UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-QSB
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the quarterly period ended September 30, 2005.
[ ] Transitional report pursuant to Section 13 or 15(d) of the securities
Exchange Act of 1934 for the transitional period from _____ to ______.
Commission File Number 0-20127
------------------------------
ESCALON MEDICAL CORP.
---------------------
(Exact name of small business issuer as specified in its charter)
PENNSYLVANIA 33-0272839
------------ -----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
565 EAST SWEDESFORD ROAD, SUITE 200
WAYNE, PA 19087
----------------------------
(Address of principal executive offices)
(610) 688-6830
---------------------------
(Registrant's telephone number)
Check whether the issuer (1) filed all reports required by Section 13 or
15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
Transitional Small Business Disclosure format. Yes [ ] No [X]
At November 7, 2005, 6,075,977 shares of common stock were outstanding.
ESCALON MEDICAL CORP.
FORM 10-QSB QUARTERLY REPORT
TABLE OF CONTENTS
Part I. Financial Information
Item 1. Condensed Consolidated Financial Statements 2
Condensed Consolidated Balance Sheets as of September 30, 2005
(Unaudited) and June 30, 2005 2
Condensed Consolidated Statements of Operations for the three- month
periods ended September 30, 2005 and 2004 (Unaudited) 3
Condensed Consolidated Statements of Cash Flows for three-month 4
periods ended September 30, 2005 and 2004 (Unaudited)
Condensed Consolidated Statement of Shareholders' Equity for the 5
three-month periods ended September 30, 2005 and 2004 (Unaudited)
Condensed Consolidated Statement of Comprehensive (Loss) Income for 6
the three-month periods ended September 30, 2005 and 2004
(Unaudited)
Item 2. Management's Discussion and Analysis or Plan of Operations 20
Item 3. Controls and Procedures 38
Part II. Other Information
Item 1. Legal Proceedings 38
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 40
Item 6. Exhibits 41
1
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
ESCALON MEDICAL CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, June 30,
2005 2005
------------- ------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 5,325,697 $ 5,115,772
Available for sale securities 44,130 1,207,317
Accounts receivable, net 5,041,319 4,752,310
Inventory, net 6,026,165 5,856,285
Note receivable 100,000 100,000
Other current assets 719,990 633,214
------------- ------------
Total current assets 17,257,301 17,664,898
------------- ------------
Furniture and equipment, net 964,382 911,700
Goodwill 20,166,450 20,166,450
Trademarks and trade names, net 616,906 616,906
Patents, net 379,380 402,814
Other assets 396,127 286,568
------------- ------------
Total assets $ 39,780,546 $ 40,049,336
============= ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt $ 233,033 $ 230,344
Accounts payable 1,834,913 1,135,680
Accrued expenses 2,272,282 2,685,670
------------- ------------
Total current liabilities 4,340,228 4,051,694
Long-term debt, net of current portion 329,565 391,793
Accrued post retirement benefits 1,087,000 1,087,000
------------- ------------
Total liabilities 5,756,793 5,530,487
Shareholders' equity:
Preferred stock, $0.001 par value; 2,000,000 shares authorized; no shares
issued Common stock, $0.001 par value; 35,000,000 shares authorized;
5,969,727 and 5,963,477 shares issued and outstanding at September 30, 2005
and June 30, 2005, respectively 5,970 5,964
Common stock warrants 1,601,346 1,601,346
Additional paid-in capital 63,909,060 63,898,190
Accumulated deficit (31,422,140) (32,136,487)
Accumulated other comprehensive (loss) income (70,483) 1,149,836
------------- ------------
Total shareholders' equity 34,023,753 34,518,849
------------- ------------
Total liabilities and shareholders' equity $ 39,780,546 $ 40,049,336
============= ============
See notes to condensed consolidated financial statements
2
ESCALON MEDICAL CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended
September 30,
2005 2004
------------ -----------
Product revenue $ 7,123,354 $ 4,636,457
Other revenue 670,180 655,704
------------ -----------
Revenues, net 7,793,534 5,292,161
------------ -----------
Costs and expenses:
Cost of goods sold 4,105,653 2,671,348
Research and development 756,160 315,762
Marketing, general and administrative 3,284,051 2,182,487
------------ -----------
Total costs and expenses 8,145,864 5,169,597
------------ -----------
(Loss) income from operations (352,330) 122,564
------------ -----------
Other income and expenses:
Gain on sale of available for sale securities 1,157,336 -
Equity in Ocular Telehealth Management, LLC (18,429) (29,201)
Interest income 4,847 32,092
Interest expense (10,677) 3,413
------------ -----------
Total other income and expenses 1,133,077 6,304
------------ -----------
Income before income taxes 780,747 128,868
Income taxes 66,400 12,969
------------ -----------
Net income $ 714,347 $ 115,899
============ ===========
Basic net income per share $ 0.120 $ 0.021
============ ===========
Diluted net income per share $ 0.112 $ 0.019
============ ===========
Weighted average shares - basic 5,964,292 5,564,469
============ ===========
Weighted average shares - diluted 6,372,742 6,141,958
============ ===========
See notes to condensed consolidated financial statements
3
ESCALON MEDICAL CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Three Months Ended
September 30,
2005 2004
------------- -------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 714,347 $ 115,899
Adjustments to reconcile net (loss)/income to net cash (used in)/
provided by operating activities:
Depreciation and amortization 107,752 91,885
Gain on sale of available for sale securities (1,157,336) -
Loss of Ocular Telehealth Management, LLC 18,429 29,201
Change in operating assets and liabilities:
Accounts receivable, net (289,009) (552,060)
Inventory, net (169,880) (294,289)
Other current and long-term assets (260,772) (306,952)
Accounts payable, accrued and other liabilities 285,845 (1,018,470)
------------- -------------
Net cash (used in) operating activities (750,624) (1,934,786)
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of Drew, net of cash acquired - 295,373
Proceeds from the sale of available for sale securities 1,157,336 -
Investment in Ocular Telehealth Management, LLC - (130,000)
Purchase of fixed assets (144,649) (39,773)
------------- -------------
Net provided by provided by/(used in) investing activities 1,012,687 125,600
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Line of credit repayment - (669,269)
Principal payments on term loans (59,539) (4,258,754)
Issuance of common stock, private placement -
Issuance of common stock, stock options 10,876 -
