Capstone Holding Corp. — Interim / Quarterly Report 2000

May 12, 2000

UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2000 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ___ to ______ Commission File Number: 0-21214 ORTHOLOGIC CORP. ------------------------------------------------------ (Exact name of registrant as specified in its charter) Delaware 86-0585310 ------------------------------- ---------------- (State of other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1275 W. Washington Street, Tempe, Arizona 85281 - ----------------------------------------- ---------- (Address of principal executive offices) (Zip Code) (602) 286-5520 ---------------------------------------------------- (Registrant's telephone number, including area code) ---------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 29,812,874 shares of common stock outstanding as of March 31, 2000 ORTHOLOGIC CORP. INDEX Page No. -------- Part I Financial Information Item 1. Financial Statements Condensed Consolidated Balance Sheets March 31, 2000 and December 31,1999 ........................... 3 Condensed Consolidated Statements of Operations and of Comprehensive Income Three months ended March 31, 2000 and 1999....................................................... 4 Condensed Consolidated Statements of Cash Flows Three months ended March 31, 2000 and 1999 .................... 5 Notes to Condensed Consolidated Financial Statements .......... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ........................ 10 Part II Other Information Item 1. Legal Proceedings .......................................... 12 Item 4. Submission of Matters to Vote of Security Holders........... 12 Item 6. Exhibits and Reports on Form 8-K ........................... 12 Page 2 PART I - Financial Information Item 1. Financial Statements OrthoLogic, Corp. Condensed Consolidated Balance Sheet (in thousands) Unaudited March 31, December 31, 2000 1999 --------- --------- ASSETS Cash and cash equivalents $ 7,053 $ 6,023 Short term investments -- 250 Accounts receivable 30,827 30,429 Inventory 8,944 9,306 Prepaids and other current assets 1,136 987 Deferred income tax 2,628 2,631 --------- --------- Total current assets 50,588 49,626 Furniture, rental fleet and equipment 27,768 26,361 Accumulated depreciation (14,945) (13,300) --------- --------- Furniture and equipment, net 12,823 13,061 Intangibles, net 28,251 28,749 Deposits and other assets 639 767 --------- --------- Total assets $ 92,301 $ 92,203 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Accounts payable $ 2,443 $ 2,569 Accrued liabilities 5,595 6,192 --------- --------- Total current liabilities 8,038 8,761 Deferred rent and capital lease obligations 190 209 --------- --------- Total liabilities 8,228 8,970 --------- --------- Series B Convertible Preferred Stock 4,720 10,180 --------- --------- Stockholders' Equity Common stock 15 14 Additional paid-in capital 130,823 125,206 Accumulated deficit (51,297) (51,992) Comprehensive loss (188) (175) --------- --------- Total stockholders' equity 79,353 73,053 --------- --------- Total liabilities and stockholders' equity $ 92,301 $ 92,203 ========= ========= See notes to condensed consolidated financial statements Page 3 OrthoLogic, Corp. Condensed Consolidated Statement of Operations and of Comprehensive Income (in thousands, except per share data) Unaudited

See notes to condensed consolidated financial statements Page 4 ORTHOLOGIC, CORP. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) UNAUDITED

See notes to condensed consolidated financial statements Page 5 ORTHOLOGIC CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. FINANCIAL STATEMENT PRESENTATION The condensed consolidated balance sheet as of March 31, 2000, and the condensed consolidated statements of operations and comprehensive income for the three months ended March 31, 2000 and 1999 and the condensed consolidated statements of cash flows for the three months ended March 31, 2000 and 1999 are unaudited, however, in the opinion of management, include all adjustments (consisting only of normal recurring adjustments) necessary for the fair presentation of the financial position, results of operations and cash flows. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the complete fiscal year. The Balance Sheet as of December 31, 1999 is derived from the Company's audited financial statements included in the 1999 Annual Report. It is suggested that these financial statements be read in conjunction with the financial statements and notes thereto included in the Company's 1999 Annual Report. The preparation of financial statements in conformity with generally accepted accounting principles necessarily requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include the allowance for doubtful accounts, which is based primarily on trends in historical collection statistics, consideration of current events, payer mix and other considerations. The Company derives a significant amount of its revenues in the United States from third-party health insurance plans, including Medicare. Amounts paid under these plans are generally based on fixed or allowable reimbursement rates. In the opinion of management, adequate allowances have been provided for doubtful accounts and contractual adjustments. However, these estimates are subject to adjustments in the near term, which could be material. Any differences between estimated reimbursement and final determinations are reflected in the year finalized. 