ITEM 1. BUSINESS
EndoSonics Corporation ("EndoSonics" or the "Company") develops, manufactures and markets intravascular ultrasound ("IVUS") imaging systems and percutaneous transluminal coronary angioplasty ("balloon angioplasty") catheters to assist in the diagnosis and treatment of cardiovascular and peripheral vascular disease. The Company's IVUS imaging products enhance the effectiveness of the diagnosis and treatment of coronary artery and other vascular diseases by providing important diagnostic information not available from conventional x-ray angiography. This information includes the location, amount and composition of atherosclerotic plaque and enables physicians to identify lesion characteristics, select an optimum course of treatment, position therapeutic devices, treat disease sites with drugs or other therapies and promptly assess the results of treatment. In 1993, the Company commenced the Pinnacle Development Project to further enhance the image quality of its IVUS imaging products. This project resulted in the Five-64 catheter line and an enhancement to the Company's Oracle Imaging System. The Company has received United States Food and Drug Administration ("FDA") clearance for its Five-64 diagnostic catheters, which were commercially available in the first quarter of 1996. The Company believes that it offers the only FDA-approved combined coronary balloon angioplasty/IVUS imaging catheters; devices that can reduce the time and cost of interventional procedures by providing both diagnostic and therapeutic functions on the same catheter.
The Company's IVUS products are based on two core proprietary technologies: digital, all-electronic IVUS imaging and specialized balloon catheter material technology. The Company's IVUS imaging system and catheters use high-speed, computer-based electronics and proprietary integrated circuit technologies to produce ultrasound images. The combination of these technologies and the Company's manufacturing expertise enables its catheters to provide high-quality ultrasound images while maintaining the small size, flexibility and trackability necessary to access, diagnose and treat a wide range of coronary and peripheral vessels. See "Risk Factors".
Cardiometrics, Inc., ("Cardiometrics"), acquired by the Company in 1997, develops, manufactures and markets intravascular medical devices to measure blood flow impairment caused by coronary artery disease. Cardiometrics' principal products, the FloWire(R)Doppler guide wire and FloMap(R) ultrasound instrument, represent an advance in functional testing of blood flow impairment, enabling cardiologists to evaluate the appropriateness of angioplasty interventions and assess post-procedural results directly in the cardiac catheterization laboratory. Clinical experience demonstrates that the measurement of blood flow impairment downstream from (or distal to) an obstruction, which Cardiometrics calls functional angiometry, provides information to improve the quality of patient care and procedure outcomes in the diagnosis and treatment of cardiovascular disease. The FloWire/FloMap system has received clearance from the U.S. Food and Drug Administration and many corresponding European and Pacific Rim regulatory agencies. As of December 31, 1998, more than 98,000 FloWire guide wires have been sold and cumulative FloMap shipments were approximately 669. Cardiometrics has also developed the WaveWire(TM)/WaveMap(TM) intracoronary blood pressure measurement system, which was first used in a clinical case in Europe in December 1996. Cardiometrics received a 510(k) approval in August 1997 for the WaveWire(TM)/WaveMap(TM) system, and commenced shipments to United States customers in 1998.
BUSINESS ACQUISITION
On August 5, 1998, the Company acquired all of the outstanding shares of Navius Corporation ("Navius") for approximately $9.5 million in Common Stock of the Company, $7.7 million in cash and $2.3 million in other costs. The financial results of Navius' operations have been combined with those of the Company since the date of acquisition. Navius is a developer of balloon angioplasty catheters, stents, and intravascular radiation catheters.
The Company believes that the acquisition of Navius provides the company with basic technology for further development of its combination imaging and therapeutic products. The acquisition was accounted for using the purchase method of accounting.
PRODUCTS
EndoSonics develops and markets IVUS imaging systems and catheters, balloon angioplasty catheters, combination balloon angioplasty/IVUS imaging catheters and coronary functional assessment products.
IVUS IMAGING PRODUCTS
The Company's IVUS imaging products capture imaging data in a digital format, providing a platform for further enhancements of image quality and increased design flexibility in the development of new application catheters such as the Company's Five-64 catheter line. Advanced features include the following: In-Vision(TM), an enhanced Windows-like user interface, ChromaFLO(TM) imaging technology, which provides images of blood flow and In-Line Digital(TM) option, which offers a three-dimensional reconstruction of a specific region of interest in the artery. The Company believes that the In-Vision(TM) option, ChromaFLO(TM) imaging and In-Line Digital(TM) enables easier image interpretation for purposes such as lesion differentiation and characterization. The Company introduced the Oracle MegaSonics imaging catheters in 1998 which utilizes combination diagnostics (ultrasound imaging) and therapeutics (angioplasty balloon) in a single device.
The images produced by the Company's IVUS imaging systems are displayed on a high resolution video screen located on the digital processor, and can be permanently stored on video tape and CD-R. The systems' software can also provide immediate measurements of lumen diameter, cross-sectional area and vessel wall thickness. The systems' fluoroscopic windowing feature lets the user simultaneously display both angiography and ultrasound images on the physician interface module's video screen. The Company believes this feature gives the physician the ability to analyze and compare ultrasound and angiographic images of the same disease site, thereby facilitating a determination of the therapeutic procedure and a review of the results.
FUNCTIONAL ASSESSMENT AND BALLOON ANGIOPLASTY PRODUCTS
The products produced by Cardiometrics include intravascular guidewires to measure blood flow and blood pressure in diseased coronary arteries. These products include the FloWire(TM) and WaveWire(TM), and the corresponding instrumentation, FloMap(TM) and WaveMap(TM). These products enable the cardiologist to evaluate the appropriateness of angioplasty interventions and assess post-procedural results directly in the cardiac catheterization laboratory. The Company believes that the use of these products can contribute to reduced procedural costs and better patient outcomes, particularly when stenting is avoided.
Navius develops and manufactures balloon angioplasty catheters in its San Diego facility. These products are currently sold in Europe and Japan. The market for these catheters is very competitive in regard to price and product performance. Fukuda, the Company's exclusive distributor in Japan for Navius balloon catheters, has submitted the latest generation of Navius' balloon catheters for regulatory approval in Japan
The following table lists the Company's key IVUS systems and imaging catheters, balloon catheters, and functional assessment instruments and guidewire products.
PRODUCT DEVELOPMENT
The Company has conducted developmental programs to refine its proprietary integrated circuit and transducer technology towards smaller and more advanced integrated circuits and transducers in order to enhance image quality. The Company is continuing to develop combination diagnostic/therapeutic catheters as well as multiple therapeutic catheters such as balloon angioplasty catheters and IVUS/radiation delivery catheters. The Company is developing core technology for imaging other bodily organs. In addition, the Company is continuing to develop advanced functional assessment guidewire products.
Substantially all of the Company's product development activities are performed by the Company's team of research scientists, engineers, technicians and consultants, who have extensive experience in ultrasound signal processing, semiconductor design, acoustics and catheter development. The Company's research, development and clinical expenditures approximated $5.7 million, $6.3 million and $7.0 million in 1996, 1997, and 1998 respectively, excluding acquired in-process research and development. The Company intends to continue to make significant investments in research and development. See "Management's Discussion and Analysis of Financial Condition and Results of Operation" and "Risk Factors Dependence on New Products; Rapid Technological Change."
MANUFACTURING
The Company fabricates certain proprietary components, then assembles, inspects, tests and packages all components into finished products. By designing and assembling its systems and catheter products, the Company believes it is better able to control quality and costs, limit third-party access to its proprietary technology, and manage manufacturing process enhancements and new product introductions. In addition, the Company purchases many standard and custom built components from independent suppliers, and contracts with third-parties for certain specialized electronic component manufacturing processes. Most of these purchased components and processes are available from more than one vendor. However, the manufacturing of the imaging integrated circuit microchips and pressure microchips is currently performed by a single vendor. Any supply interruptions from these single source vendors would have a material adverse effect on the Company's ability to manufacture its products until a new source of supply could be identified and qualified and, as a result, could have an adverse effect on the Company's business, financial condition and results of operations. Although the Company is in the process of identifying alternative vendors, the qualification of additional or replacement vendors for certain components or services is a lengthy process. See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Future Operating Results - Suppliers."
The Company provides a one-year limited warranty on its imaging systems sold in the United States. System repairs are made at the customer site by a Company service technician. In addition to the one-year warranty, the customer may purchase additional warranty coverage under the Company's extended warranty program. Service on the Company's systems sold outside the United States is provided either by the Company's European service engineer or by the international distributor responsible for the customer. The Company provides its international distributors with a one-year limited warranty covering service and parts.
The Company's success will depend in part on its ability to manufacture its products in compliance with Good Manufacturing Practices, "GMP" regulations, ISO 9000 and other regulatory requirements, in sufficient quantities and on a timely basis, while maintaining product quality and acceptable manufacturing costs. In addition, the Company continues to automate manufacturing processes for its imaging catheter line in Rancho Cordova, California. Manufacturers often encounter difficulties in scaling up production of new products and integrating automation equipment, including problems involving production yields, quality control and assurance, component supply and shortages of qualified personnel. The Company's failure to fully integrate automation into the manufacturing process for the imaging catheter line in a timely manner, or to timely increase production volumes of the imaging catheter line, would materially adversely affect the Company's business, financial condition and results of operations. Failure to increase production volumes in a timely or cost-effective manner or to maintain compliance with GMP, ISO 9000 and other regulatory requirements could have a material adverse effect on the Company's sales and the Company's business, financial
condition and results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operation" and "Risk Factors - Limited Manufacturing Experience."
BACKLOG
The Company had a backlog of customer purchase orders for products representing approximately $0.6 million as of December 31, 1997. However, the Company did not have any backlog of customer purchase orders for products as of December 31, 1998.
MARKETING AND SALES
The Company's products are sold in the United States, Canada and other international markets, principally Europe and Japan. The Company sells its products through a direct sales force in the United States and Germany, and through distributors in other geographic markets. In several countries, where products are sold through distributors, the Company employs clinical and marketing representatives.
In February 1996, EndoSonics and Cordis entered into an agreement pursuant to which Cordis was granted the exclusive right to distribute EndoSonics' IVUS imaging products for coronary applications in North America, Europe, Africa and the Middle East (the "Exclusive Distribution Agreement"). The Exclusive Distribution Agreement superseded and replaced a prior distribution agreement between Cordis and EndoSonics and a prior distribution agreement between EndoSonics Nederland B.V., a wholly owned subsidiary of EndoSonics, and Cordis S.A. Cordis was obligated during each year of the Exclusive Distribution Agreement to use reasonable efforts to purchase certain minimum annual amounts of products from EndoSonics. The Exclusive Distribution Agreement was terminated in April 1998 and replaced with a Transition Agreement which provides for Cordis to retain limited distribution rights through March, 1999.
In March 1997, the Company and Johnson & Johnson Medical KK ("JJMKK"), a subsidiary of Johnson and Johnson, entered into a distribution agreement whereby JJMKK was granted exclusive right to distribute EndoSonics IVUS imaging products for coronary applications in Japan. The agreement contained similar terms as the Exclusive Distribution Agreement between Cordis and EndoSonics. The agreement was amended in December 1998 to extend the agreement through December 1999.
In April 1997, the Company and Johnson and Johnson, Professional Group-Latin America ("J & J Medical-LA"), a subsidiary of Johnson and Johnson, entered into a distribution agreement whereby J & J Medical-LA was granted exclusive rights to distribute EndoSonics IVUS imaging products for coronary applications in certain countries of Latin America. The agreement contained similar terms as the Exclusive Distribution Agreement between Cordis and EndoSonics. The agreement was amended in December 1998 to extend the agreement through December 2000.
In July, 1998, the Company announced that it has agreed in principal to enter into a strategic relationship with Fukuda Denshi Co., Ltd. ("Fukuda"), which includes an equity investment and research and development funding totaling $13 million in EndoSonics by Fukuda. Approximately $8.4 million of Fukuda's investment was for the purchase of newly issued EndoSonics common stock. The remaining $4.6 million of the investment will fund certain research and development/technical assistance programs for products intended for the Japanese market which will be distributed by Fukuda. The funding will occur over a two-year period commencing in August, 1998.
In December 1998, the Company and JOMED N.V., ("JOMED") entered into an agreement for exclusive distribution of certain EndoSonics products into specified European and Middle Eastern countries. Also in December, EndoSonics and JOMED entered into an IVUS guided stent delivery system agreement which calls for the development of a JOMED balloon and stent incorporated into a modular EndoSonics IVUS catheter. Under the agreement, EndoSonics will supply subassemblies to JOMED who will complete the manufacturing process and distribute the resulting product in the territory which is defined as certain European and Middle Eastern countries. In certain countries within the territory, EndoSonics may distribute exclusively or jointly with JOMED.
In recent years there has been significant consolidation among medical device suppliers as the major suppliers have attempted to broaden their product lines in order to focus on product configurations that address a given procedure or treatment and in order to respond to cost pressures from health care providers. This consolidation has made it increasingly difficult for smaller suppliers, such as the Company, to effectively distribute their products without a major relationship with one of the major suppliers. The loss of one or more of these distributors could
materially affect the ability of the Company to distribute its products which could materially adversely affect the Company's business, financial condition and results of operations.
In 1996, 1997 and 1998, total export sales were $16.9 million, $21.9 million and $32.2 million respectively, or approximately 72%, 66% and 75% respectively, of total product sales. In 1996, 1997 and 1998, sales to Europe accounted for $9.8 million, $11.5 million and $10.6 million respectively, and sales to Asia represented $6.7 million, $9.3 million, and $20.3 million respectively. A significant portion of the Company's revenues, therefore, will continue to be subject to the risks associated with international sales, including economic or political instability, shipping delays, fluctuations in foreign currency exchange rates and various trade restrictions, all of which could have a significant impact on the Company's ability to deliver products on a competitive and timely basis. Future imposition of, or significant increases in the level of, customs duties, export quotas or other trade restrictions, could have an adverse effect on the Company's business, financial condition and results of operation. The regulation of medical devices, particularly in the European Community, continues to expand and there can be no assurance that new laws or regulations will not have an adverse effect on the Company.
STRATEGIC RELATIONSHIPS
The Company entered into a license agreement with Radiance (Radiance Medical Systems, Inc., "Radiance", formerly Cardiovascular Dynamics, Inc.) dated December 22, 1995 (the "Radiance Agreement"), pursuant to which Radiance granted to EndoSonics a non-exclusive, royalty-free right to Radiance's FOCAL technology for the development and sale of a combined FOCAL/Ultrasound product. In exchange, Radiance received a non-exclusive, royalty-free right to submit PMA supplemental applications utilizing an EndoSonics PMA as a reference and to manufacture and distribute Radiance products as a supplement to the EndoSonics PMA. The Radiance Agreement may be terminated in the event of breach upon 60 days notice by the non-breaching party, subject to the breaching party's right to cure. In the event of termination, Radiance would be prohibited from submitting new PMA supplements referencing the EndoSonics PMA and would be required to seek independent FDA approval for such products, which would have a material adverse effect on the Radiance's business, financial condition and results of operations.
The Company entered into a separate license agreement with Radiance on February 6, 1996, pursuant to which EndoSonics granted to Radiance a non-exclusive, royalty-free right and license to use and reference the EndoSonics PMA to enable Radiance to file for and obtain PMA approval for coronary balloon dilatation catheters from the FDA. The remaining terms of the February 6, 1996 agreement are substantially identical to the terms of the Radiance Agreement described above.
On August 31, 1998, the Company entered into a strategic relationship with the Fukuda Denshi Company, Ltd. ("Fukuda"), a Japanese medical products company, which includes an equity investment and research and development and technical guidance funding totaling $13 million in EndoSonics by Fukuda. Approximately $8.4 million of the $13 million represents an equity investment. The remaining $4.6 million will fund research and development programs over the next 24 months. In October, 1998, the Company received approximately $8.4 million in cash and issued 965,730 shares of the Company's common stock, at a price of $8.70 per share, related to this strategic relationship with Fukuda.
In December 1998, the Company and JOMED entered into an agreement for exclusive distribution of certain EndoSonics products into specified European and Middle Eastern countries. Also in December, EndoSonics and JOMED entered into an IVUS guided stent delivery system agreement which calls for the development of a JOMED balloon and stent incorporated into a modular EndoSonics IVUS catheter. Under the agreement, EndoSonics will supply subassemblies to JOMED who will complete the manufacturing process and distribute the resulting product in the territory which is defined as certain European and Middle Eastern countries. In certain countries within the territory, EndoSonics may distribute exclusively or jointly with JOMED.