------------- -------------
Net cash used in financing activities (48,663) (4,928,023)
------------- -------------
Effect of exchange rate changes on cash and cash equivalents (3,475) (2,551)
Net increase/(decrease) in cash and cash equivalents 209,925 (6,739,760)
Cash and cash equivalents, beginning of period 5,115,772 12,601,971
------------- -------------
Cash and cash equivalents, end of period $ 5,325,697 $ 5,862,211
============= =============
SUPPLEMENTAL SCHEDULE OF CASH FLOW INFORMATION:
Interest paid $ 10,667 $ 208,019
============= =============
Income taxes $ 93,000 $ 183,300
============= =============
Issuance of common stock for Drew acquisition $ - $ 7,429,100
============= =============
(Decrease)/ Increase in unrealized appreciation on available for
sale securities $ (1,163,187) $ -
============= =============
See notes to condensed consolidated financial statements
4
ESCALON MEDICAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2005
(UNAUDITED)
Accumulated
Common Additional Other Total
Stock Paid-in Accumulated Comprehensive Shareholders'
Shares Amount Warrants Capital Deficit Loss Equity
--------- --------------------------------------------------------------------------------------
Balance at June 30, 2005 5,963,477 $ 5,964 $ 1,601,346 $ 63,898,190 $(32,136,487) $ 1,149,836 $ 34,518,849
Net income - - - - 714,347 - 714,347
Change in unrealized gains
on securities - - - - - (1,163,187) (1,163,187)
Foreign currency translation - - - - - (57,132) (57,132)
Exercise of stock options 6,250 6 - 10,870 - - 10,876
--------- -------------------------------------------------------------------------------------
Balance at September 30, 2005 5,969,727 $ 5,970 $ 1,601,346 $ 63,909,060 $(31,422,140) $ (70,483) $ 34,023,753
--------- -------------------------------------------------------------------------------------
See notes to condensed consolidated financial statements
5
ESCALON MEDICAL CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OTHER COMPREHENSIVE (LOSS) INCOME
(UNAUDITED)
Three Months Ended
September 30,
2005 2004
----------- ----------
Net income $ 714,347 $ 115,899
Change in unrealized gains on securities (1,163,187) -
Foreign currency translation (57,132) 17,944
----------- ----------
Comprehensive loss $ (505,972) $ 133,843
=========== ==========
See notes to condensed consolidated financial statements
6
ESCALON MEDICAL CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements
include the accounts of Escalon Medical Corp. and its subsidiaries, collectively
referred to as "Escalon" or the "Company." Escalon's subsidiaries include
Sonomed, Inc. ("Sonomed"), Escalon Vascular Access, Inc. ("Vascular"), Escalon
Medical Europe GmbH, Escalon Digital Vision, Inc. ("EMI"), Escalon
Pharmaceutical, Inc. ("Pharmaceutical"), Escalon Holdings, Inc. and Drew
Scientific Group, Plc ("Drew"). All intercompany accounts and transactions have
been eliminated. Additionally, the Company's investment in Ocular Telehealth
Management, LLC ("OTM") is accounted for under the equity method.
The Company operates in the healthcare market, specializing in the
development, manufacture, marketing and distribution of medical devices and
pharmaceuticals in the areas of ophthalmology, diabetes, hematology and vascular
access. The Company and its products are subject to regulation and inspection by
the United States Food and Drug Administration (the "FDA"). The FDA requires
extensive testing of new products prior to sale and has jurisdiction over the
safety, efficacy and manufacture of products, as well as product labeling and
marketing.
The accompanying condensed consolidated financial statements are unaudited
and are presented pursuant to the rules and regulations of the Securities and
Exchange Commission (the "SEC"). Accordingly, these consolidated financial
statements should be read in conjunction with the consolidated financial
statements and notes thereto contained in the Company's 2005 Annual Report on
Form 10-K under the Securities Exchange Act of 1934 (the "Exchange Act"). In the
opinion of management, the accompanying consolidated financial statements
reflect all adjustments (which are of a normal recurring nature) necessary for a
fair presentation of the financial position, results of operations and cash
flows for the interim periods presented. The results of operations are not
necessarily indicative of the results that may be expected for the full year.
2. ACQUISITION OF DREW SCIENTIFIC GROUP, PLC
On July 23, 2004, Escalon acquired approximately 67% of the outstanding
ordinary shares of Drew Scientific Group, Plc ("Drew"), a United Kingdom
company, pursuant to the Company's exchange offer for all of the outstanding
ordinary shares of Drew, and since that date has acquired all of the Drew
shares. The results of Drew's operations have been included in the consolidated
financial statements since July 23, 2004.
Drew is a diagnostics company specializing in the design, manufacture and
distribution of instruments for blood cell counting and blood analysis. Drew is
focused on providing instrumentation and consumables for the physician office
and veterinary office laboratories. Drew also supplies the reagent and other
consumable materials needed to operate the instruments. The results of Drew's
operations have been included in the consolidated financial statements, and
Escalon has been operating Drew as an additional business segment since July 23,
2004.
The aggregate purchase price of Drew was $8,525,966, net of acquired cash
of $151,996, consisting of direct acquisition costs of $1,246,376, primarily for
investment banking, legal and accounting fees that were directly related to the
acquisition of Drew, and 900,000 shares of Escalon common stock valued at
$7,430,439. The value of the 900,000 shares issued was based on a five day
average of the market price of the stock (two days before through two days after
the shares were exchanged).
7
The following table summarizes the purchase price allocation of estimated
fair values of assets acquired and liabilities assumed as of the date of
acquisition of Drew of July 23, 2004.
Current assets $ 3,859,771
Furniture and equipment 868,839
Patents 297,246
Other long-term assets 7,406
Goodwill 9,574,655
-----------
Total assets acquired $14,607,917
-----------
Line of credit $ 1,617,208
Current liabilities 3,392,286
Long-term debt 1,072,457
-----------
Total liabilities assumed $ 6,081,951
-----------
Net assets acquired $ 8,525,966
===========
The following pro forma results of operations information has been
prepared to give effect to the purchase of Drew as if such transaction had
occurred at the beginning of the period being presented. The information
presented is not necessarily indicative of results of future operations of the
combined companies.
