
According to the AHA, almost 60% of SCA incidents are witnessed. However, it is estimated that 95% of SCA victims die before reaching the hospital due to delays in effective treatment. Survival is directly linked to the amount of time between the onset of SCA and defibrillation: a victim’s chances of survival are reduced by approximately 10% with every minute of delay.
The Heart
The heart has four chambers, the two upper, smaller chambers are called the left and right atria and the two lower, larger and stronger chambers are referred to as the left and right ventricles. Blood is pumped throughout the circulatory system by a series of highly coordinated contractions of the heart’s four chambers. If these contractions do not occur in a synchronized manner, then the transportation of blood throughout the body is diminished. Under normal conditions, an electrical impulse is initiated in a bundle of highly specialized cells located in the right atrium. This bundle of cells, referred to as the sinus node, is also appropriately known as the heart’s natural pacemaker. From the sinus node, this electrical current moves across a specific path in the atria, and to the ventricles, causing the chambers to contract and pump blood. If the heart is to beat properly, then the electrical current, beginning in the atria, must follow a precise path so that the heart’s chambers beat in a synchronized and coordinated fashion.
Arrhythmias
If the heart deviates from this normal series of electrical impulses, then abnormal heart rhythms result, and the ability of the heart to effectively pump blood throughout the circulatory system is diminished. Although some arrhythmias are short in duration and have little effect on the heart’s normal rhythm, certain other arrhythmias cause the heart to beat too fast-tachycardia-or too slow-bradycardia. If tachycardia originates in the ventricles, it is referred to as ventricular tachycardia (“VT”). Sustained ventricular tachycardia, and ventricular fibrillation, as described below, are immediately life threatening and must be corrected by defibrillation to prevent sudden cardiac death. Our products are designed to detect and treat these types of arrhythmia.
Ventricular Fibrillation and SCA
Ventricular fibrillation (“VF”) is a lethal form of arrhythmia in which disordered electrical activity in the heart causes the ventricles to contract in a rapid, unsynchronized, uncoordinated fashion. With the onset of VF, little or no blood is pumped from the heart to the brain and vital organs, resulting in the victim becoming quickly unconscious and experiencing sudden death unless appropriate therapy is provided immediately. This loss of normal heart function, or sudden cardiac arrest requires an application of an electric shock-defibrillation-to resynchronize the heart’s disordered electrical activity to a normal rhythm.
Where Does SCA Strike?
According to numerous clinical studies it is estimated that two-thirds of sudden cardiac arrests occurs while people are at work, home or play. The AHA, almost 60% of SCA incidents are witnessed, however if AEDs are not on premise, only about 5% of victims survive given that after calling 911, it takes on average, about 8-12 minutes for emergency personnel to arrive on scene. Clinical studies have shown that when police vehicles are equipped with AEDs it can cut response times to SCA victims by about three minutes when compared to historical response times and significantly improved victim survival rates. Communities with public access defibrillation (“PAD”) programs in place, where AEDs are placed in public buildings, airports, at sporting events and in emergency response vehicles, have reported community survival rates approaching 50 percent. In some venues, such as casino’s and corporate workplaces, when the first shock is delivered within 3-5 minutes, reported survival rates from SCA are ranging from as high as 48% to 74%.
Our Core Technology
All of our products incorporate our proprietary RHYTHMx technology. This platform technology is designed to detect and discriminate life-threatening arrhythmias. Our STAR Biphasic technology is designed to optimize the delivery of a potentially life-saving electric shock to victims of SCA. We have integrated our core technology, along with other proprietary technology that we have developed into our Powerheart AED and CRM product lines. We also sell accessories and disposable products, including our proprietary disposable defibrillator electrode pads, and are actively licensing certain components of our core technology to third-parties for integration into other products.
Our RHYTHMx Technology
Our proprietary RHYTHMx technology allows for the detection and identification of life-threatening arrhythmias and automatic delivery of defibrillation therapy. Our patented RHYTHMx software algorithm is capable of filtering noise and artifact from a patient’s electrocardiogram (“ECG”) signal without compromising its ability to correctly identify heart rhythms that are life-threatening-shockable, or non-life-threatening-non-shockable.
RHYTHMx begins by filtering the patient’s electrocardiogram signal to reduce noise artifact and then detects the heart’s QRS complexes in conjunction with the patient’s heart rate. The heart’s ECG signals contain wave shapes that are referred to as P-QRS-T waves. While a normal heartbeat contains each of these wave shapes, in the case of the chaotic and disorganized rhythm of ventricular fibrillation, these wave shapes-or QRS complexes-are absent or indistinguishable. If the heart rhythm is considered shockable by RHYTHMx, and it persists, then a shock is indicated. Further analysis by RHYTHMx, which occurs in a fraction of a second, classifies the shockable rhythm as requiring a synchronous shock-in the case of a life-threatening VT-or an asynchronous shock-in the case of life-threatening VF.
Clinical results with our RHYTHMx technology demonstrated 100% sensitivity (correct identification of shockable rhythms) and 99.4% specificity (correct identification of non-shockable rhythms). RHYTHMx technology has been clinical validated by leading researchers in numerous clinical studies and received FDA clearance in 1998.
Our STAR Biphasic Technology
Our Self-Tracking Active Response (“STAR”) Biphasic waveform technology allows our line of defibrillator devices to deliver the most effective therapy possible by delivering an optimized amount of energy in response to SCA. STAR Biphasic quickly assesses the unique characteristics of a patient and customizes the defibrillation energy he or she receives.
The STAR Biphasic waveform treats cardiac patients individually, based on three important characteristics: impedance, defibrillation threshold and cellular response.
Impedance is the number one difficulty in delivering current to the heart in external defibrillation. Tissue such as skin, fat, muscle and bone, surround the heart and impede the flow of energy delivered by a defibrillator. Impedance varies from person to person and in order to optimize energy delivery, adjustments must be made for a patient’s impedance. Our STAR Biphasic waveform technology provides optimized energy delivery by measuring a patient’s impedance and customizing a waveform to deliver the most effective defibrillation energy. This customization occurs for even the most difficult high-impedance patients. STAR Biphasic technology delivers optimal therapy for every patient.
Defibrillation threshold (“DFT”) is defined as the minimum current required to defibrillate the heart and establish normal rhythm. DFT varies from person to person, based primarily on a person’s anatomy, disease condition and metabolic state of the heart. Failure to exceed a patient’s DFT means failure to defibrillate a patient’s heart. STAR Biphasic technology automatically escalates defibrillation energy to ensure that a patient’s DFT is exceeded as rapidly as possible.
During the delivery of any defibrillation shock, the cell membranes of the heart are charged, until the cells depolarize. This allows normal electrical pathways to reestablish control and produce a coordinated rhythm. If any residual charge remains on the cells, i.e., they do not fully depolarize, then re-fibrillation may occur. The STAR Biphasic waveform has been uniquely designed to neutralize any residual charge through a process of charge balancing. STAR Biphasic precisely controls the energy delivered in the first phase of defibrillation and balances any residual cellular charge during the second phase of defibrillation. By neutralizing the residual charge, STAR Biphasic minimizes the likelihood of re-fibrillation and provides the optimal environment to defibrillate the heart.
The STAR Biphasic waveform was validated in a clinical trial led by researchers at the Cleveland Clinic and Cedars-Sinai Medical Center. This multi-center study, designed according to FDA guidelines, determined that the STAR Biphasic waveform was safe and effective
In addition to the use of STAR Biphasic waveform technology in our defibrillator devices, we also license this technology to selected partners internationally.
Our Products
The Powerheart G-3 Line of AEDs
Our Powerheart AED product line is powered by our RHYTHMx and STAR Biphasic technology, and is the only AED that can provide continuous monitoring capabilities before, during and after SCA, protecting the victim against delays in therapy and the reoccurrence of another life-threatening arrhythmia following resuscitation.
Reflecting the merger of Survivalink and Cardiac Science in September 2001, our Powerheart AED combines industry-leading AED expertise with advanced arrhythmia detection technology. In 2004, sales of Powerheart AEDs, accessories and related services represented 94% of our total revenue. To date, there are approximately 110,000 Cardiac Science AEDs deployed around the world.
Our AEDs devices have been deployed by in virtually every setting imaginable. Powerheart AEDs have been deployed at hundreds of educational institutions, federal, state and local municipal agencies, fire and police departments, ambulances, railroads, airports, airlines, military bases, hospitals, nursing homes, health clubs, physician and dental offices, and leading corporations.
Our Powerheart brand AEDs has also been chosen by many local governments and municipalities for use in community based Public Access Defibrillation (“PAD”) programs in cities such as London, San Diego, Miami, Minneapolis, Nashville, and St. Louis.
We believe that our Powerheart line of AEDs offers the following competitive advantages:
• Our patented RescueReady® technology tests not only the battery and system components, but also verifies that the pre-connected disposable electrodes are properly functioning.
• Clear, concise voice prompts guide the user through the rescue process and our exclusive one-button operation eliminates confusion and uncertainty.
• Our innovative RHYTHMx technology provides continuous monitoring capability and our STAR Biphasic waveform technology allows for customized defibrillation and escalating variable energy delivery.
• Pre-connected electrodes save time and ensure the AED is ready at time of rescue.
• Our proprietary self-testing AED defibrillator electrodes are interchangeable for body placement and are supplied pre-gelled with a self-adhesive. We have also developed and are marketing our proprietary FDA-cleared pediatric defibrillation electrode system, designed for use with our AED, to deliver reduced defibrillation energy to infants and children up to 8-years old, or up to 55 lbs. These innovative pediatric electrodes are suitably sized for a child’s smaller torso, and are less than half the size of our adult AED electrodes
In 2004, we added two new Powerheart AEDs to our line, they include:
• Powerheart AED G-3 “PRO” is a technologically advanced AED designed for use by sophisticated users of lifesaving equipment such as hospital personnel, medical professionals and emergency medical technicians. The G3 PRO is unique in that it displays the victim’s heart rhythm on a built-in high resolution color electrocardiogram (ECG) display and gives professional users the option of delivering defibrillation shocks either semi-automatically or manually during the emergency treatment of victims of sudden cardiac arrest. Other advanced features include continuous cardiac monitoring capability via an ECG patient cable, multiple rescue data storage, clear and comprehensive AED and CPR voice prompts, infrared data transfer and optional rechargeable battery.
• Powerheart AED G-3 Automatic is the first fully automatic AED in the Powerheart product line. This new generation AED has been designed specifically for public places and corporate workplace settings. A rescuer need only listen to the Powerheart's detailed voice instructions explaining how to attach the device to the heart attack victim to potentially save a life. There are no buttons to push or additional action required since the Powerheart analyzes the patient's condition to detect a life-threatening heart rhythm and, if appropriate, automatically delivers a potentially life-saving defibrillation shock(s) to restore the heart to a normal rhythm.
The Powerheart CRM
The chances of survival for a patient suffering SCA in a hospital remains at less than 25%. Because of the time it takes to defibrillate patients, even under monitored conditions, this survival rate has not changed in the last 40 years. And those that do survive are typically faced with a longer and more expensive hospital stay.
The Powerheart CRM is a lightweight fully-featured external defibrillator that offers a complete therapeutic monitoring package in a single device - continuous cardiac monitoring, synchronized cardioversion, non-invasive pacing as well as manual, semi-automatic or fully-automatic defibrillation. Once attached to patients via our disposable defibrillator electrodes, the CRM continuously monitors a patient’s cardiac rhythm, and if a life-threatening arrhythmia is detected, automatically delivers a life-saving defibrillation shock within seconds and with no human intervention.
Therapeutic monitoring with the Powerheart CRM offers cardiac patients the best chance of survival from SCA and represents a potential new standard of care for medical facilities worldwide. In December 2001, we received clearance from the FDA to market the Powerheart CRM to medically supervised environments such as hospitals, medical and dental surgery centers, physician offices, clinics and nursing homes in the United States. We have also received the necessary approvals to market the Powerheart CRM in Europe, Canada, Australia and other regions around the world. Our Powerheart CRM is in a number of hospitals worldwide.
Our Powerheart CRM is a unique therapeutic monitor incorporating state-of-the-art technology that offers medical facilities the following features and benefits:
• Powerheart CRM provides reliable, continuous monitoring, detection and treatment of life-threatening arrhythmias;
• Biphasic waveform technology customizes defibrillation energy to deliver optimal therapy for each patient;
• Non invasive external pacing;
• The Powerheart CRM’s compact design and battery operation allows for use in transporting patients and also provides for multiple mounting options at the bedside and uninterrupted operation in any hospital setting. The Powerheart CRM’s footprint measures 11 inches x 4 inches x 8.25 inches and weighs only 11.5 pounds; and
• User friendly programmable interface software and control buttons permit simple operation and a color LCD provides exceptional viewing and resolution. The Powerheart CRM can operate in manual, advisory or fully automatic modes.
We also market our proprietary disposable defibrillator electrodes for use with the Powerheart CRM. These disposable defibrillator electrodes provide reliable ECG monitoring, defibrillation and external pacing performance and offer reduced motion artifact caused by patient movement. The compact design and radiotransluscence of the Powerheart CRM disposable defibrillator electrodes also allows clearer views of the chest under x-ray and fluoroscopy and a new hydrogel adhesive reduces the potential for skin irritation.
Miscellaneous Products
As part of the Artema acquisition in 2001, we marketed a low-end line of patient monitors. The Diascope G2 is a compact, transportable vital signs monitor designed for use in hospitals and day surgery units and has been marketed in certain international markets. In 2004 we sold approximately $1.4 million of this product, compared to $2.5 million in 2003.
In connection with the Complient acquisition, we marketed a line of CPR related resuscitation products and accessories, including training mannequins and an audible CPR prompt device. These products accounted for approximately $1.6 million in revenue for the year ended December 31, 2004.
In February 2004, we made a strategic decision to discontinue the Diascope patient monitor product line and sell the CPR training related product line, both of which had below average gross margins and used disproportionate manufacturing, sales and administrative resources. We completed the transactions to execute this strategy in the third quarter of 2004.
Our Markets
We segment the market for our devices and technology into two principal categories: AEDs and related accessories and AED/CPR services, and in-hospital therapeutic monitoring-defibrillation (Powerheart CRM).
AED Market Segments
Based on Frost & Sullivan estimates of unit sales in 2004, our market share of the worldwide AED market was approximately 25%. We believe that we have a leading position in at least two of our market segments, the U.S. government agency workplace segment and the U.S. corporate workplace market. The following are our market segment highlights:
• The corporate workplace and government market segments have been our primary focus, and accounted for approximately 70% of our total U.S. AED sales in 2004. We believe these market segments are less than 10% penetrated and we will continue to focus a significant portion of our sales and marketing resources in this area.
• We estimate that less than 10% of schools in the United States have AEDs and to date only New York has mandated deployment of AEDs in public schools. In 2004, we generated 10% of our U.S. AED sales from schools and colleges.
• In the U.S. first responder market segment, we estimate that between 25 to 35% of the 285,000 police and fire vehicles are equipped with AEDs. Sales in this segment represented 12% of our U.S. 2004 AED sales.
• The medical market segment includes physician and dental offices and hospitals. We estimate that less than 10% of approximately 200,000 physician and dental offices have AEDs and only a small percentage of the 6,600 hospitals have AEDs available. About 8% of our U.S. AED sales in 2004 were to the medical market segment.
• We believe that we are the market leader in the Japanese AED market due to our strategic partnership with Nihon Kohden. We also have more than 50 distributors in all major world markets, and we continue to focus our sales and marketing efforts on growing our market share in the three largest and fastest growing global markets, Japan, Germany and the U.K. International sales represented 40% of our total 2004 AED sales.
In-Hospital Therapeutic Monitoring-Defibrillation (Powerheart CRM)
Traditionally, hospitals have deployed manual or semi-automatic defibrillators to treat SCA victims. Standard defibrillators require supervision by highly skilled medical personnel to analyze and interpret the patient’s electrocardiogram and to manually deliver a shock using handheld paddles. Standard defibrillators are typically positioned in the hospital at locations such as critical care and cardiac care units, emergency and operating rooms and electrophysiology labs. We estimate that there are 6,600 hospitals in the United States.
Despite the availability of standard defibrillators to treat SCA in hospitals, numerous hospital studies have documented delays of five minutes or more between the onset of cardiac arrest to the arrival of the first medical team member. Clinical studies show that the average survival rate of patients who have an in-hospital SCA is estimated at less than 25%, a rate of survival that has not improved since the 1960s. We believe that our Powerheart CRM is well positioned to provide hospitals with a therapeutic monitoring alternative which will result in an increase in survival rates and a reduction in patient care costs.
Technology Licensing
We are seeking strategic relationships with third parties to license our RHYTHMx and STAR Biphasic proprietary technologies for use in patient monitoring type devices.
During 2002, we entered into three separate licensing agreements with Zoll Medical, Inc., Lifecor, Inc., and Innomed Medical Corporation. During 2003, we entered into a license agreement with Medical Research Laboratories (“MRL”). We licensed our STAR Biphasic technology for use in standard emergency defibrillators for sales internationally and licensed certain patents relating to wearable defibrillators and other proprietary features of our AEDs, as well as licensing our platform RHYTHMx technology. In consideration for these licenses we received cash and ongoing royalty payments.
AED Market Drivers
SCA kills approximately 450,000 people in the United States each year. A few minutes after the onset of SCA, brain damage can start to occur and death will result unless the victim’s heart is shocked back into rhythm by a defibrillator. According to the AHA almost 60% of all SCAs are witnessed by a bystander. Moreover, the AHA currently estimates that 95% of SCA victims die before reaching the hospital. Communities that strategically place AEDs in public buildings, arenas, airports and emergency vehicles can significantly reduce response times. In venues where bystanders or first responders can defibrillate a victim within three to five minutes, the reported survival rates from SCA are as high as 48% to 74%.
There is now widespread acknowledgement and increasing awareness that AEDs save lives and can be safely used by lay people. The AHA has publicly encouraged widespread deployment of AEDs through community AED programs.
Legislation is a key market driver, and numerous AED-related bills have been introduced at the Federal level and in State governments in the past several years, which we believe will facilitate the growth of new and existing markets for AEDs:
• In 2000, the 106th Congress of the United States passed the Cardiac Arrest Survival Act, which directs placement of AEDs in all Federal buildings in order to improve survival rates of SCA victims in those buildings and establishes protections from civil liability arising from the emergency use of AEDs.
• The Rural Access to Emergency Devices Act, signed into law in 2000, authorized the spending of $25 million in federal funds over three years to help rural communities purchase AEDs and to provide training on how to use them.
• In 2001, the Office of Management and Budget directed the Occupational Safety and Health Administration (“OSHA”) to consider whether promotion of AEDs should be elevated to a priority. In response, OSHA issued a technical bulletin encouraging all employers to consider making AEDs available in the workplace. According to OSHA, 13% of all workplace fatalities are attributable to SCA
• The Community Access Emergency Defibrillation Act of 2001 was added to the Public Health Security and Bioterrorism Preparedness and Response Act of 2002, and was signed into law in June 2002. The Act provided federal funding for implementation of PAD programs.
• In 2002, the New York State Legislature passed laws requiring public school facilities, regardless of size, to retain at least one AED on school premises. Currently, seven other states are considering legislative alternatives to either recommend or mandate the use of AEDs in schools and certain other facilities and public places.
• State of Illinois House Bill 43, was passed on March 5, 2003 creating the Physical Fitness Facility Medical Emergency Preparedness Act which requires various physical fitness facilities, including (i) facilities owned or operated by a unit of local government or by a school, college, or university, (ii) golf courses, and (iii) health or fitness clubs, to have on its premises at least one AED and a trained AED user.
• On March 7, 2005, New York City based a bill Number 211-A that requires the placement of AEDs in the publicly accessible areas of certain City buildings, ferry terminals, nursing homes, senior centers, health clubs, golf courses, stadiums, arenas and selected New York City parks.
Sales and Marketing
We currently sell our AEDs through direct, indirect and OEM channels in the U.S. and internationally. During 2004, we rationalized our direct selling efforts and ended the year with a 50-person direct U.S. sales force. Internationally, we have direct operations in the U.K. with a 6-person sales team and another 7 area managers who work with our international distributors in over 50 countries worldwide. Our marketing efforts were focused on the U.S. corporate workplace and the U.S. government agency workplace market segments. As a result of this effort, we believe that we are the market leaders in those segments.
Our U.S. direct sales force is primarily focused on selling our AEDs and training services in the corporate and government workplace markets, and secondarily on the schools and first responder (police/fire/ambulance) markets, and is supported by direct marketing lead generation efforts in these market segments. In 2005, we intend to expand our direct sales force in order to maximize the revenue potential of our direct marketing efforts, and to leverage the large national distribution relationships we recently established in the second half of 2004. During 2004, we made a strategic shift in our indirect distribution channel from the smaller, local distributors we had focused on in 2003, to establishing relationships with large, national distribution organizations such as Airgas Safety, Hagemeyer North America, Concentra Health Services and Fisher Safety. Unlike a traditional distributor model, our relationships with these national companies allow us to combine the efforts of the hundreds of dedicated sales reps they have in the field with our direct sales force, thereby providing us access to their existing customer base for direct marketing activities. In 2005, our indirect channel focus will be on maximizing the potential revenue from the national distribution relationships we established last year. Internationally, we continue to sell primarily through country specific distributors, except in the U.K. where we established a direct operation in 2003, and in Japan, where we entered into an OEM relationship with Nihon Kohden in 2002. In 2005, in addition to expanding our direct efforts in the U.K. in order to leverage the sole source British Heart Foundation contract we were awarded in 2004, and we intend to increase the number of distributors worldwide by identifying and signing additional distributors in non-medical market segments, particularly in Europe. In addition to the OEM relationships we have established with Nihon Kohden for Japan, Criticare Systems, Inc. for the dental market and Quinton Cardiology Systems, Inc. for the U.S. physician’s office market, in 2003, we entered into a multi-dimensional agreement with GE, which included providing GE-branded AEDs and CRMs for sale by GE outside the U.S. We recently expanded this relationship when GE Healthcare agreed to sell our Cardiac Science branded Powerheart AED and CRM product line in U.S. hospitals through its sub-acute sales force, beginning in the first quarter of 2005.
We currently have one specialist supporting our CRM clinical studies efforts, and also utilize distributors in certain regions in the United States and internationally. In addition, in 2003 we signed an OEM agreement with GE Healthcare whereby it distributes the CRM through its distribution channels. We are also focused on the collection of clinical data supporting the cost-effectiveness and improved patient outcomes of our Powerheart CRM.
Competition
Our principal competitors in the worldwide AED market, both public-access and medical AED markets are Philips Medical’s Heartstream division, Medtronic’s Emergency Response Systems division (formerly Physio-Control) and Zoll Medical Corporation. Overall, we believe that Philips Medical is currently the market leader.
Our experience indicates that the key criteria that buyers of AEDs exhibit in their purchasing decision are:
• ease of use,
• reliability and self testing,
• overall value-a combination of features and price, and
• capability to assist in deployment and training.
We believe that our Powerheart AED compares favorably with our competitors’ products in the AED market based on these factors as well as on other competitive determinants. We also believe that our ability to provide a complete turnkey AED deployment solution provides us with a competitive advantage over other manufacturers, particularly in the government and corporate workplace segments.
Our most significant competitive disadvantage relates to our relatively small size and inferior financial position as compared to our much larger competitors. This differential in size, the debt on our balance sheet and our lack of profitability are routinely raised by our competitors at point of sale in an effort to discourage potential customers from buying from us.
The Powerheart CRM is the only FDA-cleared external defibrillator that provides fully automatic detection and treatment for patients suffering from life-threatening arrhythmias. We compete against numerous companies in the hospital marketplace where we sell our Powerheart CRM.
Manufacturing
We manufacture our Powerheart AEDs and Powerheart CRMs at our 31,000 square foot manufacturing facility in Minnetonka, Minnesota. Our current in-place test and final assembly capacity will allow us to build approximately 80,000 AEDs annually. In 2004, we manufactured approximately 37,000 AEDs, compared with 30,000 in 2003. We outsource the manufacture of major subassembly components such as printed circuit boards primarily for the benefit of reduced cost, and perform final assembly and testing in our facility.
Our FDA-registered Minnetonka facility is ISO certified for the design and manufacture of medical products. Our certifications allow us to design and manufacture medical products with the CE mark for shipment to Europe and to ship FDA-cleared products in the United States.
The manufacturing processes used to produce our products are required to comply with FDA enforced Good Manufacturing Practices (“GMP”) regulations which cover the design, testing, production, control and documentation of our products. In those foreign jurisdictions where we market our products, we are also required to comply with and obtain regulatory approvals and clearances. These regulatory requirements also apply to our third party contract manufacturers, as well as to some of our suppliers. The FDA and foreign counterparts conduct periodic inspections of manufacturing facilities to ensure compliance with “Quality System Regulation,” GMP, and other regulations, such as those promulgated by the International Standards Association. Any concern raised by such inspections could result in regulatory action, delays or termination of production.
Intellectual Property
We believe that our intellectual assets, including trademarks, patents, trade secrets and proprietary technology, are extremely valuable and constitute a cornerstone of our business. We own 77 U.S. and foreign patents relating to our automatic defibrillation technology platform and its various applications. We intend to file additional patent applications relating to each of our products and our underlying proprietary technology, as well as around new technological inventions that we are developing. We believe that our patents and proprietary technology provide us with a competitive advantage over our competitors. We will aggressively defend our inventions and also look for opportunities to generate royalty fees from licensing our intellectual property.
We have a wide range of patents covering the technology found in our AEDs, including our RescueReady technology, which features one button operation, pre-connected disposable electrode pads and self-test capabilities. Other patents we have been issued cover our proprietary RHYTHMx arrhythmia detection software technology, our STAR Biphasic defibrillation waveform technology and our disposable therapy electrodes.
Clinical Studies
We are actively engaged in, and are pursuing the sponsorship of, clinical studies at hospital medical centers both in the U.S. and Europe, relating to our Powerheart CRM product. These studies are primarily focused on demonstrating clinical efficacy, along with improved survival rates and the economic benefits associated with deployment of our Powerheart technology for hospitalized at-risk cardiac patients. We anticipate that the results of these studies will be presented in abstract form at conferences, and if accepted, as manuscripts published in peer reviewed medical journals. Various studies are ongoing, planned or proposed, at luminary medical centers in the U.S. and Europe. Currently, three clinical studies are underway to determine both clinical efficacy and cost-effectiveness of bedside CRM monitoring, including:
·
An economic and safety effectiveness study being performed at New York Methodist Hospital under the direction of Dr. Charles E. Oribabor, Director, Cardiac Surgery ICU at that institution, and;
·
On-going clinical and observational study at Maimonides Medical Center in Brooklyn, NY under the direction of Maimonides Director of Clinical Cardiology, Gerald Hollander M.D. Based on early positive results, the hospital elected to deploy more than 100 Powerheart CRM devices and has been accumulating data for more than two years and;
·
An outcomes study under the lead of Antonio Martinez-Rubio, M.D. in the Cardiology department at the Hospital de Sabadell in Barcelona, Spain.
In November 2004, a study published in the Journal Resuscitation authored by Henry Cusnir, M.D., et al, was conducted at Maimonides Medical Center in Brooklyn, N.Y. The study looked at response times by staff in monitored wards to simulated cardiac arrest as compared to the Powerheart response programmed in its fully-automatic mode. Staff verses Powerheart response time was on average nearly 3 minutes verses 38 seconds.