2. CO-PROMOTION AGREEMENT The Company entered into an exclusive co-promotion agreement (the "Agreement") with Sanofi Pharmaceuticals Inc. ("Sanofi") at a cost of $4.0 million on June 23, 1997 for the purpose of marketing Hyalgan, a hyaluronic acid sodium salt, to orthopedic surgeons in the United States for the treatment of pain in patients with osteoarthritis of the knee. During 1997 and 1998 the Company paid $3.0 million of this amount. The remaining $1.0 million was paid in the first quarter of 1999. The initial term of the agreement ends on December 31, 2002. Upon the expiration of the initial term, Sanofi may terminate the agreement, extend the agreement for up to ten additional one year periods or enter into a revised agreement with the Company. Upon termination of the agreement, Sanofi must pay the Company the amount equal to 50% of the gross compensation paid to the Company for the immediately preceding year, provided the Company met all contractual obligations pursuant to the agreement. The Company's sales force began to promote Hyalgan in the third quarter of 1997. Page 6 3. LICENSING AGREEMENT The Company announced in January 1998 that it had acquired a minority interest in a biotech firm, Chrysalis Bio Technology, Inc. ("Chrysalis") for $750,000. As part of the transaction, the Company was awarded a nine-month world-wide exclusive option to license the orthopedic applications of Chrysalin, a patented 23-amino acid peptide that has shown promise in accelerating the healing process and has completed an extensive pre-clinical safety and efficacy profile of the product. In pre-clinical animal studies, Chrysalin was also shown to double the rate of fracture healing with a single injection into the fresh fracture gap. The Company's agreement with Chrysalis contains provisions for the Company to continue and expand its options to license Chrysalin contingent upon regulatory approvals, successful preclinical trials, and certain trials and certain milestone payments to Chrysalis by the Company. As part of the equity investment, OrthoLogic acquired options to license Chrysalin for orthopedic applications. An additional fee of $750,000 for the initial license was expensed in the third quarter of 1998 and the Agreement was extended to January 1999. In January 1999, the Company exercised its option to license the U.S. development, marketing and distribution rights of Chrysalin, for fracture indications. As part of the license agreement, and in conjunction to the U.S. Food and Drug Administration (the "FDA") clearance to begin human clinical trials, OrthoLogic made a $500,000 milestone payment to Chrysalis Bio Technology which was expensed in the fourth quarter of 1999. In June 1999, the Company elected not to pursue additional marketing and distribution rights for Chrysalin for indications other than fracture healing. However, discussions are continuing between the Company and Chrysalis regarding other orthopedic indications. In January 2000, the Company began enrolling patients in the combined Phase I/II clinical trial for Chrysalin. 4. LITIGATION During 1996, certain class action lawsuits were filed in the United States District Court for the District of Arizona against the Company and certain officers and directors, alleging violations of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-6 promulgated thereunder. Plaintiffs in these actions alleged that correspondence received by the Company from the FDA pertaining principally to the promotion of the Company's OrthoLogic 1000 Bone Growth Stimulator was material and undisclosed, leading to an artificially inflated stock price. Plaintiffs further allege practices referenced in the correspondence operated as a fraud against plaintiffs. Plaintiffs further allege that once the FDA letter became known, a material decline in the stock price of the Company occurred, causing damage to the plaintiffs. On March 31, 1999, the judge in the consolidated case before the United States District Court granted the Company's Motion to Dismiss and entered an order dismissing all claims in the suit against the Company and two individual officers/directors. The judge allowed certain narrow claims based on insider trading theories to proceed against certain individual defendants. On December 21, 1999, the District Court granted plaintiffs' motion for class certification to include purchasers of common stock between June 4 through June 18, 1996, inclusive. Discovery is proceeding in the case. In addition, the Company has been served with a substantially similar action filed in Arizona State Court alleging state law causes of action grounded in the same set of facts. The Company filed a Motion to Dismiss the Complaint in Arizona State Court in May 1999. The Court denied the motion in July 1999 and granted the plaintiffs' motion for the class certification on November 24, 1999. The Company has appealed the state court's class certification and the appeal is now pending in the Arizona Supreme Court. Page 7 In addition, a shareholder derivative complaint alleging, among other things, breach of fiduciary duty in connection with the conduct alleged in the federal and state court class actions have also been filed in Arizona state court. The Company filed a Motion to Dismiss the Complaint, which was granted December 13, 1999. Management believes that the allegations in the remaining federal and state cases are without merit and will vigorously defend against them. At March 31, 2000, in addition to the matters disclosed above, the Company is involved in various other legal proceedings that arose in the ordinary course of business. The costs associated with defending the above allegations and the potential outcome cannot be determined at this time and accordingly, no estimate for such costs have been included in the accompanying Financial Statements. In management's opinion, the ultimate resolution of the above legal proceedings will not have a material effect on the financial position of the Company. 