Three Months Ended
September 30,
2005 2004
---------- -----------
Revenues $7,793,534 $ 5,926,771
Cost of goods sold 4,105,653 3,088,286
---------- -----------
Gross profit 3,687,881 2,838,485
Operating expenses 4,040,211 2,810,440
Other income (expense) 1,133,077 (522)
---------- -----------
Net income before taxes 780,747 27,523
Provision for income taxes 66,400 12,969
---------- -----------
Net income $ 714,347 $ 14,554
========== ===========
Basic net income per share $ 0.120 $ 0.003
========== ===========
Diluted net income per share $ 0.122 $ 0.002
========== ===========
Weighted average shares - basic 5,964,292 5,564,469
========== ===========
Weighted average shares - diluted 6,372,742 6,141,958
========== ===========
3. STOCK-BASED COMPENSATION
The Company reports stock-based compensation through the disclosure-only
requirements of the statement of Financial Accounting Standards No. 123 ("SFAS
123"), "Accounting for Stock-Based Compensation," as amended by Statement of
Financial Accounting Standards No. 148 ("SFAS 148"),
8
"Accounting for Stock-Based Compensation - Transition and Disclosure - an
Amendment to FASB No. 123." Compensation expense for options is measured using
the intrinsic value method in accordance with Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Under APB
25, because the exercise price of the Company's employee stock options is
generally equal to the market price of the Company's underlying stock on the
date of grant, no compensation expense is recognized.
SFAS 123 establishes an alternative method of expense recognition for
stock-based compensation awards based on fair values. The following table
illustrates the effect on net income and earnings per share if the Company had
applied the fair value recognition provisions of SFAS 123.
Three Months Ended
September 30,
2005 2004
------------ ------------
Net Income, as reported $ 714,347 $ 115,899
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects (305,199) (284,671)
------------ ------------
Pro forma net income $ 409,148 $ (168,772)
============ ============
Earnings (loss) per share:
Basic - as reported $ 0.120 $ 0.021
============ ============
Basic - pro forma $ 0.069 $ (0.030)
============ ============
Diluted - as reported $ 0.112 $ 0.019
============ ============
Diluted - pro forma $ 0.062 $ (0.030)
============ ============
The Company has followed the guidelines of SFAS 123 to establish the
valuation of its stock options. The fair value of these equity awards was
estimated at the date of grant using the Black-Scholes option pricing method.
For the purposes of pro forma disclosures, the estimated fair value of the
equity awards is amortized to expense over the options' vesting period. For the
purposes of applying SFAS 123, the estimated per share value of the options
granted during the three-month period ended September 30, 2005 was between $7.18
and $8.06. The fair value was estimated using the following assumptions:
dividend yield of 0.0%, volatility of 0.78%; risk-free interest rate of 4.20%;
and expected life of 10 years. The volatility assumption is based on volatility
experienced in the Company's stock over the last five years. This assumption was
made according to the guidance of SFAS 123. There is no reason to believe that
future volatility will compare with the historic volatility.
In December 2004, the FASB issued SFAS No.123R ("SFAS No.123R"), (revised
2004), "Share-Based Payments" SFAS No. 123R is a revision of SFAS No. 123 and
supersedes ABP Opinion No. 25, which requires the Company to expense share-based
payments, including employee stock options. With limited exceptions, the amount
of compensation costs will be measured based on the grant date fair value of the
equity or liability instrument issued. Compensation cost will be recognized over
the period that the employee provides service in exchange for the award. The
Company is a small business issuer as defined in Item 10 of Regulation S-B. As a
result, the Company will be required to adopt this standard in its fiscal year
beginning July 1, 2006. The adoption of this standard for the expensing of stock
options is expected to reduce pretax earnings in future periods. The impact of
adoption of SFAS No. 123R cannot be predicted at this time because it will
depend upon the level of share-based payments made in the future and the model
the Company elects to utilize.
4. EARNINGS PER SHARE
The Company follows Financial Accounting Standards Board Statement No.
128, "Earnings Per Share," in presenting basic and diluted earnings per share.
The following table sets forth the computation of basic and diluted earnings per
share:
9
Three Months
Ended September 30,
2005 2004
---------- -----------
Numerator:
Numerator for basic and diluted earnings per share:
Net income $ 714,347 $ 115,899
Denominator:
Denominator for basic earnings per
share - weighted average shares 5,964,292 5,564,469
Effect of dilutive securities:
Stock options and warrants 408,450 519,175
Shares reserved for future exchange - 58,314
---------- -----------
Denominator for diluted earnings
earnings per share - weighted average and
assumed conversion 6,372,742 6,141,958
---------- -----------
Basic earnings per share $ 0.120 $ 0.021
========== ===========
Diluted earnings per share $ 0.112 $ 0.019
========== ===========
5. INVENTORY
Inventory, stated at lower of cost (determined on a first-in, first-out
basis) or market, consisted of the following:
September 30, June 30,
2005 2005
----------- -----------
Raw materials $ 3,331,810 $ 3,476,493
Work in process 1,161,087 473,252
Finished goods 1,713,919 2,073,208
----------- -----------
6,206,816 6,022,953
Valuation allowance (180,651) (166,668)
----------- -----------
Total inventory $ 6,026,165 $ 5,856,285
=========== ===========
6. NOTE RECEIVABLE
Escalon entered into an agreement with an individual who was involved in
the development of the Company's now discontinued Ocufit SR(R) drug delivery
system. The Company holds a note receivable from the individual in the amount of
$150,000 that was due in May 2005. The note was not paid when due and the
individual is currently in default. The Company intends to pursue collection, is
currently evaluating collection alternatives and has recorded a $50,000 reserve
based upon its current estimate of cost to pursue collection.
7. INTANGIBLE ASSETS
PATENTS
It is the Company's practice to seek patent protection on processes and
products in various countries. Patent application costs are capitalized and
amortized over their estimated useful lives, not
10
exceeding 17 years, on a straight-line basis from the date the related patents
are issued. Costs associated with patents no longer being pursued are expensed.
Accumulated patent amortization was $212,083 and $188,649 at September 30, 2005
and June 30, 2005, respectively. Amortization expense for the three-month
periods ended September 30, 2005 and 2004 was $379,380 and $9,484, respectively.
The aggregate amortization expense for each of the next five years for
patents is estimated to be approximately $70,000 per year for each of the next
five fiscal years.
GOODWILL, TRADEMARKS AND TRADE NAMES
Goodwill, trademarks and trade names represent intangible assets obtained
from the EOI, Endologix, Inc. ("Endologix"), Sonomed and Drew acquisitions.
Goodwill represents the excess of purchase price over the fair market value of
net assets acquired.
In accordance with SFAS 142, effective July 1, 2001, the Company
discontinued the amortization of goodwill and identifiable intangible assets
that have indefinite lives. Intangible assets that have finite lives continue to
be amortized over their estimated useful lives. Management has evaluated the
carrying value of goodwill and its identifiable intangible assets that have
indefinite lives during each of the fiscal years subsequent to July 1, 2001,
utilizing discounted cash flows of the respective business units. After
evaluating the discounted cash flow of each of its respective business units,
management concluded that the carrying value of goodwill and identifiable
intangible assets did not exceed their fair values and therefore were not
impaired. In accordance with SFAS 142, these intangible assets will continue to
be assessed on an annual basis, and impairment, if any, will be recorded as a
charge against income from operations.