In October 2004, a study published in the Journal Resuscitation and authored by André Moreira Bento, M.D., et al, was conducted principally at the Instituto do Coroçào, University of Sao Paulo Medical School in Sao Paulo, Brazil. The study monitored 55 cardiac patients located in special monitoring wards. During approximately 1,300 hours of monitoring, 18 episodes of life-threatening rhythm events were documented that required treatment through defibrillation. The mean response time to defibrillation shock delivered automatically by the Powerheart was 33.4 seconds and the therapy was successful in converting the patient to a normal heart rhythm 94.4 percent of the time on the first shock (17/18) and 100 percent by the second shock (1/1). There were no patient complications.
In February 2003, a European study authored by Antonio Martinez-Rubio, M.D. et al, was published in the Journal of the American College of Cardiology. The 117-patient study was conducted at 10 European medical centers in Germany, Spain, Italy and Finland. The patients included 51 at risk cardiac patients located in special monitoring wards (intensive or coronary care units or in the emergency room), and 66 who were undergoing electrophysiological testing or implantation of cardioverter-defibrillators (ICDs) because of suspected or documented ventricular tachyarrhythmias. During a total of 1,240 hours of testing, 1,988 heart rhythm events were documented and 115 of those needed treatment through defibrillation. The mean response time was 14.4 seconds and there were no complications.
In June 2003, a study published in The American Journal of Cardiology authored by Thomas Mattioni, M.D., et al, conducted at the Arizona Heart Institute, Phoenix, AZ measured the ability of the Powerheart to accurately discriminate superventricular (SVT) from life-threatening ventricular tachyarrhythmias (VT) in patients undergoing a conventional EP study the electrophysiology lab. In a total of 98 patients the Powerheart correctly identified 122 episodes of SVT for a resultant sensitivity of 100 percent and a specificity of 94 percent. The authors concluded that the Powerheart accurately discriminates SVT from VT and is expected to correctly deliver automatic shocks in the presence of spontaneous life-threatening arrhythmia and appropriately withhold therapy during SVT.
Government Regulation
In the United States, clinical testing, manufacturing, packaging, labeling, promotion, marketing, distribution, registration, record keeping and reporting, clearance or approval of medical devices generally are subject to regulation by the FDA. Medical devices intended for human use are classified into three categories, subject to varying degrees of regulatory control. Class III devices, which we believe cover certain of our products, are subject to the most stringent control.
In October 1997, we received 510(k) clearance from the FDA to market the clinical version of the original Powerheart in the United States. In August 1998, we received 510(k) clearance from the FDA to market RHYTHMx and to integrate it into other stand-alone defibrillator monitors. In January 2000, we received clearance from the FDA to market the commercial version of the original Powerheart in the United States. In February 2001, we received notification from the FDA that allows our original Powerheart to be used in outpatient surgery centers, nursing homes and at home when prescribed by a physician. In December 2001, the FDA granted us 510(k) clearance to market our Powerheart CRM in medically supervised environments such as hospitals, medical and dental surgery centers, physician offices, clinics and nursing homes. In October 2001, the FDA granted us 510(k) clearance to market a new advanced version of our monitoring-defibrillation-pacing electrodes.
In February, 2002, the FDA granted us 510(k) clearance to market our Powerheart AED for the emergency treatment of victims of sudden cardiac arrest and in January 2003, the FDA granted us 510(k) clearance to market our Powerheart AED for use on children under eight-years of age. In July 2004, the FDA granted us 510(k) clearance to market our Powerheart G-3 Automatic AED and in August 2004, the FDA granted us 510(k) clearance to market our Powerheart G-3 AED Pro.
We have also received the necessary approvals to market the Powerheart CRM, Powerheart AEDs and related product accessories within Europe, Canada, Australia and other regions of the world.
Our products are subject to FDA review of labeling, advertising and promotional materials, as well as record keeping and reporting requirements. Failure to comply with any of the FDA’s requirements, or the discovery of a problem with any of the products, could result in FDA regulatory or enforcement action. Further, any changes to the products or their labeling may require additional FDA submissions, review, clearance or approval.
In early April 2004, we received a Warning Letter from the U.S. Food and Drug Administration (FDA) following a routine inspection of our manufacturing facility in Minneapolis. The letter specified certain procedural and documentation items in the Company’s quality system. We took corrective and preventive action to bring our quality system into compliance. In addition, during May 2004, we initiated a limited, voluntary recall of approximately 5,800 units of our older model Powerheart AEDs in order to replace a potentially faulty capacitor component. As of December 31, 2004, the majority of the recalled units in the U.S. have been replaced or repaired and we are in the process of executing our international recall plan which represents approximately 10% of total affected units.
Also, in May 2004, we initiated a limited, voluntary recall of approximately 4,800 AED batteries due to an error made by our battery supplier whereby an incorrect fuse was used in the manufacture of a certain lot of batteries. As of December 31, 2004, the recall has been completed and customers have received replacement batteries.
We estimate the cost of these voluntary recall actions could range from $1 million to $1.2 million, however, we have received from our suppliers, credits against existing and future amounts totaling $1.2 million, which have been recorded to accrued expenses to establish a warranty accrual for these recall matters and are included in accruals for warranties issued during the period. Actual recall related costs incurred have been charged against this accrual and totaled approximately $1.1 million as of December 31, 2004. At this time, we believe our remaining accrual related to the recall will cover any future costs.
Research and Development
We are committed to improving and expanding our product line through the application of our existing patented and proprietary technology, and through the research and development of new technology. Our core RHYTHMx and STAR Biphasic technologies have multiple patient monitoring and therapeutic applications, and we continue to seek out new device embodiments integrating our proprietary technology, enhancing or expanding our own product line, or by licensing to a third-party.
Research and development expenses for the years ended December 31, 2004, 2003 and 2002 were $6 million, $5.5 million, and $6.1 million, respectively. We intend to continue to devote resources and capital to research and development so we can improve and refine our existing products and technology, develop and commercialize our products currently under development, and develop new applications for our technology.
Backlog
As of December 31, 2004, we had no significant backlog of orders and approximately $1.1 million of deferred AED/CPR training and program management services revenue that was undelivered, compared to a backlog of approximately $700,000 as of December 31, 2003 of AED/CPR training and program management services orders not processed, and $61,000 of deferred AED/CPR training and program management services revenue that was undelivered. Revenue on AED/CPR training services is recognized when the services are delivered.
Employees
As of December 31, 2004, we had 212 full-time employees, of which 93 employees were involved in worldwide sales and marketing functions, 27 were involved in supporting our research and development activities, 57 were in manufacturing and 35 were general and administrative personnel. None of our employees are represented by a collective bargaining arrangement and we believe our relationship with our employees is satisfactory. We may add additional personnel as we grow.
Material Subsequent Events
On February 28, 2005, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Quinton Cardiology Systems, Inc., a Delaware corporation (“Quinton”), CSQ Holding Company, a Delaware corporation (“Holding Company”), Rhythm Acquisition Corporation, a Delaware corporation and wholly-owned subsidiary of Holding Company (“Quinton Merger Sub”) and Heart Acquisition Corporation, a Delaware corporation and wholly-owned subsidiary of Holding Company (“Cardiac Merger Sub”).
The Merger Agreement provides for the strategic combination by means of (i) a merger of Quinton Merger Sub with and into Quinton, followed immediately by a merger of Quinton with and into Holding Company, with Holding Company surviving the merger as the surviving corporation, and (ii) a merger of Cardiac Merger Sub with and into us, as a result of which we will become a wholly-owned subsidiary of Holding Company (collectively, the “Mergers”). Following the Mergers, Holding Company will change its name to “Cardiac Science Corporation” and, upon approval by Nasdaq, anticipates that its shares of common stock will be quoted on the Nasdaq National Market under the symbol “DFIB.”
As a result of the Mergers, each issued and outstanding share of our common stock will be exchanged for 0.10 shares of Holding Company common stock and each issued and outstanding share of Quinton common stock will be exchanged for approximately 0.77 shares of Holding Company common stock. Additionally, the number of shares and exercise prices of outstanding options and warrants to purchase our common stock and Quinton common stock will be adjusted based on the foregoing exchange ratios. Such options and warrants will be assumed by Holding Company and will represent the right to purchase shares of Holding Company common stock.
In connection with the Mergers, our senior note holders have agreed to exchange the entire balance of principal and accrued interest under such notes, or approximately $61 million, as well as warrants to purchase approximately 13.4 million shares of our common stock, for an aggregate of $20 million in cash and 2.8 million shares of Holding Company common stock.
Consummation of the Mergers is subject to customary closing conditions, including, among others (i) the approval of the Merger Agreement, the Mergers and any other transactions contemplated by the Merger Agreement by our stockholders and the stockholders of Quinton, (ii) the absence of any material adverse effect with respect to our business and the business of Quinton and (iii) the receipt of opinions from counsel that the Mergers will qualify as tax-free reorganizations for federal income tax purposes. The Merger Agreement contains certain termination rights and further provides that upon termination of the Merger Agreement under certain specified circumstances we or Quinton, as the case may be, may be required to pay the other a termination fee of $4 million.
We and Quinton intend to cause the Holding Company to file a registration statement on Form S-4 containing a proxy statement/prospectus in connection with the Mergers. For more information regarding the pending Mergers, please refer to this filing when it becomes available because it will contain important information about the transaction. Investors and security holders may obtain free copies of this document (when it becomes available) and other documents filed with the Securities and Exchange Commission at the Securities and Exchange Commission’s web site at www.sec.gov.
General Information
We maintain an Internet website at www.cardiacscience.com where our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports are available without charge, as reasonably practicable following the date they are filed with or furnished to the SEC. All such reports are also available free of charge via EDGAR through the SEC website at www.sec.gov. In addition, the public may read and copy materials that we file with the SEC at the SEC’s public reference room located at 450 Fifth St., N.W., Washington, D.C., 20549. Information regarding operation of the SEC’s public reference room can be obtained by calling the SEC at 1-800-SEC-0330.
A Warning About Forward-Looking Information and the Safe Harbor Under the Securities Litigation Reform Act of 1995
This Annual Report on Form 10-K and the other reports, releases, and statements (both written and oral) issued by us and our officers from time to time may contain statements concerning our future results, future performance, intentions, objectives, plans, and expectations that are deemed to be “forward-looking statements.” These statements, including statements regarding:
• products under development;
• technological and competitive advantages;
• timetable for commercial introduction of our products;
• our ability to improve patient care, increase survival rates, decrease recovery time, lessen patient debilitation, and reduce patient care costs; markets, demand for our services, purchase orders and commitments;
• strategic alliances;
• the competitive and regulatory environment;
• planned integration of technologies with products; • the completion of the Mergers;
• the expected synergies of the combined companies after the Mergers;
• the anticipated cost savings resulting from the Mergers;
• the ability of the combined companies to achieve significantly greater size and scale;
• the ability of the combined companies to achieve sustainable profitability and to continue to develop competitive new products; and
• business strategies.
Such statements are made in reliance upon safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Our actual results, performance, and achievements may differ significantly from those discussed or implied in the forward-looking statements as a result of a number of known and unknown risks and uncertainties including, without limitation, those discussed below and in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Although we believe that our assumptions underlying the forward-looking statements are reasonable, any of the assumptions could prove inaccurate and, therefore, we cannot assure you that the results discussed or implied in such forward-looking statements will prove to be accurate. In light of the significant uncertainties inherent in such forward-looking statements, the inclusion of such statements should not be regarded as a representation by us or any other person that our objectives and plans will be achieved. Words such as “believes,” “anticipates,” “expects,” “intends,” “may,” “plans,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements. We undertake no obligation to revise any of these forward-looking statements.
Sometimes we communicate with securities analysts. It is against our policy to disclose to analysts any material non-public information or other confidential commercial information. You should not assume that we agree with any statement or report issued by any analyst regardless of the content of the statement or report. We have a policy against issuing financial forecasts or projections or confirming the accuracy of forecasts or projections issued by others. If reports issued by securities analysts contain projections, forecasts or opinions, those reports are not our responsibility.
Risk Factors
The risks set forth below are not intended to be exhaustive. These are the factors that we believe could cause actual results to be different from expected and historical results. Our industry is very competitive and changes rapidly. Sometimes new risks emerge and we may not be able to predict all of them, or be able to predict how they may cause actual results to be different from those contained in any forward-looking statements. You should not rely upon forward-looking statements as a prediction of future results.
If the worldwide AED market does not grow as projected, our sales and results may suffer.
According to Frost & Sullivan, the worldwide AED market is expected to grow at approximately 20% per year over the next several years. Our current level of operations is based on assumptions concerning the future expected growth of AED markets, and if such assumptions are significantly different from actual AED market growth rates, or if we are not able to maintain or increase our market share, then we may not be able to successfully grow our revenue and, as a result, our level of revenue may not be able to support our current or future level of operations.
If we fail to successfully compete against new or existing competitors, our operating results may suffer.
Our principal competitors relating to our AED product line are Medtronic Emergency Response Systems, a unit of Medtronic, Inc., Philips Medical Systems, a unit of Koninklijke Philips Electronics N.V., and ZOLL Medical Corporation. Due to their size, financial resources, market position and well established customer relationships, it may be difficult for us to maintain or increase our market share and/or penetrate new markets. In addition, these competitors are part of much larger organizations, and thus have significantly greater resources than we do. Accordingly, Medtronic Emergency Response Systems, Philips Medical Systems and ZOLL Medical Corporation may increase the resources they devote to the development and marketing of AEDs, which could materially impact our results.
We also compete against other companies that manufacture and sell external defibrillator devices to hospitals, where we sell our Powerheart CRM. These companies include Medtronic Emergency Response Systems, Philips Medical Systems, and ZOLL Medical Corporation. These manufacturers of competing external devices are well established in the medical device field, have substantially greater experience than us in research and development, obtaining regulatory clearances, manufacturing, and sales and marketing, and have significantly greater financial, research, manufacturing, and marketing resources than us.
Other companies may develop invasive or non-invasive products capable of delivering comparable or greater therapeutic benefits than our products, or which offer greater safety or cost effectiveness than our products. Furthermore, future technologies or therapies developed by others may render our products obsolete or uneconomical, and we may not be successful in marketing our products against such competitors.
The markets for our products, in particular our Powerheart AED, are subject to price competition, which could be detrimental to our profitability.
The market for AEDs is highly competitive and is subject to significant price competition because price is an important purchase decision criteria for many customers. Average selling prices for AEDs have eroded during recent years and are projected to continue declining, and principal competitors have substantially greater resources and experience than we do, which may provide them with a competitive advantage as price erosion continues or if it accelerates. If this occurs, our level of sales and profitability may suffer.
If we are not able to satisfy the conditions to consummate the Mergers, Quinton will be able to terminate the Merger Agreement.
Consummation of the Mergers is subject to closing conditions, including, among others (i) the approval of the Merger Agreement, the Mergers and any other transactions contemplated by the Merger Agreement by our stockholders and the stockholders of Quinton, (ii) the absence of any material adverse effect with respect to our business and the business of Quinton, (iii) the expiration of any waiting periods under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 and (iv) that there be no injunction or decree which enjoins or prohibits the Mergers. We may not be able to satisfy all of the closing conditions required to consummate the Mergers, in which case Quinton could elect to terminate the Merger Agreement. If Quinton elects to terminate the Merger Agreement, we may need to seek additional financing to continue operating our business and repay the senior notes. In addition, a termination by Quinton may cause securities analysts or other investors to have a negative perception of us, which could cause our stock price to decline.
The uncertainties associated with the Mergers may cause us to lose key personnel, which could negatively impact our operations.
Some of our employees may experience uncertainty about their future roles with the combined company resulting from the Merger until or after strategies with regard to the combined company are announced or executed. This uncertainty may adversely affect our ability to attract and retain key personnel until the consummation of the Mergers, which could negatively impact our operations.
General economic conditions and geopolitical uncertainty may affect the purchasing decisions of our customers, which may result in lower revenues.
Many of our customers face challenges in their respective markets due to general economic conditions relating to fluctuating demand for their services and budgetary or financing constraints. As a result, an economic downturn in any of the markets in which we compete may affect the purchase decisions of our customers, which may in turn negatively impact our revenue and sales growth. In addition, global geopolitical uncertainty and war may also negatively impact a customer’s decision making process or timing.
We have a history of losses.
We have a history of losses, and expect to incur some losses in the future. We were formed in 1991 and have been engaged primarily in organizational activities, research and development, pre-clinical testing, human clinical trials, and capital raising activities, until the introduction of our first commercial product in December 1999. As of December 31, 2004, we had an accumulated deficit of approximately $124.4 million. We believe our current cash and cash equivalents on hand will be sufficient to finance anticipated capital and operating requirements for the next twelve months. If we are unable to generate sufficient product revenues, we may be required to raise additional capital in the future through collaborative agreements, private investment in public equity financings, and various other public or private equity or debt financings. If we are required to raise additional capital in the future, there can be no assurance that the additional financing will be available on favorable terms, or at all. If we fail to obtain additional capital as and when required, such failure could have a material adverse impact on our operating plan and business.
We are a relatively new entrant without a significant presence in the hospital market. If we are not successful in this market, our operating results may suffer.
Our Powerheart CRM is designed for bedside use in hospitals and clinics and competes against other external defibrillator products. We are relatively new to this market, and as such, face a number of challenges, including acceptance by hospital administrative and medical staff, long purchasing decision processes, and competitors’ pre-existing relationships with customers. If we are not successful in gaining market acceptance of our Powerheart CRM, our operating results may suffer.
Recurring sales of our disposable defibrillator electrodes may not grow.
Our business strategy within the in-hospital marketplace, where we market our Powerheart CRM, is to generate recurring revenue from the sale of our disposable defibrillator electrode pads, which for sanitary, performance and safety reasons, must be replaced every 24-hours. Although we have developed proprietary smart chip technology to ensure that only our electrodes will be used with the Powerheart CRM, there can be no assurance that other companies will not develop electrode adapters that will allow generic electrodes to be used with our devices. If we are not successful in preventing the use of generic electrodes with our products, or if customers do not follow the recommended protocol of regularly changing electrodes, we may not experience future sales growth of our proprietary disposable electrode pads.
Uncertain customer decision processes and long sales cycles may cause fluctuations in our operating results.
Many of our AED customers are municipalities and other quasi-governmental groups, such as schools and law enforcement agencies. As a result, these customers have numerous decision makers, as well as varying levels of procedures that must be adhered to before a purchase of our products can be made. The same is true regarding our in-hospital Powerheart CRM product, which faces several levels of purchase decision makers, at the departmental and hospital-wide level. Accordingly, the purchasing decisions of many of our customers are characterized by a protracted decision making process, which may result in period-to-period fluctuations in our operating results.
Supply shortages can cause delays in manufacturing and delivering products.
We rely upon unaffiliated suppliers for the material components and parts used to assemble our products. Most parts and components purchased from suppliers are available from multiple sources. We believe that we will be able to continue to obtain most required components and parts from a number of different suppliers, although there can be no assurance of continued availability. The lack of availability of certain components could require a major redesign of our products and could result in production and delivery delays.
During 2002, we issued $50 million in 6.9% senior notes, which are collateralized by all of our assets. Any default on such notes could cause us to substantially curtail our operations.
In May 2002, we placed $50 million in 6.9% senior notes due May 2007 with investors. The senior notes are collateralized by a senior blanket security interest in our assets. In November 2004, we obtained a waiver from the holders of the senior notes for non-compliance with a financial covenant for the quarter ended September 30, 2004. In addition, at that time, based on our expected results for the quarter and year ending December 2004, we anticipated that we would also be in non-compliance with certain financial covenants for those periods. Accordingly we reclassified the senior notes payable to current liabilities as of September 30, 2004. In January 2005, we obtained a waiver of non-compliance for certain covenants, including financial covenants for the quarter and year ended December 31, 2004. Additionally, we restructured the financial covenants and certain other terms of the senior notes for future periods. As part of the restructuring, we extended the maturity date of the senior notes and accrued interest thereon to May 2008, with interest accruing and added to the principal balance until maturity. If in the future we fail to comply with the financial covenants as amended, we could be in default under the senior notes. If we are in default we may become subject to claims by note holders seeking to enforce their security interest in our assets. Such claims, if they arise, may substantially restrict or even eliminate our ability to utilize our assets in conducting our business, and may cause us to incur substantial legal and administrative costs.
Our auditors have expressed doubt about our ability to continue as a going concern.
We received a report on our consolidated financial statements from our independent registered public accounting firm for the years ended December 31, 2004 and 2003 that includes an explanatory paragraph expressing substantial doubt as to our ability to continue as a going concern without, among other things, obtaining additional financing to support expansion plans, manufacturing, research and development activities, or achieving a level of revenues adequate to support our cost structure.
Our operating results may fluctuate from quarter to quarter, which could cause our stock price to be volatile.
The market prices of many publicly traded companies, including emerging companies in the healthcare industry, have been and can be expected to be highly volatile. The future market price of our common stock could be significantly impacted by:
• future sales of our common stock;
• general stock market conditions;
• announcements of technological innovations for new commercial products by our present or potential competitors;
• developments concerning proprietary rights;
• adverse results in our field or with clinical tests;
• adverse litigation;
• unfavorable legislation or regulatory decisions;
• public concerns regarding our products;
• variations in quarterly operating results;
• general trends in the health care industry; and
• other factors outside of our control.
Our quarterly financial results are often impacted by the receipt of a large number of customer orders in the last weeks of a quarter. Absent these orders, our sales could fall short of our targets, thus causing our stock price to decline.
We must comply with governmental regulations and industry standards.
We are subject to significant regulation by authorities in the United States and foreign jurisdictions regarding the clearance of our products and the subsequent manufacture, marketing, and distribution of our products once approved. The design, efficacy, and safety of our products are subject to extensive and rigorous testing before receiving marketing clearance from the FDA. The FDA also regulates the registration, listing, labeling, manufacturing, packaging, marketing, promotion, distribution, record keeping and reporting for medical devices. The process of obtaining FDA clearances is lengthy and expensive, and we cannot assure you that we will be able to obtain the necessary clearances for marketing our products on a timely basis, if at all. Failure to receive, or delays in receiving, regulatory clearances would limit our ability to commercialize our products, which would have a material adverse effect on our business, financial condition, and results of operations. Even if such clearances are granted by the FDA, our products will be subject to continual regulatory review. Later discovery of previously undetected problems or failure to comply with regulatory standards may result in product labeling restrictions, costly and time-consuming product recalls, withdrawals of clearances, or other regulatory or enforcement actions. Moreover, future governmental statutes, regulations, or policies, or changes in existing statutes, regulations, or policies, may have an adverse effect on the development, production, or distribution of our products.
Any regulatory clearance, if granted, may include significant limitations on the uses for which our products may be marketed. FDA enforcement policy strictly prohibits the marketing of cleared medical devices for unapproved uses. In addition, the manufacturing processes used to produce our products will be required to comply with the Good Manufacturing Practices or “GMP” regulations of the FDA. These regulations cover design, testing, production, control, documentation, and other requirements. Enforcement of GMP regulations has increased significantly in the last several years, and the FDA has publicly stated that compliance will be more strictly scrutinized. Our facilities and manufacturing processes and those of certain of our third party contract manufacturers and suppliers, if any, will be subject to periodic inspection by the FDA and other agencies. Failure to comply with applicable regulatory requirements could result in, among other things:
• warning letters;
• fines;
• injunctions;
• civil penalties;
• recalls or seizures of products;
• total or partial suspension of production;
• refusal of the government to grant pre-market clearance or pre-market approval for devices;
• withdrawal of clearances; and/or
• criminal prosecution.
To market our products in certain foreign jurisdictions, we must obtain required regulatory clearances and approvals and otherwise comply with extensive regulations regarding safety and quality. Compliance with these regulations and the time required for regulatory reviews vary from country to country. We cannot assure you that we will obtain regulatory clearances and approvals in foreign countries, and we may be required to incur significant costs in applying for, obtaining, or maintaining foreign regulatory clearances and approvals.
We are exposed to numerous risks associated with international operations.
We market our products in international markets. International operations entail various risks, including:
• political instability;
• economic instability and recessions;
• exposure to currency fluctuations;
• difficulties of administering foreign operations generally;
• reduced protection for intellectual property rights;
• potentially adverse tax consequences; and
• obligations to comply with a wide variety of foreign laws and other regulatory requirements.
Our business is dependent upon our executive officers, and our ability to attract and retain other key personnel.
Our success is dependent in large part on the continued employment and performance of our Chairman and Chief Executive Officer, Raymond W. Cohen, as well as other key management and operating personnel. The loss of any of these persons could have a material adverse effect on our business. We do not have key person life insurance on any of our employees other than Mr. Cohen.
Our future success will also depend upon our ability to retain existing key personnel, and to hire and to retain additional qualified technical, engineering, scientific, managerial, marketing, and sales personnel. The failure to recruit such personnel, the loss of such existing personnel, or failure to otherwise obtain such expertise would have a material adverse effect on our business and financial condition.
We may face product liability claims
The testing, manufacturing, marketing and sale of medical devices subjects us to the risk of liability claims or product recalls. For example, it is possible that our products will fail to deliver an energy charge when needed by the patient, or that they will deliver an energy charge when it is not needed. As a result, we may be subject to liability claims or product recalls for products to be distributed in the future or products that have already been distributed. Although we maintain product liability insurance in the countries in which we conduct business, we cannot assure you that such coverage is adequate or will continue to be available at affordable rates. Product liability insurance is expensive and may not be available in the future on acceptable terms, if at all. A successful product liability claim could inhibit or prevent commercialization of our products, impose a significant financial burden on us, or both, and could have a material adverse effect on our business and financial condition.
The outcome of and costs relating to pending shareholder class action and shareholder derivative actions are uncertain.
During March 2005, numerous complaints were filed in the Chancery Court of Delaware concerning the recent Merger Agreement entered into with Quinton. The complaints allege that the board breached its fiduciary obligations with respect to the transaction in two ways. First, the board purportedly did not negotiate for sufficient compensation for Cardiac, as opposed to the compensation received by Quinton. Second, the board allegedly engaged in self-dealing because the senior note holders purportedly received more than their fair share in the Mergers, as opposed to the common stockholders. The complaints seek an injunction enjoining the proposed Mergers, rescissionary damages if the Mergers are completed, and an order that the board hold an auction to obtain our best value.
We cannot predict with certainty the eventual outcome of such pending litigation. We intend to defend against such lawsuits vigorously and may have to expend significant efforts and incur substantial expense in such defense.
Our technology may become obsolete.
The medical equipment and healthcare industries are characterized by extensive research and rapid technological change. The development by others of new or improved products, processes, or technologies may make our products obsolete or less competitive. Accordingly, we plan to devote continued resources, to the extent available, to further develop and enhance our existing products and to develop new products. We cannot assure you that these efforts will be successful.
We depend on patents and other intellectual property rights that we may not be able to protect.
Our success will depend, in part, on our ability to obtain and maintain patent rights, preserve our trade secrets, and operate without infringing on the proprietary rights of third parties. The validity and breadth of claims covered in medical technology patents involve complex legal and factual questions and therefore may be highly uncertain. We cannot assure you that:
• any additional patents will be issued to us;
• the scope of any existing or future patents will exclude competitors or provide us with competitive advantages;
• any of our patents will be held valid and enforceable if challenged; or
• others will not claim rights in or ownership to our patents and other proprietary rights held by us.