COMPETITION
The Company believes that the primary competitive factors in the market for IVUS imaging devices are: image quality, catheter size, flexibility and trackability, ease of use, reliability and price. In addition, a company's distribution capability and the time in which products can be developed and receive regulatory approval are important competitive factors. Certain of the Company's competitors have developed IVUS imaging products with high quality images. Therefore, the Company believes that its competitive position is dependent upon its ability to establish its reputation as a producer of high quality imaging products. The Company's IVUS catheters compete with mechanical ultrasound devices manufactured by Cardiovascular Imaging Systems, a subsidiary of Boston Scientific Corporation ("CVIS"). CVIS is significantly larger than the Company, and has significantly greater financial, marketing and technical resources available. Although the Company believes that CVIS is not currently
marketing or clinically testing combined coronary balloon angioplasty/IVUS imaging catheters, there can be no assurance that CVIS will not attempt to develop and market catheters in the future that would compete with the Company's combination products. Moreover, companies currently engaged in the manufacture and marketing of non-imaging balloon angioplasty catheters could attempt to expand their product lines to include combination balloon angioplasty/IVUS imaging products. Other companies could also attempt to enter the market with competitive devices. Many of the Company's competitors and potential competitors have substantially greater financial, manufacturing, marketing, distribution and technical resources.
Competition in the market for devices used in the treatment of cardiovascular and peripheral vascular disease is intense, and is expected to increase. The interventional cardiology market is characterized by rapid technological innovation and change, and the Company's products could be rendered obsolete as a result of future innovations. The Company's non-imaging catheters and combination balloon angioplasty/IVUS imaging catheters compete with non-imaging balloon angioplasty catheters marketed by a number of manufacturers, including ACS, a subsidiary of Guidant Corporation, SciMed Life Systems, Inc., a subsidiary of Boston Scientific Corporation ("SciMed"), Cordis and Medtronic. Such companies have established market positions, substantial resources, and significantly larger sales and marketing organizations. In addition, the Company faces competition from manufacturers of atherectomy devices, vascular stents and pharmaceutical products intended to treat cardiovascular disease.
THIRD-PARTY REIMBURSEMENT
In the United States, the Company's products are purchased primarily by medical institutions, that then bill various third-party payors, (such as Medicare, Medicaid, and other government programs) and private insurance plans (such as Blue Cross/Blue Shield, United Healthcare), for the health care services provided to patients. U.S. Medical institutions are reimbursed for the care of Medicare hospital patients based on a predetermined lump sum amount for one of over 500 diagnostic related group, or DRGs (such as DRG 112 Percutaneous Cardiovascular Procedures), regardless of the costs involved. The amount of money paid for a specific DRG is determined by the average resource consumption needed to treat a specific disease, including the nursing time, operating room time and supplies. Reimbursement for Medicare patients for the equipment and hospital expense of an angioplasty procedure is usually covered under a specific DRG. However, since the amount of reimbursement is fixed and the amount of potential profit for the medical institution relating to the procedure may be reduced to the extent the physician performs additional procedures such as IVUS imaging, pressure measurement or uses a more expensive product that combines ultrasound imaging with therapeutic capabilities.
Private insurers and other payors determine whether to provide coverage for a particular procedure and reimburse hospitals for medical treatment also usually at a fixed rate base. The fixed rate of reimbursement is based on the procedure performed, and is unrelated to the specific type or number of devices used in a procedure. Some payors may deny reimbursement if they determine that the device used in a treatment was unnecessary, inappropriate or not cost-effective, experimental or used for a non-approved indication.
Physicians in the United States are reimbursed for performing medical procedures based on Current Procedural Terminology, "CPT" codes. Each type of procedure reimburses the physician a specific amount based on the amount of resource costs needed to provide the services. Included in the cost of providing each service are the physician work, practice expense and malpractice insurance. Payments are also adjusted for geographic differences. CPT codes are now available for all EndoSonics technology. CPT codes have been available since 1997 to reimburse physicians to perform ultrasound procedures and interpret the results when imaging is performed in conjunction with a therapeutic intervention. In January 1999 CPT codes were established to reimburse physician for performing physiological assessment including Doppler Flow and Pressure Measurement. These physician reimbursements are paid directly to the physician and are not intended to cover the costs of the supplies to perform the procedures. Physicians in the United States receive approximately $160 for physiological testing, $190 for IVUS and $1,232 for MegaSonics balloon and IVUS combination device for two vessel evaluation an/or treatment in a patient. Physicians are responsible for determining that the clinical benefits of intravascular ultrasound imaging justify the additional costs for the medical institutions.
On April 1, 1996, the Japanese Ministry of Health approved reimbursement for IVUS-based procedures. The reimbursements cover both the cost of the physician and the cost of the devices and are approximately $2,000.
The market for the Company's products could be adversely affected by changes in governmental and private third-party payors' policies. Capital costs for medical equipment purchased by hospitals in the United States are currently reimbursed separately from DRG payments. Medical institutions are reimbursed for a portion of the total capital equipment required to provide treatment.
Although the Company believes that less invasive procedures generally provide less costly overall therapies as compared to alternative surgical procedures, there can be no assurance that reimbursement for procedures using the Company's products will be available or, if currently available, will continue to be available, or that future reimbursement policies of payors will not adversely affect the Company's ability to sell its products on a profitable basis. Failure by hospitals and other users of the Company's products to obtain reimbursement from third-party payors, or changes in government and private third-party payors' policies toward reimbursement for procedures employing the Company's products, would have a material adverse effect on the Company's business, financial condition and results of operations. Moreover, the Company is unable to predict what additional legislation or regulation if any, relating to the health care industry or third-party coverage and reimbursement may be enacted in the future, or what effect such legislation or regulation would have on the Company. See "Management's Discussion and Analysis of Financial Condition and Results of Operation" and "Risk Factors - Limitations on Third-Party Reimbursement."
GOVERNMENT REGULATION
United States. The manufacturing and marketing of the Company's products are subject to extensive and rigorous government regulation in the United States. The process of obtaining and maintaining required regulatory approvals is lengthy, expensive and uncertain. The Company believes that its success will be significantly dependent upon commercial sales of improved versions of its imaging systems and catheter products. The Company will not be able to market these new products in the United States unless and until the Company obtains approval from the FDA.
If a medical device manufacturer can establish that a newly developed device is "substantially equivalent" to a device that was legally marketed prior to May 1976, or to a device that the FDA has found to be substantially equivalent to a legally marketed pre-1976 device, the manufacturer may seek clearance from the FDA to market the device by filing a premarket notification with the FDA under Section 510(k). A 510(k) premarket notification must be supported by appropriate data establishing the claim of substantial equivalence to the satisfaction of the FDA. Clearance under 510(k) normally takes at least three months and may require submission of clinical safety and efficacy data to the FDA. There can be no assurance that 510(k) clearance for any future product or modification of an existing product will be granted or that the process will not be unduly lengthy. In the future, the FDA will require manufacturers of certain medical devices introduced prior to 1976 to present additional safety and effectiveness data or face restrictions on the sale of these products, including the possible withdrawal of such devices from the market. All of the 510(k) clearances received for the Company's products were based on substantial equivalence to legally marketed pre-1976 devices. Review of the substantially equivalent pre-1976 devices on which the 510(k) clearances for the Company's catheters were based and any resulting restrictions on the Company or requirements imposed to present additional data could have a material adverse effect on the Company's business, financial condition and results of operations.
If substantial equivalence cannot be established, or if the FDA determines that the device or the particular application for the device requires a more rigorous review, the FDA will require that the manufacturer submit a pre-market approval ("PMA") application that must be reviewed and approved by the FDA prior to sales and marketing of the device in the United States. The PMA process is significantly more complex, expensive and time consuming than the 510(k) clearance process and frequently requires submission of clinical data. It is expected that certain of the Company's combination products under development, such as an imaging-radiation catheter, will be subject to this PMA process. There can be no assurance that PMA approval for any future product or modification of an existing product will be granted or that the process will not be unduly lengthy. Failure to comply with applicable regulatory requirements can, among other consequences, result in fines, injunctions, civil penalties, suspensions or loss of regulatory approvals, product recalls, seizure of products, operating restrictions and criminal prosecution. In addition, governmental regulations may be established that could prevent or delay regulatory approval of the Company's products. Delays in receipt of approvals, failure to receive approvals or the loss of previously received approvals would have a material adverse effect on the Company's business, financial condition and results of operations.
The Company is also required to register as a medical device manufacturer with the FDA and certain state agencies, such as the Food and Drug Branch of the California Department of Health Services ("CDHS"). As such, the Company is inspected on a routine basis by both the FDA and the CDHS for compliance with the FDA's Good Manufacturing Practices ("GMP") regulations. These regulations require that the Company manufacture its products and maintain related documentation in a prescribed manner with respect to manufacturing, testing and control activities. Further, the Company is required to comply with various FDA requirements for labeling. The Medical Device Reporting regulation requires that the Company provide information to the FDA on deaths or serious
injuries alleged to have been associated with the use of its devices, as well as product malfunctions that would likely cause or contribute to death or serious injury if the malfunction were to recur. In addition, the FDA prohibits an approved device from being marketed for unapproved applications. Specifically, the Company's FOCAL balloon catheters are approved in certain European countries, where the Company believes these catheters are being used principally for deployment of coronary stents and balloon angioplasty. In October 1995, EndoSonics received FDA approval to market Radiance's line of FACT catheters, which utilize the FOCAL technology, for coronary balloon angioplasty. These catheters may not be marketed by the Company in the United States for stent deployment without further FDA approval. If the FDA believes that a company is not in compliance with the law, it can institute proceedings to detain or seize products, issue a recall, prohibit marketing and sales of the company's products and assess civil and criminal penalties against the company, its officers or its employees.
The Company is also subject to other federal, state and local laws, regulations and recommendations relating to safe working conditions, laboratory and manufacturing practices. The extent of government regulation that might result from any future legislation or administrative action cannot be accurately predicted. Failure to comply with regulatory requirements could have a material adverse effect on the Company's business, financial condition and results of operations. See "-- Products."
International. International sales of the Company's products are subject to the regulatory agency product registration requirements of each country. The regulatory review process varies from country to country and may in some cases require the submission of clinical data. The Company typically relies on its distributors in such foreign countries to obtain the requisite regulatory approvals. Distributors have obtained regulatory approval for certain products in certain European countries and Japan and have applied for additional approvals. There can be no assurance, however, that such approvals will be obtained on a timely basis or at all.
The Company has received ISO 9001 certification of its Quality System as well as CE Mark certifications for most of its products. The ISO 9000 series of standards for quality operations has been developed to ensure that companies know the standards of quality to which they must adhere to receive certification. The European Union has promulgated rules which require that medical products obtain the right to affix the CE Mark, an international symbol of adherence to quality assurance standards and compliance with applicable European medical device directives. All medical devices placed on the market within the European Union are required to bear the CE Mark. ISO 9000 certification is one of the CE Mark certification requirements. Failure to receive the right to affix the CE Mark for any product will prohibit the Company from selling that product in member countries in the European Union. In Europe, the Company has obtained ISO 9001 certification for operations at the EndoSonics Europe, B.V. office. There can be no assurance that the Company will be successful in meeting ongoing certification requirements.
PATENTS AND PROPRIETARY INFORMATION
The Company's policy is to protect its proprietary position by, among other methods, filing U.S. and foreign patent applications to protect technology, inventions and improvements that are important to the development of its business. The Company holds 47 U.S. and 24 foreign issued patents; 38 are EndoSonics, 3 are Du-MED, and 30 are Cardiometrics. The Company has other U.S. and foreign patent applications pending covering various aspects of its technology. One issued U.S. patent covers IVUS imaging catheters, including IVUS balloon catheters, in which multiple transducer elements are electronically controlled by integrated circuits or other means mounted near the transducer elements in the catheter. This patent expires in April 2007. Two patents cover aspects of catheter design technology used by the Company in its catheters. A fourth patent covers improvements to the IVUS imaging system which enables it to obtain images closer to the transducer surface. A fifth patent covers modifications to the catheter tip transducer technology. A sixth patent covers a method and apparatus for imaging blood flow using an ultrasound catheter. Additional U.S. and foreign patent applications have been filed. No assurance can be given that pending patent applications will be approved, or that any issued patents will provide competitive advantages for the Company's products, or that they will not be challenged or circumvented by competitors.
The Company relies upon trade secrets, technical know-how and continuing technological innovation to develop and maintain its competitive position. The Company typically requires its employees, consultants and advisors to execute appropriate confidentiality and assignment of inventions agreements in connection with their employment, consulting or advisory relationships with the Company. There can be no assurance, however, that these agreements will not be breached, or that the Company will have adequate remedies for any breach. Furthermore, no assurance can be given that competitors will not independently develop substantially equivalent proprietary information and techniques, or otherwise gain access to the Company's proprietary technology, or that the Company can meaningfully protect its unpatented proprietary technology.
The interventional cardiology market in general and the market for balloon angioplasty catheters in particular, has been characterized by substantial litigation regarding patent and other intellectual property rights. In the event that any relevant claims of third-party patents are upheld as valid and enforceable, the Company could be prevented from utilizing the subject matter claimed in such patents, or would be required to obtain licenses from the patent owners of any such patents, or redesign its products or processes to avoid infringement. There can be no assurance that such licenses would be available or, if available, would be so on terms acceptable to the Company, or that the Company would be successful in any attempt to redesign its products or processes to avoid infringement. Litigation may be necessary to defend against claims of infringement, to enforce patents issued to the Company, or to protect trade secrets, and could result in substantial cost to, and diversion of effort by, the Company.
PRODUCT LIABILITY AND INSURANCE
Medical device companies are subject to a risk of product liability and other liability claims in the event that the use of their products results in personal injury claims. Although the Company has not experienced any product liability claims to date, any such claims could have an adverse impact on the Company. The Company maintains liability insurance with coverage of $1.0 million per occurrence and an annual aggregate maximum of $5.0 million. There can be no assurance that product liability or other claims will not exceed such insurance coverage limits, or that such insurance will continue to be available on commercially acceptable terms, or at all.
EMPLOYEES
As of December 31, 1998, the Company had 350 employees, including 220 in manufacturing, 65 in research, development and regulatory affairs, 42 in sales and marketing, and 23 in administration. The Company believes that the success of its business will depend, in part, on its ability to attract and retain qualified personnel.
ITEM 2.
ITEM 2. PROPERTIES
Currently, the Company leases approximately 59,000 square feet in Rancho Cordova, California, which is leased through the year 2006. The Company also leases approximately 4,100 square feet in The Netherlands for its European operations, which lease expires at the end of the year 2001. In connection with the acquisition of Navius, the Company obtained 11,000 square feet in San Diego, California, which is leased through August 31, 2000. In March 1998, the Company closed its Mountain View, California facility and consolidated the manufacturing operations conducted there into its Rancho Cordova facility. In February 1999, the Company executed a lease for approximately 44,000 square feet in San Diego, California which is leased through March 31, 2006.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In October 1998, the Company entered into a five-year litigation standstill agreement with Intravascular Research Limited with respect to certain intellectual property claims. The agreement includes the dismissal without prejudice of a pending Delaware lawsuit involving patent infringement claims. The agreement does not toll any potential patent infringement damages which may be accruing.
The Company is subject to various legal actions and claims arising in the ordinary course of business. Management believes the outcomes of these matters will have no material adverse effect on the Company's financial position, results of operations or cash flows.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers of the Company, their ages as of March 29, 1999, and their positions are as follows:
BACKGROUND
The principal occupations of each executive officer and key employee of the Company for at least the last five years are as follows:
Roger H. Salquist. Mr. Salquist was appointed Chairman of the Board in November of 1996. Since March 1997, Mr. Salquist has been a partner in Bay City Capital, a life sciences merchant banking firm. Mr. Salquist served as Chairman and Chief Executive Officer of Calgene, Inc., a Davis, California-based agribusiness biotechnology company, from 1984 through August 1996. He also served on the Board of Directors of Collagen Corporation from 1988 through October 1997. Mr. Salquist serves on the Advisory Council of the Stanford University Graduate School of Business and is a member of the Board of Trustees of the University of San Francisco.