The following table presents unamortized intangible assets by business
unit as of September 30, 2005 and June 30, 2005.
SEPTEMBER 30 JUNE 30
NET NET
CARRYING CARRYING
AMOUNT AMOUNT
------------ -----------
GOODWILL
Sonomed $ 9,525,550 $ 9,525,550
Drew 9,574,655 9,574,655
Vascular 941,218 941,218
Medical/Trek/EMI 125,027 125,027
------------ -----------
Total $ 20,166,450 $20,166,450
============ ===========
SEPTEMBER 30 JUNE 30
NET NET
CARRYING CARRYING
AMOUNT AMOUNT
------------ ------------
UNAMORTIZED INTANGIBLE
ASSETS
Sonomed $ 616,906 $ 616,906
------------ ------------
Total $ 616,906 $ 616,906
============ ============
11
The following table presents amortized intangible assets by business unit
as of September 30, 2005:
Adjusted
AMORTIZED INTANGIBLE Gross Gross
ASSETS Carrying Carrying Accumulated Net Carrying
PATENTS Amount Impairment Amount Amortization Value
--------- ---------- ---------- ------------ ------------
Drew $ 297,246 $ - $ 297,246 $ (69,316) $ 227,930
Vascular (pending issue) 36,916 - 36,916 (4,614) 32,302
Medical/Trek/EMI 257,301 - 257,301 (138,153) 119,148
--------- ----- ---------- ---------- ----------
$ 591,463 $ - $ 591,463 $ (212,083) $ 379,380
========= ===== ========== ========== ==========
The following table presents amortized intangible assets by business
unit as of June 30, 2005:
Adjusted
AMORTIZED INTANGIBLE Gross Gross
ASSETS Carrying Carrying Accumulated Net Carrying
PATENTS Amount Impairment Amount Amortization Value
--------- ---------- ---------- ------------ ------------
Drew $ 297,246 $ - $ 297,246 $ (55,908) $ 241,338
Vascular (pending issue) 36,916 - 36,916 - 36,916
Medical/Trek/EMI 257,301 - 257,301 (132,741) 124,560
--------- ----- ---------- ---------- ----------
$ 591,463 $ - $ 591,463 $ (188,649) $ 402,814
========= ===== ========== ========== ==========
8. ACCRUED EXPENSES
The following table presents accrued expenses as of September 30, 2005 and
June 30, 2005:
SEPTEMBER 30, JUNE 30,
2005 2005
------------- ----------
Accrued compensation $1,110,535 $1,276,639
Warranty accruals 199,836 201,413
Severance accruals 104,389 195,263
Legal accruals 286,606 251,000
Other accruals 570,916 761,355
---------- ----------
$2,272,282 $2,685,670
========== ==========
Severance accruals as of September 30, 2005 and June 30, 2005 relate to
certain former directors and officers of Drew who management had the intent to
terminate as of the consummation date of the transaction.
In addition to normal accrual, other accruals as of September 30, 2005 and
June 30, 2005 relate to the remaining lease payments on a facility that had been
vacated prior to the Drew acquisition, accruals for litigation existing prior to
the Drew acquisition, franchise and ad valorem tax accruals and other sundry
operating expenses and accruals
Accrued compensation as of September 30, 2005 and June 30, 2005 primarily
relates to payroll, bonus and vacation accruals and payroll tax liabilities.
9. LINE OF CREDIT AND LONG-TERM DEBT
The Company has two long-term debt facilities through its Drew subsidiary:
the Texas Mezzanine Fund and Symbiotics, Inc. The Texas Mezzanine Fund term debt
is payable in monthly installments of $14,200, which includes interest at a
fixed rate of 8.00%. The note is due in April 2008 and is secured by
12
certain assets of Drew. The outstanding balance of the note was $370,930 and
$405,471 as of September 30, 2005 and June 30, 2005, respectively. The
Symbiotics, Inc. term debt, which originated from the acquisition of a product
line from Symbiotics, Inc., is payable in monthly installments of $8,333 with
interest at a fixed rate of 5.00%. The outstanding balance of this note was
$191,668 and $216,666 as of September 30, 2005 and June 30, 2005, respectively.
The schedule below presents principal amortization for the next five years
under each of the Company's loan agreements as of September 30, 2005:
Twelve Months
Ending Texas
September 30, Mezzanine Symbiotics Total
------------- --------- ---------- ---------
2005 $ 133,037 $ 99,996 $ 233,033
2006 156,868 91,672 248,540
2007 81,025 - 81,025
2008 - - -
2009 - - -
--------- --------- ---------
Total $ 370,930 $191,668 $ 562,598
========= ========
Current portion of long-term debt 233,033
---------
Long-term portion $ 329,565
=========
10. OTHER REVENUE
Other revenue includes quarterly payments received from:
(1) Bausch & Lomb in connection with the sale of the Silicone Oil
product line, which contract expired on August 12, 2005 and from
which the Company will not receive any additional royalties;
(2) Royalty payments received from IntraLase Corp. ("IntraLase")
relating to the licensing of the Company's intellectual laser
technology; and
(3) Royalty payments received from Bio-Rad Laboratories, Inc.
("Bio-Rad").
For the three-month periods ended September 30, 2005 and 2004, Silicone
Oil revenue totaled $203,000 and $417,000, respectively, IntraLase royalties
totaled $392,000 and $239,000, respectively, and the Bio-Rad royalties totaled
$75 ,000 and $0, respectively. Accounts receivable as of September 30, 2005 and
June 30, 2005 related to other revenue was approximately $218,000 and $372,000,
respectively.
13
BAUSCH & LOMB SILICONE OIL
The Company's agreement with Bausch & Lomb, which commenced on August 13,
2000, was structured so that the Company received consideration from Bausch &
Lomb based on its adjusted gross profit from its sales of Silicone Oil on a
quarterly basis. The consideration was subject to a factor, which stepped down
through the termination date (August 2005) according to the following schedule:
From 8/13/00 to 8/12/01 100%
From 8/13/01 to 8/12/02 82%
From 8/13/02 to 8/12/03 72%
From 8/13/03 to 8/12/04 64%
From 8/13/04 to 8/12/05 45%
INTRALASE: LICENSING OF LASER TECHNOLOGY
The material terms of the license of the Company's laser patents to
IntraLase (the "License Agreement"), which expires in 2013, provide that the
Company will receive a 2.5% royalty on product sales that are based on the
licensed laser patents, subject to deductions for third party royalties
otherwise due and payable, and a 1.5% royalty on product sales that are not
based on the licensed laser patents. The Company receives a minimum annual
license fee of $15,000 per year during the remaining term of the license. The
minimum annual License Agreement fee is offset against the royalty payments.