Furthermore, others may have developed or could develop similar products or patent rights, may duplicate our products, or design around our current or future patents. In addition, others may hold or receive patents which contain claims having a scope that covers products developed by us. We also rely upon trade secrets to protect our proprietary technology. Others may independently develop or otherwise acquire substantially equivalent know-how, or gain access to and disclose our proprietary technology. We cannot assure you that we can ultimately protect meaningful rights to our proprietary technology. There has been substantial litigation regarding patent and other intellectual property rights in the medical device industry. Such litigation, if it occurs, could result in substantial expense to us and a diversion of our efforts, but may be necessary to enforce our patents;
• enforce our patents;
• protect our trade secrets and know-how;
• defend us against claimed infringement of the rights of others; or
• determine the enforceability, scope, and validity of the proprietary rights of others.
An adverse determination in any such litigation could subject us to significant liability to third parties or require us to seek licenses from third parties. Although patent and intellectual property disputes in the medical device industry have often been settled through licensing or similar arrangements, costs associated with such arrangements may be substantial and could include ongoing royalties. Moreover, we cannot assure you that necessary licenses would be available to us on satisfactory terms, if at all. If such licenses cannot be obtained on acceptable terms, we could be prevented from marketing our products. Accordingly, an adverse determination in such litigation could have a material adverse effect on our business and financial condition.
In February 2003, we filed a patent infringement action against Philips Medical Systems North America, Inc., Philips Electronics North America Corporation and Koninklijke Philips Electronics N.V. (“Philips”) in the United States District Court for the District of Minnesota. The suit alleges that Philips’ automated external defibrillators sold under the names “HeartStart OnSite Defibrillator”, “HeartStart”, “HeartStart FR2” and the “HeartStart Home Defibrillator,” infringe at least ten of our United States patents. In the same action, Philips counterclaimed for infringement of certain of its patents and we have sought a declaration from the Court that our products do not infringe such patents. Many of the Philips defibrillators’ are promoted by Philips as including, among other things, pre-connected disposable defibrillation electrodes and daily self-testing of electrodes and battery, features that the suit alleges are key competitive advantages of our Powerheart and Survivalink AEDs and are covered under our patents. At this stage, we are unable to predict the outcome of this litigation. We have not established an accrual for this matter because a loss is not determined to be probable.
Our ability to issue preferred stock could adversely affect common stockholders.
Our certificate of incorporation authorizes the issuance of preferred stock with such designations, rights, and preferences as may be determined from time to time by our board of directors, without any further vote or action by our stockholders. Therefore, our board of directors is empowered, without stockholder approval, to issue a class of stock with dividend, liquidation, conversion, voting, or other rights, which could adversely affect the voting power or other rights of the holders of our common stock.
Anti-takeover provisions may discourage takeover attempts.
Provisions of the Delaware General Corporation Law and our certificate of incorporation may discourage potential acquisition proposals, or delay or prevent a change of control.
Future issuances of our common stock could cause our stock price to decline.
We currently have reserved 14,000,000 shares of common stock for issuance upon the exercise of options that may be granted under our 1997 Stock Option/Stock Issuance Plan, as amended, 1,000,000 shares of common stock for issuance upon the exercise of options outside of our 1997 Stock Option/Stock Issuance Plan and 16,747,695 shares for issuance upon the exercise of currently outstanding warrants. The holders of these options or warrants may exercise them at a time when we would otherwise be able to obtain additional equity capital on terms more favorable to us. The exercise of these options or warrants and the sale of the common stock obtained upon exercise would have a dilutive effect on our stockholders and may have a material adverse effect on the market price of our common stock.
Significant decreases in our stock price could result in our having to record an impairment charge related to our goodwill.
Applicable accounting standards require that goodwill be tested for impairment at least annually or whenever evidence of potential impairment exists. If, in any period, our stock price decreases to the point where the fair value of our goodwill, as determined by our market capitalization, is less than the book value of our goodwill, we would be required to record an impairment charge in that period.
ITEM 2.
ITEM 2. PROPERTIES.
Our corporate headquarters is located in Irvine, California, and encompass approximately 22,000 square feet. Our lease for this property expires in 2008 and our annual base rent expense for this facility is approximately $458,000. Our R&D facility, located in Lake Forest, California comprises approximately 10,000 square feet. This lease expires in 2008 and our annual base rent expense is approximately $124,000. We also have a manufacturing facility located in Minnetonka, Minnesota, totaling approximately 31,000 square feet. The lease on this facility expires in 2007 and our annual net rent expense for this facility is approximately $335,000. As of the date of this filing, we also have international sales and marketing offices in Copenhagen, Denmark and Manchester, England.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
In February 2003, we filed a patent infringement action against Philips Medical Systems North America, Inc., Philips Electronics North America Corporation and Koninklijke Philips Electronics N.V. (“Philips”) in the United States District Court for the District of Minnesota. The suit alleges that Philips’ automated external defibrillators sold under the names “HeartStart OnSite Defibrillator”, “HeartStart”, “HeartStart FR2” and the “HeartStart Home Defibrillator,” infringe at least ten of our United States patents. In the same action, Philips counterclaimed for infringement of certain of its patents and we had sought a declaration from the Court that our products do not infringe such patents. Many of the Philips defibrillators’ are promoted by Philips as including, among other things, pre-connected disposable defibrillation electrodes and daily self-testing of electrodes and battery, features that the suit alleges are key competitive advantages of our Powerheart and Survivalink AEDs and are covered under our patents. At this stage, we are unable to predict the outcome of this litigation. We have not established an accrual for this matter because a loss is not determined to be probable.
On April 30, 2003, we filed a Complaint against Defibtech, LLC for patent infringement in the United States District Court for the District of Minnesota. The Complaint alleged that Defibtech’s Sentry and Reviver AEDs infringe our patented disposable electrode pre-connect technology as well as other patents. Defibtech answered the Complaint and asserted counterclaims alleging that we have engaged in activities that constitute tortious interference with present and prospective contractual relations, common law business disparagement and statutory business disparagement. We responded to the counterclaims with a complete and general denial of the allegations. At this stage, the we are unable to predict the outcome of this litigation. We have not established an accrual for this matter because a loss is not determined to be probable.
On March 19, 2004, William S. Parker filed suit against us for patent infringement in the United States District Court for the Eastern Division of Michigan. The Parker patent generally covers the use of a synthesized voice to instruct a person to perform certain tasks. The Complaint alleges that certain of our AEDs infringe the patent. The patent is now expired. We have filed an Answer to the Complaint stating the patent is not infringed and is otherwise invalid and unenforceable. The patent has been submitted before the United States Patent and Trademark Office for reexamination. On October 25, 2004, the District Court issued an order staying the litigation pending resolution of the reexamination. At this stage of the litigation, we are unable to predict the outcome of this litigation. We have not established an accrual for this matter because a loss is not determined to be probable.
In early March 2005, several class action complaints were filed in the Chancery Court of Delaware concerning the recent Merger Agreement entered into with Quinton. The complaints allege that the board breached its fiduciary obligations with respect to the transaction in two ways. First, the board purportedly did not negotiate for sufficient compensation for Cardiac, as opposed to the compensation received by Quinton. Second, the board allegedly engaged in self-dealing because the senior note holders purportedly are entitled to receive more than their fair share in the Mergers, as opposed to the common stockholders. The complaints seek, inter alia, an injunction enjoining the proposed Mergers, rescissionary damages if the Mergers are completed, and an order that the board hold an auction to obtain our best value. We have retained legal counsel and intend to defend the cases vigorously.
In the ordinary course of business, various lawsuits and claims are filed against us including product liability suits. While the outcome of these matters is currently not determinable, management believes that the ultimate resolution of these matters will not have a material adverse effect on our operations or financial position.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
On December 21, 2004, we held an annual meeting of the stockholders. Seven persons, all of whom were existing members of the board of directors, were nominees for election at the annual meeting. All of the following persons were elected as directors at the annual meeting:
Proposals voted on at the annual meeting were:
1. To elect seven members to the board of directors to serve until the next annual meeting of stockholders and until their successors are duly elected and qualified.
2. To ratify the selection by the audit committee of the board of directors of PricewaterhouseCoopers LLP as our independent registered public accounting firm for the year ending December 31, 2004.
The following table shows the matter voted upon except the election of the directors which is detailed above, votes cast for, against or withheld as the number of abstentions and broker non-votes.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES.
Market Information
In September 2000, our common stock was accepted for trading on the NASDAQ National Market under the symbol “DFIB”. The following table sets forth for the periods indicated the high and low closing sales prices for our common stock as reported on NASDAQ National Market.
Holders
As of December 31, 2004, there were approximately 629 holders of record of our common stock.
Dividends
We have never paid any cash dividends on our common stock. We presently intend to retain earnings, if any, to finance our operations and therefore do not anticipate paying any cash dividends in the foreseeable future. The payment of any dividends will depend upon, among other things, our earnings, assets and general financial condition.
Issuer Purchases of Equity Securities
In November 2004, we agreed to cancel 277,682 shares of our common stock beneficially owned by Raymond W. Cohen, our Chairman and Chief Executive Officer, in exchange for the cancellation of an outstanding promissory note payable to us by Mr. Cohen in an aggregate amount of approximately $588,690, including accrued interest. The cancellation of the shares held by Mr. Cohen was not part of a publicly announced repurchase plan or program.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The following selected financial information is derived from our consolidated financial statements. You should read this summary financial information in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and related notes.
Statement of Operations Data:
(In thousands, except per share data)
(1) Effective January 1, 2002, the Company ceased amortizing goodwill in accordance with SFAS No. 142.
Selected Balance Sheet Data:
(In thousands)
Summarized Quarterly Data:
(In thousands, except per share data)
(1) Loss from operations includes a gain of $832 related to a Settlement Agreement and Mutual Release with Medtronic Physio-Control Corp.
(2)
The gross profit for the quarter ended December 31, 2003 includes an impairment change of $2,917 related to the Company’s in-hospital defibrillators as a result of a strategic decision to terminate the “no cap” placement business model in U.S. hospitals.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
(In thousands, except share and per share data)
The following discussion should be read in conjunction with the consolidated financial statements and notes thereto set forth herein.
Year Ended December 31, 2004 Compared to Year Ended December 31,
Results of Operations
In 2004, the Powerheart AED G3 product line continued to be our principal revenue driver complemented by a full year of our AED/CPR training services resulting from our acquisition of the assets and liabilities of Complient Corporation in October 2003. International sales grew at a higher than expected rate due in part to delivering over half of a $3,000 British government contract and significant growth in the Japanese market. This international revenue growth was partially offset by lower sales in the U.S., particularly to U.S. distributors, resulting from competitive pressures and a strategic shift from smaller dealers to recently signed large distribution partners such as Airgas Safety, Concentra Health Services, Hagemeyer North America and Fisher Safety. Our gross margin as a percentage of revenue increased in 2004 to 55.7% from 53.9% in 2003. Our gross margin in 2004, compared with the 2003 margin excluding the impact of the one time inventory impairment charge, decreased due to a higher mix of lower margin international OEM sales and the impact of a full year of lower margin service revenue. In 2004, we sold our training related equipment and supplies product lines acquired from Complient and discontinued selling our Diascope patient monitoring line, as these product lines were not part of our core AED and hospital defibrillation markets.
Revenue
The following is a summary of net revenue by product line:
Net revenue for the year ended December 31, 2004 increased $6,531 or 10.5% compared to the year ended December 31, 2003. This increase was attributable to higher services revenue resulting from a full year of ownership of the Complient business and increased international AED sales, partially offset by lower sales in the U.S. resulting from competitive pressures and a shift in our indirect distribution strategy. Sales of AED products and related accessories and services, which represented 93.5% of our total revenue, increased by $7,543, or 13.3%, a significant portion of which was attributable to AED/CPR training and program management services, which accounted for $7,406 of sales in 2004 compared to $1,519 in 2003, all of which was in the fourth quarter following the Complient acquisition. In addition, we sold $3,272 of patient monitors, training equipment and accessories in 2004 compared to $4,194 in 2003. The decrease of $922, or 22.0%, is due to the fact that we dedicated less resources to our patient monitoring line, which is not part of our core AED and hospital defibrillation markets, and resulted in a strategic change for 2004 to exit the patient monitoring line at the end of the third quarter, along with the training related equipment and supplies product line we acquired from Complient, which we sold in August 2004. Sales of Powerheart CRMs were $451 for 2004 compared to $431 in 2003, which represents less than 1% of total revenue in both years. Sales of our Powerheart proprietary disposable defibrillation electrodes used with the first generation Powerheart and the Powerheart CRM were $718 for 2004 compared to $828 for 2003.
Gross Margin
Cost of goods sold for the year ended December 31, 2004 was $30,362, compared to $28,543 including an impairment charge of $2,917 for the year ended December 31, 2003. Gross margins as a percentage of revenue, including the impairment charge in 2003, were 55.7% in 2004 compared to 53.9% in 2003. Excluding the impairment charge in 2003, gross margins as a percentage of revenue declined to 55.7% in 2004 from 58.7% in 2003. This decrease was a result of a higher mix of lower margin international OEM sales and the impact of a full year of service revenue in 2004 which has lower margins. Cost of service revenue was $4,282 for the year ended December 31, 2004, with a gross margin of 42.2%, compared to cost of service revenue of $747 in 2003, all of which was in the fourth quarter following the Complient acquisition, with a gross margin of 50.8%. The decrease was primarily the result of significantly higher than normal costs we incurred for personnel and travel associated with meeting a deadline to fulfill certain installment services and AED training for the New York City Schools contract. After the deadline, margins on service revenue related to the New York City Schools increased to normal levels.
During 2004, sales of first generation Powerhearts and accessories that were written off in 2003 totaled $229 and had a favorable impact to our margin in 2004. The majority of the inventory written off in 2003 is still on hand. We will continue to try to sell some of these units internationally, but it is still uncertain as to how many units we will be able to sell and at what price. Eventually we will scrap the units or use them for parts.
Operating Expenses
The following is a summary of operating expenses as a percentage of net revenue:
Sales and marketing expenses increased by 28.7% to $23,959 for the year ended December 31, 2004, and as a percentage of revenue to 35.0% in 2004 from 30.0% in 2003. The increase is primarily attributable to the expansion of our international sales operations of $2,113, particularly in the U.K and Germany, a full year of sales and marketing expenses related to program management and training services of $2,454 pursuant to the acquisition of Complient in the fourth quarter of 2003, higher direct marketing costs of $2,706, and a full year of our inside sales team established in late 2003 of $560. This increase is offset by reductions in sales and marketing headcount and related expenses in the U.S., primarily in the indirect sales channel, of $2,612.
Research and development expenses for the year ended December 31, 2004 increased $489 or 8.8% compared to 2003. The increase is directly related to additional headcount and project costs of $991 associated with the development of an in-hospital crash-cart defibrillator for GE Healthcare pursuant to a development agreement signed in July 2003, increased facility costs of $203 year over year resulting from the relocation of the research and development team to a new facility in mid 2003, offset by the reallocation of resources of $711 focused on engineering support in 2003 to regulatory and quality assurance activities included in general and administrative expenses in 2004.
General and administrative expenses increased $4,521 or 30.7% for the year ended December 31, 2004 compared to 2003. The increase was primarily due to: (i) increased legal costs of $1,707 related to the Philips patent litigation, (ii) increased provision for bad debts of $1,314 resulting from uncertainty as to the collectibility of certain accounts, (iii) increased audit, tax and consulting fees primarily related to Sarbanes-Oxley compliance of $835, (iv) a full year of headcount and facilities resulting from the Complient acquisition in October 2003 of $751, (v) increased corporate insurance costs of $396, and (vi) increased regulatory and quality assurance costs, including the reallocation of resources that were focused on engineering support in 2003 to regulatory and quality assurance activities included in general and administrative expenses in 2004, of $972. This increase is partially offset by: (i) a decrease in costs related to our relocation and expansion of facilities expenses in 2003 of $718, (ii) a reduction of headcount and related expenses from consolidating our international operations of $237, and (iii) a decrease in executive headcount and compensation of $392.
Amortization of intangibles included in operating expenses was $1,931 for the year ended December 31, 2004, an increase of $275 or 16.6% from the $1,656 for the year ended December 31, 2003. The increase is primarily the result of a full year of amortization on certain identifiable intangible assets in 2004 that were related to the Complient acquisition in October 2003.
Net gain on sales of assets and other costs was $1,077 for the year ended December 31, 2004 and consisted of the gains on sales of the CPR Prompt product line of $1,368 and the AED trainer product of $387, offset by a loss on sales of fixed assets of $203, an impairment of assets related to the discontinuance of the Diascope product line of $190, and severance related to headcount reductions from consolidating our international operations of $285.
Interest Expense
Interest expense for the year ended December 31, 2004 was $7,031 compared to interest expense of $6,031 for 2003. The increase was primarily due to a higher average outstanding balance on the Senior Notes, higher amortization of the note discount using the effective interest rate method, and the amortization of the value of warrants issued in March 2004 in connection with an amendment to the Senior Note and Warrant Purchase Agreement.
Year Ended December 31, 2003 Compared to Year Ended December 31,
Results of Operations
On October 21, 2003, in a move to capture additional revenue related to the sale of our AEDs, we acquired substantially all the assets and liabilities of Complient Corporation, the nation’s leading independent provider of AED and CPR training and comprehensive AED program management. Corporations, municipalities, schools, government agencies and others who purchase and deploy AEDs are required by certain federal and state laws to obtain a medical prescription and have designated personnel trained annually in AED use and CPR by a certified trainer. Traditionally, buyers of AEDs have had to arrange for their own training with non-profit organizations or off-duty paramedics, coordinate their own site assessment and deployment, and assure ongoing compliance with recertification and other regulations. Complient was the first organization of its kind to offer a comprehensive training program that included the management and coordination of all aspects of AED deployment including site surveys, medical direction, web-based software for record-keeping and AED/CPR training with 150 certified trainers on staff covering all 50 states nationwide. Strategically, Complient fit well with us and was a logical extension of our core business. The acquisition provides additional point-of-sale revenue as well as a recurring revenue opportunity linked to AED sales. Moreover, we believe this will provide us with a significant competitive advantage over our competitors who do not offer comparable programs. We reduced Complient’s non-trainer staff by approximately one third and substantially completed the integration of its operations into ours as of December 31, 2003. In 2002, Complient generated revenue of approximately $12,600 from sales of AEDs and related services.
At the end of 2003, we made a strategic decision to discontinue the “no cap” Powerheart CRM placement business model in U.S. hospitals in favor of a capital sale model focused on key distribution relationships such as those we entered into in 2003 with General Electric Medical Systems and the Premier, Inc. buying group. In 2001, we adopted the “no cap” model, whereby we marketed the Powerheart to U.S. hospitals directly, and agreed to place Powerheart units in a customer’s facility, while retaining ownership of the unit, with no upfront capital equipment charge to the customer in exchange for an agreement to purchase our proprietary, disposable defibrillation electrodes monthly or quarterly. We believed this “no cap” model would increase the rate of adoption of our AECD/CRM technology by addressing the capital budget constraints many U.S. hospitals face and would ultimately result in higher levels of recurring revenue from disposable electrodes. While this model did initially increase adoption of the technology, it has failed to produce the expected levels of revenue required to continue with this business model going forward. As a result of this strategic change, we incurred a $2,917 inventory impairment charge to write down the value of first generation Powerheart and Powerheart CRM in-hospital defibrillators in inventory and at certain customer sites. However, there are a number of customer sites where the technology has been successfully deployed and that are generating sufficient revenue on disposable electrode sales to justify the continuation of this program for those specific customers. At December 31, 2003, we still had on hand all of the inventory that was written off. We will attempt to sell some of these units internationally, but it is uncertain as to how many units we will be able to sell, at what price, and over what time frame. Eventually, we will scrap the units or use them for parts.
Revenue
The following is a summary of net revenue by product line:
Net revenue for the year ended December 31, 2003 increased $11,939 or 23.9% compared to the year ended December 31, 2002. This increase was primarily attributable to our expanding share of the growing worldwide market for AEDs. Sales of AED products and related accessories and services, which represented 91.2% of our total revenue, increased by $17,957, or 46.6%. The AED product line, led by the Powerheart AED G3, continued to be the principal growth driver and was fueled and complemented by the acquisition of Complient and the addition of AED/CPR training and program management services, which accounted for $1,519 of sales in 2003, primarily in the period following the acquisition of Complient on October 21, 2003. In addition, we sold $4,194 of emergency defibrillators, monitors, training equipment and accessories in 2003 compared to $10,193 in 2002. This decrease of $5,999, or 58.9%, is due to the fact that we dedicated less resources to our patient monitoring line, which is not part of our core AED and hospital defibrillation markets, and has resulted in a strategic change for 2004 to exit the patient monitoring line, along with the training related equipment and supplies product line we acquired from Complient. Sales of Powerheart CRMs and related accessories were $431 for 2003 compared to $240 in 2002, which represents less than 1% of total revenue in both years. Sales of our Powerheart proprietary disposable defibrillation electrodes related to the first generation Powerheart and the Powerheart CRM were $828 for 2003 and $1,038 for 2002. The lack of growth in these in-hospital products contributed to the business model change in late 2003 discussed earlier under “Results of Operations.”
Gross Margin
Cost of revenue for the year ended December 31, 2003 was $28,543, including an impairment charge of $2,917, compared to $24,737 for the year ended December 31, 2002. Gross margins as a percentage of revenue, including the impairment charge, improved to 53.9% in 2003 from 50.6% in 2002. The improvement was a result of increased sales of higher margin AEDs as a percentage of total revenue from 77.1% in 2002 to 91.2% in 2003, as well as the reduced cost of the AED product line due to significant cost reduction initiatives taken in 2003 and the introduction of our new lower cost version Powerheart AED G3 in August 2003. Cost of service revenue for the year ended December 31, 2003 was $747, for a gross margin on the AED/CPR training business acquired from Complient of 50.8%.
Operating Expenses
The following is a summary of operating expenses as a percentage of net revenue:
Sales and marketing expenses increased by 7.5% to $18,616 for the year ended December 31, 2003, but decreased as a percentage of revenue to 30.0% in 2003 from 34.6% in 2002. The absolute dollar increase is primarily attributable to increased sales and marketing activities related to international sales operations ($1,228), including the establishment of direct sales operations in the U.K and Germany, and increased U.S. sales activities related to the growth of AED related sales ($1,073), including new sales and marketing expenses related to program management and training services pursuant to the acquisition of Complient. This increase is offset by a decrease in the sales and clinical efforts associated with the Powerheart CRM in-hospital product line ($1,129). The decrease in expenses as a percentage of revenue reflects our operating leverage and an increasing mix of revenue flowing through lower-cost indirect distribution channels.
Research and development expenses for the year ended December 31, 2003 decreased 8.5% compared to 2002. In 2003, research and development expenses were 8.9% of revenue, down from 12.1% of revenue in 2002. The absolute dollar decrease is primarily attributable to: (i) the development and completion of the Powerheart CRM project in 2002 which resulted in higher salaries, bonuses and benefits as well as project design, consulting and materials expenses during 2002 and (ii) the fact that we reallocated resources previously focused on preproduction activities included in research and development expenses in 2002, but now focused on Company-wide operations which are included in general and administrative in 2003. The second half of 2003 compared with the first half of 2003 shows an increase in research and development expenses directly related to more headcount and project costs associated with the development of a standard crash-cart biphasic defibrillator for GE Healthcare pursuant to a development agreement signed in July 2003.
General and administrative expenses increased $3,246 or 28.3% during the year ended December 31, 2003 compared with 2002. As a percentage of revenue, general and administrative expenses increased to 23.8% in 2003 from 22.9% in 2002. This increase was primarily comprised of new expenses, primarily headcount and facilities, related to the Complient acquisition ($435), our relocation of corporate headquarters and expansion of corporate, manufacturing and R&D facilities in 2003 ($936), increased salaries and benefits ($675), depreciation expense ($449) and the fact that we reallocated resources previously focused on preproduction activities included in research and development expenses in 2002, but now focused on Company-wide operations which are included in general and administrative in 2003 ($585).
Amortization of intangibles was $1,656 for the year ended December 31, 2003, a decrease of $455 or 21.6% from the $2,111 for the year ended December 31, 2002. The decrease is primarily the result of certain identifiable intangible assets becoming fully amortized during 2003 offset by approximately two months of amortization of intangibles related to the Complient acquisition.
Gain on settlement of $832 in 2002 relates to a settlement agreement with Medtronic Physio-Control (“MPC”) to terminate a distribution and licensing agreement between the parties (see Note 20 of the financial statements).
Interest
Interest expense for the year ended December 31, 2003 was $6,031 compared to interest expense of $4,452 for 2002. The increase was a result of a full year of interest expense and warrant and debt issuance cost amortization in 2003 associated with the senior secured promissory notes issued in May 2002.
Liquidity and Capital Resources
The increase in our current ratio, working capital and cash and cash equivalents is primarily due to proceeds from our private placement of common stock in July 2004.
At December 31, 2004, our days sales outstanding on accounts receivable (“DSO”) was approximately 79 days compared to approximately 105 days at December 31, 2003, calculated based on a quarterly period using the ending net accounts receivable balance. We anticipate that our DSO will average less than 90 days during 2005. The decrease in our DSO is primarily due to more aggressive collection efforts and a decrease in the revenue mix in 2004 compared to 2003 for sales in the U.S. indirect distribution channel which typically have longer payment terms.
In February 2004, we secured a $5,000 line of credit with Silicon Valley Bank. The line of credit may be used to provide additional working capital, as needed, to fund our continued growth. This 24-month facility is collateralized by accounts receivable, inventory and cash and cash equivalents, has an interest rate of the bank’s prime rate plus .75% (with a floor of 5%) payable monthly, and requires us to maintain certain financial covenants. In January 2005, we obtained a waiver from the bank for the quarter and year ended December 31, 2004 for non-compliance with certain financial covenants required by the line of credit agreement. There was no outstanding balance on the line at December 31, 2004 or through the date of this filing.
From inception, our sources of funding for operations and mergers and acquisition activity were derived from placements of debt and equity securities. In 2001, we raised approximately $37,000 in a series of private equity placements and through the exercise of outstanding options and warrants. In May 2002, we issued notes payable totaling $50,000. With the proceeds from these notes, we repaid the $26,468 plus accrued interest in senior promissory notes relating to the Survivalink acquisition. In September 2003, we raised $8,375 in a private equity placement of 2,233,334 shares of our common stock at $3.75 per share to a small group of institutional and accredited investors. In connection with this offering, we also issued 223,333 five-year warrants with an exercise price of $5.00 per share. In July 2004, we raised gross proceeds of $12,370 in a private equity placement of 5,219,409 shares of our common stock at $2.37 per share. In connection with this offering, we issued five-year warrants to purchase 2,087,763 shares of common stock at a price of $2.84 per share. In January 2005, as consideration for delays in filing the required registration statement for the July 2004 private placement, we agreed with the investors to make a cash payment of $556, to issue an additional aggregate of 476,637 shares of common stock at the fair market value on the date of the agreement, and to reduce the exercise price on all the investors’ warrants to $2.50 per share. We expect to incur expense of approximately $1,500 in 2005 as a result of this agreement.