Reinhard J. Warnking. Mr. Warnking joined EndoSonics in 1993 as a director, President and Chief Operating Officer. Mr. Warnking was appointed Chief Executive Officer on February 1, 1995. He was the President and Chief Executive Officer of Acoustic Imaging Technology Corporation, a manufacturer of ultrasound and transducer systems, from August 1991 to March 1993. From February 1989 to September 1990, he founded and operated Warnking Medizintechnik GmbH, which was acquired by Dornier Medizintechnik GmbH in September 1990. After the acquisition, Mr. Warnking founded and managed the ultrasound division of Dornier Medizintechnik. From August 1985 to February 1989, he held positions as Technical Director, General Manager and Vice President International for Squibb Medical Systems and Advanced Technology Laboratories (ATL).
Dr. Hans P. de Weerd. Dr. de Weerd became Senior Vice President and Managing Director of European Operations effective September 1994. From June 1993 to August 1994, he was the Managing Director of Du-MED BV, a Dutch company which the Company acquired. Prior to joining Du-MED, he was the Managing Director of EME GmbH, a transcranial Doppler ultrasound company which he acquired for Nicolet Instrument Corporation in July 1992. From April 1983 until July 1992, Dr. De Weerd was with Nicolet Instrument Corporation, a division of Thermo Electron Corporation, in a variety of research and development, new business and general management positions.
Michael J. Eberle. Mr. Eberle joined the Company as Director of Engineering in January 1985. In December 1985, he became a Vice President and Director of Research, with primary responsibility for the development of the Company's products. In 1992, Mr. Eberle became Senior Vice President, Engineering and Chief Technical Officer. In 1998, Mr. Eberle became Senior Vice President and General Manager of the Smart Wire Division. Prior to joining EndoSonics, Mr. Eberle served as an independent consultant, Manager of Electronic Research and Development at Second Foundation, an ultrasound imaging company, and as a scientist at GEC Hirst Research Center in the United Kingdom.
Richard L. Fischer. Mr. Fischer joined the Company in November 1997 as Vice President, Finance, and Chief Financial Officer. From August 1996 to August 1997 he was Vice President and Chief Financial Officer of Calydon, Inc., an emerging biopharmaceutical company developing therapeutics for the treatment of prostate cancer. From October 1989 to August 1996, Mr. Fischer was Vice President and Chief Financial Officer of Microgenics Corporation, a manufacturer of immunoassays for medical diagnostics. Prior to joining Microgenics, he was Vice President, Finance and Chief Financial Officer for Verilink Corporation, a manufacturer of telecommunications equipment.
Joerg Schulze-Clewing. Mr. Schulze-Clewing joined the Company in February 1997 as Vice President and Chief Technical Officer of MicroSound Corporation a former subsidiary of EndoSonics Corporation. In September 1998, MicroSound was merged with and into EndoSonics. Mr. Schulze-Clewing was promoted to the Vice President and General Manager of EndoSonics' Imaging Division in July, 1998. Before joining EndoSonics in 1997, he was an independent consultant.
Clifford R. Varney. Mr. Varney became Vice President of Catheter Development and Manufacturing in March 1994 and was promoted in 1998 to Vice President and General Manager, Image Guided Therapy Division. He joined the Company in October 1990 as Director of Catheter Manufacturing. From September 1984 to October 1990, prior to joining the Company, Mr. Varney was the Vice President, Manufacturing of BSW Technologies, a private automated equipment manufacturing and consulting company.
Oti M. Wooster. Ms. Wooster joined the Company in April 1997 as Vice President, Human Resources and Administration. She is responsible for directing the Company's human resources, facilities and administration activities. From 1994 to 1997, Ms. Wooster was Director, Human Resources and Operations for U.S. West Cellular, a multinational telecommunications company. From 1987 to 1994, she was Vice President, Human Resources and Administration for Government Technology Services, Inc., the world's largest seller of computer products and services to the federal government. Prior to 1987, Ms. Wooster was a member of the Executive Staff, and Cabinet member at Northern Telecom. She held various line, human resources and administration management positions in both domestic and international levels there and at General Electric Corporation.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's Common Stock has been traded on the Nasdaq National Market under the symbol "ESON" since the Company's initial public offering in March 1992. The following table sets forth the high and low close of market sales prices for the Common Stock for the periods indicated, as reported on the Nasdaq National Market.
On March 29, 1999, the last reported sale price of the Common Stock as reported on the Nasdaq National Market was $6.5625 per share. As of March 29, 1999, there were approximately 213 holders of record of the Company's Common Stock.
DIVIDEND POLICY
The Company declared a dividend for all stockholders of record on September 5, 1997 of .04 shares of Radiance Medical Systems, Inc. (NASDAQ: RADX) Common Stock for each outstanding EndoSonics share. The dividend was distributed on September 26, 1997. The Company has never declared or paid any cash dividends on its capital stock. The Company currently intends to retain any earnings to finance future growth and does not anticipate paying any cash dividends in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Annual Report on Form 10-K contains forward looking statements which involve risks and uncertainties. The Company's actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in "Risk Factors" beginning on page 19.
INTRODUCTION
Since its inception in 1984, EndoSonics has been engaged primarily in the research and development of products for the diagnosis and treatment of cardiovascular disease. Since 1991, a majority of the Company's net revenue has been derived from sales of its IVUS imaging systems and catheters.
The Company markets and distributes its IVUS imaging products in the United States, Europe and Japan through relationships with strategic partners, certain other distributors and, to a lesser extent, through a direct sales force. In February 1996, EndoSonics and Cordis entered into the Exclusive Distribution Agreement pursuant to which Cordis was granted the exclusive right to distribute EndoSonics' IVUS imaging products for coronary applications in North America, Europe, Africa and the Middle East. Cordis was obligated during each year of the Exclusive Distribution Agreement to use reasonable efforts to purchase certain minimum annual amounts of products from EndoSonics. In connection with the execution of the Exclusive Distribution Agreement, the Company issued 350,877 shares of its Common Stock to Cordis in a private placement transaction for an aggregate purchase price of approximately $5.0 million. The Company has since registered the shares of Common Stock issued to Cordis. The exclusive Distribution Agreement was terminated in April, 1998. EndoSonics and Cordis entered into a Transition Agreement in April, 1998 which provided for Cordis to maintain significantly reduced distribution rights. These distribution rights terminated in March, 1999.
In March 1997, the Company and Johnson & Johnson Medical K.K. ("JJMKK"), entered into a distribution agreement whereby JJMKK was granted exclusive right to distribute EndoSonics IVUS imaging products for coronary applications in Japan. The agreement contained similar terms as the Exclusive Distribution Agreement between Cordis and EndoSonics. The agreement was amended in December 1998 to extend the agreement through December 1999.
In April 1997, the Company and Johnson & Johnson, Professional Group - Latin America ("J & J Medical-LA"), entered into a distribution agreement whereby J & J Medical-LA was granted exclusive rights to distribute EndoSonics IVUS imaging products for coronary applications in certain countries of Latin America. The agreement contained similar terms as the Exclusive Distribution Agreement between Cordis and EndoSonics. The agreement was amended in December 1998 to extend the agreement through December 2000.
In July, 1998, the Company announced that it has agreed in principal to enter into a strategic relationship with Fukuda which includes an equity investment and research and development funding totaling $13 million in EndoSonics by Fukuda. Approximately $8.4 million of Fukuda's investment was for the purchase of newly issued EndoSonics common stock. The balance of the investment will fund certain research and development/technical assistance programs for products intended for the Japanese market which will be distributed by Fukuda. The funding will occur over a two-year period commencing in August, 1998.
In December 1998, the Company and JOMED N.V., ("JOMED") entered into an agreement for exclusive distribution of certain EndoSonics products into specified European and Middle Eastern countries. Also in December, EndoSonics and JOMED entered into an IVUS-guided stent delivery system agreement which calls for the development of a JOMED balloon and stent incorporated into a modular EndoSonics IVUS catheter. Under the agreement, EndoSonics will supply subassemblies to JOMED who will complete the manufacturing process and distribute the resulting product in the territory which is defined as certain European and Middle Eastern countries. In certain countries within the territory, EndoSonics may distribute exclusively or jointly with JOMED.
Radiance, formerly a majority-owned subsidiary of the Company, designs, develops, manufactures and markets catheters used to treat certain vascular diseases. Radiance's catheters are used in conjunction with angioplasty and other interventional procedures such as vascular stenting and drug delivery. Radiance completed its initial public offering in June of 1996 and, as a result, its assets, liabilities and results of operations are no longer included in the Company's consolidated financial statements. At December 31, 1998, the Company held approximately 15% of the outstanding shares of the Common Stock of Radiance and accounted for its investment on the cost method.
The Company's business strategy includes acquiring related businesses, products or technologies. On July 23, 1997, the Company acquired Cardiometrics through the merger of a wholly owned subsidiary of the Company with and into Cardiometrics, with Cardiometrics surviving as a wholly owned subsidiary of the Company.
Cardiometrics develops, manufactures, and markets intravascular medical devices to measure blood flow impairment caused by coronary artery disease. Cardiometrics' initial products, the FloWire(TM) Doppler guide wire and FloMap ultrasound instrument, represent an advance in functional testing of blood flow impairment, enabling cardiologists to evaluate the appropriateness of angioplasty interventions and assess post-procedural results directly
in the cardiac catheterization laboratory. Clinical experience demonstrates that the measurement of blood flow impairment downstream from (distal to) an obstruction, which Cardiometrics calls functional angiometry, provides information to improve the quality of patient care and procedure outcomes in the diagnosis and treatment of cardiovascular disease. The FloWire(TM)/FloMap(TM) systems has received clearance from the FDA and many corresponding European and Pacific Rim regulatory agencies. Cardiometrics has also developed the WaveWire(TM)/WaveMap intracoronary blood pressure measurement system, which was first used in a clinical case in Europe in December 1996. Cardiometrics received a 510(k) approval in August 1997 for the WaveWire(TM)/WaveMap(TM) System, and commenced shipment to United States customers in 1998.
On August 5, 1998, the Company acquired Navius Corporation, a San Diego based, privately-held developer of angioplasty balloons, stents, intravascular radiation devices and other medical products. Navius' results of operations are combined with those of the Company since the date of the acquisition.
The Company expects that it may pursue additional acquisitions in the future. Any future acquisitions may result in potentially dilutive issuances of equity securities, the write-off of in-process research and development, the incurrence of debt and contingent liabilities and amortization expenses related to intangible assets acquired, any of which could materially adversely affect the Company's business financial condition and results of operations. In particular, if the Company is unable to use the "pooling of interests" method of accounting, the Company will be required to amortize any intangible assets acquired in connection with any additional acquisitions and the amortization periods for such costs will be over the useful lives of such assets, which range from three years to eight years. Additionally, unanticipated expenses may be incurred relating to the integration of technologies and research and development, and administrative functions. Any acquisition will involve numerous risks, including difficulties in the assimilation of the acquired company's employees, operations and products, uncertainties associated with operating in new markets and working with new customers, the potential loss of the acquired company's key employees as well as the costs associated with completing the acquisition and integrating the acquired company.
The Company's financial results will be affected in the future by certain factors, market acceptance of the Company's new products, the revenue mix between sales of imaging systems and catheters and changes in government regulation regarding third-party reimbursement applicable to the Company's System and Products. See "Risk Factors."
RESULTS OF OPERATIONS
Comparison of the Year Ended December 31, 1998 with the Year Ended December 31, 1997
Cardiometrics' results of operations were included in the Company's consolidated results of operations beginning July 24, 1997. Navius' results of operations were included in the Company's consolidated results of operations beginning August 5, 1998. (See Note 3 to Consolidated Financial Statements.)
Total Revenue. Total revenue in 1998 increased by 30% to approximately $44.1 million from $34.0 million in 1997. The increase is a result of an additional $4.4 million in IVUS sales, primarily in Europe and Japan, and $4.4 million in Cardiometrics revenue. The majority of the increase in Cardiometrics revenue was due to the inclusion of Cardiometrics for a full twelve month period in 1998 as compared to 5 months in 1997. In addition, there was an increase of $1.4 million, primarily sales of balloon catheters, as a result of the Navius acquisition.
Sales of the Company's digital all-electronic IVUS imaging system and catheters accounted for 72% of total revenue and a 16% increase over 1997 results. The increase is due both to the growth of the overall market for IVUS imaging products and increased unit sales of the Company's imaging catheters.
The sales of IVUS imaging catheters as a percentage of total IVUS sales has increased from 42% in 1997 to 50% in 1998 due to the increase in the Company's installed base. In 1998, export sales as a percentage of total revenue increased to 73% as compared to 64% in 1997, primarily due to strong customer demand in Japan. The Company currently anticipates that export sales will continue to represent a substantial portion of the Company's total revenue in future periods.
Cost of Product Sales. Cost of product sales as a percentage of product sales decreased to approximately 46% from approximately 52% in 1997. Cost of sales as a percentage of product sales in 1998 was reduced principally by volume increases and improved manufacturing efficiencies, as well as favorable margins on Cardiometrics products. Gross profit margins on product sales improved to 54% in 1998 as compared to 48% in 1997. Due to the uncertainty associated with continued improvements in efficiency of the Company's manufacturing processes and
the impact of increasingly competitive pricing, there can be no assurance that the Company's gross profit margin will be maintained or continue to improve in future periods.
Acquisition Related Expenses. In connection with the Company's acquisition of Navius in 1998 , the Company wrote off in-process research and development totaling $10.6 million. This amount was expensed as an Acquisition Related Charge on the acquisition date. This write-off was necessary because the acquired technology had not yet reached technological feasibility and had no future alternative uses. The Navius acquired in-process research and development relates primarily to the development of intravascular ultrasound radiation devices. The Company anticipates that products using the acquired in-process technology will be generally released before the end of 2001. The Company expects that the acquired in-process research and development will be successfully developed, but there can be no assurance that technological viability of these products will be achieved.
The nature of the efforts required to develop the purchased in-process technology into technologically viable products principally relate to efficacy validation and regulatory approval.
The value of the purchased in-process technology was determined by estimating the projected net cash flows related to such products, which incorporate the in-process technology including percent complete prior to the date of acquisition, percent remaining to be developed post acquisition, time to completion, and costs to complete the development of the technology and the future revenues to be earned upon commercialization of the products. These cash flows were discounted back to their net present value. The resulting projected net cash flows from such projects were based on management's estimates of revenues and operating profits related to such projects.
The purchased in-process technology acquired in the Navius acquisition primarily relates to the radiation guide wire technology. The Company intends to use this technology to develop an IVUS radiation delivery product. This product will combine Navius' guide wire technology with the Company's IVUS imaging technology.
Revenue attributable to the in-process technology was assumed to begin in 2001 and increase over the 12 year projection period (2001 to 2012) at rates ranging from 591% to 10%, resulting in projected annual revenues of approximately $2 million to approximately $98 million. Such projections were derived from the projected number of units sold and the expected price per unit. Projected revenues consider, among other factors, presumed market penetration, retention of the Company's existing customer base, as well as, new customer transactions
Operating expenses include cost of goods sold, general and administrative expense, selling and marketing expense, and maintenance research and development costs. Operating expenses were estimated as a percentage of annual revenue. Cost of goods sold was estimated to be approximately 40%. General and administrative expenses and sales and marketing expenses as a percent of revenues were estimated to be 12% and 20% , respectively. Maintenance research and development cost are the costs to sustain the products once they have been introduced to the market. Maintenance research and development costs were estimated to be 2% of revenues. Operating profits were estimated to be approximately 26% of revenues and ranged from approximately $0.6 million to $25.5 million during the projection period.
The projected net cash flows were discounted to their present value. The Weighted Average Cost of Capital ("WACC") was used to determine an appropriate discount rate. The WACC calculation produces the average required rate of return of an investment in an operating enterprise, based on required rates of return from investments in various areas of the enterprise. The Company used a 30% discount rate to calculate the present value of the in process technology. This rate was determined by applying a risk premium of 11%, to the calculated WACC of 19%. The risk premium was added to reflect the general business risks associated with the technology which has not yet reached technological feasibility.
In calculating the present value of the developed technology and other acquired intangibles a 20% discount rate, which approximates the Company's WACC, was used. This rate reflects the fact that these assets face substantially the same risks as the business as a whole.
The Company estimates that the cost to complete development of the in process technology will be approximately $6 million.
Research, Development and Clinical. Research, development and clinical expenses increased 12% to $7.0 million in 1998 from approximately $6.3 million in 1997. This increase is due to a $0.9 million increase in clinical expenses compared to 1997 and the acquisition of Navius offset in part by research and development expenses which increased by $0.4 million. The majority of the increase in clinical expenses was due to the inclusion of Cardiometrics for a full twelve-month period in 1998.