The material termination provisions of the License Agreement of the laser
technology are as follows:
1. Termination by the Company if IntraLase defaults in the payment of
any royalty;
2. Termination by the Company if IntraLase makes any false report;
3. Termination by the Company if IntraLase defaults in the making of
any required report;
4. Termination by either party due to the commission of any material
breach of any covenant or promise by the other party under the
license agreement; or
5. Termination of the License Agreement by IntraLase after 90 days
notice (if IntraLase were to terminate, it would not be permitted
to utilize the licensed technology necessary to manufacture its
current products).
BIO-RAD ROYALTY
The royalty received from Bio-Rad relates to a certain non-exclusive
Eighth Amendment to an OEM Agreement ("OEM Agreement") between the Company's
Drew subsidiary and Bio-Rad, dated July 19, 1994. Bio-Rad pays a royalty based
on sales of certain of Drew's products in certain geographic regions.
The material terms of the OEM Agreement, provided:
- Drew receives an agreed royalty per test;
- Royalty payments will be made depending on the volume of tests provided by
Bio-Rad. If less than 3,750 tests per month are provided by Bio-Rad,
Bio-Rad will calculate the number of tests used on a quarterly basis in
arrears and pay Drew within 45 days of the end of the quarter. If more
than 3,750 tests per month are provided by Bio-Rad, Bio-Rad will pay an
estimated monthly royalty and within 45 days of the end of the quarter
will make final settlement upon the actual number of tests.
While the agreement, as amended by the Eighth Amendment, expired on May 15,
2005, the parties have continued to operate under the terms of the expired
agreement pending negotiation of a potential extension and/or revision.
14
11. COMMITMENTS AND CONTINGENCIES
COMMITMENTS
The Company leases its manufacturing, research and corporate office
facilities and certain equipment under non-cancelable operating lease
arrangements. The future amounts to be paid under these arrangements as of
September 30, 2005 are as follows:
Lease
Twelve Months Ending Obligations
------------
2006 $ 889,749
2007 721,029
2008 411,235
2009 284,615
2010 292,710
Thereafter 425,124
------------
Total $ 3,024,462
============
Rent expense charged to operations during the three-month periods ended
September 30, 2005 and 2004 was $215,111 and $141,191, respectively.
CONTINGENCIES
ROYALTY AGREEMENT: CLINICAL DIAGNOSTICS SOLUTIONS
Drew and Clinical Diagnostics Solutions, Inc. ("CDS") entered into a
Private Label/Manufacturing Agreement dated April 1, 2002 for the right to sell
formulations or products of CDS including reagents, controls and calibrators
("CDS products") on a private label basis. The agreement term is 15 years and
automatically renews year-to-year thereafter. Drew is obligated to pay CDS a
royalty of 7.5% on all sales of CDS products produced from Drew's United Kingdom
facility.
INTRALASE CORP. LEGAL PROCEEDINGS
In October 1997, Escalon and IntraLase entered into a License Agreement
wherein Escalon granted IntraLase the exclusive right to use Escalon's
intellectual laser properties, including patented and non-patented technology,
in exchange for an equity interest in IntraLase as well as royalties based on a
percentage of net sales of future products. The shares of common stock were
restricted for sale until April 6, 2005 (see note 15)
On June 10, 2004, Escalon gave IntraLase notice of its intention to
terminate the License Agreement due to IntraLase's failure to pay certain
royalties that Escalon believed were due under the License Agreement. On June
21, 2004, IntraLase sought a preliminary injunction and temporary restraining
order with the United States District Court for the Central District of
California, Southern District against Escalon to prevent termination of the
License Agreement. Contemporaneously, IntraLase filed an action for declaratory
relief asking the Court to validate its interpretation of certain terms of the
License Agreement relating to the amount of royalties owed to Escalon ("First
Action"). The parties mutually agreed to the entry of a temporary restraining
order which was entered by the Court shortly thereafter. At the close of
discovery, IntraLase and Escalon filed cross-motions for summary judgment. On
May 5, 2005, the District Court, having ruled on such motions, entered judgment
in the First Action.
The Court, in ruling on the parties' cross-motions for summary judgment,
did not agree with IntraLase's interpretation of certain terms and declared
that, under the terms of the License Agreement, IntraLase must pay Escalon
royalties on revenue from maintenance contracts and one-year warranties.
15
Further, the Court rejected IntraLase's argument that it is entitled to deduct
the value of non-patented components of its ophthalmic products, which it sells
as an integrated unit, from the royalties due Escalon. Non-patented components
of the products include computer monitors, joysticks, keyboards, universal power
supplies, microscope assemblies, installation kits and syringes. In addition,
the Court rejected IntraLase's assertion that accounts receivable are not
"consideration received" under the License Agreement and expressly ruled that
IntraLase must pay Escalon royalties on IntraLase's accounts receivable. The
Court agreed with IntraLase, however, holding that IntraLase is not required to
pay royalties on research grants. The Court also held that IntraLase must give
Escalon an accounting of third-party royalties.
Further, the Court agreed with Escalon in finding that royalties are
"monies" and the default in the payment of royalties must be remedied within 15
days of written notice of the default. The Court rejected IntraLase's position
concerning the effective date of the Amended and Restated License Agreement
holding that the effective date of such Agreement was dated October 17, 2000.
IntraLase has appealed the judgment to the Ninth Circuit Court of Appeals.
Currently, briefing is scheduled to occur in February/March, 2006.
Intralase, after entry of the Court's ruling, attempted to cure its
default under the License Agreement, but underpaid based upon a purported
interpretation of "accounts receivable" that discounts the receivables recorded
on the sales substantially, and in a manner that appears to directly contradict
Intralase's own published financial statements.
In May 2005, IntraLase also filed a second suit against Escalon in the
Central District of California, case number SAVC 05-440-AHS ("Second Action"),
again for declaratory relief as well as for reformation of the License
Agreement. In this action, IntraLase has asked the Court to, among other things,
validate its interpretation of certain other terms of the License Agreement
relating to the amount of royalties owed to Escalon and a declaration concerning
Escalon's audit rights under the License Agreement. Escalon filed a motion to
dismiss the Second Action on jurisdictional and substantive grounds. The motion
has been fully briefed and is currently under consideration by the Court for the
Central District of California.