In May 2002, we entered into a Senior Note and Warrant Purchase Agreement (“the Agreement”) with investors, pursuant to which the investors loaned the Company $50,000. Under the original terms of the Agreement, the Senior Notes (the “Notes”) were due and payable in cash on May 30, 2007, unless accelerated pursuant to the terms of the Agreement, and accrue interest at 6.9% per annum. During the first three years of the term of the Notes, accrued and unpaid interest on the Notes would, at the option of the Company, a) be due and payable in cash, or b) accrue and be paid in kind, in each case quarterly in arrears, and then due on the termination date of the Notes. After the end of the third year of the term of the Notes, any additional accrued and unpaid interest on the Notes would be due and payable in cash quarterly in arrears, and on the termination date of the Notes. The Notes have certain monthly and quarterly financial and non-financial covenants. The Notes are collateralized by our assets and the assets of our subsidiaries, to the extent permitted by law. Proceeds from the Notes were used to repay $26,468 of senior promissory notes plus accrued interest issued in connection with the acquisition of Survivalink Corporation and the remaining proceeds were used for working capital purposes.
In connection with the Notes, the investors were issued warrants (the “Warrants”) for the purchase of an aggregate of 10,000,000 shares of our common stock at an exercise price of $3.00 per share, and an aggregate of 3,000,000 shares of common stock at an exercise price of $4.00 per share. The Warrants are immediately exercisable, expire by their terms on May 30, 2009 and are subject to certain limited antidilution adjustments. After two years, we have the right to force the exercise of the Warrants pursuant to the terms of the Agreement. The proceeds from the Notes were allocated between the Notes and the Warrants based on their relative fair values which resulted in a discount being recorded on the Notes pursuant to APB No. 14 “Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants.” We considered a number of factors, including an independent valuation, when determining the fair value of the Warrants. The significant assumptions used in the Black-Scholes model were: stock price of $2.90, adjusted downward for a dilution factor to $2.68; risk free rate of 4.98%; volatility of 0.90; dividend yield of 0%; and contractual term of 7 years. Such allocation resulted in a discount being recorded on the Notes in the amount of $11,815, which is being amortized over the five-year term of the Notes using the effective interest method. In addition, we paid approximately $2,760 in debt issuance costs which are being amortized over the five-year term of the Notes using the effective interest method.
In March 2004, we amended the Agreement in order to ease certain financial covenants into 2005 to reflect our actual and expected financial results. In exchange for these modifications, we issued the note holders 500,000 additional warrants to purchase shares of common stock at $3.95 per share. The warrants were valued at $1,301 using a Black-Scholes model. The significant assumptions used in the model were: stock price of $3.98; risk free rate of 3.2%; volatility of 0.65; dividend yield of 0%; and contractual term of seven years. The value of the warrants was recorded as additional discount to the Senior Notes to be amortized over the remaining term of the Senior Notes using the effective interest method. This modification was not considered to be a significant modification of the Agreement.
Under the antidilution provisions of the Agreement, which were triggered by the September 2003 and July 2004 private placements (see Note 15 to the financial statements) and the July 2003 warrant issuance to GE Healthcare (see Note 20 to the financial statements), an additional 205,451 warrants were issuable to the note holders at exercise prices ranging from $2.97 to $3.88. In addition, the exercise prices of the original warrants issued were also reduced to: (i) $2.97 for the 10,000,000 warrants that had an original exercise price of $3.00, (ii) $3.88 for the 3,000,000 warrants that had an original exercise price of $4.00, and (iii) $3.86 for the 500,000 warrants that had an original exercise price of $3.95.
In January 2005, we entered into an amendment and limited waiver (the “Amendment”) to the Agreement with the senior note holders. Pursuant to the terms of the Amendment, we and the Senior Note Holders agreed to: (i) extend the maturity date of the $50,000 in aggregate principal amount of Senior Notes issued under the Agreement by twelve months to May 29, 2008; (ii) defer all cash interest payments until maturity; and (iii) modify certain financial covenants regarding minimum EBITDA, minimum debt to capitalization and maximum capital expenditures, and delete certain other financial covenants for 2005 through maturity. Additionally, the senior note holders waived certain covenant violations, including all financial covenant violations for the quarter and year ended December 31, 2004. In exchange for the foregoing amendments and waiver contained in the Amendment, we and the senior note holders agreed to reduce the number of warrants to purchase shares of common stock to 13,438,599 and reduce the exercise price of those warrants to $2.00 per share, down from the original weighted average price of approximately $3.21 per share.
The accompanying consolidated financial statements have been prepared on the basis that we will continue as a going concern and that we will recover our assets and satisfy our liabilities in the normal course of business. From inception, we have incurred substantial losses and negative cash flows from operations. For the years ended December 31, 2004 and 2003, we incurred losses of $18,669 and $12,537, respectively, and negative cash from operations of $8,776 and $16,347, respectively. As of December 31, 2004, we had cash on hand of $13,913, working capital of $27,046, short and long term debt of $52,664, and an accumulated deficit of $124,357.
We believe that our current cash balance, in combination with net cash expected to be generated from operations and our unused line of credit of $5,000, will fund ongoing operations for the next twelve months. Our expected net cash from operations is predicated on achieving certain revenue levels and maintaining our cost of goods, operating expenses, DSO ratio.
If we do not realize the expected revenue and cost of goods, or if operating expenses increase substantially, or if we cannot maintain our DSO ratio, we may not be able to fund our operations for the next twelve months. In addition, our line of credit and our Senior Notes require maintenance of certain financial covenants, of which we were in violation during 2004. Even though we have obtained waivers for all covenant violations and have amended the covenants for 2005 and going forward, if in the future, we fail to comply with these financial covenants as amended, we could be unable to use our line of credit or be in default under the Senior Notes. If we are in default, we may be subject to claims by the note holders seeking to enforce their security interest in our assets. Such claims, if they arise, may substantially restrict or even eliminate our ability to utilize our assets in conducting our business, and may cause us to incur substantial legal and administrative costs.
In the event that we require additional funding during the next twelve months, we will attempt to raise the required capital through either debt or equity arrangements. We cannot provide any assurance that the required capital would be available on acceptable terms, if at all, or that any financing activity would not be dilutive to our current stockholders. If we are not able to raise additional funds, we may be required to significantly curtail our operations and this would have an adverse effect on our financial position, results of operations and cash flows and as such, there may be substantial doubt about our ability to continue as a going concern.
Cash Flows
The following table presents the abbreviated cash flows for the years ended December 31, 2004 and 2003:
Cash used by operating activities for the year ended December 31, 2004 was $8,776, a decrease of $7,571 or 46.3% from $16,347 in 2003. The decrease is primarily due to a reduction in cash used in accounts receivable, inventory, and accounts payable of $12,935 and a reduction of cash used in net assets and liabilities held for sale of $1,460, offset by an increase in our net loss of $6,132.
Cash provided by investing activities for the year ended December 31, 2004 was $596, an increase of $377 or 172.1% from $219 in 2003. This change was primarily attributable to a decrease in purchases or property and equipment of $1,080 year over year and an increase in proceeds from sales of assets of $1,731 year over year, substantially offset by cash inflows in 2003 related to the refund of the MRL investment of $3,001 and goodwill cash adjustments of $1,050, offset by the purchase of Artema minority interest of $843.
Cash provided by financing activities for the year ended December 31, 2004 was $13,227, an increase of $3,718 or 39.1% from $9,509 in 2003. This increase was primarily due to an increase in proceeds from private placements of common stock year over year of $3,995 offset by a decrease in proceeds from the exercise of common stock options and warrants year over year of $365.
Off-Balance Sheet Arrangements
At December 31, 2004, our Danish subsidiary has outstanding bank guarantees/performance bonds totaling 2,373 Danish Kroner (approximately $435 in U.S. dollars) that were issued in 1999 through 2002 in connection with sales contracts to foreign governments. These performance bonds expire in ____. In addition, during 2004, we issued a performance bond for $88 collateralized by a letter of credit issued by Silicon Valley Bank under our line of credit in connection with a sales contract with a city municipality. The performance bond expires in November 2007. We have no further performance obligations under these contracts other than providing normal warranty service on the products sold under the contracts.
In addition, we have non-cancelable operating leases entered into in the ordinary course of business. For liquidity purposes, we choose to lease our facilities, automobiles, and certain equipment instead of purchasing them.
Contractual Obligations and Other Commercial Commitments
We had no material commitments for capital expenditures as of December 31, 2004.
The following table presents our expected cash requirements for contractual obligations outstanding as of December 31, 2004:
In January 2005, the terms of the Senior Notes were amended (see Note 22 of the financial statements). The following table presents our expected cash requirements for contractual obligations reflecting the amendment:
Income Taxes
As of December 31, 2004, we have research and experimentation credit carry forwards for federal and state purposes of approximately $3,000 and $1,000, respectively. These credits begin to expire in 2006 for federal purposes and carry forward indefinitely for California state purposes. We have capital loss carry forwards of approximately $1,000 for both federal and state purposes which begin to expire in 2006 for federal purposes and carry forward indefinitely for state purposes. We also have approximately $139,000 and $69,000, respectively, of federal and state net operating loss carry forwards which will begin to expire in 2006 and 2005, respectively.
Internal Revenue Code Sections 382 and 383, and similar state provisions place certain limitations on the annual amount of loss and credit carryforwards that can be utilized if certain changes to a company’s ownership occur. The acquisition of Survivalink in 2001 resulted in a change in ownership pursuant to Section 382 of the Internal Revenue Code. The annual limitation is as follows: $8,300 for 2005, $6,500 for 2006 and $1,800 thereafter. The amount of net operating loss subject to this limitation, for federal and state purposes, is approximately $53,000 and $24,000, respectively. Research and experimentation credits and capital loss carryovers are also subject to the limitation under Internal Revenue Code Sections 382 and 383 and similar state provisions. The utilization of net operating loss carryovers and other tax attributes may be subject to further substantial limitations if certain ownership changes occur in future periods.
We recorded deferred tax assets of approximately $16,000 upon the acquisition of Survivalink in 2001. The deferred tax assets are composed primarily of loss and tax credit carryforwards and other temporary differences. The deferred tax assets recorded were reduced by a valuation allowance of $16,000. Due to the expiration of some of the net operating loss carryovers the balance is $13,000 as of December 31, 2004. If we determine that we will realize the tax benefit related to these Survivalink deferred assets in the future, the related decrease in the valuation allowance will reduce goodwill instead of the provision for taxes.
We also recorded deferred tax assets of approximately $8,000 upon the acquisition of Cadent in 2000. The deferred tax asset was composed primarily of loss carryforwards and other temporary differences. The deferred tax assets recorded were also reduced by a valuation allowance of $8,000. Due to the expiration of some of the net operating loss carryovers, the balance is $7,000 as of December 31, 2004. If we determine that we will realize the tax benefit related to these Cadent deferred assets in the future, the related decrease in the valuation allowance will reduce goodwill instead of the provision for taxes.
Additionally, approximately $1,600 of the net operating loss carryforward represents deductions claimed as the result of stock options. If we determine that we will realize the benefit of this net operating loss carryforward in the future, the related decrease in the valuation allowance will be credited to additional paid-in capital instead of the provision for taxes.
At December 31, 2004, we had foreign net operating loss carryforwards. The losses carry over indefinitely, unless certain defined changes in business operations occur during the carryover period. We have established a full valuation allowance against these deferred tax assets since it cannot be established that these foreign subsidiaries’ net operating loss carryforwards will be fully utilized.
Critical Accounting Policies and Estimates
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 us to make estimates and judgments that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenue and expenses for each period.
The following represents a summary of our critical accounting policies, defined as those policies that we believe are: (a) the most important to the portrayal of our financial condition and results of operations, and (b) that require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.
Valuation of Accounts Receivable
We maintain an allowance for uncollectible accounts receivable to estimate the risk of extending credit to customers. The allowance is estimated based on customer compliance with credit terms, the financial condition of the customer, and collection history, where applicable. Additional allowances could be required if the financial condition of our customers were to be impaired beyond our estimates.
Valuation of Inventory
Inventory is valued at the lower of cost (estimated using the first-in, first-out method) or market. We periodically evaluate the carrying value of inventories and maintain an allowance for obsolescence to adjust the carrying value, as necessary, to the lower of cost or market. The allowance is based on our assessment of future product demand, historical experience and technical obsolescence, as well as other factors affecting the recoverability of the asset through future sales. Unfavorable changes in estimates of obsolete inventory would result in an increase in the allowance and a decrease in gross profit.
Goodwill and Other Intangibles
In accordance with SFAS No. 142 “Goodwill and Other Intangible Assets,” goodwill and other intangible assets with indeterminate lives are no longer subject to amortization but are tested for impairment annually or whenever events or changes in circumstances indicate that the asset might be impaired. We operate in one operating segment and have one reporting unit, therefore, we test goodwill for impairment at the consolidated level against the fair market value of the Company. Per SFAS No. 142, the fair value of a reporting unit refers to the amount at which the unit as a whole could be bought or sold in a current transaction between willing parties. Quoted market prices in active markets are the best evidence of fair value and shall be used as the basis on the last day of the year for the measurement, if available. We assess potential impairment on an annual basis on the last day of the year and compare our market capitalization to the carrying amount of goodwill. A significant decrease in our stock price could indicate a material impairment of goodwill which, after further analysis, could result in a material charge to operations. To date, we have not determined or recorded an impairment of goodwill since our market capitalization at the date of the impairment tests has never been less than the carrying amount of goodwill. Other intangible assets with finite lives continue to be subject to amortization, and any impairment is determined in accordance with SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.
Valuation of Long-Lived Assets
In accordance with SFAS No. 144, long-lived assets and intangible assets with determinate lives are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We evaluate potential impairment by comparing the carrying amount of the asset with the estimated undiscounted future cash flows associated with the use of the asset and its eventual disposition. Should the review indicate that the asset is not recoverable, our carrying value of the asset would be reduced to its estimated fair value, which is generally measured by future discounted cash flows. In our estimate, no provision for impairment is currently required on any of our long-lived assets.
Valuation of Warrants
We periodically issue warrants in connection with debt issuances and in exchange for goods and services. We follow the guidance of APB No. 14 “Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants” for warrants we issue in connection with debt. We follow the guidance in EITF No. 96-18 “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” and EITF No. 01-9 “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)” for warrants we issue in exchange for or in connection with goods and services. Management considers a number of factors, including independent valuations, when determining the fair value of warrants issued. We estimate the fair value of warrants issued using the Black-Scholes model. Of the various assumptions considered by the Black-Scholes model, the volatility and the risk free rate used require us to make certain assumptions and estimations. We estimate volatility using a statistical method based on the historical daily stock price for the historical period equal to the expected life of the warrant being valued. The risk free interest rate is determined using the treasury note rate for the number of years corresponding to the expected life of the warrant being valued. Potentially, the value of warrants could be materially different if different assumptions were used and under different markets conditions.
Revenue Recognition
We record revenue in accordance with Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (SAB 104). SAB 104 requires that product sales be recognized when there is persuasive evidence of an arrangement which states a fixed and determinable price and terms, delivery of the product has occurred in accordance with the terms of the sale, and collectibility of the sale is reasonably assured. We record product sales when we have received a valid customer purchase order for product at a stated price, the customer’s credit is approved, and we have shipped the product to the customer whereby title and risk have passed to the customer.
We are not contractually obligated to repurchase any inventory from distributors or end user customers. Some of our customers are distributors that sell goods to third party end users. For certain identified distributors where collection may be contingent on the distributor’s resale, revenue recognition is deferred and recognized on a “sell through” basis. The determination of whether sales to distributors are contingent on resale is subjective because we must assess the financial wherewithal of the distributor to pay us regardless of resale. For sales to distributors, we consider several factors, including past payment history, where available, trade references, bank account balances, Dun & Bradstreet reports and any other financial information provided by the distributor, in assessing whether the distributor has the financial wherewithal to pay regardless of, or prior to, resale of the product and that collection of the receivable is not contingent on resale.
We offer limited volume price discounts and rebates to certain customers. Volume price discounts are on a per order basis based on the size of the order and are netted against the revenue recorded at the time of shipment. We have no arrangements that provide for volume discounts at a later date, such as based on meeting certain quarterly or annual purchase levels. Rebates are paid quarterly or annually based on sales performance and are accrued for at the end of a reporting period. To date, all rebate arrangements have been immaterial.
We follow the guidance of EITF No. 00-21 “Accounting for Revenue Arrangements with Multiple Deliverables.” In accordance, we consider our program management packages and training and other services as separate units of accounting when sold with an AED based on the fact that the items have value to the customer on a stand alone basis and could be acquired from another vendor. Training and AED program management service revenue is deferred and recognized at the time the training occurs. AED program management services pursuant to agreements that existed with Complient customers pursuant to annual or multi-year terms are deferred and amortized straight-line over the related contract period.
Upfront license fees are deferred and recognized to revenue using the straight-line method over the term of the related license agreement. Royalty revenue are due and payable quarterly (generally 60 days after period end) pursuant to the related license agreements. An estimate of royalty revenue is recorded quarterly in the period it is earned based on the prior quarter’s historical results adjusted for any new information or trends known to management at the time of estimation.
Product Warranty
Products sold are generally covered by a warranty against defects in material and workmanship for a period of one to seven years. We accrue a warranty reserve to estimate the risk of incurring costs to provide warranty services. The accrual is based on our historical experience and our expectation of future conditions. An increase in warranty claims or in the costs associated with servicing those claims would result in an increase in the accrual and a decrease in gross profit.
Litigation and Others Contingencies
We regularly evaluate our exposure to threatened or pending litigation and other business contingencies. Because of the uncertainties related to the amount of loss from litigation and other business contingencies, the recording of losses relating to such exposures requires significant judgment about the potential range of outcomes. We are not presently affected by any litigation or other contingencies that have had, or are currently anticipated to have, a material impact on our results of operations or financial position. As additional information about current or future litigation or other contingencies becomes available, we will assess whether such information warrants the recording of additional expense relating to these contingencies. To be recorded as expense, a loss contingency must generally be both probable and measurable. If a loss contingency is material but is not both probable and estimable, we will disclose it in notes to the financial statements.
New Accounting Standards
In November 2004, the FASB issued SFAS No. 151 “Inventory Costs, an Amendment of ARB No. 43, Chapter 4, ‘Inventory Pricing,’” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. This statement requires those items be recognized as current-period charges. The provisions of this statement shall be effective for inventory costs incurred during fiscal periods beginning after June 15, 2005. We do not expect adoption of this statement to have a material impact on our financial statements.
In December 2004, the FASB issued SFAS No. 123 (revised 2004) “Share-Based Payment” or FAS 123R. FAS 123R revises SFAS No. 123 “Accounting for Stock-Based Compensation.” and supersedes APB No. 25 “Accounting for Stock Issued to Employees” and related interpretations and SFAS No. 148 “Accounting for Stock-Based Compensation-Transition and Disclosure.” FAS 123R requires compensation cost relating to all share-based payments to employees to be recognized in the financial statements based on their fair values in the first interim or annual reporting period beginning after June 15, 2005. The pro forma disclosures previously permitted under FAS 123 will no longer be an alternative to financial statement recognition. We are evaluating the requirements of FAS 123R and expect that the adoption of FAS 123R will have a material impact on our consolidated financial position or results of operation. We have not determined the method of adoption or determined whether the adoption will result in amounts recognized in the income statement that are similar to the current pro forma disclosures under FAS 123.
In December 2004, the FASB issued SFAS No. 153 “Exchanges of Non-monetary Assets -- an amendment of Accounting Principles Board ("APB") Opinion No. 29 “Accounting for Non-monetary Transactions.” The guidance in APB 29 is based on the principle that exchanges of non-monetary assets should be measured based on the fair value of the assets exchanged. The guidance in that Opinion, however, included certain exceptions to that principle. SFAS 153 amends APB 29 to eliminate the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The provisions of SFAS 153 are applicable for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We are currently evaluating the provisions of this statement.
In December 2004, the FASB issued FSP 109-2 “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004” ("FSP 109-2"). FSP 109-2 provides enterprises more time (beyond the financial-reporting period during which the American Jobs Creation Act took effect) to evaluate the impact on the enterprise's plan for reinvestment or repatriation of certain foreign earnings for purposes of applying SFAS No. 109. The FSP, issued on December 21, 2004, went into effect upon being issued. We are not yet in a position to decide on whether, and to what extent, it might repatriate foreign earnings that have not yet been remitted to the U.S. We expect to conclude our analysis of this repatriation incentive during 2005.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate and Market Risk
We do not use derivative financial instruments in our investment portfolio. We are averse to principal loss and try to ensure the safety and preservation of our invested funds by limiting default risk, market risk, and reinvestment risk. We attempt to mitigate default risk by investing in only the safest and highest credit quality securities. At December 31, 2004, we invested our available cash in money market securities of high credit quality financial institutions.
Interest expense on our existing long-term debt commitments is based on a fixed interest rate and therefore it is unaffected by fluctuations in interest rates. However, our line of credit with our bank bears interest at our bank’s prime rate plus .75% and if we ever draw down upon the line of credit, the outstanding balance could be affected by fluctuations in interest rates.
Foreign Currency Exchange Rate Risk
The majority of our international sales are made in U.S. dollars, however, some sales to the U.K. are in pounds and to Germany and other parts of Europe in Euros, and thus may be adversely affected by fluctuations in currency exchange rates. Additionally, fluctuations in currency exchange rates may adversely affect foreign demand for our products by increasing the price of our products in the currency of the countries in which the products are sold. The majority of inventory purchases, both components and finished goods, in our foreign operations are made in U.S. dollars. The functional currency of our foreign operations in Denmark, the U.K. and Germany is the U.S. dollar and therefore, the financial statements of these operations are maintained in U.S. dollars. Any assets and liabilities in foreign currencies, such as bank accounts and certain payables, are re-measured in U.S. dollars at period-end exchange rates in effect. Any transactions in foreign currencies, such as wages paid in local currencies, are re-measured in U.S. dollars using an average monthly exchange rate. Any resulting gains and losses are included in operations and were not material in any period.
The functional currency of our Swedish holding company is the local currency. Thus, assets and liabilities are translated to U.S. dollars at period end exchange rates in effect. Translation adjustments are included in accumulated other comprehensive income in stockholders’ equity. Gains and losses on foreign currency transactions are included in operations and were not material in any period.
Our Danish subsidiary has outstanding performance bonds totaling $2,373 Danish Kroner (approximately $435 U.S. dollars). Fluctuations in currency could increase the U.S. dollar value exposure under these guarantees.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
For an index to the financial statements and supplementary data, see Item 15(a).
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Cardiac Science, Inc.
We have completed an integrated audit of Cardiac Science, Inc.’s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements and financial statement schedule
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Cardiac Science, Inc. and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (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 of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has suffered recurring losses from operations that raise substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
Internal control over financial reporting
Also, in our opinion, management’s assessment, included in Management Report on Internal Control over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ PRICEWATERHOUSECOOPERS LLP
PricewaterhouseCoopers LLP
Orange County, California
March 16,
CARDIAC SCIENCE, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
CARDIAC SCIENCE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
CARDIAC SCIENCE, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(In thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
CARDIAC SCIENCE, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(In thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
CARDIAC SCIENCE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share data)
1. Organization and Description of the Business
Cardiac Science, Inc. (the “Company”) was incorporated in May 1991 and develops, manufactures and markets portable public access defibrillators and a fully-automatic in-hospital bedside defibrillator-monitor that continuously monitors cardiac patients, instantly detects the onset of life-threatening abnormal heart rhythms, and, when appropriate, delivers defibrillation shocks within seconds and without human intervention to convert the heart back to its normal rhythm. The Company’s core technology platform consists of its proprietary arrhythmia detection and discrimination software (“RHYTHMx®”), which is combined with its proprietary STAR® Biphasic defibrillation hardware and electrode technology to create the only fully automatic in-hospital cardioverter defibrillator (the “Powerheart® CRM®” or “CRM”) and a unique semi-automatic, or automated defibrillator, (the “Powerheart AED” or “AED”) for use in out-of-hospital settings. The Company’s Powerheart® Cardiac Rhythm Module™ and Powerheart® brand AEDs along with Diascope G2® patient monitoring products are marketed by its direct sales force and distribution network in the United States and by international distributors around the world.
On July 1, 2000, the Company acquired Cadent Medical Corporation, a privately held company, for an aggregate of 4,500,000 shares of the Company’s common stock.
On September 26, 2001, the Company acquired Survivalink Corporation, a privately held company, for $10,500 in cash, $25,800 in Senior secured promissory notes, and 18,150,000 shares of the Company’s common stock.
On November 30, 2001, the Company acquired 94.7% of Artema Medical AB and Subsidiaries (“Artema”) for 4,150,976 shares of common stock and approximately $215 in cash. During 2003, the Company acquired the remaining minority interest for $843 in cash. On September 1, 2003, the Company transferred ownership of the shares in Cardiac Science International A/S, its Danish operations and a subsidiary of Artema, from Artema to Cardiac Science, Inc. in exchange for forgiveness of intercompany debt. Then on September 21, 2003, the Company sold 100% of its shares in Artema to an outside party for $600 in cash.
On May 29, 2003, the Company acquired Lifetec Medical Limited, its U.K. distributor, for $383 in cash.
On October 21, 2003, the Company acquired substantially all of the assets and liabilities of Complient Corporation, a privately held company, for 10,250,000 shares of the Company’s common stock.
2. Continued Existence
The accompanying consolidated financial statements have been prepared on the basis that the Company will continue as a going concern and that the Company will recover its assets and satisfy its liabilities in the normal course of business. From inception, the Company has incurred substantial losses and negative cash flows from operations. For the years ended December 31, 2004, 2003, and 2002, the Company incurred losses of $18,669, $12,537, and $15,052, respectively, and negative cash from operations of $8,776, $16,347, and $20,781, respectively. As of December 31, 2004, the Company had cash on hand of $13,913, working capital of $27,046, short and long term debt of $52,664, and an accumulated deficit of $124,357.
The Company believes that its current cash balance, in combination with net cash expected to be generated from operations and its unused line of credit of $5,000, will fund ongoing operations for the next twelve months. The Company’s expected net cash from operations is predicated on achieving certain revenue levels and maintaining its cost of goods, operating expenses and DSO ratio.
If the Company does not realize the expected revenue and cost of goods, or if operating expenses increase substantially, or if it cannot maintain its DSO ratio, it may not be able to fund its operations for the next twelve months. In addition, the Company’s line of credit and its Senior Notes require maintenance of certain financial covenants, of which the Company was in violation during 2004. Even though the Company has obtained waivers for all covenant violations and has amended the covenants for 2005 and going forward, if in the future, it fails to comply with these financial covenants as amended, the Company could be unable to use its line of credit or be in default under the Senior Notes. If the Company is in default, it may be subject to claims by the note holders seeking to enforce its security interest in its assets. Such claims, if they arise, may substantially restrict or even eliminate the Company’s ability to utilize its assets in conducting its business, and may cause the Company to incur substantial legal and administrative costs.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share data)
In the event that the Company requires additional funding during the next twelve months, it will attempt to raise the required capital through either debt or equity arrangements. The Company cannot provide any assurance that the required capital would be available on acceptable terms, if at all, or that any financing activity would not be dilutive to its current stockholders. If the Company is not able to raise additional funds, it may be required to significantly curtail its operations and this would have an adverse effect on its financial position, results of operations and cash flows, and as such there may be substantial doubt about the Company’s ability to continue as a going concern.
3. Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All inter-company accounts and transactions 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 reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates.
Cash and Cash Equivalents
The Company considers all highly liquid investments with original maturities of three months or less when purchased to be cash equivalents.
Allowance for Doubtful Accounts
The Company maintains an allowance for uncollectible accounts receivable to estimate the risk of extending credit to customers. The allowance is based on customer compliance with credit terms, the financial condition of the customer, and collection history, where applicable.
Inventories
Inventories are valued at the lower of cost (estimated using the first-in, first-out method) or market. The Company periodically evaluates the carrying value of inventories and maintains an allowance for obsolescence to adjust the carrying value, as necessary, to the lower of cost or market. The allowance is based on its assessment of future product demand, historical experience, and technical obsolescence, as well as other factors affecting the recoverability of the asset through future sales. Inventories consist of the following at December 31:
The Company placed $45, $531 and $1,397 during 2004, 2003 and 2002, respectively, of completed Powerheart units at customer locations. The Company retains title to these units and such amounts were transferred to property and equipment where they are being depreciated through cost of goods sold over a five year period.
During the year ended December 31, 2003, the Company wrote down $2,917 of inventory related to its first generation Powerheart and CRM in-hospital defibrillators as a result of a strategic decision to terminate the “no cap” placement business model in U.S. hospitals, in favor of a capital sale model.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share data)
Property and Equipment
Property and equipment is stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are provided using the straight-line method over the estimated useful lives of the related assets, or over the lesser of the term of the lease or the estimated useful life of the asset for assets under capital lease. Computer equipment and tooling are depreciated over 3 years. Equipment, vehicles, Powerhearts on loan to hospitals and equipment on lease to customers are depreciated over 5 years. Furniture is depreciated over 7 years. Leasehold improvements are amortized over the lesser of the term of the lease or the estimated useful life of the improvements. Normal repairs and maintenance are expensed as incurred whereas significant improvements that materially increase values or extend useful lives are capitalized and depreciated over the remaining estimated useful lives of the related assets. Upon sale or retirement of depreciable assets pursuant to SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” the related cost and accumulated depreciation or amortization are removed from the accounts, and any gain or loss not previously recognized during an impairment analysis is recognized at the date of sale or retirement.
Goodwill and Other Intangibles
In accordance with SFAS No. 142 “Goodwill and Other Intangible Assets,” goodwill and other intangible assets with indeterminate lives are no longer subject to amortization but are tested for impairment annually or whenever events or changes in circumstances indicate that the asset might be impaired. The Company operates in one operating segment and has one reporting unit, therefore, the Company tests goodwill for impairment at the consolidated level against the fair market value of the Company. Per SFAS No. 142, the fair value of a reporting unit refers to the amount at which the unit as a whole could be bought or sold in a current transaction between willing parties. Quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for the measurement, if available. The Company assesses potential impairment on an annual basis on December 31 and compares its market capitalization to the carrying amount of goodwill. Other intangible assets with finite lives continue to be subject to amortization, and any impairment is determined in accordance with SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.”
Goodwill and other intangible assets consist of the following at:
The increase in goodwill during the year ended December 31, 2004 was due to adjustments to finalize the purchase price allocation related to the Complient acquisition as follows:
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share data)
Patents and patent applications are being amortized over three to twenty years. Customer base is being amortized over two to seven years while the trade name was amortized over one year. The covenants not to compete and software are being amortized over 3 years. The URL website addresses are being amortized over 5 years.
The Company had amortization expense for identifiable intangibles with finite lives of $2,034, $1,656, and $2,111 for the years ended December 31, 2004, and 2003 and 2002, respectively. Future amortization expense on existing identifiable intangibles for the years ending December 31 is as follows:
Long-Lived Assets
In accordance with SFAS No. 144, long-lived assets and intangible assets with determinate lives are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company evaluates potential impairment by comparing the carrying amount of the asset with the estimated undiscounted future cash flows associated with the use of the asset and its eventual disposition. Should the review indicate that the asset is not recoverable, the Company’s carrying value of the asset would be reduced to its estimated fair value, which is generally measured by future discounted cash flows.
Per Share Information
The Company has adopted SFAS No. 128 “Earnings Per Share.” This statement requires the presentation of basic and diluted earnings per share, as defined, on the statement of operations for companies whose capital structure includes convertible securities and options.
Net loss per share as presented in the accompanying statements of operations is computed based on the weighted average number of common shares outstanding. Shares issuable upon exercise of outstanding stock options and warrants are not included since the effects would be anti-dilutive.
Valuation of Warrants
The Company periodically issues warrants in connection with debt issuances and in exchange for goods and services. The Company follows the guidance of Accounting Principles Bulletin (“APB”) No. 14 “Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants” for warrants the Company issues in connection with debt. The Company follows the guidance in Emerging Issues Task Force (“EITF”) No. 96-18 “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” and EITF No. 01-9 “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)” for warrants the Company issues in exchange for or in connection with goods and services. Management considers a number of factors, including third party valuations, when determining the fair value of warrants issued. The Company estimates the fair value of warrants issued using the Black-Scholes model. Of the various assumptions considered by the Black-Scholes model, the volatility and the risk free rate used require the Company to make certain assumptions and estimations. The Company estimates volatility using a statistical method based on the historical daily stock price for the historical period equal to the life of the warrant being valued. The risk free interest rate is determined using the treasury note rate for the number of years corresponding to the life of the warrant being valued.
Revenue Recognition
The Company records revenue in accordance with Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (“SAB 104”). SAB 104 requires that product sales be recognized when there is persuasive evidence of an arrangement which states a fixed and determinable price and terms, delivery of the product has occurred in accordance with the terms of the sale, and collectibility of the sale is reasonably assured. The Company records product sales when it has received a valid customer purchase order for product at a stated price, the customer’s credit is approved, and it has shipped the product to the customer whereby title and risk have passed to the customer.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share data)
The Company is not contractually obligated to repurchase any inventory from distributors or end user customers. Some of the Company’s customers are distributors that sell goods to third party end users. For certain identified distributors where collection may be contingent on the distributor’s resale, revenue recognition is deferred and recognized on a “sell through” basis. The determination of whether sales to distributors are contingent on resale is subjective because the Company must assess the financial wherewithal of the distributor to pay us regardless of resale. For sales to distributors, the Company considers several factors, including past payment history, where available, trade references, bank account balances, Dun & Bradstreet reports and any other financial information provided by the distributor, in assessing whether the distributor has the financial wherewithal to pay regardless of, or prior to, resale of the product and that collection of the receivable is not contingent on resale.
The Company offers limited volume price discounts and rebates to certain distributors. Volume price discounts are on a per order basis based on the size of the order and are netted against the revenue recorded at the time of shipment. The Company has no arrangements that provide for volume discounts at a later date, such as based on meeting certain quarterly or annual purchase levels. Rebates are paid quarterly or annually based on sales performance and are accrued for at the end of a reporting period. To date, all rebate arrangements have been immaterial.
The Company follows the guidance of EITF No. 00-21 “Accounting for Revenue Arrangements with Multiple Deliverables.” In accordance, the Company considers our program management packages and training and other services as separate units of accounting when sold with an AED based on the fact that the items have value to the customer on a stand alone basis and could be acquired from another vendor. Training and AED program management service revenue is deferred and recognized at the time the training occurs. AED program management services pursuant to agreements that existed with Complient customers pursuant to annual or multi-year terms are deferred and amortized straight-line over the related contract period.
Upfront license fees are deferred and recognized to revenue using the straight-line method over the term of the related license agreement. Royalty revenue are due and payable quarterly (generally 60 days after period end) pursuant to the related license agreements. An estimate of royalty revenue is recorded quarterly in the period it is earned based on the prior quarter’s historical results adjusted for any new information or trends known to management at the time of estimation.
Deferred Revenue
Deferred revenue consists of license fees received in connection with certain licensing agreements and invoiced training and service revenue that has not been delivered. License fees are amortized over the term of the respective agreements using the straight-line method and deferred service revenue is recognized at the time the service is provided.
Product Warranty
The Company’s products are generally under warranty against defects in material and workmanship for a period of one to five years. Warranty costs are estimated at the time of sale based on historical experience. Estimated warranty expenses are recorded as an accrued liability, with a corresponding provision to cost of sales.
Changes in the product warranty accrual for the years ended December 31, 2004, 2003, and 2002 were as follows:
In early April 2004, the Company received a Warning Letter from the U.S. Food and Drug Administration (FDA) following a routine inspection of its manufacturing facility in Minneapolis. The letter specified certain procedural and documentation items in the Company’s quality system. The Company took corrective and preventive action to bring its quality system into compliance. In addition, during May 2004, the Company initiated a limited, voluntary recall of approximately 5,800 units of its older model Powerheart AEDs in order to replace a potentially faulty capacitor component. As of December 31, 2004, the majority of the recalled units in the U.S. have been replaced or repaired and the Company is in the process of executing its international recall plan which represents approximately 10% of total affected units.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share data)
Also in May 2004, the Company initiated a limited, voluntary recall of approximately 4,800 AED batteries due to an error made by the Company’s battery supplier whereby an incorrect fuse was used in the manufacture of a certain lot of batteries. As of December 31, 2004, the recall has been completed and customers have received replacement batteries.
The Company estimates the cost of these voluntary recall actions could range from $1,000 to $1,200, however, the Company has received from its suppliers credits against existing and future amounts due to these suppliers totaling $1,240, which have been recorded to accrued expenses to establish a warranty accrual for these recall matters and are included in accruals for warranties issued during the period in the table above. Actual recall related costs incurred have been charged against this accrual and totaled approximately $1,131 as of December 31, 2004. At this time, the Company believes its remaining accrual related to the recall will cover any future costs.
Excluding the impact of the recall costs incurred and vendor credits recorded discussed above, the Company’s warranty accrual as of December 31, 2004 would be $508. The decrease in warranty reserve requirements in 2004 compared with 2003 result primarily from AED battery design changes, which dramatically extended the life of the battery, and battery warranty policy enforcement, both of which resulted in a significant reduction in the overall warranty reserve necessary.
In 2003, the company experienced an increase in AED unit returns that was due to a faulty component on the board and resulted in the 2004 recall discussed above. Approximately $500 of costs were incurred in 2003 related to this one-time component defect. The decrease in the warranty reserve at December 31, 2003 compared with 2002 is based on the Company’s determination that future warranty requirements were anticipated to be significantly less due to AED battery design changes in 2002 and 2003 that dramatically extended the life of the battery, and batter warranty policy enforcement, both of which resulted in a significantly reduction in battery replacements in 2003.
Foreign Currency
The functional currency of the Company’s foreign operations in Denmark, the U.K. and Germany is the U.S. dollar and therefore, the financial statements of these operations are maintained in U.S. dollars. Any assets and liabilities in foreign currencies, such as bank accounts and certain payables, are re-measured in U.S. dollars at period-end exchange rates in effect. Any transactions in foreign currencies, such as wages paid in local currencies, are re-measured in U.S. dollars using an average monthly exchange rate. Any resulting gains and losses are included in operations and were not material in any period.
The functional currency of the Company’s Swedish holding company is the local currency. Thus, assets and liabilities are translated to U.S. dollars at period end exchange rates in effect. Translation adjustments are included in accumulated other comprehensive income in stockholders’ equity. Gains and losses on foreign currency transactions are included in operations and were not material in any period.
Research and Development Costs
Research and development costs are expensed as incurred.
Advertising Costs
The Company expenses advertising costs as incurred. Advertising expense was $3,174, $925 and $1,280, for the years ended December 31, 2004, 2003, and 2002, respectively.
Software Development Costs
The Company expenses all costs incurred, prior to the achievement of technological feasibility of a working model, related to the development of the proprietary software used in its products. Such costs incurred subsequent to the attainment of technological feasibility have been nominal.
Discontinued Operations
The Company has classified certain facilities operations related to its MCS gas business (see Note 9) as discontinued operations in accordance with SFAS No. 144. SFAS No. 144 established accounting and reporting standards requiring that long-lived assets to be disposed of be reported as discontinued operations if management has committed to a plan to dispose of the asset under usual and customary terms within one year of establishing the plan. Subsequent to the initial one year period, the Company follows the guidance of EITF 90-6 “Accounting for Certain Events Not Addressed in Issue No. 87-11 Relating to an Acquired Operating Unit to Be Sold.”
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share data)
Fair Value of Financial Instruments
The fair value of the Company’s financial instruments, which include cash equivalents, accounts receivable, accounts payable, and notes payable, are based on assumptions concerning the amount and timing of estimated future cash flows. The carrying value of these financial instruments, excluding the Senior Notes, approximated their fair value at December 31, 2004 and 2003. In February 2005, the Company entered into a definitive merger agreement with Quinton Cardiology Systems (see Note 22). In connection with the merger, the Senior Note Holders agreed to exchange approximately $61,000 in principal and accrued interest ($59,726 at December 31, 2004) and warrants to purchase 13.4 million shares of Cardiac Science, Inc. common stock having an exercise price of $2.00, for $20,000 in cash and 2.8 million shares in the newly combined entity which had an imputed value of approximately $53,750.
Stock-Based Compensation
On December 31, 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS 148 “Accounting for Stock-Based Compensation-Transition and Disclosure,” which amends SFAS 123 “Accounting for Stock-Based Compensation.” SFAS 148 allows for three methods of transition for those companies that adopt SFAS 123’s provisions for fair value recognition. SFAS 148’s transition guidance and provisions for annual and interim disclosures are effective for fiscal periods ending after December 15, 2002. The Company has not adopted fair value accounting for employee stock options under SFAS 123 and SFAS 148.
The Company has adopted the disclosure-only provisions of SFAS No. 123. SFAS No. 123 defines a fair value based method of accounting for an employee stock option. Fair value of the stock option is determined considering factors such as the exercise price, the expected life of the option, the current price of the underlying stock, expected dividends on the stock, volatility of the expected market prices, and the risk-free interest rate for the expected term of the option. Under the fair value based method, compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period. Pro forma disclosures are required for entities that elect to continue to measure compensation cost under the intrinsic method provided by APB No. 25.
Additionally, in accordance with SFAS 123 and EITF Issue No. 96-18 “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services,” the Company measures stock based non-employee compensation at fair value.
Under SFAS No. 123, stock based compensation expense related to stock options granted to consultants is recognized as the stock options are earned. The fair value of the stock options granted is calculated at each reporting date using the Black-Scholes option pricing model. As a result, the stock based compensation expense will fluctuate as the fair market value of the Company’s stock fluctuates.
Pro Forma Effect of Stock-Based Compensation
In calculating pro forma information as required by SFAS No. 123, the fair value was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions for the options on the Company’s common stock for the years ended December 31, 2004, 2003, and 2002: risk free weighted average rate 3.15%, 2.64% and 2.81%, respectively; dividend yield of 0%; volatility of the expected market prices of the Company’s common stock of 74.7%, 63.0%, and 63.0%, respectively; and expected life of the options of four years.
Had compensation costs been determined based upon the fair value at the grant date, consistent with the methodology prescribed under SFAS 123, the Company’s total stock-based compensation cost, proforma net loss, and proforma net loss per share, basic and diluted, would have been as follows:
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
Income Taxes
The Company follows SFAS No. 109 “Accounting for Income Taxes,” which requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred income taxes are recognized for the tax consequences in future years of differences between the tax basis of assets and liabilities and their financial reporting amounts at each year-end based on enacted tax laws and statutory rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets when it is more likely than not that a portion of such assets will not be recoverable through future operations. The provision for income taxes represents the tax payable for the period and the change during the period in deferred tax assets and liabilities.
Comprehensive Income
In June 1997, the FASB issued SFAS No. 130 “Reporting Comprehensive Income.” SFAS No. 130 requires disclosure of all components of comprehensive income on an annual and interim basis. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. In 2004, 2003, and 2002, comprehensive income includes only foreign currency translation adjustments.
Reclassifications
Certain reclassifications have been made in the 2003 and 2002 statements to conform to the 2004 presentation.
New Accounting Standards
In November 2004, the FASB issued SFAS No. 151 “Inventory Costs, an Amendment of ARB No. 43, Chapter 4, ‘Inventory Pricing,’” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. This statement requires those items be recognized as current-period charges. The provisions of this statement shall be effective for inventory costs incurred during fiscal periods beginning after June 15, 2005. The Company does not expect adoption of this statement to have a material impact on its financial statements.
In December 2004, the FASB issued SFAS No. 123 (revised 2004) “Share-Based Payment” or FAS 123R. FAS 123R revises SFAS No. 123 “Accounting for Stock-Based Compensation.” and supersedes APB No. 25 “Accounting for Stock Issued to Employees” and related interpretations and SFAS No. 148 “Accounting for Stock-Based Compensation-Transition and Disclosure.” FAS 123R requires compensation cost relating to all share-based payments to employees to be recognized in the financial statements based on their fair values in the first interim or annual reporting period beginning after June 15, 2005. The pro forma disclosures previously permitted under FAS 123 will no longer be an alternative to financial statement recognition. The Company is evaluating the requirements of FAS 123R and expects that the adoption of FAS 123R will have a material impact on the Company’s consolidated financial position or results of operation. The Company has not determined the method of adoption and it has not determined whether the adoption will result in amounts recognized in the income statement that are similar to the current pro forma disclosures under FAS 123.
In December 2004, the FASB issued SFAS No. 153 “Exchanges of Non-monetary Assets -- an amendment of Accounting Principles Board ("APB") Opinion No. 29 “Accounting for Non-monetary Transactions.” The guidance in APB 29 is based on the principle that exchanges of non-monetary assets should be measured based on the fair value of the assets exchanged. The guidance in that Opinion, however, included certain exceptions to that principle. SFAS 153 amends APB 29 to eliminate the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The provisions of SFAS 153 are applicable for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The Company is currently evaluating the provisions of this statement.
In December 2004, the FASB also issued FSP 109-2 “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004” ("FSP 109-2"). FSP 109-2 provides enterprises more time (beyond the financial-reporting period during which the American Jobs Creation Act took effect) to evaluate the impact on the enterprise's plan for reinvestment or repatriation of certain foreign earnings for purposes of applying SFAS No. 109. The FSP, issued on December 21, 2004, went into effect upon being issued. The Company is not yet in a position to decide on whether, and to what extent, it might repatriate foreign earnings that have not yet been remitted to the U.S. The Company expects to conclude its analysis of this repatriation incentive during 2005.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
4. Segment Reporting
The Company follows the provisions of SFAS No. 131 “Disclosures about Segments of an Enterprise and Related Information.” SFAS No. 131 established standards for reporting information about operating segments in annual financial statements and requires selected information about operating segments in interim financial reports issued to stockholders. It also established standards for related disclosures about products and services, geographic areas and major customers. An operating segment is defined as a component of an enterprise that engages in business activities from which it may earn revenues and incur expenses whose separate financial information is available and is evaluated regularly by the Company’s chief operating decision makers, or decision making group, to perform resource allocations and performance assessments.
The Company’s chief operating decision makers are the Executive Management Team which is comprised of the Chief Executive Officer (“CEO”) and senior executive officers of the Company. Based on evaluation of the Company’s financial information, management believes that the Company operates in one reportable segment with its various product lines that service the external defibrillation and cardiac monitoring industry. The product lines include AEDs and related training, services, and accessories; Powerhearts, electrodes and related accessories; and emergency defibrillators, monitors, CPR products and related accessories.
The Company’s chief operating decision makers evaluate revenue performance of product lines, both domestically and internationally, however, operating, strategic and resource allocation decisions are not based on product line performance, but rather on the Company’s overall performance in its operating segment.
The following is a breakdown of net revenue by product line for the years ended December 31:
The following is a breakdown of net sales by geographic location for the years ended December 31:
In 2004, one customer represented 15.7% of net revenue and 13.5% of net accounts receivable at December 31, 2004. In 2004, sales to Japan were 16.1% of net revenue. No other country had sales greater than 10% in 2004, 2003, or 2002.
The following is a breakdown of the Company’s long-lived assets by geographic location at December 31:
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
5. Property and Equipment
Property and equipment consist of the following at December 31:
Equipment on lease to customers relates to contracts originally entered into by Complient, whereby Complient leased AED units to customers in connection with comprehensive AED deployment, training and maintenance programs with a stated contract term. The majority of the contracts have annual lease/contract billings which are deferred and amortized straight-line over the contract term with the corresponding cost of the leased units being recorded to fixed assets and depreciated to cost of goods sold over the same period. The Company recognizes revenue and depreciation costs with respect to these units leased to customers in accordance with paragraph 19 of SFAS No. 13, “Accounting for Leases.”
Powerhearts on loan to hospitals relates to the “no cap” placement program, whereby the Company placed in-hospital Powerheart or CRM defibrillation units in a customer’s facility at no charge in exchange for an agreement to purchase the Company’s proprietary, disposable defibrillation electrodes monthly or quarterly pursuant to the related contract. Agreements under the “no cap” program are typically open-ended (i.e. no stated term or expiration date). The customer has the option to cancel the agreement with 30 days written notice, or discuss purchase options at any time during the agreement. The Company retains title and risk of loss to equipment placed under the “no cap” program, and as such, placements are considered withdrawals from inventory and capitalized as Property and Equipment. The Company estimated that the useful life (i.e. revenue-generating life) of a Powerheart or CRM unit is five years and depreciates the placed units over this period. If the Company and the customer agree to discontinue the agreement, the customer can either discuss purchase options for the equipment or return the equipment to the Company. If the customer returns the unit before the five year depreciation period is completed, the net book value of the unit in Property & Equipment is reclassified to inventory and is available for resale as used equipment or shipped to another customer under the “no cap” program. The Company then evaluates the carrying value in inventory based on the expected selling price to determine if an impairment write-down is necessary as was determined in 2003 for $2,917 of returned placed units in inventory at December 31, 2003 (See Note 3).
6. Other Assets
In July 2002, the Company entered into preliminary negotiations regarding a possible transaction with Medical Research Laboratories, Inc. (“MRL”), a privately-held medical device manufacturer. The Company made an initial investment in the common stock of the manufacturer in the amount of $1,000 and placed $2,001 into an escrow account pending the outcome of further negotiations. On December 3, 2002, the Company filed a Complaint in Orange County Superior Court against Medical Research Laboratories, Inc. (“MRL”) alleging declaratory relief and breach of contract arising out of a July 29, 2002 letter of intent entered into between the parties. The Company alleged that MRL failed to comply with certain conditions of closing set forth in the letter of intent whereby the Company would acquire all of MRL’s stock. MRL filed a cross-complaint, also seeking breach of contract and declaratory relief arising out of the same letter of intent. On February 25, 2003, the Company filed suit against MRL for patent infringement in the United States District Court for the District of Minnesota. The Company alleged that MRL’s LifeQuest JumpStart AED infringed the Company’s patented disposable electrode pre-connect technology. The Company settled both law suits with MRL on June 24, 2003. Under the terms of the confidential settlement agreement, the Company received a settlement amount from MRL and MRL received the right to license two of the Company’s patents for additional royalties.
On December 18, 2000, the Company entered into a non-binding letter of intent to acquire Inovise Medical, Inc., a privately held Oregon based corporation, which potential acquisition was terminated in February 2001. In connection with this proposed transaction, the Company advanced funds for a bridge loan to support working capital requirements. The bridge loan was collateralized by all assets of Inovise, excluding certain receivables from royalty payments, accrued interest at 6% and was convertible into equity of Inovise. The total amount advanced to Inovise was $1,038. In February 2002, the Company’s convertible bridge loan was converted into 13,000,000 shares of Inovise’s Series D convertible preferred stock. As there is currently no market for these shares and there is no foreseeable recovery of the initial investment, the Company has determined that these shares have no value. Accordingly, the Company has written down the cost basis of this investment to zero at December 31, 2004 and 2003.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
Included in other assets at December 31, 2004 and 2003 is $246 of restricted cash in the form of two certificates of deposit that are collateral on letters of credit issued in connection with facilities leases. The letters of credit, and the underlying certificates of deposit, renew annually unless requested otherwise by the landlord, until the final expiration dates of May 2008 and January 2009, respectively, when the facilities leases expire.
7. Accrued Expenses
Accrued expenses consist of the following as of December 31:
8. Business Combinations
Complient Corporation
On October 21, 2003, the Company acquired substantially all of the assets and certain liabilities of Cleveland-based Complient Corporation, a privately-held company that is the nation’s leading independent provider of AED and CPR training and comprehensive AED program management in order to strategically position itself in the AED market as the first and only manufacturer to provide customers with a complete, turnkey AED deployment solution. In addition to the revenue generated from Complient’s existing customer base, the acquisition was a logical vertical market extension for the Company and should generate additional point of sale revenue, as well as a future recurring revenue opportunity, linked to AED sales. As consideration, the Company issued to Complient 10,250,000 shares of its common stock. The common stock was subject to a lock-up agreement, which expired in November 2004, and a general indemnification escrow. The resale of the shares was registered with the Securities and Exchange Commission. In February 2005, the Company and Complient agreed that 512,500 of the 1,025,000 shares of common stock previously held in escrow would be returned to us in settlement of the escrow and the remaining 512,500 shares were released to Complient Liquidating Trust.
The acquisition was accounted for as a purchase under SFAS No. 141 “Business Combinations.” In accordance with SFAS No. 141, the Company allocated the purchase price based on the fair value of the assets acquired and liabilities assumed. Portions of the purchase price were identified by management as intangible assets and were valued based on a number of factors including an independent appraisal. These intangible assets include $42,494 for goodwill, $2,907 in customer relationships, $726 for covenants not to compete, and $128 for custom-developed software. The customer relationships are being amortized over 7 years, and the covenants not to compete and the software are being amortized over 3 years.
The Company determined the value of the stock consideration ($4.42 per share) using the average closing stock price for a five day period before and a five day period after the October 21, 2003 transaction announcement date. The Company believes this method is consistent with guidance provided in EITF No. 99-12, “Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination” and paragraph 22 of SFAS NO. 141 “Business Combinations.” Historically, the Company has used an average closing stock price based on a two day period before and a five day period after the measurement date due to the stock’s volatility during 2003.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
The components of the purchase price allocation are as follows:
The following unaudited pro forma data summarizes the results of operations for the periods indicated as if the Complient acquisition had been completed as of the beginning of the periods presented. The pro forma data gives effect to actual operating results prior to the acquisition, adjusted to include the pro forma effect of amortization of identified intangible assets and the elimination of sales to Complient prior to the acquisition.
During 2004, final adjustments to Complient goodwill were made related to the purchase price allocation as follows:
Lifetec Medical Limited
On May 29, 2003, the Company acquired Lifetec Medical Limited, its U.K. distributor. The purchase price was $383 in cash and $61 in acquisition costs. The acquisition was accounted for as a purchase under SFAS No. 141. The Company allocated the purchase price based on the fair value of the assets and liabilities assumed. Current assets acquired were valued at $418, including cash of $89, and current liabilities assumed were valued at $557, and goodwill was valued at $583.
Artema Medical AB
On November 30, 2001, the Company acquired a 94.7% ownership interest in Artema Medical AB (“Artema”), a Swedish based manufacturer of patient monitors and external defibrillator devices. As consideration, the Company paid approximately $215 in cash and issued 4,150,976 shares of common stock to Artema shareholders.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
The components of the purchase price and original allocation were as follows:
During 2002, goodwill related to the Artema acquisition was adjusted for the following:
During 2003, final adjustments to Artema goodwill were made related to acquiring the minority interest and subsequent sale of the MCS gas business.