Marketing and Sales. Marketing and sales expenses increased 58% to approximately $9.6 million from $6.1 million in 1997, primarily due to increased staffing and marketing programs related to staffing a direct sales force in the United States and Germany. As a percentage of total revenue, marketing and sales expenses increased to 22% as compared to 18% in 1997.
General and Administrative. General and administrative expenses decreased by 17% to approximately $4.8 million in 1998 from approximately $5.8 million in 1997. After adjusting for integration charges of $1.4 million in 1997, general and administrative expenses increased $0.4 million. The increase is attributable to an overall increase in the Company's level of operations; however, general and administrative expenses decreased to 11% of total revenue in 1998 as compared to 17% of total revenue in 1997.
Other Income. Other income decreased to approximately $1.9 million in 1998 from approximately $5.9 million in 1997. The decrease is due to the 1997 gains realized on the shares of Radiance common stock used to acquire Cardiometrics, distributions to the Company's stockholders and option holders, and the sale of Radiance stock. Interest income declined by $0.7 million due to reduced cash balances and lower short-term interest rates.
Net Loss. Net loss was $7.8 million, or $0.47 per share for 1998, as compared to a net loss of approximately $47.2 million, or $3.22 per share in 1997.
Comparison of the Year Ended December 31, 1997 with the Year Ended December 31,
Radiance Medical Systems' results of operations were included in the Company's consolidated results through June 19, 1996, and accounted for on the equity method thereafter. Cardiometrics' results of operations were included in the Company's consolidated results of operations beginning July 24, 1997. (See Note 3 to Consolidated Financial Statements.)
Total Revenue. Total revenue in 1997 increased by 39% to approximately $34.0 million from $24.4 million in 1996. The increase is a result of the Cardiometrics acquisition, which resulted in an additional $6.8 million in revenue and a $6.6 million increase in IVUS sales, primarily in Europe and Japan.
Sales of the Company's digital all-electronic IVUS imaging system and catheters accounted for approximately 78% of total revenue and a 32% increase over 1996 results. The increase is due both to the growth of the overall market for IVUS imaging products and increased sales under the Company's distribution agreements with Cordis and Fukuda.
Total revenue from Cardiometrics was approximately $6.8 million for the period from the acquisition, July 24, 1997 through December 31, 1997. Total Radiance revenue was approximately $3.8 million in 1996. There was no Radiance revenue included in 1997.
A majority of the Company's sales of IVUS products consists of sales of IVUS imaging systems. The sales of IVUS imaging catheters as a percentage of total IVUS sales has increased from 30% in 1996 to 42% in 1997 due to the increase in the Company's installed base. In 1997, export sales as a percentage of total revenue decreased to 64% as compared to 69% in 1996, as domestic sales increased at a greater rate than export sales. The Company currently anticipates that export sales will continue to represent a substantial portion of the Company's total revenue in future periods.
Cost of Product Sales. Cost of product sales as a percentage of product sales decreased to approximately 52% from approximately 63% in 1996. Cost of sales as a percentage of product sales in 1997 was reduced principally by volume increases and improved manufacturing efficiencies, as well as favorable margins on Cardiometrics products. Gross profit margins on product sales improved to 48% in 1997 as compared to 37% in 1996. Due to the uncertainty associated with continued improvements in efficiency of the Company's manufacturing process and the impact of increasingly competitive pricing, there can be no assurance that the Company's gross profit margin will be maintained or continue to improve in future periods.
Acquisition Related Expenses. In connection with the Company's acquisition of Cardiometrics in 1997, the Company wrote-off in-process research and development totaling $43.0 million. This write-off was necessary because the acquired technology had not reached technological feasibility and had no future alternative uses. The Cardiometrics acquired in-process research and development relates primarily to the development of intravascular guidewires to measure blood flow and blood pressure in diseased coronary arteries, as well as, other functional assessment instruments. The nature of the efforts required to complete development of the various purchased in-process research and development projects into technologically viable products principally relate to efficacy and regulatory approval and are projected to be completed from 1997 to 1999. Additionally, the Company recorded restructuring charges of $5.0 million related to corporate reorganization costs
and plans to reduce overhead of the combined companies. The charges primarily consist of cash expenditures anticipated in 1998 related to termination of certain agreements and relocation and consolidation of facilities.
Research, Development and Clinical. Research, development and clinical expenses increased 10% to $6.3 million in 1997 from approximately $5.7 million in 1996. Cardiometrics portion of research, development and clinical expense for 1997 was approximately $1.9 million.
Marketing and Sales. Marketing and sales expenses increased 12% to approximately $6.1 million from $5.4 million in 1996, primarily due to increased staffing and marketing programs related to the acquisition of Cardiometrics. After adjusting for $0.5 million in integration charges in 1997, marketing and sales remained constant. As a percentage of total revenue, marketing and sales expenses decreased to 18% as compared to 22% in 1996.
General and Administrative. General and administrative expenses increased by 21% to approximately $5.8 million in 1997 from approximately $4.8 million in 1996. After adjusting for integration charges of $1.4 million in 1997 and $0.3 million in 1996, general and administrative expenses increased $0.1 million. The increase is attributable to an overall increase in the Company's level of operations; however, general and administrative expenses decreased to 17% of total revenue in 1997 as compared to 20% of total revenue in 1996.
Other Income. Other income increased to approximately $5.9 million in 1997 from approximately $2.3 million in 1996. The increase is due to the result of gains realized on the shares of Radiance common stock used to acquire Cardiometrics, distributions to the Company's stockholders and option holders, and the sale of Radiance stock, offset in part by a reduction in interest income of $0.4 million due to reduced cash balances.
Net Loss. Net loss was $47.2 million, or $3.22 per share for 1997, as compared to a net loss of approximately $7.2 million, or $0.53 per share in 1996.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1998, the Company had cash, cash equivalents and short-term investments of $25 million and no borrowings or credit facilities. Net cash provided from operations was $2.1 million in 1998, as compared to cash used in operations of $3.6 million in 1997. Working capital increased to $34.3 million in 1998, as compared to $30.1 million in 1997. The increase is primarily due to the sale of common stock to Fukuda, the sale of Radiance common stock, and reduced accrued restructuring and integration expenses offset in part by the cash used in the acquisition of Navius and the acquisition of stock under the Company's stock repurchase program.
Net cash used in investing activities was $11.3 million, as compared to $17.9 million in 1997. On August 5, 1998, the Company acquired all of the outstanding shares of Navius. As a result, Navius' assets, liabilities and results of operations since the acquisition date are included in the Company's consolidated statements of cash flows. Net cash used in the acquisition was $6.5 million.
Net cash provided by financing activities was $4.0 million as compared to $0.6 million in 1997. In 1998, the Company received $8.8 million from the issuance of common stock, primarily related to the sale of common stock to Fukuda for $8.4 million and the exercise of stock options of $0.4 million. In 1997 proceeds from the issuance of common stock was $0.6 million.
Intangible assets total approximately $12.4 million as of December 31, 1998 and consist primarily of developed technology, goodwill, and other intangible assets acquired in connection with the acquisitions of Cardiometrics and Navius in 1997 and 1998, respectively. The Company continually evaluates the value and future benefits of its intangible assets, and assesses the recoverability of the intangible assets using cash flows and income from operations of the related acquired businesses as measures. Under this approach, the carrying value would be reduced if it becomes probable that our best estimate for expected future cash flows of the related business would be less than the carrying amount of the intangible assets. As of December 31, 1998, there have been no adjustments to the carrying amounts of intangibles resulting from these evaluations. As of December 31, 1998, intangible assets represented approximately 19% of our total assets and 23% of stockholders equity.
The Company anticipates using cash resources primarily for capital expenditures, product development, sales and marketing efforts and working capital purposes prior to achieving positive cash flow from operations. The Company believes that its existing cash, cash equivalents and short-term investments as of December 31, 1998 will be sufficient to meet the Company's operating expenses and capital requirements through 1999. However, there can be no assurance that the Company will not be required to seek other financing or that such financing, if required, will be available on terms satisfactory to the Company. See " Risk Factors--Future Operating Results--History of Operating Losses; Anticipated Future Losses."*
IMPACT OF YEAR 2000
The Year 2000 Issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions to operations, including, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. Should any of these disruptions occur, the financial impact on the Company is unknown.
The Company has completed an assessment and will have to modify or replace certain portions of its existing software in order for its computer systems to function properly with respect to dates in the year 2000 and thereafter. However, independent of the Year 2000 Issue, the Company has plans to replace the majority of its existing computer programs with an integrated, enterprise-wide software platform. The Company has identified a software program which meets the Company's operational needs and is also Year 2000 compliant. The Company believes that the new software can be installed and tested with regards to the Year 2000 Issue by September, 1999. It is expected that the cost of the new software, installation, and testing will be approximately $1.2 million, the majority of which would be capitalized. In the event that the new software does not function properly with regard to the Year 2000, and an adequate solution is not readily available, the Company's believes that it can make the necessary modifications, primarily software version upgrades, to its current computer programs in order to make them Year 2000 compliant.
It is anticipated that the Year 2000 project will be completed not later than September, 1999, which is prior to any anticipated impact on its operating systems. The Company believes that with the planned software conversion or with modifications to the existing software, the Year 2000 Issue will not pose a significant operational problem. However, if such modifications are not completed timely, the Year 2000 Issue could have a material impact on the operations of the Company. Likewise, if any of the Company's key suppliers, vendors or customers experience a prolonged business interruption as a result of the Year 2000 Issue, it could have a material impact on the operations of the Company.
The costs of the project and the date on which the Company believes it will complete the Year 2000 modifications are based on management's best estimates, which assume certain future events, including the continued availability of certain resources. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the effectiveness of the new software and, if necessary, the upgrades received from the Company's software vendors at addressing the Year 2000 Issue and similar uncertainties.
TAX MATTERS
As of December 31, 1998, the Company had federal and state net operating loss carryforwards of approximately $50.0 million and $8.5 million, respectively. The Company also had federal research and development and other tax credit carryforwards for federal and state income tax purposes, of approximately $2.4 million and $1.0 million respectively. The net operating loss and credit carryforwards began expiring and will continue to expire at various dates beginning in 1999 through 2018 if not utilized. Utilization of the net operating losses and credits may be subject to a substantial annual limitation due to the "change of ownership" rules provided by the Internal Revenue Code and similar state tax provisions. As a result of the annual limitation, a portion of these carryforwards may expire before ultimately becoming available to reduce future income tax liabilities.
RISK FACTORS
History of Operating Losses; Anticipated Future Losses. The Company was founded in 1984 and has experienced annual operating losses since its inception. The Company's accumulated deficit at December 31, 1998 was approximately $116 million. There can be no assurance that the Company will be able to achieve or sustain profitability in the future. Although the Company believes that its existing cash, cash equivalents and short-term investments will be sufficient to meet its liquidity requirements through 1999, there can be no assurance that the Company will not require additional financing or that such financing, if required, will be available on satisfactory terms, if at all.
Uncertainty of Market Acceptance. Although external ultrasound imaging and balloon angioplasty are widely used technologies, the use of IVUS imaging in connection with interventional cardiology is relatively new. The commercial success of the Company's products will depend upon their acceptance by the medical community as a useful, cost-effective component of interventional cardiovascular and peripheral vascular procedures. IVUS imaging is used in conjunction with angioplasty and other intravascular procedures such as vascular stenting. Accordingly, the medical community must determine that the information obtained from the use of the Company's ultrasound products will increase the safety or effectiveness or lower the overall cost of the care being provided and that the value of such information justifies the incremental expense of obtaining IVUS imaging. In addition, market acceptance of the Company's combination balloon angioplasty/IVUS imaging catheters will depend, among other things, on a determination by the medical community that the efficacy of the therapeutic component of the Company's combination catheters is at least comparable to that of competing non-imaging angioplasty catheters and other types of therapy. Although IVUS imaging devices have been available for over ten years, the market for such products has remained relatively small. Although the Company believes the benefits of IVUS imaging can be demonstrated, there can be no assurance that the benefits will be considered sufficient by the medical community to enable the Company's products to achieve widespread market acceptance. Failure of the Company's products to achieve market acceptance would have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Products."
Dependence on Strategic Relationships. In recent years there has been significant consolidation among medical device suppliers as the major suppliers have attempted to broaden their product lines in order to focus on product configurations that address a given procedure or treatment and in order to respond to cost pressures from health care providers. This consolidation has made it increasingly difficult for smaller suppliers, such as the Company, to effectively distribute their products without a major relationship with one of the major suppliers. There can be no assurance that the Company will be able to maintain its relationship with Cordis or replace Cordis in the event the Company's relationship with Cordis would be terminated. In the event of such a termination, the Company's ability to distribute its IVUS imaging products would be materially adversely affected, which would have a material adverse effect on the Company's business, financial condition and results of operations.
Dependence on New Products; Rapid Technological Change. The medical device industry generally, and the IVUS imaging device market in particular, are characterized by rapid technological change, changing customer needs, and frequent new product introductions. The Company's future success will depend upon its ability to develop and introduce new products that address the increasingly sophisticated needs of its customers. There can be no assurance that the Company will be successful in developing and marketing new products that achieve market acceptance or that the Company will not experience difficulties that could delay or prevent the successful development, introduction and marketing of new products. See "Business -- Products."
Dependence on International Sales. The Company derives, and expects to continue to derive, a significant portion of its revenue from international sales. In 1996, 1997, and 1998, the Company's international sales were $16.9 million, $21.9 million and $32.2 million respectively, or 69%, 64% and 73% of total revenue. Therefore, a significant portion of the Company's revenues will continue to be subject to the risks associated with international sales, including economic or political instability, shipping delays, changes in applicable regulatory policies, fluctuations in foreign currency exchange rates and various trade restrictions, all of which could have a significant impact on the Company's ability to deliver products on a competitive and timely basis. Future imposition of, or significant increases in the level of, customs duties, import quotas or other trade restrictions, could have an adverse effect on the Company's business, financial condition and results of operation. The regulation of medical devices, particularly in the European Community, continues to expand and there can be no assurance that new laws or regulations will not have an adverse effect on the Company.
Suppliers. The Company purchases many standard and custom built components from independent suppliers, and contracts with third parties for certain specialized electronic component manufacturing processes. Most of these purchased components and processes are available from more than one vendor. However, the manufacturing of the connection points on the integrated circuit microchips and the pressure microchip are currently performed by single vendors. Although the Company is in the process of identifying alternative vendors, the qualification of additional or replacement vendors for certain components or services is a lengthy process. Any supply interruption from these single source vendors would have a material adverse effect on the Company's ability to manufacture its products
until a new source of supply was qualified and, as a result, could have an adverse effect on the Company's business, financial condition and results of operations. See "Business --Manufacturing" and "-- Government Regulation."
Limitations on Third-Party Reimbursement. In the United States, the Company's products are purchased primarily by medical institutions that then bill various third-party payors. Medical institutions are reimbursed for the care of Medicare hospital patients based at a predetermined lump sum amount for diagnostic related group or DRGs regardless of the costs involved. The amount of money paid for a specific DRG is determined by the average resource consumption needed to treat a specific disease, including the nursing time, operating room time and supplies. The amount of reimbursement is fixed and thus the amount of potential profit for the medical institution relating to the procedure may be reduced to the extent the physician performs additional procedures such as IVUS imaging, pressure measurement or uses a more expensive product that combines ultrasound imaging with therapeutic capabilities.
Private insurers and other payors determine whether to provide coverage for a particular procedure and reimburse hospitals for medical treatment also usually at a fixed rate based. The fixed rate of reimbursement is based on the procedure performed, and is unrelated to the specific type or number of devices used in a procedure. Some payors may deny reimbursement if they determine that the device used in a treatment was unnecessary, inappropriate or not cost-effective, experimental or used for a non-approved indication.
Physicians are reimbursed for performing medical producers based on the amount of resource costs needed to provide the services. Included in the cost of providing each service is the physician work, practice expense and malpractice insurance. Payments are adjusted for geographic differences. CPT codes are now available for all EndoSonics technology. CPT codes have been available since for ultrasound procedures since 1997 and since January 1999 for Doppler flow and pressure measurement. Physicians are responsible to determine that the clinical benefits of intravascular ultrasound imaging and physiological assessment justify the additional costs for the medical institutions.