On May 15, 2005, Escalon, not having been served with IntraLase's Second
Action, filed a Complaint against IntraLase in the Delaware Court of Chancery
for, among other things, breach of contract, breach of fiduciary duty arising
out of IntraLase's bad faith conduct under, and multiple breaches of, the
License Agreement ("Delaware Action"). Escalon seeks declaratory relief,
specified damages, and specific performance of its rights under the License
Agreement, including its express right under the Agreement to have independent
certified accountants audit the books and records of IntraLase to verify and
compute payments due Escalon.
On June 3, 2005, IntraLase, after having been served with Escalon's
Complaint, filed its First Amended Complaint in the Second Action adding new
matters that had already been raised by Escalon in its Delaware Action.
IntraLase also filed a motion to dismiss Escalon's Delaware Action. In July,
2005, the parties agreed to postpone briefing on IntraLase's motion until after
the California Court has ruled on Escalon's motion to dismiss the Second Action.
Separately, on April 22, 2005, Escalon, as record holder of common stock
of IntraLase, made a formal written demand to inspect certain of IntraLase's
books and records pursuant to Section 220 of the Delaware General Corporation
Law. IntraLase rejected Escalon's demand. Escalon recently filed an action in
the Delaware Court of Chancery against IntraLase seeking to enforce its
shareholder rights to inspect IntraLase's books and records. The 220 Case is
currently in the discovery stage.
Escalon is cognizant of the legal expenses and costs associated with the
IntraLase matter. Escalon, however, is taking all necessary actions to protect
its rights and interests under the License Agreement. Escalon expects expenses
associated with this litigation to adversely impact earnings in the near term.
Escalon believes that IntraLase has sufficient funds to support such payments
based on its filings with the SEC and filings in connection with the First
Action.
16
DREW LEGAL PROCEEDINGS
CARVER LITIGATION
On December 17, 2002, Edward Carver, David DeCava and Diane Carver, former
principal shareholders of CDC Technologies, Inc., filed a complaint in the State
of Connecticut, Superior Court, Judicial District of Waterbury at Waterbury
against CDC Acquisition, IV Diagnostics and certain other principal shareholders
of CDC Technologies seeking a total of approximately $420,000 for, among other
things, repayment of loans made to CDC Technologies, payment of past wages and
reimbursement of business expenses. The Plaintiffs' claims arose out of a
certain asset purchase for stock transaction in which CDC Acquisition, a wholly
owned subsidiary of Drew, acquired the assets of CDC Technologies and IV
Diagnostics. CDC Acquisition and IV Diagnostics, also a subsidiary of Drew,
asserted counterclaims against the plaintiffs for, among other things, breach of
fiduciary duty, unfair trade and conversion. In addition, CDC Acquisition and IV
Diagnostics asserted cross-claims against its co-defendants for indemnification
pursuant to the transaction agreements. A bench trial was held in June, 2005. In
August, 2005 the Court rendered a decision resulting in the Court's award of
only $76,000 to Plaintiffs. CDC Acquisition and IV Diagnostics filed a motion
for reconsideration of certain issues ruled upon by the Court. The motion was
denied. Plaintiffs' counsel filed a motion for attorneys' fees seeking over
$181,000. The Court recently granted such motion but awarded only $3,000 to
plaintiffs' counsel. On November 1, 2005, CDC Acquisition and IV Diagnostics
timely appealed the Court's ruling that CDC Acquisitions and IV Diagnostics are
liable to the plaintiffs. Further, CDC Acquisition and IV Diagnostics are
presently negotiating with co-defendants over the companies' indemnification
claims.
On December 30, 2002, Source One, a distributor of CDC Technologies, Inc.
filed suit in state court in Minnesota, later removed to the United States
District Court in Minnesota, against CDC Technologies, Edward Carver and CDC
Acquisition, Inc. and IV Diagnostics, as successors in interest to CDC
Technologies. CDC Acquisition and IV Diagnostics asserted cross-claims against
Carver for indemnification. The court granted summary judgment to the plaintiff
against defendants and awarded plaintiff approximately $185,000 plus interest
and costs. The Court also found Carver liable to CDC Acquisition for
indemnification. Plaintiff agreed to accept $140,000 from CDC Acquisition in
settlement of its claims. CDC Acquisition settled its indemnification claim
against Carver for $75,000.
The $140,000 settlement, $79,000 award (including legal fees) and $75,000
indemnification referred to above have been recorded by the Company during the
year ended June 30, 2005. The Company does not believe that these matters have,
had or are likely to have a material adverse impact on the Company's business,
financial condition or future results of operations.
OTHER LEGAL PROCEEDINGS
Escalon, from time to time is involved in various legal proceedings and
disputes that arise in the normal course of business. These matters have
included intellectual property disputes, contract disputes, employment disputes,
and other matters. The Company does not believe that the resolution of any of
these matters has had or is likely to have a material adverse impact on the
Company's business, financial condition or results of operations.
12. SEGMENTAL INFORMATION
During the three-month periods ended September 30, 2005 and 2004, the
Company operations were classified into four principal reportable segments that
provide different products or services. One of the business segments, Drew,
became a reportable segment following its acquisition by the Company on July 23,
2004.
Separate management of each segment is required because each business unit
is subject to different marketing, production and technology strategies.