Survivalink Corporation
On September 26, 2001, the Company acquired Survivalink Corporation (“Survivalink”), a privately held Minneapolis-based company that is a leading provider of Automated External Defibrillators (“AEDs”), in order to enter the rapidly growing public access defibrillation market. Through the acquisition, the Company acquired patents and know-how relating to biphasic defibrillation waveform and AED technology which the Company believes is essential to its competitiveness, as well as a manufacturing facility and an assembled and experienced workforce which allows it to build a range of defibrillation products. As consideration, the Company paid $10,500 in cash, issued $25,800 in senior secured promissory notes (see Note 11) and tendered 18,150,000 shares of common stock to Survivalink shareholders.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
The shares and cash were released after a settlement was reached on certain breaches of representation on November 6, 2002. On November 6, 2002, the Company received $1,901 in cash and 474,231 shares of Cardiac Science common stock valued at $1,095. The remaining balance of the escrow was 430,227 shares of Cardiac Science common stock which has been transferred to the original Survivalink shareholders. These settlement proceeds from the escrow account were recorded against goodwill associated with the Survivalink acquisition.
As partial consideration for the acquisition of Survivalink, the Company issued senior promissory notes to Survivalink shareholders in the principal amount of $25,800 with simple interest payable upon maturity at the rate of 10% per annum. In addition, the Company assumed $1,500 plus accrued interest of bridge notes from certain shareholders of Survivalink. The Company and the bridge note holders agreed to convert the bridge notes into a senior note payable with terms and conditions similar to the notes issued as merger consideration. During 2002, the Company issued $50,000 of Senior Notes to a third party (see Note 11) and the proceeds of the Notes were used to redeem the senior promissory notes issued to the Survivalink shareholders and held in escrow, the assumed bridge loan and all accrued interest.
The Company entered into an agreement with Survivalink shareholders to establish a tax escrow fund to make loans to employees of Survivalink who owned options to purchase Survivalink common stock to help them meet their tax obligations arising from the exercise of their employee stock options. The Company deposited $2,108 of cash into this fund as of December 31, 2001. Each loan from the fund was documented by an individual secured tax note. The tax notes were collateralized by any amounts payable to the Survivalink employee under the senior secured promissory notes issued to the employee as consideration in the acquisition of Survivalink. During 2002, upon repayment of the senior secured promissory notes, all loans to employees were paid back to the Company and the tax escrow account was refunded to the Company.
The acquisition was accounted for as a purchase under SFAS No. 141 “Business Combinations.” In accordance with SFAS No. 141, the Company allocated the purchase price based on the fair value of the assets acquired and liabilities assumed. Portions of the purchase price were identified by management as intangible assets and were valued based on a number of factors including an independent appraisal. These intangible assets included $73,803 for goodwill, $7,584 for patents, $676 for customer base, and $378 for the Survivalink tradename. The patents are being amortized over seven years, the customer base over two years, and the Survivalink tradename over one year.
The Company determined the value of the stock consideration ($2.31 per share) using the average closing stock price for a two day period before and a two day period after the August 3, 2001 “measurement date.” The August 3, 2001 date was determined as the measurement date as that was when the purchase agreement fixed an absolute number of shares to be issued as consideration consistent with the requirements of EITF No. 99-12.
The components of the purchase price allocation are as follows:
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
During 2002, goodwill related to the Survivalink acquisition was adjusted for the following:
9. Artema Restructuring and Disposition of the MCS Gas Business
As part of the Artema acquisition, the Company developed a plan to restructure the operations of the manufacturing facility in Denmark (“the plan”). Originally, the Company recorded certain purchase price adjustments in connection with the plan totaling $3,064. The plan included plant and facility closure costs that were either contractually obligated or were incremental in nature, adjustments to fair market value for owned facilities to be disposed of based on market assessments, adjustments to fair value for raw materials that would not be converted into finished goods and certain severance related costs for employees in closed facilities that the Company was obligated to pay upon execution of the plan.
The plan, which included closing the manufacturing facility in Denmark, relocating from the then current facility in Copenhagen, as well as discontinuing or subcontracting the manufacturing of certain product lines, was completed in the quarter ended September 30, 2002. Additionally, an existing defibrillator product line and the accompanying future service obligations were sold to a European company as part of the plan. The Company sold related inventories, manufacturing assets and the right to manufacture and sell the existing products for consideration of cash and future royalty payments based on future units produced. No gain or loss was recognized on the transaction as the disposal of these assets was contemplated as a part of the plan. Upon execution of the plan, the Company recorded an additional $905 of purchase price adjustments to reflect the fair value of the assets disposed.
The Company also entered into a licensing agreement with the European company granting them the right to use Cardiac Science’s proprietary biphasic defibrillation technology. In consideration, the Company received an upfront payment of $487 and eight quarterly installments over the next 2 years totaling $500. The total licensing revenue of $987 will be recognized on a pro-rata basis over the next seven years, which is the term of the agreement and, accordingly, the Company recognized $141 and $141 of licensing revenue in the years ended December 31, 2004 and 2003, respectively.
Also as part of the Artema acquisition, the Company identified the MCS gas business, located in Stockholm, Sweden, as a business segment acquired in a business combination accounted for as a purchase, to be disposed of. The MCS gas business designs, develops and manufactures gas analyzers, which are sold to OEM patient monitoring customers. The MCS gas business is a distinct and separate business unit. The Company was, for the period from acquisition through November 30, 2002 accounting for this in accordance with EITF 87-11 “Allocation of Purchase Price to Assets to be Sold,” which requires that the operations of the MCS gas business be excluded from the consolidated operating results of the Company. The Company had initially estimated that the operating loss of the MCS gas business from the acquisition date until disposition would be approximately $1,017 and had included this as a liability assumed in the acquisition and included it in the purchase price allocation. This estimated loss was subsequently revised to an estimated operating loss of $306. The Company sold the MCS gas business to an outside party for $600 in cash excluding selling costs of $111, on September 21, 2003. The operating loss of $306 has been excluded from the statements of operations for the one year period from acquisition through November 30, 2002 (i.e. included in the purchase price allocation) and the MCS operating loss of $52 in December 2002 and the net operating income of $493 for the period from January 1, 2003 through the sale on September 21, 2003, has been recorded as discontinued operations in accordance with EITF 90-6 “Accounting for Certain Events not Addressed in Issue No. 87-11 Relating to Acquired Operating Unit to be Sold.”
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
The following is a breakdown of the restructuring accruals recorded related to the Danish facilities shutdown and relocation and the MCS gas business disposal:
10. Relocation, Restructuring, and Disposal of Assets
During the first quarter of 2003, the Company commenced its plan to relocate its corporate headquarters, expanded its manufacturing capacity, and consolidate its accounting and finance functions in Irvine, California.
The costs which were incurred are included in general and administrative expenses in the accompanying consolidated statement of operations for the year ended December 31, 2003. All expansion, relocation, and restructuring activities were completed in the second quarter of 2003 and there are no future expected costs.
The following is a breakdown of the accrual recorded related to the expansion, relocation and restructuring activities:
The accrual represented costs recognized pursuant to SFAS 146 “Accounting for Costs Associated with Exit or Disposal Activities” and SAB 100 “Restructuring and Impairment Charges.” The Company committed to a sufficiently detailed plan that identified significant actions to be taken and the activities that would not be continued. The plan was completed during the quarter ended June 30, 2003 and there were no significant changes to the original plan. The involuntary one-time employee-termination arrangement established the benefits to be paid to employees and specifically identified the classifications or functions of those employees, their locations, and their expected completion date. All employees were informed about the terms of the benefit arrangement, including the benefits that employees would receive upon termination (including but not limited to cash payments), in sufficient detail to enable employees to determine the type and amount of benefits they would receive. The Company reviewed the net book value of leasehold improvements to be abandoned in certain facilities in accordance with SFAS 144, and appropriately recorded an adjustment to accelerate the related depreciation over the revised useful life through their cease-use dates.
In May 2004, the Company sold fixed assets in connection with closing our Ohio facility from the Complient acquisition for $23 in cash resulting in a loss of $203 recorded to other operating expenses in the year ended December 31, 2004.
In June 2004, the Company sold the rights to an AED trainer that the Company manufactured for one specific customer for $700 in cash, resulting in a gain of $387 recorded to other operating expenses in the year ended December 31, 2004.
In July 2004, the Company initiated a plan to streamline its international operations by transferring certain administrative and logistics functions to the U.S. and U.K., which resulted in headcount reductions and an accrual for severance of $285 recorded to other operating expenses in the year ended December 31, 2004.
In August 2004, the Company sold the CPR Prompt product line, which includes products such as CPR Prompt devices, manikins, and training related equipment and supplies, for $1,875 in cash resulting in a net gain of $1,368 recorded to other operating expenses in the year ended December 31, 2004.
In September 2004, the Company discontinued its Diascope product line, which is manufactured by a contract manufacturer in Asia and sold only in international markets in the quarter ended September 30, 2004. Substantially all of the inventory on hand was sold in the quarter ended September 30, 2004. The Company recorded an impairment of assets related to the discontinuance of the product line of $190 to other operating expenses in the year ended December 31, 2004.
11. Senior Secured Promissory Notes
As partial consideration for the acquisition of Survivalink (see Note 8), the Company issued senior secured promissory notes to Survivalink shareholders during 2001 in the principal amount of $25,800, with simple interest payable upon maturity at the rate of 10% per annum. In addition, the Company assumed $1,500 of bridge notes from certain shareholders of Survivalink. The Company and the bridge note holders agreed to convert the bridge notes into a senior secured promissory note with terms and conditions similar to the notes issued as merger consideration. The notes issued to Survivalink shareholders were subsequently redeemed pursuant to the note and warrant financing described in the immediately following paragraph.
On May 29, 2002, the Company entered into a Senior Note and Warrant Purchase Agreement (“the Agreement”) with investors, pursuant to which the investors loaned the Company $50,000. Under the original terms of the Agreement, the Senior Notes (the “Notes”) were due and payable in cash on May 30, 2007, unless accelerated pursuant to the terms of the Agreement, and accrue interest at 6.9% per annum. During the first three years of the term of the Notes, accrued and unpaid interest on the Notes would, at the option of the Company, a) be due and payable in cash, or b) accrue and be paid in kind, in each case quarterly in arrears, and then due on the termination date of the Notes. After the end of the third year of the term of the Notes, any additional accrued and unpaid interest on the Notes would be due and payable in cash quarterly in arrears, and on the termination date of the Notes. The Notes have certain monthly and quarterly financial and non-financial covenants. The Notes are collateralized by all the assets of the Company and its subsidiaries, to the extent permitted by law. Proceeds from the Notes were used by the Company to repay $26,468 of senior promissory notes including accrued interest issued in connection with the acquisition of Survivalink Corporation (see Note 8). The remaining proceeds were used for working capital purposes. Interest expense and amortization of the discount and issuance costs related to these notes was $6,975, $5,983 and $3,207 for 2004, 2003 and 2002, respectively. The terms of the Notes have been amended subsequent to December 31, 2004 (see Note 22). As of December 31, 2004, the Company was not in compliance with certain of the required covenants, as amended, however, the Company received a waiver for the quarter and year ended December 31, 2004 (see Note 22).
In connection with the Notes, the investors were issued warrants (the “Warrants”) for the purchase of an aggregate of 10,000,000 shares of the Company’s common stock at an exercise price of $3.00 per share, and an aggregate of 3,000,000 shares of common stock at an exercise price of $4.00 per share. The Warrants are immediately exercisable, expire by their terms on May 30, 2009 and are subject to certain limited antidilution adjustments. After two years, the Company has the right to force the exercise of the warrants pursuant to the terms of the Agreement. The proceeds from the Notes were allocated between the Notes and the Warrants based on their relative fair values which resulted in a discount being recorded on the Notes pursuant to APB No. 14 “Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants.” The Company considered a number of factors, including an independent valuation, when determining the fair value of the Warrants. The significant assumptions used in the Black-Scholes model were: stock price of $2.90, adjusted downward for a dilution factor to $2.68; risk free rate of 4.98%; volatility of 0.90; dividend yield of 0%; and contractual term of 7 years. Such allocation resulted in a discount being recorded on the Notes in the amount of $11,815, which is being amortized over the five-year term of the Notes using the effective interest method. In addition, the Company paid approximately $2,760 in debt issuance costs which are being amortized over the five-year term of the Notes using the effective interest method.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
On March 15, 2004, the Company amended the Agreement, effective as of and for the year ended December 31, 2003, in order to ease certain financial covenants into 2005 to reflect the Company’s actual and expected financial results. In exchange for modifying these covenants, the Company issued warrants to the note holders to purchase 500,000 shares of common stock at $3.95 per share. The warrants were valued at $1,301 using a Black-Scholes model. The significant assumptions used in the model were: stock price of $3.98; risk free rate of 3.2%; volatility of 0.65; dividend yield of 0%; and contractual term of seven years. The value of the warrants was recorded as additional discount to the Senior Notes to be amortized over the remaining term of the Senior Notes using the effective interest method. This modification was not considered to be a significant modification of the Agreement.
Under the antidilution provisions that were triggered by the September 2003 and July 2004 private placements (see Note 15) and the July 2003 warrant issuance to GE Healthcare (see Note 20), an additional 205,451 warrants were issuable to the note holders at exercise prices ranging from $2.97 to $3.88. In addition, pursuant to the antidilution provisions, the exercise prices of the original warrants issued were also reduced to: (i) $2.97 for the 10,000,000 warrants that had an original exercise price of $3.00, (ii) $3.88 for the 3,000,000 warrants that had an original exercise price of $4.00, and (iii) $3.86 for the 500,000 warrants that had an original exercise price of $3.95.
12. Promissory Note and Security Agreement
In July 1999, the Company terminated its agreement to acquire HeartSine Technologies, Inc. (“HeartSine”). In December 1999, the Company entered into an exclusive license and development agreement with HeartSine Technologies, Inc. to utilize HeartSine’s biphasic defibrillation waveform technology in the Company’s in-hospital defibrillation products. HeartSine Technologies is a privately held research and development firm with its primary operations in Northern Ireland. Pursuant to the agreement, the Company could have paid to HeartSine a total of $650 upon the attainment of agreed upon milestones. During 2000 the Company terminated the development portion of the agreement and therefore there are no additional development fees to be earned by HeartSine. Included in the amount of $650 was a one time license fee of $250 which was paid in December 1999 and included in research and development expense for the year ended December 31, 1999. Also, during 1999, the Company advanced cash to HeartSine in the amount of $189. The Company obtained a promissory note and security agreement with regard to these advances. The principal amount plus interest at 10% was due and payable on December 31, 2001.
In prior periods, the Company wrote-off to research and development expense this $189, as the Company believed that the note receivable was permanently impaired and uncollectible. In February 2002, the Company received from HeartSine $236, which represented full repayment of the original promissory note plus accrued interest and late fees. The Company has included this recovery of $236 as an offset to research and development expense in the statement of operations for the year ended December 31, 2002. In November 2002, the Company agreed to terminate its development and license agreement with HeartSine in exchange for $100. The Company also included this $100 as an offset to research and development expense in the statement of operations for the year ended December 31, 2002.
13. Related Party Transaction
In November 2001, the Company advanced $500 (the “Loan”) to its CEO. The principal amount plus interest of 6% was due and payable in November 2004 and was not collateralized. In November 2004, the Loan plus accrued interest was settled by the CEO’s surrender of 277,682 shares of his common stock in the Company, valued at $589 based on the closing share price on the due date of the Loan. The shares were not legally cancelled until 2005 and were recorded as issued but not outstanding in the consolidated balance sheet and consolidated statement of stockholders’ equity at December 31, 2004. The Loan was included in other current assets on the consolidated balance sheet at December 31, 2003.
In May 2002, the Company entered into a Senior Note and Warrant Purchase Agreement (“the Agreement”) with investors, pursuant to which the investors loaned the Company $50,000. In March 2004, the Company amended the Agreement in order to ease certain financial covenants into 2005 to reflect our actual and expected financial results. In exchange for these modifications, the Company issued the note holders 500,000 additional warrants to purchase shares of common stock at $3.95 per share. The warrants were valued at $1,301 using a Black-Scholes model. The value of the warrants was recorded as additional discount to the Senior Notes to be amortized over the remaining term of the Senior Notes using the effective interest method.
Under the antidilution provisions of the Agreement, which were triggered by the September 2003 and July 2004 private placements and our July 2003 warrant issuance to GE Healthcare, an additional 205,451 warrants were issuable to the note holders at exercise prices ranging from $2.97 to $3.88. In addition, the exercise prices of the original warrants issued were also reduced to: (i) $2.97 for the 10,000,000 warrants that had an original exercise price of $3.00, (ii) $3.88 for the 3,000,000 warrants that had an original exercise price of $4.00, and (iii) $3.86 for the 500,000 warrants that had an original exercise price of $3.95.
In January 2005, the Company entered into an amendment and limited waiver (the “Amendment”) to the Agreement with the Senior Note holders. Pursuant to the terms of the Amendment, the Company and the Senior Note holders agreed to: (i) extend the maturity date of the $50,000 in aggregate principal amount of Senior Notes issued under the Agreement by twelve months to May 29, 2008; (ii) defer all cash interest payments until maturity; and (iii) modify certain financial covenants regarding minimum EBITDA, minimum debt to capitalization and maximum capital expenditures, and delete certain other financial covenants for 2005 through maturity. Additionally, the Senior Note holders waived certain covenant violations, including all financial covenant violations for the quarter and year ended December 31, 2004. In exchange for the foregoing amendments and waiver contained in the Amendment, the Company and the Senior Note holders agreed to reduce the number of warrants to purchase shares of common stock to 13,438,599 and reduce the exercise price of those warrants to $2.00 per share, down from the original weighted average price of approximately $3.21 per share.
In January 2005, as consideration for delays in filing a required registration statement in connection with the July 2004 financing, the Company agreed with the investors in such financing to make a cash payment of $556, to issue an additional aggregate of 476,637 shares of common stock and to reduce the exercise price on the investors’ warrants to $2.50 per share.
14. Line of Credit
In February 2004, the Company secured a $5,000 line of credit with Silicon Valley Bank. The line of credit may be used to provide additional working capital, as needed, to fund our continued growth. This 24-month facility is collateralized by accounts receivable, inventory and cash and cash equivalents, has an interest rate of the bank’s prime rate plus .75% (with a floor of 5%) payable monthly, and requires us to maintain certain financial covenants. In January 2005, the Company obtained a waiver from the bank for the quarter and year ended December 31, 2004 for non-compliance with certain financial covenants required by the line of credit agreement. There was no outstanding balance on the line at December 31, 2004, however, there was a letter of credit for $88 issued in December 2004 as collateral for a performance bond (see Note 16) that reduces the available balance on the line of credit.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
15. Common Stock Issuances
During September 2003, the Company completed a private placement of its common stock to a small group of institutional and accredited investors, raising $8,375 in gross proceeds. The transaction involved the sale of 2,233,334 newly issued shares of Cardiac Science common stock at a price of $3.75 per share. In addition to the common stock, 223,333 five-year warrants with an exercise price of $5.00 per share were issued in connection with the transaction.
In July 2004, the Company completed a private placement of its common stock to a small group of institutional and accredited investors, raising $12,370 in gross proceeds. The transaction involved the sale of 5,219,409 newly issued shares of Cardiac Science common stock at a price of $2.37 per share. In addition to the common stock, 2,087,763 five-year warrants with an exercise price of $2.84 per share were issued in connection with the transaction. See Note 22 regarding subsequent amendment and settlement related to this private placement.
16. Commitments and Contingencies
Concentrations of Risk
The Company is exposed to credit loss for the amount of cash deposits with financial institutions in excess of federally-insured limits. The Company invests its excess cash deposits in money market cash portfolios with major financial institutions.
Litigation
In November 2002, the Company settled a patent infringement suit with ZOLL Medical Corporation (“ZOLL”), which it originally initiated in March 2002. The terms of the settlement included the cross licensing of a number of patents between the two parties. Under the terms of the confidential settlement agreement, the Company received a settlement amount and will be entitled to royalties under a licensing agreement based on ZOLL’s AED sales. The Company recorded the settlement as an offset to legal expense included in general and administrative expenses in the quarter ended December 31, 2002.
On December 3, 2002, the Company filed a Complaint in Orange County Superior Court against Medical Research Laboratories, Inc. (“MRL”) alleging declaratory relief and breach of contract arising out of a July 29, 2002 letter of intent entered into between the parties. The Company alleged that MRL failed to comply with certain conditions of closing set forth in the letter of intent whereby the Company would acquire all of MRL’s stock. MRL filed a cross-complaint, also seeking breach of contract and declaratory relief arising out of the same letter of intent. On February 25, 2003, the Company filed suit against MRL for patent infringement in the United States District Court for the District of Minnesota. The Company alleged that MRL’s LifeQuest JumpStart AED infringed the Company’s patented disposable electrode pre-connect technology. The Company settled both law suits with MRL on June 24, 2003. Under the terms of the confidential settlement agreement, the Company received a settlement amount from MRL and MRL received the right to license two of the Company’s patents for additional royalties.
In February 2003, the Company filed a patent infringement action against Philips Medical Systems North America, Inc., Philips Electronics North America Corporation and Koninklijke Philips Electronics N.V. (“Philips”) in the United States District Court for the District of Minnesota. The suit alleges that Philips’ automated external defibrillators sold under the names “HeartStart OnSite Defibrillator”, “HeartStart”, “HeartStart FR2” and the “HeartStart Home Defibrillator,” infringe at least ten of the Company’s United States patents. In the same action, Philips counterclaimed for infringement of certain of its patents and the Company has sought a declaration from the Court that the Company’s products do not infringe such patents. Many of the Philips defibrillators’ are promoted by Philips as including, among other things, pre-connected disposable defibrillation electrodes and daily self-testing of electrodes and battery, features that the suit alleges are key competitive advantages of the Company’s Powerheart and Survivalink AEDs and are covered under the Company’s patents. At this stage, the Company is unable to predict the outcome of this litigation. The Company has not established an accrual for this matter because a loss is not determined to be probable.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
On April 30, 2003, the Company filed a Complaint against Defibtech, LLC for patent infringement in the United States District Court for the District of Minnesota. The Complaint alleged that Defibtech’s Sentry and Reviver AEDs infringe the Company’s patented disposable electrode pre-connect technology as well as other patents. Defibtech answered the Complaint and asserted counterclaims alleging that the Company has engaged in activities that constitute tortious interference with present and prospective contractual relations, common law business disparagement and statutory business disparagement. The Company responded to the counterclaims with a complete and general denial of the allegations. At this stage, the Company is unable to predict the outcome of this litigation. The Company has not established an accrual for this matter because a loss is not determined to be probable.
On March 19, 2004, William S. Parker filed suit against the Company for patent infringement in the United States District Court for the Eastern Division of Michigan. The Parker patent generally covers the use of a synthesized voice to instruct a person to perform certain tasks. The Complaint alleges that certain of the Company’s AEDs infringe the patent. The patent is now expired. The Company has filed an Answer to the Complaint stating the patent is not infringed and is otherwise invalid and unenforceable. The patent has been submitted before the United States Patent and Trademark Office for reexamination. On October 25, 2004, the District Court issued an order staying the litigation pending resolution of the reexamination. At this stage of the litigation, the Company is unable to predict the outcome of this litigation. The Company has not established an accrual for this matter because a loss is not determined to be probable.
In the ordinary course of business, various lawsuits and claims are filed against the Company. While the outcome of these matters is currently not determinable, management believes that the ultimate resolution of these matters will not have a material adverse effect on the Company’s operations or financial position.
Employee Benefit Plan
In 1995, the Company adopted the Cardiac Science, Inc. 401(k) Profit Sharing Plan (the “Plan”) which is a 401(k) plan covering all of the Company’s full-time employees who meet certain eligibility requirements. The Company may contribute to the Plan on a discretionary basis. As of December 31, 2004, the Company had never contributed to the Plan.
Operating Leases
The Company leases office space and equipment under various operating lease agreements. Most of our facilities leases include annual rent escalations which are recognized on a straight-line basis over the lease term. In addition, certain of these leases also include tenant improvement allowances and other lease incentives which are recorded as deferred rent and amortized as reductions to rent expense over the term of the lease. Total rent expense for the years ended December 31, 2004, 2003 and 2002 was $1,614, $1,153, and $666, respectively. The minimum lease payments, net of sublease payments, under the terms of the lease agreements for the years ending December 31 are as follows:
Performance Guarantees
At December 31, 2004 the Company’s Danish subsidiary has outstanding bank performance guarantees totaling 2,373 Danish Kroner (approximately $435 in U.S. dollars) issued in 1999 through 2002 in connection with sales contracts to foreign governments. These bank performance guarantees expire in 2005 and 2006 but are not officially released until the customer notifies the bank that renewal is not required. In addition, during 2004, the Company issued a performance bond of $88 collateralized by a letter of credit issued by Silicon Valley Bank under the Company’s line of credit in connection with a sales contract with a city municipality. The performance bond expires in November 2007. The Company has no further performance obligations under these contracts other than providing normal warranty service on the products sold under the contracts.
17. Income Taxes
The Company’s provision for income tax represents the current state minimum taxes. There is no deferred income tax provision due to the valuation allowance.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
The temporary differences which give rise to the deferred tax provision (benefit) consist of the following for the years ended December 31:
The temporary differences which give rise to deferred income tax assets and liabilities at December 31 are as follows:
The provision for income taxes differs from the amount that would result from applying the federal statutory rate for the years ended December 31 as follows:
As of December 31, 2004, the Company has research and experimentation credit carry forwards for federal and state purposes of approximately $3,000 and $1,000, respectively. These credits begin to expire in 2006 for federal purposes and carry forward indefinitely for California state purposes. The Company has capital loss carry forwards of approximately $1,000 for both federal and state purposes which begin to expire in 2006 for federal purposes and carry forward indefinitely for state purposes. The Company also has approximately $139,000 and $69,000 of federal and state net operating loss carry forwards which will begin to expire in 2006 and 2005, respectively.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
Internal Revenue Code Sections 382 and 383, and similar state provisions place certain limitations on the annual amount of loss and credit carryforwards that can be utilized if certain changes to a company’s ownership occur. The acquisition of Survivalink in 2001 resulted in a change in ownership pursuant to Section 382 of the Internal Revenue Code. The annual limitation is as follows: $8,300 for 2005, $6,500 for 2006 and $1,800 thereafter. The amount of net operating loss subject to this limitation, for federal and state purposes, is approximately $53,000 and $24,000, respectively. Research and experimentation credits and capital loss carryovers are also subject to the limitation under Internal Revenue Code Sections 382 and 383 and similar state provisions. The utilization of net operating loss carryovers and other tax attributes may be subject to further substantial limitations if certain ownership changes occur in future periods.
The Company recorded deferred tax assets of approximately $16,000 upon the acquisition of Survivalink in 2001. The deferred tax assets are composed primarily of loss and tax credit carryforwards and other temporary differences. The deferred tax assets recorded were reduced by a valuation allowance of $16,000. Due to the expiration of some of the net operating loss carryovers the balance is $13,000 as of December 31, 2004. If the Company determines that it will realize the tax benefit related to these Survivalink deferred assets in the future, the related decrease in the valuation allowance will reduce goodwill instead of the provision for taxes.