Although the Company believes that less invasive procedures generally provide less costly overall therapies as compared to alternative surgical procedures, there can be no assurance that reimbursement for such less invasive procedures will continue to be available, or that future reimbursement policies of payors will not adversely affect the Company's ability to sell its products on a profitable basis. Failure by hospitals and other users of the Company's products to obtain reimbursement from third-party payors, or changes in government and private third-party payors' policies toward reimbursement for procedures employing the Company's products, would have a material adverse effect on the Company's business, financial condition and results of operations.
The market for the Company's products could be adversely affected by changes in governmental and private third-party payors' policies. A portion of capital costs for medical equipment purchased by hospitals are currently reimbursed separately from DRG payments. Moreover, the Company is unable to predict what additional legislation or regulation if any, relating to the health care industry or third-party coverage and reimbursement may be enacted in the future, or what effect such legislation or regulation would have on the Company. See "Third-Party Reimbursement."
Competition. Competition in the market for devices used in the diagnosis and treatment of cardiovascular and peripheral vascular disease is intense, and is expected to increase. The interventional cardiology market is characterized by rapid technological innovation and change, and the Company's products could be rendered obsolete as a result of future innovations. The Company's digital, all-electronic IVUS imaging catheters compete with mechanical ultrasound devices manufactured by CVIS and Hewlett-Packard. Both CVIS and Hewlett-Packard are significantly larger than the Company, and have significantly greater financial, sales and marketing and technical resources available. These competitors have also developed IVUS imaging products with high quality images and the Company believes that its competitive position is dependent upon its ability to establish its reputation as a producer of high quality IVUS imaging products. There can be no assurance that these companies are not currently developing, or will not attempt to develop, combination balloon angioplasty/IVUS imaging catheters that would compete with the Company's combination balloon angioplasty/IVUS imaging products. Moreover, companies currently engaged in the manufacture and marketing of non-imaging angioplasty catheters could attempt to expand their product lines to include combination balloon angioplasty/IVUS imaging products.
The Company's combination balloon angioplasty/IVUS imaging catheters compete or will compete with therapeutic catheters marketed by a number of manufacturers, including CVIS, Cordis, Guidant and Medtronic, Inc. Such companies have substantial resources, established market positions, and significantly larger sales and marketing organizations. In addition, the Company faces competition from manufacturers of atherectomy devices, vascular stents and pharmaceutical products intended to treat cardiovascular disease. See "Business - -- Competition."
Reliance on Patents and Proprietary Technology; Risk of Patent Infringement. The Company holds six issued United States patents and has other United States and several foreign patent applications pending covering various aspects of its IVUS imaging technology. No assurance can be given, however, that the Company's patent applications will issue as patents or that any issued patents will provide competitive advantages for the Company's products or will not be successfully challenged or circumvented by its competitors. Although the Company attempts to ensure that its products do not infringe other party's patents and proprietary rights, there can be no assurance that its products do not infringe such patents or rights. The interventional cardiovascular market has been characterized by substantial litigation regarding patent and other intellectual property rights. In the event that any relevant claims of third-party patents are upheld as valid and enforceable, the Company could be prevented from practicing the subject matter claimed in such patents, or would be required to obtain licenses from the owners of any such patents or redesign its products or processes to avoid infringement. There can be no assurance that such licenses would be available or, if available, would be so on terms acceptable to the Company or that the Company would be successful in any attempt to redesign its products or processes to avoid infringement. The Company also relies on trade secrets and proprietary technology and enters into confidentiality and non-disclosure agreements with its employees and consultants. There can be no assurance that the confidentiality of such trade secrets or proprietary information will be maintained by employees, consultants, advisors or others, or that the Company's trade secrets or proprietary technology will not otherwise become known or be independently developed by competitors in such a manner that the Company has no practical recourse. Litigation may be necessary to defend against claims of infringement or invalidity, to enforce patents issued to the Company or to protect trade secrets and could result in substantial cost to, and diversion of effort by, the Company. See "Business -- Patents and Proprietary Technology" and "Legal Proceedings."
Government Regulation. The manufacturing and marketing of the Company's products are subject to extensive and rigorous government regulation in the United States and in other countries. The Company believes that its success will be significantly dependent upon commercial sales of improved versions of its imaging systems and catheter products. The Company will not be able to market these new products in the United States unless and until the Company obtains approval from the FDA.
If a medical device manufacturer can establish that a newly developed device is "substantially equivalent" to a device that was legally marketed prior to May 1976, or to a device that the FDA has found to be substantially equivalent to a legally marketed pre-1976 device, the manufacturer may seek clearance from the FDA to market the device by filing a premarket notification with the FDA under Section 510(k) of the Federal Food, Drug, and Cosmetic Act ("510(k)"). There can be no assurance that 510(k) clearance for any future product or modification of an existing product will be granted or that the process will not be unduly lengthy. All of the 510(k) clearances received for the Company's catheters were based on substantial equivalence to legally marketed pre-1976 devices. Review of the substantially equivalent pre- 1976 devices on which the 510(k) clearances for the Company's catheters were based and any resulting restrictions on the Company or requirements imposed to present additional data could have a material adverse effect on the Company's business, financial condition and results of operations.
If substantial equivalence cannot be established, or if the FDA determines that the device or the particular application for the device requires a more rigorous review, the FDA will require that the manufacturer submit a PMA application that must be reviewed and approved by the FDA prior to sales and marketing of the device in the United States. The PMA process is significantly more complex, expensive and time consuming than the 510(k) clearance process and frequently requires the submission of clinical data. It is expected that certain of the Company's combination angioplasty/IVUS imaging products under development will be subject to this PMA process. Failure to comply with applicable regulatory requirements can, among other consequences, result in fines, injunctions, civil penalties, suspensions or loss of regulatory approvals, product recalls, seizure of products, operating restrictions and criminal prosecution. In addition, governmental regulations may be established that could prevent or delay regulatory approval of the Company's products. Delays in receipt of approvals, failure to receive approvals or the loss of previously received approvals would have a material adverse effect on the Company's business, financial condition and results of operations.
The Company is also required to register as a medical device manufacturer with the FDA and certain state agencies, such as the Food and Drug Branch of CDHS. As such, the Company is inspected on a routine basis by both the FDA and the CDHS for compliance with the GMP regulations. These regulations require that the Company manufacture its products and maintain related documentation in a prescribed manner with respect to manufacturing, testing and control activities. Further, the Company is required to comply with various FDA requirements for labeling. The Medical Device Reporting regulation requires that the Company provide information to the FDA on deaths or serious injuries alleged to have been associated with the use of its devices, as well as product malfunctions
that would likely cause or contribute to death or serious injury if the malfunction were to recur. In addition, the FDA prohibits an approved device from being marketed for unapproved applications. Specifically, the Company's FOCAL balloon catheters are approved in certain European countries. The Company believes that these catheters are being used in those countries principally for deployment of coronary stents and balloon angioplasty. In October 1995, EndoSonics received FDA approval to market Radiance's line of FACT catheters, which utilize the FOCAL technology, for coronary balloon angioplasty. Without specific FDA approval for use in stent deployment, these catheters may not be marketed by the Company in the United States for such use. If the FDA believes that a company is not in compliance with applicable laws and regulations, it can institute proceedings to detain or seize products, issue a recall, prohibit marketing and sales of the company's products and assess civil and criminal penalties against the company, its officers or its employees.
The Company is also subject to other federal, state and local laws, regulations and recommendations relating to safe working conditions, laboratory and manufacturing practices. The extent of government regulation that might result from any future legislation or administrative action cannot be accurately predicted. Failure to comply with regulatory requirements could have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Products" and "-- Government Regulation."
International sales of the Company's products are subject to the regulatory agency product registration requirements of each country. The regulatory review process varies from country to country and may in some cases require the submission of clinical data. The Company typically relies on its distributors in such foreign countries to obtain the requisite regulatory approvals. There can be no assurance, however, that such approvals will be obtained on a timely basis or at all.
The Company has received ISO 9001 certification of its Quality System as well as CE Mark certifications for most of its products. The ISO 9000 series of standards for quality operations has been developed to ensure that companies know the standards of quality to which they must adhere to receive certification. The European Union has promulgated rules which require that medical products obtain the right to affix the CE Mark, an international symbol of adherence to quality assurance standards and compliance with applicable European medical device directives. All medical devices placed on the market within the European Union are required to bear the CE Mark. ISO 9000 certification is one of the CE Mark certification requirements. Failure to receive the right to affix the CE Mark for any product will prohibit the Company from selling that product in member countries in the European Union. In Europe, the Company has obtained ISO 9001 certification for operations at the EndoSonics Europe, B.V. office. There can be no assurance that the Company will be successful in meeting ongoing certification requirements.
Potential Product Liability; Limited Insurance. The Company faces the risk of financial exposure to product liability claims. The Company's products are often used in situations in which there is a high risk of serious injury or death. Such risks will exist even with respect to those products that have received, or in the future may receive, regulatory approval for commercial sale. The Company maintains product liability insurance with coverage limits of $1.0 million per occurrence and $5.0 million per year in the aggregate. There can be no assurance that the Company's product liability insurance is adequate or that such insurance coverage will remain available at acceptable costs. There can be no assurance that the Company will not incur significant product liability claims in the future. A successful claim brought against the Company in excess of its insurance coverage could have a material adverse effect on the Company's business, financial condition and results of operations. Additionally, adverse product liability actions could negatively affect the reputation and sales of the Company's products as well as the Company's ability to obtain and maintain regulatory approval for its products. See "Business -- Product Liability and Insurance."
Volatility of Stock Price. The Company's Common Stock has experienced and can be expected to continue to experience substantial price volatility in response to actual or anticipated quarterly variations in operating results, announcements of technological innovations or new products by the Company or its competitors, developments related to patents or other intellectual property rights, developments in the Company's relationships with its customers, distributors or suppliers, acquisitions or divestitures of other companies in the health care industry, and other events or factors. In addition, any shortfall or changes in revenue, gross margins, earnings, or other financial results from analysts' expectations could cause the price of the Company's Common Stock to fluctuate significantly. In recent years, the stock market in general has experienced extreme price and volume fluctuations, which have particularly affected the market price of many technology and health care companies and which have often been unrelated to the operating performance of those companies. These broad market fluctuations may adversely affect the market price of the Company's Common Stock. See "Market for Registrant's Common Equity and Related Stockholder Matters."
Item 8.
Item 8. FINANCIAL STATEMENTS
Report of Ernst & Young LLP, Independent Auditors
Financial Statements Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Stockholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements
The financial statement schedule listed under Part IV, Item 14, is filed as part of this Form 10-K.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND OFFICERS OF THE REGISTRANT
The information concerning the Company's directors required by this item is incorporated by reference from the Company's Proxy Statement, to be mailed to stockholders for the Annual Meeting to be held on or about June 10, 1999. The information concerning the Company's executive officers required by this item is incorporated by reference to the section of Part I hereof entitled "Executive Officers of the Registrant."
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from the Company's Proxy Statement, to be mailed to stockholders for the Annual Meeting to be held on or about June 10, 1999.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference from the Company's Proxy Statement, to be mailed to stockholders for the Annual Meeting to be held on or about June 10, 1999.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference from the Company's Proxy Statement, to be mailed to stockholders for the Annual Meeting to be held on or about June 10, 1999.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) THE FOLLOWING DOCUMENTS ARE FILED AS A PART OF THIS ANNUAL REPORT ON FORM 10-K:
1. Financial Statements of the Company.
Report of Ernst & Young LLP, Independent Auditors Consolidated Balance Sheets - December 31, 1997 and 1998 Consolidated Statements of Operations for the years ended December 31, 1996, 1997 and 1998 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1996, 1997 and 1998
Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1997 and 1998 Notes to Consolidated Financial Statements for the years ended December 31, 1996, 1997 and 1998
2. Financial Statement Schedule.
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 or the notes thereto.
3. Exhibits. Reference is made to Item 14(c) of this Annual Report on Form 10-K.
(b) REPORTS ON FORM 8-K. No reports on Form 8-K were filed during the last quarter of the fiscal year covered by this Annual Report on Form 10-K.
(c) EXHIBITS.
- ------------
* Confidential Treatment Requested.
(1) Filed as an exhibit to the Company's Current Report on Form 8-K (File No. 0-19880) filed with the Commission on July 14, 1993.
(2) Filed as an exhibit to the Company's Registration Statement on Form 8-B filed with the Securities and Exchange Commission (the "Commission") on September 25, 1992 and incorporated by reference herein.
(3) Filed as an exhibit to the Company's Registration Statement on Form S-1 (File No. 33-45280) filed with the Securities and Exchange Commission on January 24, 1992 (the "Registration Statement") and incorporated by reference herein.
(4) Filed as an exhibit to the Company's Annual Report on Form 10-K (File No. 0-19880) filed with the Commission on March 31, 1993.
(5) Filed as Exhibit 10.13 to Amendment No. 1 to the Company's Registration Statement on Form S-1 (File No. 33-45280) filed with the Commission on February 25, 1992 and incorporated herein by reference.
(6) Filed as an exhibit to the Company's Annual Report on Form 10-K (File No. 0-19880) filed with the Commission on March 24, 1994.
(7) Filed as an exhibit to the Company's Annual Report on Form 10-K/A (File No. 0-19880) filed with the Commission on July 29, 1996.
(8) Filed as an exhibit to the Company's Form 8-K (File No. 0-19880) filed with the Commission on February 10, 1997 and incorporated herein by reference.
(9) Filed as an exhibit to the Company's Annual Report on Form 10-K (File No. 0-19880) filed with the Commission on March 21, 1995.
(10) Filed as an exhibit to the Company's Annual Report on Form 10-K (File No. 0-19880) filed with the Commission on March 19, 1997.
(11) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q, filed with the Commission on November 15, 1998, for the quarter ended September 30, 1998.
(d) 1. Financial Statement Schedule.
Report of Ernst & Young LLP, Independent Auditors
Consolidated Balance Sheets - December 31, 1996 and 1997
Consolidated Statements of Operations for the years ended December 31, 1995, 1996 and 1997
Consolidated Statements of Stockholders Equity for the years ended December 31, 1995, 1996 and 1997
Consolidated Statements of Cash Flows for the years ended December 31, 1995, 1996 and 1997
Notes to Consolidated Financial Statements for the years ended December 31, 1995, 1996 and 1997
2. Financial Statement Schedule.
II. Valuation and Qualifying Accounts
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 on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
ENDOSONICS CORPORATION
Date: March 31, 1999 By: /s/ REINHARD J. WARNKING -------------- ----------------------------------- Reinhard J. Warnking Chief Executive Officer (Principal Executive Officer)
By: /s/ RICHARD L. FISCHER ----------------------------------- Richard L. Fischer Vice President, Finance (Principal Financial Officer)
By: /s/ KATHLEEN E. REDD ----------------------------------- Kathleen E. Redd Controller (Principal Accounting Officer)
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints, jointly and severally, Reinhard J. Warnking and Richard L. Fischer, and each of them, as his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments (including post-effective amendments) to this Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Report on Form 10-K has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders EndoSonics Corporation
We have audited the accompanying consolidated balance sheets of EndoSonics Corporation as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedule listed in the Index at Item 14(a)2. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of EndoSonics Corporation at December 31, 1998 and 1997, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ ERNST & YOUNG LLP
Sacramento, California February 16, 1999
ENDOSONICS CORPORATION
CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share amounts)
See accompanying notes
\ ENDOSONICS CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except share and per share amounts)
See accompanying notes
ENDOSONICS CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
See accompanying notes
See accompanying notes
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
1. Organization, Business and Summary of Significant Accounting Policies
Organization and Business
EndoSonics Corporation (EndoSonics), a Delaware corporation, develops, manufactures and markets intravascular ultrasound imaging systems and diagnostic imaging catheters, functional measurement guidewires, angioplasty balloon catheters, combined angioplasty imaging catheters and medical devices for the diagnosis and treatment of coronary and peripheral vascular disease.
Consolidation
The accompanying consolidated financial statements include the accounts of EndoSonics and its subsidiaries (EndoSonics and its subsidiaries are collectively referred to hereinafter as the "Company"). All significant inter-company accounts and transactions have been eliminated in consolidation. Investments in unconsolidated subsidiaries, and other investments in which the Company has a 20% to 50% interest or otherwise has the ability to exercise significant influence, are accounted for under the equity method (see Note 4).