17
SEGMENTAL STATEMENTS OF OPERATIONS (IN THOUSANDS) - THREE MONTHS ENDED SEPTEMBER 30,
Drew Sonomed Vascular Medical/Trek/EMI Total
2005 2004 2005 2004 2005 2004 2005 2004 2005 2004
-------- -------- ------- -------- --------- ------- --------- -------- --------- ---------
Product revenue $ 4,071 $ 1,904 $ 1,798 $ 1,644 $ 931 $ 695 $ 323 $ 393 $ 7,123 $ 4,636
Other revenue 75 - - - - - 595 656 670 656
-------- -------- ------- -------- --------- ------- --------- -------- --------- ---------
Total revenue 4,146 1,904 1,798 1,644 931 695 918 1,049 7,793 5,292
-------- -------- ------- -------- --------- ------- --------- -------- --------- ---------
Costs and expenses:
Cost of goods sold 2,594 1,251 976 859 320 320 216 241 4,106 2,671
Operating expenses 1,822 937 1,040 629 529 409 679 523 4,040 2,498
-------- -------- ------- -------- --------- ------- --------- -------- --------- ---------
Total costs and expenses 4,416 2,188 2,016 1,488 849 729 895 764 8,146 5,169
-------- -------- ------- -------- --------- ------- --------- -------- --------- ---------
(Loss)/income from operations (270) (284) (218) 156 82 (34) 23 285 (353) 123
Other income and
expenses:
Equity in OTM - - - - - - (18) (29) (18) (29)
Gain on sale of available for
sale securities - - - - - - 1,157 1,157
Interest income 4 - - - - 5 137 5 141
Interest expense (10) (24) - (81) - (1) - - (10) (106)
-------- -------- ------- -------- --------- ------- --------- -------- --------- ---------
Total other income and
expenses (10) (20) - (81) 82 (1) 1,144 108 1,133 6
-------- -------- ------- -------- --------- ------- --------- -------- --------- ---------
(Loss)/income before taxes (280) (304) (218) 75 82 (35) 1,167 393 780 129
Income taxes - - - - - - 66 13 66 13
-------- -------- ------- -------- --------- ------- --------- -------- --------- ---------
Net (loss)/income $ (280) $ (304) $ (218) $ 75 $ 82 $ (35) $ 1,101 $ 380 $ 714 $ 116
======== ======== ======= ======== ========= ======= ========= ======== ========= =========
Depreciation and
amortization $ 55 $ 46 $ 5 $ 7 $ 17 $ 11 $ 28 28 $ 108 $ 92
Assets $ 15,295 $ 15,128 $13,623 $ 12,844 $ 2,208 $ 2,226 $ 8,655 $ 7,941 $ 39,781 $ 38,139
Expenditures for
long-lived assets $ 88 $ 2 $ 0 $ 19 $ 13 $ 7 45 $ 11 146 $ 39
13. SHAREHOLDERS' EQUITY
WARRANTS TO PURCHASE COMMON STOCK
In connection with debt issued by a former lender to Escalon in November
2001, the Company issued the lender warrants to purchase 60,000 shares of the
Company's common stock at $3.66 per share. The lender exercised the warrants on
December 13, 2004, in a cashless exercise receiving 32,855 shares of the
Company's common stock in satisfaction of the warrants.
In connection with the private placement of the Company's common stock in
March 2004, the Company issued to several accredited investors warrants to
purchase 120,000 shares of the Company's common stock at $15.60 per share. The
warrants are currently exercisable and expire in March 2009.
14. RELATED-PARTY TRANSACTIONS
Escalon and a member of the Company's Board of Directors are founding and
equal members of Ocular Telehealth Management, LLC ("OTM"). OTM is a diagnostic
telemedicine company providing remote examination, diagnosis and management of
disorders affecting the human eye. OTM's initial solution focuses on the
diagnosis of diabetic retinopathy by creating access and providing annual
dilated retinal examinations for the diabetic population. OTM was founded to
harness the latest advances in telecommunications, software and digital imaging
in order to create greater access and a more successful disease management for
populations that are susceptible to ocular disease. Through September 30, 2005,
Escalon had invested $256,000 in OTM. As of September 30, 2005, Escalon owned
45% of OTM. The members of OTM have agreed to review the operations of OTM after
24 months, at which time the
18
members each have the right to sell their membership interest back to OTM at
fair market value. The Company provides administrative support functions to OTM.
From inception through September 30, 2005, OTM had revenue of approximately
$10,000 and incurred expenses of approximately $160,000. This investment is
accounted for under the equity method of accounting and is included in other
assets.
Commencing July 2004, a relative of a senior executive officer of Escalon
began providing legal services to the Company in connection with various legal
proceedings. Expenditures related to this individual during the three-month
periods ended September 2005 and 2004 were $0 and $13,062, respectively.
Commencing in August 2005, this individual was retained as an employee of the
Company.
15. INTRALASE INITIAL PUBLIC OFFERING
In October 1997, Escalon licensed its intellectual laser properties to
IntraLase in exchange for an equity interest of 252,535 shares of Common Stock
(as adjusted for splits), as well as royalties on future product sales. The
Company has historically accounted for these shares a $0 basis because a readily
determinable market value was previously not available. On October 7, 2004,
IntraLase announced the initial public offering of shares of its common stock at
a price of $13.00 per share. The shares of common stock were restricted for a
period of less than one year and were permitted to be sold after April 6, 2005
pursuant to a certain Fourth Amended Registration Rights Agreement between the
Company and IntraLase. The Company sold 191,000 shares of IntraLase common stock
in May 2005 at $17.9134 per share resulting in net proceeds, after fees and
commissions, of $3,411,761. As of June 30, 2005, the Company's remaining 61,535
shares of IntraLase were classified as available-for-sale securities and had a
market value of $1,207,317.
On July 8, 2005, Company sold an additional 58,535 shares of IntraLase
common stock at $19.8226 per share resulting in gross proceeds of $1,160,316.
After paying broker commissions and other fees of $2,980, the Company received
net proceeds of $1,157,336. The net proceeds from the sale were recorded in
other income and expense. The Company's remaining 3,000 shares of IntraLase at
September 30, 2005 are classified as available-for-sale securities
16. SUBSEQUENT EVENTS
On October 14, 2005, the Company announced that its subsidiary, Escalon
Medical Imaging, Inc., signed a letter of intent to acquire substantially all
of the assets of MRP Group, Inc. ("MRP"). The transaction, which is expected to
close in the Company's second fiscal quarter ending December 31, 2005, is
subject to customary closing conditions, including the completion of a
definitive agreement.
MRP is a privately held ophthalmic technology solutions provider that
currently offers two retinal imaging systems and has approximately 200 systems
installed at leading medical and retinal care centers. If the transaction is
successfully completed, upon closing, the operating results of MRP will be
included in the consolidated results of the Company, and MRP will become part of
the Medical/Trek/EMI business unit.
On October 11, 2005 the Company signed a non-exclusive co-marketing
agreement with privately held Anka Systems, Inc. ("Anka"), a provider of
web-based connectivity solutions for the ophthalmic physician. Anka's
connectivity solutions are used in major eye healthcare centers and provide
seamless integration of data from various clinical modalities commonly used in
eye healthcare settings. Upon closing of the MRP acquisition, the co-marketing
agreement will enable Escalon to jointly market its existing digital imaging
hardware and MRP's digital imaging hardware with Anka's connectivity solutions.
By integrating the sales and marketing efforts, the alliance should provide
economies of operation and a greater market reach. Anka is an early stage
privately held company located in the Washington D.C. area.
The Company extended a $300,000 loan, pursuant to a demand mote, to Anka.
Under the terms of this note repayment will occur within six months after
written demand or immediately upon an event of default.