5. LINE OF CREDIT The Company has secured a $10.0 million accounts receivable revolving line of credit with a bank. The Company may borrow up to 75% of the eligible accounts receivable. The interest rate is at prime for the revolving note. Interest accruing on the note and a monthly administration fee is due in arrears on the first day of each month. The revolving note matures February 28, 2003. There are certain financial covenants and reporting requirements associated with the loan. Included in the financial covenants are (1) tangible net worth of not less than $43 million, (2) a quick ratio of not less than 2.0 to 1.0, (3) a debt to tangible net worth ratio of not less than 0.50 to 1.0, and (4) capital expenditures will not exceed more than $7.0 million during any fiscal year. 6. SERIES B CONVERTIBLE PREFERRED STOCK In July 1998, the Company completed a private placement with two investors, an affiliate of Credit Suisse First Boston Corp. and Capital Ventures International. Under the terms of the Purchase Agreement, OrthoLogic sold 15,000 shares of Series B Convertible Preferred Stock for $15 million (prior to costs). The Series B Convertible Preferred Stock will automatically convert, to the extent not previously converted, into Common Stock four years following the date of issuance. Each share of Series B Convertible Preferred Stock is convertible into Common Stock at a per share price equal to the lesser of the average of the 10 lowest closing bids during the 30 days prior to conversion or, $ 3.0353. In the event of certain Mandatory Redemption Events, each holder of Series B Preferred Shares will have the right to require the Company to redeem those shares for cash at the Mandatory Redemption Price. Mandatory Redemption Events include, but are not limited to: the failure of the Company to timely deliver Common Shares as required under the terms of the Series B Preferred Shares or Warrants; the Company's failure to satisfy registration requirements applicable to such securities; the failure by the company to maintain the listing of its Common Stock on NASDAQ or another national securities exchange; and certain transactions involving the sale of assets or business combinations involving the Company. In the event of any liquidation, dissolution or winding up of the Company, holders of the Series B Preferred Shares are entitled to receive, prior and in preference to any distribution of any assets of the Company to the holders of Common Stock, the Stated Value for each Series B Preferred Share outstanding at that time. The Purchase Agreement contains strict covenants that protect Page 8 against hedging and short-selling of OrthoLogic Common Stock while the purchasers hold shares of the Series B Convertible Preferred Stock. In connection with the private placement of the Series B Convertible Preferred Stock, OrthoLogic issued to the purchasers warrants to purchase 40 shares of Common Stock for each share of Series B Convertible Preferred Stock, exercisable at $5.50 per share. These warrants expire in 2008. The warrants were valued at $1,093,980. Additional costs of the private placement were approximately $966,000. Both the value of the warrants and the cost of the private placement were recognized over the 10 month conversion period ending April 1999 as an "accretion of non-cash Preferred Stock Dividends" for the amount of $617,994 per quarter. The Company filed a registration statement covering the underlying Common Stock. Proceeds from the private placement are being used to fund new product opportunities, including SpinaLogic, Chrysalin and Hyalgan as well as to complete the re-engineering of the Company's key business processes. As of March 31, 2000, 10,280 shares of Series B Convertible Preferred Stock had been converted into 4,147,639 shares of Common Stock. 7. RELATED PARTIES In the second quarter of 1999, the Company extended the maturity date on a loan of $157,800 to an officer of the Company to February 15, 2000. On January 27, 2000, the loan was extended to a maturity date of February 29, 2000. An additional loan of $81,200 was entered into with the same officer on January 27, 2000 with a maturity date of February 29, 2000. The principal and interest of both loans were paid in full on the maturity date. Page 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS. The following is management's discussion of significant factors that affected the Company's interim financial condition and results of operations. This should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations included in the Company's Annual Report on Form 10-K for the year ended December 31, 1999. RESULTS OF OPERATIONS REVENUES The Company reported revenues of $22.5 million for the first quarter of 2000 representing a 6.7% increase over revenues of $21.1 million for the same quarter of 1999. The increase in sales is attributable to the first full quarter of SpinaLogic sales as well as strong sales for both the OL-1000 product line and Hyalgan. GROSS PROFIT Gross profits increased from $16.4 million for the three months ended March 31, 1999 to $17.7 million for the three months ended March 31, 2000, an 8.1% increase. Gross profits as a percentage of revenues was 78.6% for the quarter compared to 77.6% for the same period last year. The emphasis in Continuous Passive Motion business has been to improve overall profitability by offsetting lower-margin business during the quarter by expanding more profitable market segments. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses for the three months ended March 31, 2000 were $16.3 million, an increase from $15.7 million for the three months ended March 31, 1999. The largest component of this increase was for additional bad debt reserves which is the result of increased sales. RESEARCH AND DEVELOPMENT Research and development expenses increased with expenses of $666,000 in the three-month period ended March 31, 2000 compared to $520,000 for the same period last year. The increase is attributable to the costs associated with the addition of a size two single coil OL-1000, the development of a new CPM elbow machine, and the combined Phase I/II human clinical trials for Chrysalin. OTHER INCOME AND EXPENSES Other income, consisting primarily of interest income, increased from $57,000 to $85,000 for the three-month periods ended March 31, 1999 and 2000 respectively. LIQUIDITY AND CAPITAL RESOURCES On March 31, 2000 the Company had cash and investments of $7.1 million compared to $6.3 million as of December 31, 1999. The Company has an available $10.0 million accounts receivable revolving line of credit with a bank. Page 10 The Company anticipates that its cash and short-term investments on hand, cash from operations and the funds available from the line of credit and revolving term loan will be sufficient to meet the Company's presently projected cash and working capital requirements for the next 12 months. There can be no assurances, however, that this will prove to be the case. The timing and amounts of cash used will depend on many factors, including the Company's ability to continue to increase revenues, reduce and control its expenditures, become profitable and collect amounts due from third party payers. Additional funds may be required if the Company is not successful in any of these areas. The Company's ability to continue funding its planned operations beyond the next 12 months is dependent on its ability to generate sufficient cash flow to meet its obligations on a timely basis, or to obtain additional funds through equity or debt financing, or from other sources of financing, as may be required. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including projections of results of operations and financial condition, statements of future economic performance, and general or specific statements of future expectations and beliefs. The matters covered by such forward-looking statements are subject to known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company to differ materially from those contemplated or implied by such forward-looking statements. Important factors which may cause actual results to differ include, but are not limited to, the following matters, which are discussed in more detail in the Company's Form 10-K, as amended, for the 1999 fiscal year. The Company intends to pursue sales in international markets. The Company, however, has had little experience in such markets. Expanded efforts at pursuing new markets necessarily involves expenditures to develop such markets and there can be no assurance that the results of those efforts will be profitable. There can be no assurance that the Company's estimates of the market will not cause the nature and extent of that market to deviate materially from the Company's expectations. To the extent that the Company presently enjoys perceived technological advantages over competitiors, technological innovation by present or future competitors may erode the Company's position in the market. To sustain long-term growth, the Company must develop and introduce new products and expand applications of existing products; however, there can be no assurance that the Company will be able to do so or that the market will accept any such new products or applications. The Company operates in a highly regulated environment and cannot predict the actions of regulatory authorities. The action or non-action of regulatory authorities may impede the development and introduction of new products and new applications for existing products, and may have temporary or permanent effects on the Company's marketing of its existing or planned products. There can be no assurance that the influence of managed care will continue to grow either in the United States or abroad, or that such growth will result in greater acceptance or sales of the Company's products. In particular, there can be no assurance that existing or future decision makers and third party payors within the medical community will be receptive to the use of the Company's products or replace or supplement existing or future treatments. Moreover, the transition to managed care and the increasing consolidation underway in the managed care industry may concentrate economic power among buyers of the Company's products, which concentration could foreseeable adversely affect the Company's margins. Although the company believes that existing litigation initiated against the Company is without merit and the Company intends to defend such litigation vigorously, an adverse outcome of such litigation could have a material adverse effect on the Company's business, financial condition and results of operation. Page 11 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS See "Note 4 - Litigation" of the Notes to Consolidated Financial Statements above. ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS None ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits See Exhibit Index following the signature page which is incorporated herein by reference. (b) Reports on Form 8-K None Page 12 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ORTHOLOGIC CORP. (Registrant) Signature Title Date - --------- ----- ---- /s/ Thomas R. Trotter President and Chief Executive Officer May 10, 2000 - --------------------- (Principal Executive Officer) Thomas R. Trotter /s/ Terry D. Meier Sr. Vice-President and Chief Financial May 10, 2000 - --------------------- Officer (Principal Financial and Terry D. Meier Accounting Officer) Page 13 OrthoLogic Corp. Exhibit Index to Quarterly Report on Form 10-Q For the Quarterly Period Ended March 31, 2000 Incorporated by Filed Exhibit No Description Reference to: Herewith - ---------- ----------- ------------- -------- 3 Amended and Restated X Certificate of Incorporation 27 Financial Data Schedule X