The Company also recorded deferred tax assets of approximately $8,000 upon the acquisition of Cadent in 2000. The deferred tax asset was composed primarily of loss carryforwards and other temporary differences. The deferred tax assets recorded were also reduced by a valuation allowance of $8,000. Due to the expiration of some of the net operating loss carryovers, the balance is $7,000 as of December 31, 2004. If the Company determines that it will realize the tax benefit related to these Cadent deferred assets in the future, the related decrease in the valuation allowance will reduce goodwill instead of the provision for taxes.
Additionally, approximately $1,600 of the net operating loss carryforward represents deductions claimed as the result of stock options. If the Company determines that it will realize the benefit of this net operating loss carryforward in the future, the related decrease in the valuation allowance will be credited to additional paid-in capital instead of the provision for taxes.
At December 31, 2004, the Company had foreign net operating loss carryforwards. The losses carryover indefinitely, unless certain defined changes in business operations occur during the carryover period. The Company has established a full valuation allowance against these deferred tax assets since it cannot be established that these foreign subsidiaries’ net operating loss carryforwards will be fully utilized.
The American Jobs Creation Act of 2004 (the Act) was signed into law in October 2004, which allows companies to elect to repatriate cash into the United States in 2005 at a special temporary effective tax rate of 5.25%. The Company’s evaluation of the amount of foreign earnings that may elect to treat under this special provision, and the financial statement impact, is in progress. As such, the Company is not in a position to decide on whether, and to what extent, its foreign earnings will be affirmatively designated for this treatment. The related potential range of the income tax effect of the repatriation cannot be reasonably estimated at this time.
18. Stock Options
Stock Option/Stock Issuance Plan
In May 1998, the Company’s 1997 Stock Option/Stock Issuance Plan (the “1997 Plan”) was approved by stockholders at the Annual Meeting of Stockholders. All outstanding stock options under the Company’s 1991 Stock Option Plan and 1993 Stock Option Plan were exchanged for stock options in the 1997 Plan. The 1997 Plan provides for the granting of stock options intended to qualify as incentive stock options and stock options not intended to qualify as incentive stock options (“non-statutory options”) to employees of the Company, including officers, and non-statutory stock options to employees, including officers and directors of the Company, as well as to certain consultants and advisors.
The 1997 Plan is administered by a Compensation Committee (the “Committee”) which is comprised of three members appointed by the Company’s Board of Directors. The Committee may grant options to any officers, directors or key employees of the Company or its subsidiaries and to any other individuals whose participation in the 1997 Plan the Committee determines is in the Company’s best interest. In 2001, stockholders approved an amendment to the 1997 Plan to increase the number of shares of common stock up to a maximum of 8.8 million shares. In 2002, stockholders approved another amendment to increase the number of shares of common stock up to a maximum of 11 million shares. In 2003, stockholders approved another amendment to increase the number of shares of common stock up to a maximum of 14 million shares. The 1997 Plan is subject to adjustment upon the occurrence of certain events, including, but not limited to, stock dividends, stock splits, combinations, mergers, consolidations, reorganizations, reclassifications, exchanges, or other capital adjustments. The 1997 Plan limits to $100 the fair market value (determined at the time the option is granted) of the common stock with respect to which incentive stock options are first exercisable by any individual employee during any calendar year.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
The 1997 Plan incorporates the federal tax law requirements for incentive stock options. Among other such requirements, the per share exercise price of an incentive stock option granted under the 1997 Plan must not be less than 100% of the fair market value of a share of the common stock on the date of grant and the option may not be exercised more than 10 years after its grant date. If an incentive stock option is granted to an employee owning more than 10% of the total combined voting power of all classes of stock of the Company, the exercise price may not be less than 110% of such fair market value and the option may not be exercised more than five years after its grant date. Option grants under the 1997 Plan generally vest over a period of four years.
Outstanding options may be terminated or accelerated in the event of certain corporate acquisitions or other change of control events. An option granted under the 1997 Plan will not be assignable or transferable by the grantee other than by will or the laws of inheritance, except that a non-statutory option will be transferable by the grantee pursuant to a qualified domestic relations order as defined in the Code, Title I of the Employee Retirement Income Security Act or the rules thereunder. Other vesting, termination and payment provisions for incentive and non-statutory options may be determined by the Committee.
Stock option activity for the years ended December 31 is summarized as follows:
(1)
Includes 205,500 options to purchase shares of the Company’s common stock granted in 2001 outside the Plan and pursuant to consulting agreements for services rendered to the Company, 160,750 of which are still outstanding at December 31, 2004. The stock options issued to these consultants are subject to the same vesting requirements as employee stock options issued pursuant to the Company’s 1997 Stock Option/Stock Issuance Plan. The services contracted for included business sales services and consulting in the areas of operations, business plan implementation and marketing, and such services did not include capital raising activities.
(2)
Includes 475,500 options to purchase shares of the Company’s common stock granted in 2003 outside the Plan, 444,500 of which are still outstanding at December 31, 2004. The stock options issued to employees outside the U.S. are subject to the same vesting requirements as employee stock options issued pursuant to the Company’s 1997 Stock Option/Stock Issuance Plan.
(3)
Includes 369,000 options to purchase shares of the Company’s common stock granted in 2004 outside of the Plan, all of which are still outstanding at December 31, 2004. The stock options issued to employees outside the U.S. are subject to the same vesting requirements as employee stock options issued pursuant to the Company’s 1997 Stock Option/Stock Issuance Plan.
The following table summarizes information about stock options, including options granted outside the Plan, outstanding at December 31, 2004:
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
At December 31, 2004 there were 12,345,139 shares reserved or available for issuance under the 1997 Plan and 976,396 shares reserved or available for issuance outside of the 1997 Plan.
No stock options were granted to non-employees (consultants) during 2004, 2003 or 2002.
19. Warrants
Historically, the Company has granted warrants in connection with fund raising activities and as consideration for certain services. In 2003, warrants were also issued in connection with a distribution and development agreement (see note 20). The following summarizes warrants to purchase shares of common stock that were outstanding and exercisable at December 31, 2004 (see note 22 related to subsequent amendment of warrants):
20. Distribution and License Agreements
In December 1998, the Company entered into a five-year exclusive distribution and licensing agreement with Medtronic Physio-Control (“MPC”), a subsidiary of Medtronic, Inc. (“Medtronic”). In 2001, MPC provided the Company with notice that, among other things, the acquisition of Survivalink (see Note 8), a significant competitor of MPC, placed MPC at substantial risk of violating restrictions placed on Medtronic by the Federal Trade Commission in connection with Medtronic’s acquisition of Physio-Control. MPC believed these restrictions, among other things, directly impacted MPC’s ability to continue its relationship with Cardiac Science. MPC had stated that in light of such fact, it believed it to be in the best interests of the parties to terminate the agreement. The Company entered into a settlement agreement and mutual release with MPC in February 2002. The terms of this settlement agreement provided that MPC return to the Company, at no charge, approximately 220 Powerheart units, which MPC had previously purchased and paid for, in substantially the same condition in which the units were originally sold to MPC. Additionally, the Company owed MPC $1.1 million pursuant to a senior secured promissory note issued by the Company to MPC in the merger transaction between the Company and Survivalink. This $1.1 million is part of the $25.8 million of senior secured promissory notes issued in the Survivalink merger. Pursuant to this settlement agreement, MPC agreed to forgive and release payment of $832 of the amount owing under the promissory note to MPC.
In July 2003, the Company entered into two separate agreements with GE Healthcare under which they will market the Company’s AED and CRM products under the GE Healthcare name in international markets. Under the OEM Purchase and Supply Agreement (the “OEM Agreement”), the Company sells to GE Healthcare a private labeled version of its G-3 AED and CRM products. GE Healthcare has the right to sell these products on a non-exclusive basis worldwide, excluding Japan. Product pricing is fixed for the term of the OEM Agreement irrespective of volume purchased. The term of the OEM Agreement is three years and there are no minimum purchase requirements. The Company began shipping AED and CRM products to GE Healthcare in September 2003. Under the OEM Purchase Agreement (the “Development Agreement”), the Company has agreed to develop and manufacture for GE Healthcare a line of standard “crash-cart” type defibrillators which incorporate the Company’s proprietary technology, as well as certain GE Healthcare technology. GE Healthcare has the exclusive worldwide marketing and distribution rights to this product line. Product prices are tied to annual purchase quantities. The term of the Development Agreement is three years from the date GE Healthcare receives product for resale, but may be cancelled by GE Healthcare if certain product development milestones are not met. In the Development Agreement, GE Healthcare agreed to minimum purchases quantities per calendar quarter, commencing with the first full calendar quarter after the delivery of product for resale. The minimum purchase requirements are subject to certain product development and regulatory milestones being met by the Company. To date, all costs incurred related to this Development Agreement have been expensed as incurred. In connection with the Development Agreement, the Company issued to GE Healthcare a warrant to purchase 750,000 shares of common stock at an exercise price of $3.00 per share. The warrants must be exercised by July 29, 2007, or within 30 days of termination in the event that the Development Agreement is terminated by GE Healthcare. The Company followed the guidance of EITF No. 96-18 “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” and EITF No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).” The Company determined the fair value using the Black-Scholes model. The significant assumptions used were: stock price of $2.54; risk free rate of 2.27%; volatility of 0.67; dividend yield of 0%; and contractual term of 4 years. The value of the warrants of $907 was recorded to Other Assets in the accompanying consolidated balance sheet and will be amortized as a reduction of revenue beginning with the first shipment of the product over the term of the Development Agreement in accordance with EITF No. 01-9.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
21. Supplemental Cash Flow Disclosures
22. Subsequent Events
On January 28, 2005, the Company entered into an amendment and limited waiver (the “Amendment”) to the Senior Note and Warrant Purchase Agreement dated as of May 29, 2002, as amended July 1, 2003, further amended March 15, 2004, with the Senior Note Holders. Pursuant to the terms of the Amendment, the Company and the Senior Note Holders agreed to: (i) extend the maturity date of the $50,000 in aggregate principal amount of Senior Notes issued under the Agreement by 12 months to May 29, 2008; (ii) defer all cash interest payments until maturity; and (iii) modify certain financial covenants regarding minimum EBITDA, minimum debt to capitalization and maximum capital expenditures, and delete certain other financial covenants for 2005 through maturity. Additionally, the Senior Note Holders waived certain covenant violations, including all financial covenant violations for the quarter and year ended December 31, 2004. In exchange for modifying the Agreement the Company and the Senior Note Holders agreed to reduce the number of warrants to purchase shares of common stock to 13,438,599 and reduce the exercise price of those warrants to $2.00 per share, down from the original weighted average price of approximately $3.21 per share.
CARDIAC SCIENCE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(In thousands, except share and per share data)
In January 2005, as consideration for delays in filing the required registration statement related to our July 2004 private placement, the Company agreed with those investors to make a cash payment of $556, to issue an additional 476,637 shares of common stock, and to reduce the exercise of all warrants to $2.50 per share. We expect to incur expense of approximately $1,500 in 2005 in connection with this transaction.
On February 28, 2005 the Company announced the signing of a definitive merger agreement with Quinton Cardiology Systems, Inc (“Quinton”). The transaction was unanimously approved by the boards of directors of both companies and is anticipated to close during the third quarter of 2005, subject to regulatory review, the approval of its respective shareholders and other customary closing conditions. The merger agreement calls for each Company shareholder to receive 0.10 of a share of common stock of the new company for each share of Company common stock owned and each Quinton shareholder to receive approximately 0.77 of a share of common stock of the new holding company for each share of Quinton common stock owned. The number of all Company and Quinton stock options and warrants outstanding at the effective time of the transaction, as well as their respective exercise prices, will be adjusted in accordance with the same exchange ratios. In connection with the transaction, the Company’s senior note holders have agreed to exchange the entire balance of principal and accrued interest under such notes, or approximately $61,000, as well as warrants to purchase approximately 13,438,599 shares of the Company’s common stock, for an aggregate of $20,000 in cash and $53,750, or approximately 13 percent, of the new holding company’s common stock.
In early March 2005, several class action complaints were filed in the Chancery Court of Delaware concerning the recent Merger Agreement entered into with Quinton. The complaints allege that the Company’s board breached its fiduciary obligations with respect to the transaction in two ways. First, the board purportedly did not negotiate for sufficient compensation for the Company, as opposed to the compensation received by Quinton. Second, the board allegedly engaged in self-dealing because the Senior Note Holders purportedly received more than their fair share in the merger, as opposed to the common stockholders. The complaints seek, inter alia, an injunction enjoining the proposed merger, rescissionary damages if the merger is completed, and an order that the board hold an auction to obtain the Company’s best value. The Company has retained legal counsel and intends to defend the cases vigorously.
Financial Statement Schedule
CARDIAC SCIENCE, INC.
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS
For The Years Ended December 31, 2004, 2003 and 2002
(in thousands)
(1) Includes a $2,917 impairment charge
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures.
Our management, including the Chief Executive Officer, Chief Financial Officer and Vice President Finance, conducted an evaluation as of the end of the period covered by this annual report of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934 as amended). Based on that evaluation, our management concluded that the disclosure controls and procedures were effective in ensuring that all material information required to be disclosed in the reports we file and submit under the Securities and Exchange Act of 1934, as amended, have been made known to them on a timely basis and that such information has been properly recorded, processed, summarized and reported, as required.
Changes in Internal Control Over Financial Reporting.
There have been no significant changes in our internal control over financial reporting during the most recent fiscal quarter ended December 31, 2004 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Our management conducted as evaluation of the effectiveness of our internal control over financial reporting based on the criteria set forth in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our assessment, we have concluded that, as of December 31, 2004, the Company’s internal control over financial reporting is effective based on those criteria.
Our management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein
ITEM 9B
ITEM 9B OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The following table sets forth certain information with respect to the directors and executive officers of the Company as of December 31, 2004:
Raymond W. Cohen has served as the Company’s Chairman and Chief Executive Officer since September 2003 and as the Company’s President, Chief Executive Officer, and as a member of the Board of Directors since joining the Company in January 1997. Prior to joining the Company, Mr. Cohen was President of Diagnostic Monitoring, a privately held manufacturer and international distributor of non-invasive cardiac monitoring devices which was acquired by Cardiac Science in 1997. From 1982 to 1990, Mr. Cohen held various sales and marketing positions in firms that manufactured and marketed cardiology products including Brentwood Instruments, Inc., where he was instrumental in the Company being ranked in Inc. Magazine’s list of Fastest Growing Small Public Companies from 1986 through 1988. Mr. Cohen holds a B.S. in Business Management from the State University of New York at Binghamton.
Howard L. Evers has served as President and Chief Operating Officer since September 2003, as Executive Chairman of the Company’s Board of Directors since April 2001 and as a member of the Company’s Board of Directors since March 1998. Prior to joining the Company, Mr. Evers served as President, Chief Executive Officer and Chairman of the Board of Diagnostics On Call, a mobile x-ray and EKG services provider to the long-term care and home health care markets. From 1992 to 1995, he was the Chief Executive Officer and Chairman of the Board of PSI, a medical supply distribution company servicing the physician office market. From 1988 to 1992, Mr. Evers was the Chief Executive Officer and Chairman of the Board of Lake Industries, an environmental services company. From 1973 to 1988, Mr. Evers was President and Chief Executive Officer of Tru Green Corporation, a lawn, tree and shrub care and pest control company sold to Waste Management Inc. in 1987.
Roderick de Greef has served as the Company’s Executive Vice President, Chief Financial Officer and Secretary since March 2001. From 1995 to 2001, Mr. de Greef has provided corporate finance advisory services to a number of early stage companies including Cardiac Science, where he was instrumental in securing the Company’s equity capital beginning in 1997, and advising on merger and acquisition activity. From 1989 to 1995, Mr. de Greef was Vice President and Chief Financial Officer of BioAnalogics, Inc. and International BioAnalogics, Inc., both publicly held, development stage medical technology companies located in Portland, Oregon. From 1986 to 1989, Mr. de Greef was Controller and then Chief Financial Officer of publicly held Brentwood Instruments, Inc. Mr. de Greef has a B.A. in Economics and International Relations from California State University at San Francisco and an M.B.A. from the University of Oregon. Mr. de Greef also serves on the boards of Endologix, Inc. (Nasdaq: ELGX), a developer, manufacturer and seller of minimally invasive therapies for the treatment of cardiovascular disease, BioLife Solutions, Inc. a public biotechnology company located in Binghamton, New York and DentalView, Inc. an Irvine-based privately held medical device company.
Kenneth F. Olson has served as the Company’s Chief Technical Officer since the Company’s merger with Survivalink in September 2001. Mr. Olson previously held the position of Vice President of Research and Development for Survivalink Corporation from August 1995 after holding the position of Director of Engineering from January 1993 to July 1995. From June 1992 to December 1992, Mr. Olson was Senior Design Engineer for Ancor Communications, a high-speed communications switching company. From June 1990 to June 1992, Mr. Olson was Senior Design Engineer for Network Systems Corporation, a computer network design company. Mr. Olson holds a Master of Business Administration degree and a Bachelor’s degree in Electrical Engineering, both from the University of Minnesota and is named as an inventor on more than 30 U.S. and International issued patents.
Michael Gioffredi has served as the Company’s Chief Marketing Officer since December 2003 and Vice President, Sales and Marketing since September 1998. Mr. Gioffredi previously held the position of Vice President, Sales and Marketing for Britesmile, Inc., a public dental laser technology company located in Salt Lake City. Prior to 1997, Mr. Gioffredi was Senior Vice President, Marketing and Business Development for the EMPath Group, a private emergency medicine consulting firm and Vice President, Marketing for Laserscope, Inc., a publicly traded medical laser company. From 1982 to 1993, Mr. Gioffredi held marketing management and sales positions with the cardiology and cardiovascular divisions of C.R. Bard, Inc., a fortune 500 medical device company. Mr. Gioffredi has a BA in Business Administration and Marketing from California State University at Fullerton.
Dongping Lin, Ph.D., has served as the Company’s Chief Software Architect since November 2000. Dr. Lin held the position of Chief Technical Officer from July 1998 to November 2000. Dr. Lin held the position of Director of Software Engineering from January 1997 until July 1998. Dr. Lin joined the Company as Software Development Manager in January 1993. From 1988 to 1993, Dr. Lin held senior software engineering positions at Del Mar Avionics located in Irvine, Calif. Dr. Lin received his B.S. in Electrical Engineering from Beijing Normal University in Beijing, China. Dr. Lin received an M.S.E. in Computer Engineering and Ph.D. in Electrical Engineering and Computer Science from the University of Michigan. Dr. Lin is recognized as an expert in the field of computer arrhythmia analysis and real-time ventricular tachyarrhythmia detection and is a named inventor on four issued patents.
Prabodh Mathur has served as the Company’s Chief Product Development Officer since May 2000. Mr. Mathur previously held the position of Vice President of Research & Development from the Company’s formation in 1991 through January 1997. Between 1997 and April 2000, Mr. Mathur was the Vice President of Engineering at Medstone International Inc., a manufacturer of shockwave lithotripters used in the treatment of kidney stones. Between 1986 and 1991, Mr. Mathur held various positions in the engineering department of Medstone, where he was initially responsible for software development, and finally, for all product development activities as head of the department. From 1983 to 1986, Mr. Mathur was a senior research engineer for Amada Laser Systems, Inc., a subsidiary of Amada, Japan, where he was responsible for integrating lasers and robots for material processing applications. Mr. Mathur earned an MS degree in Mechanical Engineering from the University of Missouri in 1983 and a BS degree in Mechanical Engineering from the Indian Institute of Technology in 1981.
Peter Crosby has been a member of the Company’s Board of Directors since November 1997. Mr. Crosby is Chief Operating Officer of Ventracor Limited, an international medical device company focused on an artificial heart device. From 1999 to 2004, Mr. Crosby was Chief Executive Officer of Ischemia Technology, Inc. From 1997 to 1999 Mr. Crosby consulted for various medical device companies. Mr. Crosby was CEO and a director of NeoVision Corporation, an ultrasound imaging system developer until NeoVision was sold to United States Surgical Corporation in September 1997. From 1981 to 1996, Mr. Crosby held numerous senior management positions for Nucleus Group, an Australian medical device company and a division of Pacific Dunlop, Ltd. During his tenure at Nucleus, he served as Vice President, R&D, and Vice President of Business Development for Telectronics Pacing Systems, a global developer of implantable medical devices such as defibrillators, pacemakers and cardiomyoplasty stimulators. Mr. Crosby is the author of many publications, holds numerous patents in the defibrillation technology field, and has a B.S. in Electrical Engineering and a M.E.S. from the University of Melbourne, Australia. Mr. Crosby also serves as chairman of the board of Cardiocomm Solutions, a Canadian developer of ECG software products.
Brian H. Dovey has been a member of the Company’s Board of Directors since August 2000. Mr. Dovey has been a General Partner of Domain Associates since 1988. Since joining Domain, he has served as Chairman of Athena Neurosciences, Creative BioMolecules, and Univax Biologics. He has also served on the Board of Directors of British Biotech, Connetics, Geron, Nabi, ReSound Corp., Trimeris, and Vivus, as well as several private companies. In 1983, Mr. Dovey joined Rorer Group, Inc. (now Aventis). As President of Rorer from 1986 to 1988, he was the primary architect of that Fortune 500 company’s strategic shift to pharmaceuticals that resulted in a doubling of annual sales to approximately $1 billion. Previously, Mr. Dovey was President of Survival Technology, Inc., a medical products company whose sales growth placed it in the top ten of the Inc. 100; he has also held management positions with Howmedica, Inc., Howmet Corporation, and New York Telephone. Mr. Dovey has served as both President and Chairman of the National Venture Capital Association and is on the Board of Trustees for the Coriell Institute and the University of Pennsylvania School of Nursing. He is currently listed in Marquis Who’s Who and is a former Board Member of the Health Industry Manufacturers Association and the Non-Prescription Drug Manufacturers Association. Mr. Dovey has a B.A. from Colgate University and an M.B.A. from Harvard Business School.
Ray E. Newton, III has been a member of the Company’s Board of Directors since May of 2002. Mr. Newton is a Managing Director of Perseus, LLC, a merchant bank and private equity fund management company with offices in Washington D.C. and New York City. Prior to joining Perseus, Mr. Newton was a general partner at J.H. Whitney & Co., a private equity and subordinated debt investment firm. Mr. Newton joined Whitney as an associate in 1989 and in 1992 was named the youngest general partner in the firm’s 52-year history. While at Whitney, Mr. Newton was responsible for all aspects of the investment process, including identifying and developing opportunities, negotiating and closing transactions, developing strategic plans and liquidity paths for portfolio companies, and monitoring limited partner relationships. Prior to Whitney, Mr. Newton was in the Merchant Banking Department at Morgan Stanley & Co., Incorporated. Mr. Newton holds an M.B.A. from Stanford University’s Graduate School of Business and a B.A., magna cum laude, from Princeton University.
Jeffrey O’Donnell Sr. has been a member of the Company’s Board of Directors since September of 2003. Mr. O’Donnell is the President and Chief Executive Officer and a member of the Board of Directors of PhotoMedex (Nasdaq: PHMD) since 1999. Prior, he served as President and CEO of Irvine, CA-based Radiance Medical Systems (originally Cardiovascular Dynamics) from 1997 to 1999, having joined that company as Vice President of Sales and Marketing in 1995. He subsequently assumed a role as non-executive Chairman of the Board at that company. From 1994 to 1995, Mr. O’Donnell held the position of President and CEO of Exton, PA-based Kensey Nash Corporation. Additionally, he has held several senior sales and marketing management positions at Boston Scientific, Guidant and Johnson & Johnson Orthopedic. Mr. O’Donnell currently serves on a number of corporate boards and has a bachelor’s degree in business administration and marketing from La Salle University, in Philadelphia, PA.
Bruce Barclay has been a member of the Company’s Board of Directors since September of 2003. Since 2003, Mr. Barclay has been President and Chief Operating Officer of SurModics, Inc., a leading provider of surface modification and drug delivery for medical device and biomedical applications. He is also a member of the Board of Directors of SurModics. From 2000 to 2003, Mr. Barclay served as the President and Chief Executive Officer of Vascular Architects, a venture capital backed private company focused on the treatment of peripheral vascular disease. Mr. Barclay has over 25 years of experience in the healthcare industry, including Eli Lilly and Company and Guidant Corporation. Mr. Barclay served at Guidant in both business and legal roles. His tenure at Guidant culminated in the position of Senior Vice President and an Officer of the Company. Mr. Barclay has earned bachelor degrees in biology and chemistry from Purdue University and a law degree from Indiana University School of Law.
There is no family relationship between any of the directors or executive officers of the Company. Section 16(a) Beneficial Ownership Reporting Compliance.
Audit Committee and Audit Committee Financial Expert
The members of the Audit Committee of the Board of Directors (the “Audit Committee”) are Messrs. Dovey, Crosby, and O’Donnell, all of whom meet the definition of “independence” set forth in the NASDAQ corporate governance listing standards. The Board of Directors has also designated Mr. Dovey as our “audit committee financial expert,” as defined by the rules of the SEC. The Audit Committee’s responsibilities include: (i) reviewing the independence, qualifications, services, fees, and performance of the independent auditors, (ii) appointing, replacing and discharging the independent auditors, (iii) pre-approving the professional services provided by the independent auditors, (iv) reviewing the scope of the annual audit and reports and recommendations submitted by the independent auditors, and (v) reviewing our financial reporting and accounting policies, including any significant changes, with management and the independent auditors.
Code of Ethics and Conduct
We have adopted a Code of Ethics and Conduct that is applicable to all of our directors, officers and employees and have posted this Code of Ethics and Conduct on our website at www.cardiacscience.com.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company’s directors, officers, and any persons holding more than ten percent of the Company’s common stock to file reports of their initial ownership of the common stock and any subsequent changes in that ownership with the Securities and Exchange Commission. Specific filing deadlines of these reports have been established, and the Company is required to disclose any failure to meet such deadlines during the year ended December 31, 2004. Based solely on a review of such reports furnished to the Company, the Company believes all of these filing requirements have been satisfied.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The following table sets forth information regarding compensation paid by the Company to its Chief Executive Officer and to the Company’s four most compensated executive officers, other than the Chief Executive Officer, who received salary and bonus payments in excess of $100,000 during the year ended December 31, 2004 (collectively the “Named Executive Officers”).
Summary Compensation Table
(1) Annual automobile allowance.
(2) Personal use of company vehicle
(3) Annual automobile allowance of $12,000 plus $37,217 taxable commuting travel expenses
(4) Annual automobile allowance of $12,000 plus $10,912 taxable commuting travel expenses
Option Grants In 2004
The following table provides information related to options granted to each of the Named Executive Officers during the year ended December 31, 2004.
(1) Represents shares of common stock underlying stock options. These options vest over four years, 25% of such options are exercisable on the first anniversary of the grant date and the remaining options vest monthly thereafter.
Aggregated Option Exercises In 2004 and Year-End Option Values
The following table sets forth certain information as of December 31, 2004 regarding options held by the Named Executive Officers.
______________________
(1) The closing price of the common stock on December 31, 2004 was $2.14. Value is calculated on the difference between the exercise price of in-the-money options and multiplied by the number of shares of common stock underlying the option.