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and in the accompanying notes. Actual results could differ from those estimates.
Foreign Currency Translation
The local currency is the functional currency of the Company's foreign subsidiary. Exchange gains or losses resulting from foreign currency translation are included as a component of other comprehensive income. Transaction exchange gains or losses are included in general and administrative expense in the consolidated statement of operations, and have not been significant in any year presented.
Cash Equivalents and Short-Term Investments
The Company invests its excess cash in various investment grade, interest-bearing securities. As of December 31, 1998 and 1997, cash equivalents and short-term investments consisted of money market mutual funds, U.S. Treasury Notes and obligations of other U.S. government agencies and corporate debt securities. With the exception of the U.S. government and its agencies, by policy, the amount of credit exposure to any one issuer is limited. The Company has not experienced any significant losses on such investments.
Management determines the appropriate classification of debt securities at the time of purchase and re-evaluates such designation as of each balance sheet date. At December 31, 1998 and 1997, the Company's entire portfolio of investments is classified as available-for-sale. These securities are stated at fair market value, determined based on quoted market prices, with the unrealized gains and losses reported in a separate component of other comprehensive income.
The amortized cost of debt securities classified as available-for-sale is adjusted for amortization of premiums and accretion of discounts to maturity, over the estimated life of the security. Such amortization is included in interest income. Realized gains and losses, which were not significant in any year presented, and declines in value judged to be other-than-temporary are included in general and administrative expense. The cost of securities sold is based on the specific identification method.
For purposes of reporting cash flows, the Company considers highly liquid investments with original maturities of three months or less as cash equivalents.
Inventories
Inventories are stated at the lower of cost, determined on a first-in, first-out (FIFO) basis, or market value.
Property and Equipment
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
Property and equipment are stated at cost and depreciated or amortized on a straight-line basis over the lesser of the estimated useful lives of the assets or the lease term. The estimated useful lives range from three to seven years.
Intangible Assets
Intangible assets consist of goodwill, assembled workforce, and developed technology arising from business acquisitions. The values are being amortized on a straight-line basis over periods ranging from three to nine years.
The Company continually evaluates the value and future benefits of its intangible assets, and assesses the recoverability of the intangible assets using cash flows and income from operations of the related acquired businesses as measures. Under this approach, the carrying value would be reduced if it becomes probable that our best estimate for expected future cash flows of the related business would be less than the carrying amount of the intangible assets. As of December 31, 1998, there have been no adjustments to the carrying amounts of intangibles resulting from these evaluations.
Concentrations of Credit Risk, Significant Customers, Export Sales and Suppliers
The Company sells its products primarily to medical institutions and distributors worldwide (see Note 5). The Company performs ongoing credit evaluations of its customers' financial condition and generally does not require collateral from customers. Management believes that an adequate allowance for doubtful accounts has been provided. Accounts receivable from two of the Company's customers represented 0.4% and 8% of net trade accounts receivable, respectively, at December 31, 1998 ( 55% and 13%, respectively, at December 31, 1997).
During 1998, sales to two of the Company's customers comprised 47% and 15% of the Company's total product sales, respectively. During 1997, sales to two customers comprised 58% and 19% of the Company's total product sales, respectively. During 1996, sales to two customers comprised 62% and 9% of the Company's total product sales.
The Company had sales to customers outside the United States as follows:
The manufacturing of the Company's integrated circuit microchip and the pressure microchip, important components for imaging and functional measurement catheters, are currently performed by single vendors. Although management believes that other vendors could provide similar microchips on comparable terms, a change in suppliers can be a lengthy process. Consequently, any supply interruption from these single sources could delay production and have a material adverse effect on the Company's business, financial condition and results of operations.
Revenue Recognition and Warranties
The Company recognizes revenue from the sale of its products when the goods are shipped to its customers, including distributors. Contract revenue is recognized upon the completion of specified milestones. For ultrasound imaging systems sold in the United States, the Company provides a 12-month limited warranty covering materials and workmanship. For ultrasound imaging systems sold to its international distributors, the Company provides various warranty periods up to 12 months covering replacement parts. Customers may purchase extended warranty coverage for additional one-year periods. Revenue from sales of extended warranties is deferred and recognized as revenue on a straight-line basis over the term of the extended warranty.
Stock Compensation
In accordance with the provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123") which the Company adopted in 1996, the Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related interpretations in accounting for its employee stock option plans. Under APB 25, if the exercise price of the Company's employee stock options equals or exceeds the fair value of the underlying stock on the date of grant as determined by the Company's Board of Directors, no compensation expense is recognized.
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
Net Loss Per Share
Net loss per share is computed using the weighted average number of shares of common stock outstanding. Common equivalent shares from stock options and warrants are excluded from the computation because their effect is antidilutive.
At December 31, 1996, 1997 and 1998 the Company had outstanding options to purchase 2,315,366, 2,993,638 and 3,744,030 shares of common stock, respectively (with exercise prices ranging from $0.125 to $16.50), and outstanding warrants to purchase 12,304 shares of common stock (with exercise prices from $11.76 to $12.55). If exercised, these options could potentially dilute basic earnings per share in future periods. These options have not been included in the computation of net loss per share, because to do so would have been antidilutive for the periods presented.
New Accounting Pronouncements
In 1998 the company adopted Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income, which establishes new rules for the reporting and display of comprehensive income and its components. SFAS No. 130 requires to report, in addition to net income, other components of comprehensive income including unrealized gains or losses on available for sale securities and foreign currency translation adjustments. Adoption of SFAS No. 130 had no effect on the Company's results of operations or financial position as reported elsewhere in the condensed consolidated financial statements.
Reclassifications
Certain reclassifications have been made to the 1997 and 1996 Consolidated Financial Statements to conform to the 1998 presentation.
2. SHORT-TERM INVESTMENTS
The following is a summary of available-for-sale securities at December 31, 1998 and 1997:
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
Included in the above table are securities with fair values totaling $4,868 and $4,425 at December 31, 1998 and 1997, respectively, which are classified as cash equivalents in the accompanying balance sheet.
The amortized cost and estimated fair value of debt securities at December 31, 1998, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because the issuers of the securities may have the rights to prepay obligations without prepayment penalties.
All short-term investments have maturity dates within one year.
3. BUSINESS ACQUISITIONS
Cardiometrics, Inc.
On July 23, 1997, the Company acquired all of the outstanding shares of Cardiometrics, Inc. (Cardiometrics) for approximately $73,400. The results of Cardiometrics' operations have been combined with those of the Company since the date of acquisition.
The acquisition was accounted for using the purchase method of accounting. Consideration for this transaction consisted of the following (in thousands):
A summary of the purchase price allocation is as follows:
In connection with the Company's acquisition of Cardiometrics in 1997, the Company wrote-off in-process research and development totaling $43,000. This write-off was necessary because the acquired technology had not reached technological feasibility and had no future alternative uses. The Cardiometrics acquired in-process research and development relates primarily to the development of intravascular guidewires to measure blood flow and blood pressure in diseased coronary arteries, as well as, other functional assessment instruments. The nature of the efforts required to complete development of the various purchased in-process research and development projects into technologically viable products principally relate to efficacy validation and regulatory approval and are projected to be completed from 1997 to 1999. Goodwill and other intangible assets are being amortized over three-to-eight years. Amortization expense was $1,068 and $475 and accumulated amortization was $1,543 and $475 at December 31, 1998. In addition, the Company recognized a gain of $3,700 related to the excess of the fair value over the book value of Radiance common stock used as part of the purchase price consideration.
The purchase price includes $1,900 in severance and relocation liabilities assumed by the Company related to plans to relocate certain Cardiometrics employees to its corporate offices, and to terminate others. Approximately $1,000 was paid in 1997 and $470 in 1998. The Company expects to pay the remainder of this cash outlay by December 2000.
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
Unaudited proforma combined results of operations for the twelve month periods ending December 31, 1997 and 1996, giving effect to certain adjustments, including the acquisition restructuring, as if the Cardiometrics acquisition had occurred at the beginning of each period, are displayed in the following table:
The unaudited proforma results of operations for the twelve months ended December 31, 1997 and 1996, include one-time charges of $43,000 related to the write-off of acquired in-process research and development, and $5,000 related to restructuring and integration of the two companies.
Navius Corporation
On August 5, 1998, the Company acquired all of the outstanding capital stock of Navius Corporation (Navius) for approximately $19,500. The results of Navius' operations have been combined with those of the Company since the date of acquisition.
The acquisition was accounted for using the purchase method of accounting. Consideration for this transaction consisted of the following.
A summary of the purchase price allocation is as follows:
In connection with the Company's acquisition of Navius in 1998 , the Company wrote off in-process research and development totaling $10.6 million. This write-off was necessary because the acquired technology had not yet reached technological feasibility and had no future alternative uses. The Navius acquired in-process research and development relates primarily to the development of intravascular ultrasound radiation devices. The Company anticipates that products using the acquired in-process technology will be generally released before the end of 2001. The nature of the efforts required to develop the purchased in-process research and development into technologically viable products principally relate to validation and regulatory approval. The Company expects that the acquired in-process research and development will be successfully developed, but there can be no assurance that commercial viability of these products will be achieved.
Acquired intangibles are being amortized over three to nine years. Amortization expense and accumulated amortization were $323 at December 31, 1998.
Unaudited pro forma combined results of operations for the twelve month period ending December 31, 1998 and 1997 giving effect to certain adjustments including acquisition restructuring as if the Navius acquisition had occurred at the beginning of each period, are displayed in the following table.
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
4. CHANGE IN OWNERSHIP PERCENTAGE OF RADIANCE MEDICAL SYSTEMS, INC.
On June 19, 1996, EndoSonics' 84% owned subsidiary, Radiance Medical Systems, Inc., successfully completed an Initial Public Offering (IPO) of 3,400,000 shares of common stock at $12.00 per share, followed by an additional 510,000 shares issued in July 1996 (over-allotment option granted to Radiance's underwriters). As a result of this transaction, Radiance's results of operations for 1996 have been consolidated through June 19, 1996, and accounted for on the equity method thereafter. In June 1996, the Company recorded an increase to additional paid-in capital of approximately $17,600 representing the Company's proportionate share of Radiance's net assets following the IPO.
For the years ended December 31, 1998 and 1997, the Company recorded ($158) and ($2,358) respectively, representing its proportionate share of Radiance's net losses for the period. As of December 31, 1998 and 1997, EndoSonics owned 14% and 24% respectively of the outstanding shares of Radiance.
During 1998, the Company sold approximately 843,000 shares of Radiance stock resulting in a gain of $739. Since March 1, 1998, the Company has accounted for its investment in Radiance under the cost method.
Radiance Medical Systems, Inc.'s stock is quoted on the Nasdaq Stock Market. The closing price of Radiance stock at December 31, 1997 was $5.50 per share. The Company held 1,350,566 and 2,194,016 shares of Radiance's common stock at December 31, 1998 and 1997 respectively. In 1998, unrealized gains and losses on the Company's investment in Radiance are reported as a separate component of comprehensive income pursuant to the requirements of SFAS 115.
5. DISTRIBUTION AGREEMENTS
Cordis
In February 1996, EndoSonics and Cordis entered into an agreement pursuant to which Cordis was granted the exclusive right to distribute EndoSonics' IVUS imaging products for coronary applications in North America, Europe, Africa and the Middle East (the "Exclusive Distribution Agreement"). The Exclusive Distribution Agreement superseded and replaced a prior distribution agreement between Cordis and EndoSonics and a prior distribution agreement between EndoSonics Nederland B.V., a wholly owned subsidiary of EndoSonics, and Cordis S.A. Cordis was obligated during each year of the Exclusive Distribution Agreement to use reasonable efforts to purchase certain minimum annual amounts of products from EndoSonics. The Exclusive Distribution Agreement was terminated in April 1998 and replaced with a Transition Agreement which provides for Cordis to retain limited distribution rights through March, 1999.
JJMKK
In March 1997, the Company and Johnson & Johnson Medical KK (JJMKK), a subsidiary of Johnson and Johnson, entered into an exclusive distribution agreement whereby JJMKK was granted exclusive right to distribute EndoSonics IVUS imaging products for coronary applications in Japan. The agreement contained similar terms as the Exclusive Distribution Agreement between Cordis and EndoSonics. The agreement was amended in December 1998 to extend the agreement through December 1999.
J & J Medical - LA
In April 1997, the Company and Johnson and Johnson, Professional Group-Latin America (J & J Medical-LA), a subsidiary of Johnson and Johnson, entered into an exclusive distribution agreement whereby J & J Medical-LA was granted exclusive rights to distribute EndoSonics IVUS imaging products for coronary applications in certain countries of Latin America. The agreement contained similar terms as the Exclusive Distribution Agreement between Cordis and EndoSonics. The agreement was amended in December 1998 to extend the agreement through December 2000.
Fukuda
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
In August 1998, the Company entered into a strategic relationship with the Fukuda Denshi Co., Ltd. (Fukuda), a Japanese medical products company, which includes an equity investment, research and development funding and technical guidance totaling $13 million in EndoSonics by Fukuda. Approximately $8.4 million of the $13 million represents an equity investment. The remaining $4.6 million will fund research and development programs over the next 24 months. In October 1998, the Company issued 965,730 shares of the Company's common stock at a price of $8.70 per share to Fukuda and received approximately $8.4 million in cash, related to the equity investment and $1.0 million related to research and development funding.
JOMED
In December 1998, the Company and JOMED N.V., (JOMED) entered into an agreement for exclusive distribution of certain EndoSonics products into specified European and Middle Eastern countries. Also in December, EndoSonics and JOMED entered into an IVUS guided stent delivery system agreement which calls for the development of a JOMED balloon and stent incorporated into a modular EndoSonics IVUS catheter. Under the agreement, EndoSonics will supply subassemblies to JOMED who will complete the manufacturing process and distribute the resulting product in the territory which is defined as certain European and Middle Eastern countries. In certain countries within the territory, EndoSonics may distribute exclusively or jointly with JOMED.
6. ACQUISITION RELATED EXPENSES
Acquisition related expenses include acquired in process research and development and restructuring expenses relating primarily to the Company's acquisition of Cardiometrics in 1997 and Navius in 1998. Acquisition expenses consist of the following:
During the fourth quarter of 1998, the Company determined that approximately $776 of restructuring reserves provided for in connection with the Cardiometrics acquisition relating to corporate reorganization were not required.
Due to changes in conditions subsequent to the initial recording of the restructuring and integration charges, the Company reduced the provision for the 1997 charges to $8,606 during the fourth quarter of 1997.
Concurrent with the purchases of Navius and Cardiometrics, the Company recorded restructuring and integration charges of $223 and $9,456 respectively, related to plans to reduce overhead of the combined companies and increase operating efficiency in future periods. The restructuring and integration charges for Navius are for corporate reorganization charges; the restructuring and integration charges for Cardiometrics include $7,491 of corporate reorganization costs and $1,965 related to relocation of certain product lines and overall integration of the Company operations.
Additionally in June 1996, the Company recorded restructuring and integration charges of approximately $3,066 in connection with the consolidation of the Company's IVUS manufacturing operations and with the start-up production of the new Five-64 imaging devices.
These charges are included in the accompanying Consolidated Statements of Operations, as follows:
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
The elements of the 1998 restructuring accrual as of December 31, 1998 were as follows:
The elements of the 1997 restructuring accrual as of December 31, 1998 were as follows:
The elements of the 1996 restructuring accrual as of December 31, 1998 were as follows:
The accrual for restructuring and integration charges was approximately $3,674 and $6,017 as of December 31, 1998 and 1997.
7. INVENTORIES
Inventories consisted of the following as of December 31:
8. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following as of December 31:
9. CURRENT LIABILITIES
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
Current liabilities consisted of the following as of December 31:
10. OPERATING LEASES
The Company leases its administrative, research and manufacturing facilities and certain equipment under long-term non-cancelable lease agreements that have been accounted for as operating leases. Certain of these leases include scheduled rent increases and renewal options as prescribed by the agreements.
Future minimum payments by year under long-term non-cancelable operating leases are as follows:
Rental expense charged to operations for all operating leases during 1998, 1997 and 1996 was approximately $1,058, $742, and $630 respectively.