Employment Agreements
Mr. Cohen entered into an employment agreement with the Company effective as of December 31, 2002. This employment agreement was subsequently amended on August 20, 2004. Mr. Cohen’s employment agreement provides for an initial base salary of $349,500, an annual incentive bonus based on Mr. Cohen meeting certain performance objectives, and certain perquisites and participation in employee benefit programs made available to other senior executives. The initial term of the employment agreement is three years. The terms of the employment agreement provide that on January 1, 2006, and each successive anniversary thereafter, the term of the employment agreement will automatically extend by one year unless the Company delivers to Mr. Cohen a notice not to extend the employment term. The terms of the employment agreement provide that if Mr. Cohen’s employment is involuntarily terminated by the Company without cause, he will be entitled to severance equal to his base salary, payable over the course of twelve months, plus a pro rata incentive bonus for the year of termination; or if Mr. Cohen’s employment is involuntarily terminated by the company due to a change in control of the Company, or if Mr. Cohen resigns for good reason, he will be entitled to severance equal to two times his base salary, payable over the course of two years, plus a pro rata incentive bonus for the years of severance. In either event, Mr. Cohen would also be entitled to retirement benefits together with continued health, life insurance and other employee welfare benefits during the years of severance. Any unvested stock options or shares of restricted stock held on the date of such event shall continue to vest over the severance period.
Mr. Evers entered into an employment agreement with the Company effective as of December 31, 2002. This employment agreement was subsequently amended on August 20, 2004. Mr. Evers’ employment agreement provides for an initial base salary of $240,000, an annual incentive bonus based on Mr. Evers meeting certain performance objectives and certain perquisites and participation in the employee benefit programs made available to other senior executives. The initial term of the employment agreement is three years. The terms of the employment agreement provide that on January 1, 2006, and each successive anniversary thereafter, the term of the employment agreement will automatically extend by one year unless the Company delivers to Mr. Evers a notice not to extend the employment term. The employment agreement provides that if Mr. Evers’ employment is involuntarily terminated by the Company without cause or due to a change of control of the Company, or if Mr. Evers resigns for good reason, he will be entitled to severance equal to his base salary, payable over twelve months, together with continued retirement, health, life insurance and other employee welfare benefits for one year, plus a pro rata incentive bonus for the year of termination. Any unvested stock options or shares of restricted stock held on the date of such event shall continue to vest over a twelve-month period.
Mr. de Greef entered into an employment agreement with the Company effective as of December 31, 2002. This employment agreement was subsequently amended on August 20, 2004. Mr. de Greef’s employment agreement provides for an initial base salary of $240,000, an annual incentive bonus based on Mr. de Greef meeting certain performance objectives, and certain perquisites and participation in the employee benefit programs made available to other senior executives. The initial term of the employment agreement is three years. The terms of the employment agreement provide that on January 1, 2006, and each successive anniversary thereafter, the term of the employment agreement will automatically extend by one year unless the Company delivers to Mr. de Greef a notice not to extend the employment term. The employment agreement provides that if Mr. de Greef’s employment is involuntarily terminated by the Company without cause or due to a change of control of the Company, or if Mr. de Greef resigns for good reason, he will be entitled to severance equal to his base salary, payable over twelve months, together with continued retirement, health, life insurance and other employee welfare benefits for one year, plus a pro rata incentive bonus for the year of termination. Any unvested stock options on shares of restricted stock held on the date of such event shall continue to vest over a twelve-month period.
Each of Messrs. Evers, Cohen and de Greef’s agreements provides a car allowance of up to $12,000 per annum.
The Company is also a party to at-will employment agreements with the other named executive officers. Each agreement automatically renews annually unless the Company or the employee shall give the other written notice of termination. The agreements provide for a base salary, plus such bonuses and stock options based on incentive plans approved by the Board of Directors. Each agreement contains a non-competition covenant. The agreements also provide that in the event of an involuntary termination:
• each employee shall receive his base salary and retirement and welfare benefits for six to twelve months following the event as well as a pro rata portion of their target bonus; and
• any unvested stock options or shares of restricted stock held on the date of such event shall continue to vest over a six to twelve-month period.
Compensation Committee Interlocks and Insider Participation
The current members of the Compensation Committee of the Board of Directors are Messrs. Barclay, Dovey and O’Donnell. No interlocking relationship exists between any member of the Board of Directors or the Compensation Committee and any member of the board of directors or compensation committee of any other company.
Compensation of Directors
The non-employee members of the Board of Directors receive an annual retainer of $20,000. The directors also are reimbursed for expenses incurred in attending meetings of the Board of Directors and its committees. Directors also are eligible to receive options under the Company’s 1997 Stock Option/Stock Issuance Plan.
Compensation Committee Report on Executive Compensation
This report, prepared by the Compensation Committee, addresses the Company’s executive compensation policies and the basis on which 2004 executive officer compensation determinations were made. The Compensation Committee designs and approves all components of the executive pay.
During 2004, the Compensation Committee members were Messrs. Barclay, Dovey and O’Donnell.
Compensation Philosophy
The Company’s executive compensation policies are intended to attract, retain, motivate and reward executives who can lead the Company in achieving its long-term growth and earnings goals. The objective of the Compensation Committee is to implement a compensation program that will provide appropriate incentives while, at the same time, encourage executive officers to increase their equity ownership in the Company and thereby align their interests with those of the Company’s stockholders. The compensation program consists primarily of three components, namely (a) base salary, (b) bonus and (c) stock options. Each of these factors are further described below. In addition, executive officers are eligible to participate, on a non-discriminatory basis, in various benefit programs provided to all full-time employees, including the Company’s 401(k) plan and group medical, disability and life insurance programs. The Compensation Committee believes that executive compensation packages should be viewed as a whole in order to properly assess their appropriateness.
In establishing total compensation packages for the Company’s executive officers, the Compensation Committee takes into account the compensation packages offered to executives of other medical device design and manufacturing companies of similar stature. The Compensation Committee uses this comparative data primarily as benchmarks to ensure that the Company’s executive compensation packages are competitive and comparable. Individual amounts are based not only on comparative data, but also on such factors as length of service with the Company and the Compensation Committee’s judgment as to individual contributions. These factors are not assigned specific mathematical weights. The Compensation Committee generally meets quarterly and at other times that it deems are necessary and, from time to time, confers with outside advisors concerning acceptable industry practices.
Salary
Except in the case of a multi-year employment agreement, base salaries are reviewed annually. It is the Compensation Committee’s intention to pay an at-market base salary and provide a significant equity ownership opportunity to create incentives for the Company’s executive officers to maximize the Company’s growth and success while increasing stockholders’ value over the long term. Changes in base salary from time to time depend upon such factors as individual performance, cost of living changes and the economic and business conditions affecting the Company.
Bonus
Executive bonuses are determined in accordance with achievement of the Company’s goals for the most recent fiscal year. The amounts are intended to reward management for achieving certain milestones set out at the beginning of the fiscal year which may under certain circumstances be modified throughout the year. The cash bonus for the Chief Executive Officer is also influenced by his ability to execute strategic plans determined by the Board of Directors, including merger and acquisition programs.
Stock Options
As noted above, stock options are an important component of total executive compensation. Stock options are considered long-term incentives that link the long-term interests of management with those of the Company’s stockholders. Stock options that the Compensation Committee has granted to executive employees generally vest over a four year period. 25% of such options are exercisable on the first anniversary of the grant date and the remaining options vest at the rate of 1/36th per month thereafter. The Compensation Committee has absolute discretion to determine the recipients and the number of options to be awarded. Each award is at the Committee’s discretion and is not subject to any specific formula or criteria. The Compensation Committee generally awards options on an annual basis. The number of shares for which options were granted to executive officers in fiscal 2003 was determined by the Compensation Committee based upon several factors, including the executive’s position, his or her past and future expected performance, the comparative data described above, and the number of shares under options previously granted. These factors were evaluated in a qualitative manner and were not assigned predetermined weights.
Compensation of Raymond W. Cohen, Chairman and Chief Executive Officer
During 2004, the compensation of Mr. Cohen was determined by applying the same criteria discussed in this report used to determine salaries, bonuses and stock option grants for all executive officers. Mr. Cohen’s compensation for 2004 is set forth in the Summary Compensation Table
Date: March 16, 2005
Comparison of Cumulative Total Stockholder Return
The following chart provides an annual comparison, from December 31, 1999 of the cumulative total shareholder return (assuming reinvestment of any dividends) among the Company, the Russell 2000 Index and a self constructed peer group consisting of three medical device companies. The Russell 2000 Index covers a broad cross-section of public companies, many of which have relatively small market capitalizations. The historical information set forth below is not necessarily indicative of future performance.
COMPARES 5-YEAR CUMULATIVE TOTAL RETURN
AMONG CARDIAC SCIENCE,
RUSSELL 2000 INDEX
AND SELF CONSTRUCTED PEER GROUP
ASSUMES $100 INVESTED ON DEC. 31, 1999
ASSUMES DIVIDEND REINVESTED
FISCAL YEAR ENDING DEC. 31, 2004
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The following table sets forth certain information, as of December 31, 2004, regarding beneficial ownership of the Common Stock by:
• each stockholder known by the Company to be the beneficial owner of more than five percent (5%) of the outstanding shares of Common Stock;
• each Director of the Company;
• each Named Executive Officer of the Company; and
• all of the Company’s current executive officers and directors as a group.
* Less than 1%.
(1) Shares of common stock subject to options and warrants currently exercisable or exercisable within 60 days of the date hereof are deemed outstanding for computing the number of shares beneficially owned and the percentage of outstanding shares of the class held by a person holding such options or warrants, but are not deemed outstanding for computing the percentage of any other person. Except as indicated by footnote, and subject to community property laws where applicable, the persons named in the table have sole voting and investment power with respect to all shares of common stock shown as beneficially owned by them.
(2) Includes 14,599,340 shares issuable upon exercise of outstanding warrants owned by Perseus Acquisition/Recapitalization Fund, LLC, Perseus Market Opportunity Fund, LP and Cardiac Science Co-Investment, LP. Frank H. Pearl, an executive officer of Perseus, LLC, may be deemed a beneficial owner of the shares.
Raymond E. Newton, III, is a member of our board of directors and a Managing Director of Perseus EC, L.L.C. Perseus Acquisition/Recapitalization Management, L.L.C. is a Managing Member of Perseus Acquisition/Recapitalization Fund, L.L.C. Perseus EC, L.L.C. is a Managing Member of Perseus Acquisition/Recapitalization Management, L.L.C. Perseuspur, L.L.C. is a Managing Member of Perseus EC, L.L.C. By reason of such relationships, each of (i) Perseus Acquisition/ Recapitalization Management, L.L.C, (ii) Perseus EC, L.L.C., and (iii) Perseuspur, L.L.C. may be deemed to have the power to direct the voting and disposition of the shares beneficially owned by Perseus Acquisition/ Recapitalization Fund, L.L.C. Mr. Frank H. Pearl, a Managing Director of Perseus EC, L.L.C., may also be deemed to have the power to direct the voting and disposition of the shares beneficially owned by Perseus Acquisition/ Recapitalization Fund, L.L.C.
Raymond E. Newton, III, is also a Managing Director of Perseus, L.L.C. Perseus Market Opportunity Partners, L.P. is a General Partner of Perseus Market Opportunity Fund, L.P. Perseus Market Opportunity Partners GP, L.L.C. is a General Partner of Perseus Market Opportunity Partners, L.P. Perseus, L.L.C. is a Managing Member of Perseus Market Opportunity Partners, L.P. Perseus MF, L.L.C. is a Managing Member of Perseus, L.L.C. By reason of such relationships, each of (i) Perseus Market Opportunity Partners, L.P, (ii) Perseus Market Opportunity Partners GP, L.L.C., (iii) Perseus, L.L.C., and (iv) Perseus MF, L.L.C. may be deemed to have the power to direct the voting and disposition of the shares beneficially owned by Perseus Market Opportunity Fund, L.P. Mr. Frank H. Pearl, a Managing Director of Perseus, L.L.C., may also be deemed to have the power to direct the voting and disposition of the shares beneficially owned by Perseus Market Opportunity Fund, L.P.
Raymond E. Newton, III, is also a Managing Director of Perseus EC, L.L.C. Perseus Acquisition/Recapitalization Management, L.L.C. is a General Partner of Cardiac Science Co-Investment, L.P. Perseus EC, L.L.C. is a Managing Member of Perseus Acquisition/Recapitalization Management, L.L.C. Perseuspur, L.L.C. is a Managing Member of Perseus EC, L.L.C. By reason of such relationships, each of (i) Perseus Acquisition/ Recapitalization Management, L.L.C, (ii) Perseus EC, L.L.C., and (iii) Perseuspur, L.L.C. may be deemed to have the power to direct the voting and disposition of the shares beneficially owned by Cardiac Science Co-Investment, L.P. Mr. Frank H. Pearl, a Managing Director of Perseus EC, L.L.C., may also be deemed to have the power to direct the voting and disposition of the shares beneficially owned by Cardiac Science Co-Investment, L.P.
(3) Individuals having investment power over Domain Partners are:
(4) Includes 1,943,749 shares issuable upon exercise of outstanding vested options.
(5) Includes 647,499 shares issuable upon exercise of outstanding vested options.
(6) Includes 90,988 shares issuable upon exercise of outstanding vested options.
(7) Includes 6,930,467 shares owned by Domain Partners and listed elsewhere in this table. Mr. Dovey is an affiliate of Domain Partners and may be deemed to beneficially own such shares. Mr. Dovey disclaims beneficial ownership of such shares. Also includes 79,686 shares issuable upon exercise of outstanding vested options.
(8) See footnote 2.
(9) Includes 35,000 shares issuable upon exercise of outstanding warrants and 783,771 shares issuable upon exercise of outstanding vested options.
(10) Includes 513,332 shares issuable upon exercise of outstanding vested options.
(11) Includes 114,582 shares issuable upon exercise of outstanding vested options
(12) Includes 285,936 shares issuable upon exercise of outstanding vested options.
(13) Includes 226,041 shares issuable upon exercise of outstanding vested options.
(14) Includes 35,000 shares issuable upon exercise of outstanding warrants and 4,774,124 shares issuable upon exercise of outstanding vested options.
Equity Compensation Plan Information
(1) Includes 974,250 options to purchase shares of the Company’s common stock issued to international employees and pursuant to consulting agreements for services rendered to the Company. The stock options issued to these consultants are subject to the same vesting requirements as employee stock options issued pursuant to the Company’s 1997 Stock Option/Stock Issuance Plan.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
In November 2004, we agreed to cancel 277,682 shares of common stock beneficially owned by Raymond W. Cohen, our Chairman and Chief Executive Officer, in exchange for the cancellation of an outstanding promissory note payable to the Company by Mr. Cohen in an aggregate amount of approximately $588,690, including accrued interest. The cancellation of the shares held by Mr. Cohen was not part of a publicly announced repurchase plan or program.
In May 2002, we entered into a Senior Note and Warrant Purchase Agreement (“the Agreement”) with investors, pursuant to which the investors loaned the Company $50,000. In March 2004, we amended the Agreement in order to ease certain financial covenants into 2005 to reflect our actual and expected financial results. In exchange for these modifications, we issued the note holders 500,000 additional warrants to purchase shares of common stock at $3.95 per share. The warrants were valued at $1,301 using a Black-Scholes model. The value of the warrants was recorded as additional discount to the Senior Notes to be amortized over the remaining term of the Senior Notes using the effective interest method.
Under the antidilution provisions of the Agreement, which were triggered by our September 2003 and July 2004 private placements and our July 2003 warrant issuance to GE Healthcare, an additional 205,451 warrants were issuable to the note holders at exercise prices ranging from $2.97 to $3.88. In addition, the exercise prices of the original warrants issued were also reduced to: (i) $2.97 for the 10,000,000 warrants that had an original exercise price of $3.00, (ii) $3.88 for the 3,000,000 warrants that had an original exercise price of $4.00, and (iii) $3.86 for the 500,000 warrants that had an original exercise price of $3.95.
In January 2005, we entered into an amendment and limited waiver (the “Amendment”) to the Agreement with the Senior Note holders. Pursuant to the terms of the Amendment, we and the Senior Note holders agreed to: (i) extend the maturity date of the $50,000 in aggregate principal amount of Senior Notes issued under the Agreement by twelve months to May 29, 2008; (ii) defer all cash interest payments until maturity; and (iii) modify certain financial covenants regarding minimum EBITDA, minimum debt to capitalization and maximum capital expenditures, and delete certain other financial covenants for 2005 through maturity. Additionally, the Senior Note holders waived certain covenant violations, including all financial covenant violations for the quarter and year ended December 31, 2004. In exchange for the foregoing amendments and waiver contained in the Amendment, we and the Senior Note holders agreed to reduce the number of warrants to purchase shares of common stock to 13,438,599 and reduce the exercise price of those warrants to $2.00 per share, down from the original weighted average price of approximately $3.21 per share.
In January 2005, as consideration for delays in filing a required registration statement in connection with our July 2004 financing, we agreed with the investors in such financing to make a cash payment of $556, to issue an additional aggregate of 476,637 shares of common stock and to reduce the exercise price on the investors’ warrants to $2.50 per share.
There were no other transactions in which the amount involved exceeded $60,000 and in which any director, executive officer or holder of more than 5% of our capital stock had or will have a direct or indirect material interest during the fiscal year ended December 31, 2004, other than compensation arrangements that are described under “Compensation of Directors” and “Executive Officer Compensation.”
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The following is a summary of the fees billed to us by PricewaterhouseCoopers LLP for professional services rendered for the fiscal years ended December 31, 2004 and 2003:
Audit Fees. Consists of fees billed for professional services rendered for the audit of our consolidated financial statements ($510,000 in 2004, $253,000 in 2003) and review of the interim consolidated financial statements included in quarterly reports ($49,000 in 2004, $40,000 in 2003).
Audit-Related Fees. Consists of fees billed for the review of other SEC filing ($36,000 in 2004; $19,000 in 2003) and the annual license fee for the PWC Comperio research software ($2,000 in 2004; $1,000 in 2003).
Tax Fees. Consists of fees billed for professional services for tax compliance, tax advice and tax planning. These services include assistance related to state tax incentives.
All Other Fees. Consists of fees billed in 2003 for the performance of the audit of the Company’s 401K Plan for the 2002 Plan year.
The Audit Committee’s policy is to pre-approve all audit and permissible non-audit services performed by the independent auditors. These services may include audit services, audit-related services, tax services and other services. For audit services, the independent auditor provides an engagement letter in advance of the February meeting of the Audit Committee, outlining the scope of the audit and related audit fees. If agreed to by the Audit Committee, this engagement letter is formally accepted by the Audit Committee at the next scheduled Audit Committee meeting.
For non-audit services, the our senior management will submit from time to time to the Audit Committee for approval non-audit services that it recommends the Audit Committee engage the independent auditor to provide for the fiscal year. Our senior management and the independent auditor will each confirm to the Audit Committee that each non-audit service is permissible under all applicable legal requirements. A budget, estimating non-audit service spending for the fiscal year, will be provided to the Audit Committee along with the request. The Audit Committee must approve both permissible non-audit services and the budget for such services. The Audit Committee will be informed routinely as to the non-audit services actually provided by the independent auditor pursuant to this pre-approval process.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
(a)(1)
(a)(2) Financial Statement Schedules
II. Valuation and Qualifying Accounts
Schedules not listed above have been omitted because they are not applicable or are not required to be set forth herein as such information is included in the consolidated financial statements and notes thereto.
Exhibit
No.
Description
2.1
Agreement for Purchase and Sale of Assets Between Innovative Physician Services, Inc. (DBA Diagnostic Monitoring) and Biosensor Corporation, dated December 31, 1998.(5)
2.2
Agreement and Plan of Merger, dated June 22, 2000, between Cardiac Science, Inc., Cardiac Acquisition Corp., and Cadent Medical Corporation.(10)
2.3
Press Release, dated January 10, 2001, announcing tender offer to acquire outstanding shares of Artema Medical AB.(11)
2.4
Agreement and Plan of Merger, dated February 14, 2001, among Cardiac Science, Inc., Cardiac Science Acquisition Corp., and Survivalink Corporation.(12)
2.5
Asset Purchase Agreement, dated as of October 21, 2003, by and among Compliant Corporation, CPR Limited Partnership and Cardiac Science, Inc.(14)
2.6
Registration Rights and Lock-Up Agreement, dated as of October 21, 2003, by and between Cardiac Science, Inc. and Complient Corporation.(14)
2.7
Agreement and Plan of Merger, dated February 28, 2005, by and between Cardiac Science, Inc., Quinton Cardiology Systems, Inc., CSQ Holding Company, Rhythm Acquisition Corporation and Heart Acquisition Corporation.(17)
3.1
Certificate of Incorporation.(1)
3.2
Bylaws .(1)
4.1
Form of Common Stock Certificate.(1)
4.2
Form of Warrant Certificates of A.R. Baron, Breslow & Walker, Howard K. Cooper, J. Donald Hill, Fran Daniels and Medstone, Inc.(2)
4.3
Form of Warrant Certificate held by various foreign investors.(7)
4.4
Senior Note and Warrant Purchase Agreement, dated May 29, 2002, by and among Cardiac Science, Inc., Perseus Acquisition Recapitalization Fund, L.L.C., Perseus Market Opportunity Fund, L.P., and Cardiac Science Co-Investment, L.P.(13)
4.5
Form of Senior Note.(13)
4.6
Form of Warrant.(13)
4.7
Security Agreement, dated May 30, 2002, between Cardiac Science and its subsidiaries, the Perseus Funds, and HSBC Bank USA as collateral agent.(13)
4.8
Form of Guaranty Agreement.(13)
4.9
Registration Rights Agreement, dated May 30, 2002, between Cardiac Science, Inc. and the Perseus Funds.(13)
4.10
Common Stock and Warrant Purchase Agreement, dated July 20, 2004, by and among Cardiac Science, Inc., Perseus Market Opportunity Fund, L.P., Winterset Master Fund, L.P., Mill River Master Fund, L.P., Massachusetts Mutual Life Insurance Company and Walter Villager.(16)
4.11
Amended and Restated Registration Rights Agreement, dated July 20, 2004, by and among Cardiac Science, Inc., Perseus Market Opportunity Fund, L.P., Winterset Master Fund, L.P., Mill River Master Fund, L.P., Massachusetts Mutual Life Insurance Company and Walter Villager.(16)
Exhibit
No.
Description
4.12
Form of Warrant.(16)
10.1
Stock Option/Stock Issuance Plan, as amended.(3)
10.2
Standard Employment Agreement for Cardiac Science Executives. ++(15)
10.3
Employment Agreement between Cardiac Science and Raymond Cohen, dated December 31, 2002. ++(15)
10.4
Employment Agreement between Cardiac Science and Roderick de Greef, dated December 31, 2002. ++(15)
10.5
Employment Agreement between Cardiac Science and Howard Evers, dated December 31, 2002. ++(15)
10.6
Employment Agreement between Cardiac Science and Kurt Lemvigh, dated December 1, 2001. ++(15)
10.7
Facility lease, dated September 9, 1999, for 16931 Millikan Avenue, Irvine, CA.(6)
10.8
Data Critical Corporation Technology Integration and Distribution Letter Agreement, dated March 17, 2000.(4)
10.9
Assignment of Patent, dated July 1, 2000, by Lindell Bradley, M.D., and Thang-Quang Nguyen in favor of Cardiac Science, Inc.(8)
10.10
Patent Acquisition agreement, dated July 1, 2000, by and among Lindell Bradley, M.D. and Thang-Quang Nguyen together with Cardiac Science, Inc.(9)
10.11
Senior Note and Warrant Conversion Agreement dated February 28, 2005, by and between Cardiac Science, Inc., CSQ Holding Company and the other signatories thereto.(18)
21*
List of Subsidiaries.
23*
Consent of Independent Registered Public Accounting Firm.
24*
Power of Attorney.
31.1*
Certification of the Chief Executive Officer as required by Section 302 of the Sarbanes-Oxley Act of 2002.
31.2*
Certification of the Chief Financial Officer as required by Section 302 of the Sarbanes-Oxley Act of 2002.
32*
Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Filed herewith
(1) Incorporated by reference to Exhibits 3.1 and 3.2 to the Company’s Application for Registration on Form 10 dated October 2, 1991.
(2) Incorporated by reference to Exhibit 4.1 to the Company’s Form 10-K for the year ended December 31, 1993.
(3) Incorporated by reference to the Company’s Definitive Proxy Statement for the Annual Meeting of Stockholders held on September 9, 2002.
(4) Incorporated by reference to Exhibit 10.15 to Form 10-K for the year ended December 31, 1999.
(5) Incorporated by reference to Exhibit 10.12 to Form 10-KSB for the year ended December 31, 1998.
(6) Incorporated by reference to Exhibit 10.1 to Form 10-QSB for the quarter ended September 30, 1999.
(7) Incorporated by reference to Exhibit 4.3 to Form S-1/A dated February 4, 2000.
(8) Incorporated by reference to Exhibit 10.1 to Form 10-Q for the quarter ended June 30, 2000.
(9) Incorporated by reference to Exhibit 10.2 to Form 10-Q for the quarter ended June 30, 2000.
(10) Incorporated by reference to Exhibit 7(c) to Form 8-K filed July 17, 2000.
(11) Incorporated by reference to Exhibit 7.1 to Form 8-K filed March 27, 2001.
(12) Incorporated by reference to Exhibit 7.1 to Form 8-K filed March 23, 2001.
(13) Incorporated by reference to Exhibits 4.1 to 4.6 to Form 8-K filed June 6, 2002.
(14) Incorporated by reference to Exhibits 2.1 and 2.2 to Form 8-K filed November 4, 2003.
(15) Incorporated by reference to Exhibits 10.1 to 10.6 to Form 10-K for the year ended December 31, 2002.
(16) Incorporated by reference to Exhibits 4.1 to 4.3 to Form 8-K filed July 22, 2004.
(17) Incorporated by reference to Exhibit 2.1 to Form 8-K filed March 1, 2005.
(18) Incorporated by reference to Exhibit 10.1 to Form 8-K filed March 1, 2005.
+ Portions have been omitted pursuant to a request for confidential treatment.
++ This exhibit is identified as a management contract or compensation plan or arrangement pursuant to item 15(b) of Form 10-K.
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.
POWER OF ATTORNEY
Each person whose signature appears below constitutes and appoints each of Raymond W. Cohen and Roderick de Greef as his attorney-in-fact, with full power of substitution, in any and all capacities, to sign any amendments to this Form 10-K, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each attorney-in-fact, or his substitute, may do or cause to be done by virtue hereof.
Date: March 16, 2004
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED.
Signature
Title
Date
/s/ RAYMOND W. COHEN
Director
March 16, 2005
Raymond W. Cohen
/s/ RAY E. NEWTON, III
Director
March 16, 2005
Ray E. Newton, III
/s/ PETER CROSBY
Director
March 16, 2005
Peter Crosby
/s/ HOWARD L. EVERS
Director
March 16, 2005
Howard Evers
/s/ BRIAN H. DOVEY
Director
March 16, 2005
Brian Dovey
/s/ JEFFREY F. O’DONNELL SR.
Director
March 16, 2005
Jeffrey F. O’Donnell Sr.
/s/ BRUCE J. BARCLAY
Director
March 16, 2005
Bruce J. Barclay