11. EQUITY
Common Stock
On September 26, 1997, the Company distributed to stockholders and common stock option holders of record as of September 5, 1997, .04 shares of Radiance common stock for each share of the Company's common stock outstanding or subject to options. The Company recorded approximately $1,000 in compensation expense, related to the distribution to stock option holders, which consisted of $540 in Radiance common stock and $460 in cash. The compensation expense was based on the closing price of $8.75 per share of Radiance common stock on September 25, 1997. The book value of the Radiance common stock distributed to stockholders totaled $3,019, and was charged to accumulated deficit.
In February, 1998, the Board of Directors authorized a stock repurchase program whereby the Company may repurchase up to $5,000 of its common stock from time-to-time in the open market or private transactions. During the year ended December 31, 1998, the Company repurchased 860,000 shares of its common stock on the open market at an aggregate cost of approximately $4,839. In September, 1998, the Board of Directors expanded the existing stock repurchase program, such that the Company may, from time-to-time, purchase a total of up to 1.7 million shares of its common stock in open market or private transactions.
Stockholder Rights Plan
In October 1998, the Company adopted a Stockholder Rights Plan (the "Rights Plan"). Under the Rights Plan, each common stockholder receives one "Right" for each share of common stock held. Each Right, once exercisable, entitles the holder to purchase from the Company one one-thousandth of a share of the Company's Series A Participating Preferred Stock at an exercise price of $35. All Rights expire on October 20, 2008 unless earlier redeemed, exchanged or exercised. At December 31, 1998, the Rights were neither exercisable nor traded separately from the Company's common stock, and become exercisable only if a person or a group of affiliated or associated persons has acquired, or obtained the right to acquire, beneficial ownership of 20% or more of the voting power of all outstanding shares of the Company's common stock and in certain other limited circumstances. Upon separation from the common stock, each Right will entitle the holder, other than the acquiring person that has triggered such separation, to effectively purchase certain shares of the Company's common stock equal in market value to two times the then applicable exercise price of the Right. If the Company is acquired in a merger or other business combination transaction, or 50% or more of the Company's assets or earning power are sold in one or more related transactions, the Rights will entitle holders, upon exercise of the Rights, to receive shares of common stock of the acquiring or surviving company with a market value equal to twice the exercise price of each Right.
Employee Stock Purchase Plan
In June 1998, EndoSonics established the 1998 Employee Stock Purchase Plan (the "1998 Purchase Plan") under which a total of 250,000 shares of common stock are reserved. As of December 31, 1998, there were no shares issued under the 1998 Purchase Plan.
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
Stock Options
In March 1988 and June 1998, EndoSonics established stock option plans (the "1988 Plan" and the "1998" Plan) under which key employees, directors, officers and consultants may participate. Either incentive stock options or nonstatutory stock options may be granted under the 1988 and 1998 Plan. Option prices are established by the Board of Directors and cannot be less than 85% of the fair market value of a share of common stock on the date of the option grant in the case of nonstatutory options, or 100% of the fair market value in the case of incentive stock options (110% in the case of any options granted to a person who owns more than 10% of the total combined voting power of all classes of stock of the Company). Options generally vest over periods ranging from one to four years (principally four years) and are exercisable upon vesting over five or ten year terms as specified in the option grants. Certain options granted in 1995 and 1996 have accelerated vesting provisions. Additionally, from 1993 through 1998 the Company has purchased four companies. Pursuant to the terms of the merger agreements, the Company has agreed to the assumption of all of the outstanding stock options previously granted by these four acquired companies. These options are included in the table below. As of December 31, 1998, 4,850,000 common shares were reserved for issuance, 2,105,231 shares were fully exercisable (1,488,072 at December 31, 1997) and 159,350 shares were available for future grant (279,089 at December 31, 1997).
The following is a summary of the activity, including the range of per share option prices, in the option plans during each of the three years in the period ended December 31, 1998:
No shares purchased under the option plan are subject to repurchase at December 31, 1998.
The options outstanding at December 31, 1998 have been segregated into ranges for additional disclosure as follows:
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
Pro forma information regarding net loss and loss per share is required by Statement 123. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions:
The weighted-average fair value on the date of grant for options granted during 1998, 1997 and 1996 was $6.02, $9.25 and $10.90 respectively.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information follows (in thousands except for earnings per share information):
12. INCOME TAXES
The provision for income taxes for the year ended December 31, 1998 consists of currently payable federal, state, and foreign taxes of $97, $13, and $112, respectively.
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
The income tax provisions differ from the amount computed by applying the federal statutory rate (35% used in each year presented) to income (loss) before income taxes. A reconciliation to the statutory federal income tax rate is as follows:
Significant components of the Company's deferred tax assets are as follows at December 31, 1998:
Income tax payments were $212 in 1998, $93 in 1997 and $0 in 1996. The valuation allowance increased by $4,415 in 1997, and decreased by $275 in 1996.
At December 31, 1998, the Company has net operating loss carryforwards for federal and state income tax purposes of approximately $50,000 and $8,500, respectively, which expire in the years 1999 through 2018. At December 31, 1998, the Company has research and development and other tax credit carryforwards for federal and state income tax purposes of approximately $2,363 and $986, respectively, which expire in the years 2005 through 2011.
As a result of the "change of ownership" provision of the Tax Reform Act of 1986, the utilization of the federal net operating loss and the deduction equivalent of federal tax credit carryforwards of approximately $3,900 included in the above amounts are subject to a cumulative annual limitation of approximately $1,375 per year pursuant to certain stock ownership changes of Cardiometrics prior to July 24, 1997. Due to the acquisition of Cardiometrics by EndoSonics in 1997, a second annual limitation of approximately $4,000 per year applies to approximately $15,500 of federal net operating loss, $630 of federal research and development credits, $4,500 of state net operating loss and $360 of state tax credit carryforwards included in the above amounts.
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
Future "changes in ownership" may further limit the ability of the Company to utilize its net operating loss and tax credit carryforwards prior to their expiration.
13. CONTINGENCIES
In October, 1998, the Company entered into a five-year litigation standstill agreement with Intravascular Research Limited with respect to certain intellectual property claims. The agreement includes the dismissal without prejudice of a pending Delaware lawsuit involving patent infringement claims. The agreement does not toll any potential patent infringement damages which may be accruing. Management believes the outcomes of these matters will have no material adverse effect on the Company's financial position, results of operations or cash flows.
The Company is subject to various legal actions and claims arising in the ordinary course of business. Management believes the outcomes of these matters will have no material adverse effect on the Company's financial position, results of operations or cash flows.
ENDOSONICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS)
SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS Years ended December 31, 1998, 1997, 1996
- -------------
(1) Deductions represent actual warranty expenses charged against the accrual.
(2) Deductions represent accounts written off, net of recoveries.
(3) Deductions represent impact of Radiance Medical Systems, Inc. initial public offering.
(4) Deductions represent impact of Cardiometrics acquisition.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Shareholders CardioVascular Dynamics, Inc.
We have audited the accompanying consolidated balance sheets of CardioVascular Dynamics, Inc. and subsidiaries as of December 31, 1996 and 1997, and the related consolidated statements of operations, stockholders' equity (net capital deficiency) and cash flows for each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of CardioVascular Dynamics, Inc. and subsidiaries at December 31, 1996 and 1997, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ ERNST & YOUNG LLP
Orange County, California January 29, 1998
CARDIOVASCULAR DYNAMICS, INC.
CONSOLIDATED BALANCE SHEETS (in thousands, except share and per share amounts)
See accompanying notes.
CARDIOVASCULAR DYNAMICS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts)
See accompanying notes.
CARDIOVASCULAR DYNAMICS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY) (In thousands, except share amounts)
See accompanying notes
CARDIOVASCULAR DYNAMICS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
See accompanying notes.
CARDIOVASCULAR DYNAMICS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (in thousands, except share and per share amounts)
1. BUSINESS, BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Business and Basis of Presentation
CardioVascular Dynamics, Inc. (the "Predecessor") was incorporated on March 16, 1992 in the State of California. The Predecessor, and its successor corporation discussed below, develops, manufactures and markets proprietary therapeutic catheters used to treat certain vascular diseases.
In June 1992, EndoSonics Corporation ("EndoSonics") acquired a 40% preferred interest in the Predecessor. EndoSonics, a Delaware corporation, develops, manufactures, and markets intravascular ultrasound imaging systems and diagnostic, therapeutic and imaging catheters for the treatment of coronary and peripheral vascular disease.
In June 1993, EndoSonics acquired all of the remaining Preferred and Common Stock of the Predecessor. The acquisition was accomplished through a merger between the Predecessor and EndoSonics Acquisition Corp., a wholly owned subsidiary of EndoSonics (which then changed its name to CardioVascular Dynamics, Inc.) (hereinafter referred to as "CVD" or the "Company").
The acquisition by EndoSonics resulted in a new basis for the CVD assets and liabilities. Accordingly, the purchase price paid by EndoSonics has been allocated to the identifiable assets and liabilities, including in-process research and development, which was immediately expensed as no CVD products had received regulatory approval and the technology did not have identifiable alternative uses. The amount by which the purchase price exceeded the Predecessor's net book value has been reflected as paid-in capital in the accompanying financial statements. Pursuant to the terms of the original merger agreement, in June 1995 EndoSonics issued an additional 50,000 shares of its Common Stock to the former shareholders of the Predecessor. The fair market value of such shares of $488 has been reflected in the accompanying financial statements as an additional charge for acquired in-process technology.
Subsequent to the acquisition, EndoSonics began performing certain services for CVD (see Note 4), including general management, accounting, cash management, and other administrative and engineering services. The amounts charged to CVD for such services have been determined based on proportional cost allocations and have been agreed to by the management of CVD and EndoSonics. In the opinion of CVD's management, the allocation methods used are reasonable. Such allocations, however, are not necessarily indicative of costs that would have been incurred had CVD continued to operate independent of EndoSonics. No formal agreement currently exists which specifies the nature of services to be provided by EndoSonics to CVD, or the charges for such services. Therefore, amounts are not necessarily indicative of the future charges to be incurred by CVD.
In 1994 and 1996, the Board of Directors of CVD approved a 16,200-for-1 and a 2-for-1 Common Stock split, respectively, which has been reflected retroactively for all periods in the accompanying financial statements.
On June 25, 1996, the Company closed its initial public offering (the "Offering") which consisted of 3,400,000 shares of Common Stock at $12.00 per share. On July 17, 1996, the Company's underwriters exercised their overallotment option to purchase an additional 510,000 shares of Common Stock at $12.00 per share. CVD received net offering proceeds from the sale of Common Stock of approximately $42.8 million after deducting underwriting discounts and commissions and other expenses of the Offering.
CARDIOVASCULAR DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
In October 1996, CVD acquired 100% of the common stock of Intraluminal Device, Inc. ("IDI") in exchange for CVD common stock valued at $1.4 million. The acquisition was accomplished through the formation of IDI Acquisition, Inc., a wholly-owned subsidiary of CVD, and the merging of IDI into IDI Acquisition, Inc. (See Note 2).
In July 1997, CVD the Company acquired all of the common stock of Clinitec GmbH ("Clinitec") its independent distributor in Germany and Switzerland, in exchange for the assumption of the assets and liabilities of Clinitec.
The consolidated financial statements for December 31, 1996 and 1997 include the accounts of the Company and its subsidiaries. Intercompany transactions have been eliminated.
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 at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash and Cash Equivalents
Cash and cash equivalents includes cash on hand, demand deposits, and short-term investments with original maturities of three months or less.
Marketable Securities Available-For-Sale
The Company accounts for its investments pursuant to Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115").
The Company has classified its entire investment portfolio as available-for-sale. Available-for-sale securities are stated at fair value with unrealized gains and losses included in shareholders' equity. The amortized cost of debt securities is adjusted for amortization of premiums and accretions of discounts to maturity. Such amortization is included in interest income. Realized gains and losses are included in other income (expense). The cost of securities sold is based on the specific identification method.
Inventories
Inventories are comprised of raw materials, work-in-process and finished goods and are stated at the lower of cost, determined on an average cost basis, or market value.
Property and Equipment
Property and equipment are stated at cost and depreciated or amortized on a straight-line basis over the lesser of the estimated useful lives of the assets or the lease term. The estimated useful lives range from three to seven years.
CARDIOVASCULAR DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Goodwill
The excess of the purchase price over the net assets of the business acquired ("goodwill") is amortized on the straight-line method over the estimated recovery period. The goodwill stemming from the purchase of Clinitec is amortized over ten years (See Note 2).
The carrying value of goodwill is reviewed if the facts and circumstances suggest that it may be impaired. If this review indicates that goodwill will not be recoverable, as determined based on the undiscounted cash flows of the entity acquired over the remaining amortization period, the carrying value of the goodwill is reduced to estimated fair value.
Long-lived Assets
The Company records impairment losses on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets.
Concentrations of Credit Risk and Significant Customers
The Company maintains its cash and cash equivalents in deposit accounts and in pooled investment accounts administered by a major financial institution.
The Company sells its products primarily to medical institutions and distributors worldwide. The Company performs ongoing credit evaluations of its customers' financial condition and generally does not require collateral from customers. Management believes that an adequate allowance for doubtful accounts has been provided.
During 1995, 1996 and 1997 product sales to Fukuda Denshi Co., Ltd., ("Fukuda"), the Company's Japanese distributor (see Note 5), comprised 18%, 14% and 7% of total revenue, respectively. Accounts receivable from Fukuda represented 1% and 0% of net accounts receivable at December 31, 1996 and 1997, respectively.
The Company terminated its Agreement with Fukuda in May 1997 and signed a five-year agreement with another Japan distributor, Cathex, LTD. ("Cathex"). During 1997, Product sales to Cathex comprised 13% of total revenues. Accounts receivable from Cathex represented 44% of net accounts receivable at December 31, 1997.
Product sales to Medtronic, Inc. ("Medtronic") accounted for 21% and 13% of total revenues during 1996 and 1997, respectively. At December 31, 1996 and 1997, 27% and 0%, respectively, of net accounts receivable were due from Medtronic. In May of 1997, Medtronic advised the Company of its election to not make minimum purchases of product for the second year of the agreement. In June 1997, Medtronic informed CVD it would not fulfill its commitment for the first year of the agreement and it did not believe it was required to fulfill such commitment.
One other customer comprised 12% of revenues for the year ended December 31, 1995 and 14% of accounts receivable at December 31, 1995.
CARDIOVASCULAR DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Export Sales
The Company had export sales by region as follows:
Revenue Recognition and Warranty
The Company recognizes revenue from the sale of its products when the goods are shipped to its customers. Reserves are provided for anticipated product returns and warranty expenses at the time of shipment. License fees are recognized on a contract with SCIMED Life Systems, Inc. ("SCIMED") when distribution rights to certain markets are made available to SCIMED for the sale of products based upon certain limited catheter technology. Contract revenues are recognized on contracts with SCIMED and Advanced CardioVascular Systems, Inc. ("ACS") for transferring certain limited catheter technology based upon the Company's completion of (1) technical Assistance to aid SCIMED in manufacturing the related products, and (2) research and development to develop the related products for ACS and SCIMED (See Note 3).
Accounting for Stock-Based Compensation
The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related Interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under FASB Statement No. 123, "Accounting for Stock-Based Compensation," requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.
Pro forma information regarding net income and earnings per share is required by Statement 123, which also requires that the information be determined as if the Company has accounted for its employee stock options granted subsequent to December 31, 1994 under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using the Black-Scholes option pricing model. The Black-Scholes model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
CARDIOVASCULAR DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
In calculating pro forma information regarding net income and net income per share the fair value was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for the options on the Company's common stock: risk-free interest rate of 6.0 %, 6.0% and 5.5%; a dividend yield of 0%, 0% and 0%; volatility of the expected market price of the Company's common stock of 0.475, 0.475 and 0.692; and a weighted-average expected life of the options of 3.5, 3.5 and 5.0 years for 1995, 1996 and 1997, respectively.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information for the years ended December 31, 1995, 1996 and 1997 follows:
Because Statement 123 is applicable only to options granted subsequent to December 31, 1994, its pro forma effect will not be fully reflected until 1997.
Recent Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income (Statement No. 130), which is effective for years beginning after December 15, 1997. Statement No. 130 establishes standards for reporting and displaying comprehensive income and its components with the same prominence as other financial statement information. Management has not completed its review of Statement No. 130, but does not anticipate that the adoption of this statement, other than required financial statement reclassifications, will have a significant effect on the Company's reported financial position.
In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information (Statement No. 131), which is effective for years beginning after December 15, 1997. Statement No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. Statement No. 131 is effective for financial statements for fiscal years beginning after December 15, 1997, and therefore the Company will adopt the new requirements retroactively in 1998. The Company operates in one business segment. Accordingly, the Company does not anticipate that the adoption of this statement will have a significant effect on the Company's financial statements.
In March 1998, the AICPA issued SOP 98-1, Accounting for the Costs of Computer Software Developed For or Obtained For Internal Use. The SOP is effective for companies beginning on January 1, 1999. The SOP will require the capitalization of certain costs incurred after the date of adoption in connection with developing or obtaining software for internal use. The Company currently expenses such costs. The Company has not yet assessed what the impact of the SOP will be on the Company's future earnings or financial position.
Income Taxes
From June 1993 until June 1996, the Company's results of operations have been included in consolidated tax returns filed by EndoSonics. There was no income tax provision for the consolidated tax group during the periods covered by these financial statements. All net operating loss and credit carryforwards and deferred tax assets and liabilities have been disclosed herein on a separate company basis for CVD.
Net Loss Per Share
In 1997, the Financial Accounting Standards Board issued Statement No. 128, Earnings per Share. Statement No. 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented to conform with Statement No. 128.
Net loss per common share after the Company's initial public offering is computed using the weighted average number of common shares outstanding during the periods presented. Options to purchase shares of the Company's common stock granted under the Company's stock option plan may have a dilutive effect on the Company's earnings per share in the future. Net loss per share prior to the Company's initial public offering is computed on a pro forma basis using the weighted average number of shares of Common Stock, convertible Preferred Stock (using the as-if-converted method) and Common Stock issuable upon conversion of the Convertible Obligation, outstanding. The following table sets forth the computation of basic and diluted net loss per share:
CARDIOVASCULAR DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
2. ACQUISITIONS
On October 16, 1996, the Company acquired all of the outstanding shares of Intraluminal Devices, Inc. ("IDI") in exchange for approximately 93,000 shares of CVD common stock valued at $1.4 million. The acquisition was accounted for using the purchase method of accounting. As the assets of IDI were patents for products still in their development stage, the purchase price and the associated costs of acquisition $0.7 million were expensed as acquired in-process research and development.
On July 29, 1997, the Company acquired all of the common stock of its independent distributor in Germany and Switzerland, Clinitec GmbH ("Clinitec"). The aggregate purchase price of the acquisition was $1,636 and consisted of cash of $30 and the forgiveness of debt of $1,606. The transaction was accounted for by the purchase method of accounting and, accordingly, the purchase price was allocated to the assets acquired and the liabilities assumed based on their fair market values at the date of acquisition. In connection with the acquisition, the Company acquired assets and assumed liabilities with fair market values of $401 and $652, respectively. The excess of the purchase price over the fair value of the net assets acquired of $1,887 has been allocated to goodwill. The results of operations of Clinitec are included in the consolidated statement of operations subsequent to the date of acquisition.
The following table reflects unaudited pro forma combined results of operations of the Company, IDI and Clinitec on the basis that the acquisitions had taken place and the related charge for IDI, noted above, was recorded at the beginning of 1996 for IDI and Clinitec, as IDI operations were not material to the Company's operations prior to 1996:
CARDIOVASCULAR DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
In management's opinion, the unaudited pro forma combined results of operations are not indicative of the actual results that would have occurred had the acquisitions been consummated at the beginning of 1996 or 1997, respectively, or of future operations of the combined companies under the ownership and management of the Company.
3. SCIMED LIFE SYSTEMS, INC.
In September 1994, CVD and EndoSonics entered into a Stock Purchase and Technology License Agreement with SCIMED Life Systems, Inc. ("SCIMED"). SCIMED acquired a 19% interest in CVD in exchange for $2,500 in cash.
CVD also granted SCIMED an exclusive license to certain patents in the cardiovascular field of use, which allows SCIMED to manufacture the Transport PTCA infusion catheter (the "Transport") developed by CVD in exchange for a $1,000 license fee that was paid in 1994. SCIMED will pay royalties to CVD on sales of the Transport and other products which use this patented technology. CVD retains rights to this technology and the associated patents for use outside of the cardiovascular field.
During June 1995, the Company issued a warrant to SCIMED to purchase up to 80,000 shares of Series A Preferred Stock at an exercise price of $3.29 per share in exchange for a waiver of SCIMED's anti-dilution right.
During May 1996, the Company issued an additional warrant to SCIMED to purchase up to 40,000 shares of Series A Preferred Stock at an exercise price of $3.29 per share in exchange for a waiver of SCIMED's anti-dilution right related to the shares to be issued under the 1996 Plan. In August 1997, SCIMED exercised all 120,000 warrants, mentioned above.
SCIMED also paid CVD $641, $200 and $0 in 1995, 1996 and 1997, respectively, on a cost reimbursement basis to fund continuing development of the technology and for other support.
4. RELATED PARTY TRANSACTIONS
The following is a summary of significant transactions between CVD and EndoSonics:
During a portion of 1995, EndoSonics manufactured certain of the Company's catheter products at cost plus a mark-up of 30%. Total purchases from EndoSonics during 1995 amount to $172.
Prior to the Company's initial public offering in June 1996, certain EndoSonics corporate expenses, primarily related to executive management time, accounting, cash management, and other administrative and engineering services, have been allocated to the Company. Total expenses allocated were $340 and $156 for the years ended December 31, 1995 and 1996, respectively.
No interest expense has been charged on the net payable due to EndoSonics. The following is an analysis of the payable to EndoSonics:
CARDIOVASCULAR DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
In connection with the initial public offering, CVD and EndoSonics entered into a Tax Allocation Agreement that provides, among other things, for (i) the allocation of tax liabilities and adjustments thereto as between the business of the Company and other businesses conducted by EndoSonics and its affiliates related to periods in which the Company is includable in consolidated federal income tax returns filed by EndoSonics, (ii) the allocation of responsibility for filing tax returns and (iii) the conduct of and responsibility for taxes owed in connection with tax audits and various related matters.
EndoSonics and CVD had entered into a Stockholder Agreement providing that all transactions between the Company and EndoSonics or any affiliate of EndoSonics must be approved by a special committee of CVD's Board of Directors comprised of two directors who are not officers, directors, employees or affiliates of EndoSonics. The provisions of this agreement became effective upon the consummation of the initial public offering and terminated in the fourth quarter of 1997 when EndoSonics beneficially owned less than 25% of CVD's Common Stock. See also Notes 5 and 11.
5. AGREEMENTS WITH FUKUDA AND CATHEX
The Company had a distribution agreement with Fukuda which provided them with exclusive distribution rights relative to certain of the Company's products in Japan for periods extending through May 1999, which could be extended at the option of the parties. Distribution fee revenues received from Fukuda were deferred and were being recognized as revenue over the initial periods covered by the respective agreement.
In July 1995 and May 1996, the distribution agreement with Fukuda was amended. In exchange for the exclusive distribution rights to additional CVD products, the Company received $750 which converted into the right to receive 62,500 shares of Common Stock upon the consummation of the initial public offering. In November, 1996, Fukuda exercised the conversion feature of said obligation. In May 1997, the Company terminated the existing distribution agreement and does not expect that any material obligations will arise as a result of such termination.
The Company entered into a distribution agreement, dated May 1, 1997, with Cathex, Ltd. (The "Cathex Agreement"), whereby Cathex serves as CVD's exclusive distributor for certain of the Company's products in Japan. In exchange for this exclusive distributorship, Cathex shareholders agreed to purchase $200,000 in CVD
CARDIOVASCULAR DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
common stock or approximately 25,000 shares, in addition to payments owing upon the purchase of the products. Cathex also agreed to undertake all necessary clinical trails to obtain approval from Japanese regulator authorities for the sale of the products in Japan. Cathex's purchases under the Cathex Agreement are subject to certain minimum requirements. The initial term of the Cathex Agreement expires on January 1, 2001, subject to a five-year extension. The Cathex Agreement may also be terminated in the event of breach upon 90 days notice by the non-breaching party, subject to cure within the notice period.
6. LICENSE AGREEMENTS
In January 1995 the Company entered into a license agreement with Advanced CardioVascular Systems, Inc. ("ACS") under which the Company acquired the exclusive worldwide rights to ACS' SmartNeedle technology. The Company assumed responsibility for manufacturing the product in 1996, subject to the payment of royalties. ACS was granted an option, which was exercised in February 1996, to obtain exclusive worldwide rights to certain CVD perfusion technology. In exchange for the perfusion technology, ACS was obligated to make milestone and minimum royalty payments to CVD, and also has certain obligations to develop and market the perfusion technology. An initial milestone of $150 was earned in the year ended December 31, 1996. In February 1997, ACS elected to terminate the perfusion technology agreement.
The Company entered into a license agreement with EndoSonics pursuant to which CVD granted EndoSonics the non-exclusive, royalty-free right to certain technology for use in the development and sale of certain products. In exchange, CVD received the non-exclusive, royalty-free right to utilize certain of EndoSonics' product regulatory filings to obtain regulatory approval of CVD products.
7. MARKETABLE SECURITIES AVAILABLE-FOR-SALE
The Company's investments in debt securities are diversified among high credit quality securities in accordance with the Company's investment policy. The Company's investment portfolio is managed by a major financial institution. The following is a summary of investments in debt securities classified as current assets and available-for-sale at December 31, 1996 and 1997.
All short-term investments at December 31, 1996 and December 31, 1997 were due within one year.
8. INVENTORIES
Inventories are stated at the lower of cost, determined on an average cost basis, or market value. Inventories consisted of the following:
CARDIOVASCULAR DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
9. ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses consisted of the following:
10. COMMITMENTS
Operating Leases
The Company leases its administrative, research and manufacturing facilities and certain equipment under long-term, noncancelable lease agreements that have been accounted for as operating leases. Certain of these leases include scheduled rent increases and renewal options as prescribed by the agreements.
Future minimum payments by year under long-term, noncancelable operating leases were as follows as of December 31:
Rental expense charged to operations for all operating leases during the years ended December 31, 1995, 1996 and 1997, was approximately $171, $365 and $574, respectively.
11. SHAREHOLDERS EQUITY
Preferred Stock
In February 1995, every two shares of the Company's outstanding Common Stock was exchanged for one share of Series A Preferred Stock with a liquidation preference of $6.58 per share. In March 1996, the Company issued 400,000 shares of Series B Preferred Stock to EndoSonics at $20.00 per share for aggregate proceeds of $8,000.
CARDIOVASCULAR DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The preferred stockholders converted their shares to common shares upon the consummation of the Company's initial public offering.
Stock Option Plan
In May 1996, the Company, adopted the 1996 Stock Option/Stock Issuance Plan (the "1996 Plan") which is the successor to the Company's 1995 Stock Option Plan. Under the terms of the 1996 Plan, eligible key employees, directors, and consultants can receive options to purchase shares of the Company's Common Stock at a price not less than 100% for incentive stock options and 85% for nonqualified stock options of the fair value on the date of grant, a determined by the Board of Directors. The Company has authorized 1,990,000 shares of Common Stock for issuance under the 1996 Plan. At December 31, 1997, the Company had 48,000 shares of Common Stock available for grant under the 1996 Plan. The options granted under the 1996 Plan are exercisable over a maximum term of ten years from the date of grant and generally vest over a four year period. Shares underlying the exercise of unvested options are subject to various restrictions as to resale and right of repurchase by the Company which lapses over the vesting period.
On April 21, 1997, the Board of Directors approved repricing of the options granted on August 5, 1996 at $13.25 per share and on November 4, 1996 at $12.50 per share. As a result of the repricing, the exercise price became $6.88 and the vesting period on the aforementioned options started anew.
The following table summarizes information regarding stock options outstanding at December 31, 1997:
As of December 31, 1996 and 1997, 253,525 and 268,204 options were exercisable, respectively.
CARDIOVASCULAR DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The weighted-average grant-date fair value of options granted during 1995, 1996 and 1997, for options where the exercise price on the date of grant was equal to the stock price on that date, was $0.40, $5.12 and $4.50. The weighted-average grant-date fair value of options granted during 1995, 1996 and 1997, for options where the exercise price on the date of grant was less than the stock price on that date, was $1.44, $3.16 and $0.
During 1996, the Company recorded deferred compensation of approximately $150 for financial reporting purposes to reflect the difference between the exercise price of certain options and the deemed fair value, for financial statement presentation purposes, of the Company's shares of Common Stock. An additional $437 of deferred compensation was recorded to recognize compensation for non-employee option grants during the year ended December 31, 1997. Deferred compensation is being amortized over the vesting period of the related options. $119 and $179 of deferred compensation was amortized in the year ended December 31, 1996 and 1997, respectively.
Stock Purchase Plan
Under the terms of the Company's 1996 Employee Stock Purchase Plan (the "Purchase Plan"), eligible employees can purchase Common Stock through payroll deductions at a price equal to the lower of 85% of the fair market value of the Company's Common Stock at the beginning or end of the applicable offering period. A total of 200,000 shares of Common Stock are reserved for issuance under the Purchase Plan. During 1997, a total of approximately 33,000 shares of common stock was purchased at an average price of $8.18 per share.
12. INCOME TAXES
Significant components of the Company's deferred tax assets are as follows at December 31:
The valuation allowance increased by $3,150 and $1,569 in 1997 and 1996, respectively.
The Company's effective tax rate differs from the statutory rate of 35% due to federal and state losses which were recorded without tax benefit.
At December 31, 1997, the Company has net operating loss carryforwards for federal and state income tax purposes of approximately $11,000,000 and $1,000,000, respectively, which expire in the years 1998 through 2010. In addition, the Company has research and development tax credits for federal and state income tax purposes of approximately $520,000 and $320,000, respectively, which expire in the years 2008 through 2011.
Because of the "change of ownership" provision of the Tax Reform Act of 1986, utilization of the Company's net operating loss and research credit carryforwards may be subject to an annual limitation against taxable income in future periods. As a result of the annual limitation, a portion of these carryforwards may expire before ultimately becoming available to reduce future income tax liabilities.
CARDIOVASCULAR DYNAMICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
13. EMPLOYEE BENEFIT PLAN
The Company provides a 401(k) Plan for all employees 21 years of age or older with over 3 months of service. Under the 401(k) Plan, eligible employees voluntarily contribute to the Plan up to 15% of their salary through payroll deductions. Employer contributions may be made by the Company at its discretion based upon matching employee contributions, within limits, and profit sharing provided for in the Plan. No employer contributions were made in 1996 and 1997.
14. FOURTH QUARTER ADJUSTMENTS
Adjustments were made in the fourth quarter of 1997 to increase the reserve for excess and obsolete inventories by $955, increase the allowance for doubtful accounts by $270 and to accrue expenses of $780.
CARDIOVASCULAR DYNAMICS, INC.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995 (IN THOUSANDS)
EXHIBIT INDEX
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* Confidential Treatment Requested.
(1) Filed as an exhibit to the Company's Current Report on Form 8-K (File No. 0-19880) filed with the Commission on July 14, 1993.
(2) Filed as an exhibit to the Company's Registration Statement on Form 8-B filed with the Securities and Exchange Commission (the "Commission") on September 25, 1992 and incorporated by reference herein.
(3) Filed as an exhibit to the Company's Registration Statement on Form S-1 (File No. 33-45280) filed with the Securities and Exchange Commission on January 24, 1992 (the "Registration Statement") and incorporated by reference herein.
(4) Filed as an exhibit to the Company's Annual Report on Form 10-K (File No. 0-19880) filed with the Commission on March 31, 1993.
(5) Filed as Exhibit 10.13 to Amendment No. 1 to the Company's Registration Statement on Form S-1 (File No. 33-45280) filed with the Commission on February 25, 1992 and incorporated herein by reference.
(6) Filed as an exhibit to the Company's Annual Report on Form 10-K (File No. 0-19880) filed with the Commission on March 24, 1994.
(7) Filed as an exhibit to the Company's Annual Report on Form 10-K/A (File No. 0-19880) filed with the Commission on July 29, 1996.
(8) Filed as an exhibit to the Company's Form 8-K (File No. 0-19880) filed with the Commission on February 10, 1997 and incorporated herein by reference.
(9) Filed as an exhibit to the Company's Annual Report on Form 10-K (File No. 0-19880) filed with the Commission on March 21, 1995.
(10) Filed as an exhibit to the Company's Annual Report on Form 10-K (File No. 0-19880) filed with the Commission on March 19, 1997.
(11) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q, filed with the Commission on November 15, 1998, for the quarter ended September 30, 1998.