19
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
EXECUTIVE OVERVIEW - THREE-MONTH PERIOD ENDED SEPTEMBER 30, 2005
The following highlights are discussed in further detail within this
report. The reader is encouraged to read this report in its entirety to gain a
more complete understanding of factors impacting Company performance and
financial condition.
- On July 23, 2004, Escalon acquired 67% of the outstanding ordinary
shares of Drew pursuant to the Company's exchange offer for all of
the outstanding ordinary shares of Drew, and since that date has
acquired all of the Drew shares. The Company has been operating Drew
as a separate business unit since its acquisition and its results of
its operations are included in the "Management's Discussion and
Analysis or Plan of Operation" for all periods since the acquisition
in July 2004. Prior to the acquisition, Drew's ability to obtain raw
materials and components was severely restricted due to prolonged
liquidity constraints. These constraints were pervasive throughout
all of Drew's locations and affected all aspects of Drew's
operations. Escalon's operational priorities with respect to Drew
have been to stabilize and increase Drew's revenue base and to
infuse Drew with working capital in the areas of manufacturing,
sales and marketing and product development in an effort to remove
the pre-acquisition liquidity constraints.
- In connection with the acquisition of Drew, the Company issued
900,000 shares of its common stock during the fiscal year ended June
30, 2005, of which 841,686 shares were issued in the three month
period ended September 30, 2004.
- Product revenue increased approximately 53.6% during the three-month
period ended September 30, 2005 as compared to the same period last
fiscal year. The increase is primarily related to strong sales in
the Company's Drew, Sonomed and Vascular business units. Sales at
these business units increased approximately 138.1%, 9.4% and 34.0%
during the three month period ended September 30, 2005 when compared
to the same period last fiscal year.
- During July 2005, the Company sold 58,555 shares of IntraLase common
stock that had originally been received in connection with the
license of its intellectual laser properties to IntraLase in 1997
(see note 15 to the notes to the condensed consolidated financial
statements). The stock was sold at $19.8226 per share and yielded
net proceeds of $1,157,336 after the payment of brokers' commissions
and other fees. The net proceeds were recorded as other income in
the three-month period ended September 30, 2005.
- Other revenue increased approximately $14,500 or 2% during the
three-month period ended September 30, 2005 as compared to the same
period last fiscal year. The increase primarily relates to an
increase in royalty payments received from Intralase and Bio Rad,
which offset lower royalties received from Bauch and Lomb in
connection with the Silicone Oil Product line. During the
three-month periods ended September 30, 2005 and 2004, 2.6% and
7.9%, respectively, of the Company's revenue was received from the
Bauch and Lomb contract, which expired in August 2005. Accordingly,
the Company will receive no additional revenue related to this
contract.
- Cost of goods sold as a percentage of product revenue increased
slightly to approximately 57.64% of revenues during the three-month
period ended September 30, 2005, as compared to approximately 57.61%
of product revenue for the same period last fiscal year. The
increase is primarily due to the significant increase in the
revenues of the Drew business unit, which offset margin improvements
in the Company's other business units. Gross margins in the Drew
business unit, while improving in the three-month period ended
September 30, 2005 as compared to the same period in the prior
fiscal year, have historically been lower than those in the
Company's other business units. The aggregate cost of goods sold as
a percentage of product
20
revenue of the Sonomed, Vascular and Medical/Trek/EMI business units
during the three-month period ended September 30, 2005 decreased to
approximately 49.5% of product revenue from approximately 52% in the
same period last fiscal year.
- Operating expenses, while decreasing slightly as a percentage of
product revenue, increased approximately 50.5% during the
three-month period ended September 30, 2005 as compared to the same
period in the prior fiscal year. During the three-month period ended
September 30, 2005, the Company incurred higher personnel costs to
support the growth in the Company's business operations, higher
advertising, marketing, travel and trade show costs related to both
the higher sales volumes and the continued emphasis to increase
sales, especially in international markets, and increased research
and development costs to support planned introductions of new and or
enhanced products, especially in the Drew and Sonomed business
units. In addition, the Company continues to experience an unusually
high amount of legal and accounting fees primarily related to
Intralase litigation costs, and increased auditor's fees in
proportion to the increase in the Company's size due to the
acquisition of Drew and initial costs related to compliance with the
Sarbanes -Oxley Act of 2002. While the Company expects these legal,
accounting and compliance expenses to impact earnings in the near
term, it does not believe that all of these expenses will continue
in the future at such high levels.
CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS
Certain statements contained in, or incorporated by reference in, this
report are forward-looking statements made pursuant to the safe harbor
provisions of the Private Securities Litigation Reform Act of 1995, which
provide current expectations or forecasts of future events. Such statements can
be identified by the use of terminology such as "anticipate," "believe,"
"could," "estimate," "expect," "forecast," "intend," "may," "plan," "possible,"
"project," "should," "will," and similar words or expressions. The Company's
forward-looking statements include certain information relating to general
business strategy, growth strategies, financial results, liquidity, product
development, the introduction of new products, the potential markets and uses
for the Company's products, the Company's regulatory filings with the United
States Food and Drug Administration (the "FDA"), acquisitions, the development
of joint venture opportunities, the loss of revenue due to the expiration on
termination of certain agreements, the effect of competition on the structure of
the markets in which the Company competes and defending the Company in
litigation matters. The reader must carefully consider forward-looking
statements and understand that such statements involve a variety of risks and
uncertainties, known and unknown, and may be affected by assumptions that fail
to materialize as anticipated. Consequently, no forward-looking statement can be
guaranteed, and actual results may vary materially. It is not possible to
foresee or identify all factors affecting the Company's forward-looking
statements, and the reader therefore should not consider the following list of
such factors to be an exhaustive statement of all risks, uncertainties or
potentially inaccurate assumptions.
The Company cautions the reader to consider carefully these factors as
well as the specific factors discussed with each specific forward-looking
statement in this quarterly report and in the Company's other filings with the
SEC. In some cases, these factors have impacted, and in the future (together
with other unknown factors) could impact the Company's ability to implement the
Company's business strategy and may cause actual results to differ materially
from those contemplated by such forward-looking statements. No assurance can be
made that any expectation, estimate or projection contained in a forward-looking
statement can be achieved.
The Company also cautions the reader that forward-looking statements speak
only as of the date made. The Company undertakes no obligation to update any
forward-looking statement, but investors are advised to consult any further
disclosures by the Company on this subject in the Company's filings with the
SEC, in which the Company discusses in more detail various important factors
that could cause actual results to differ from expected or historical results.
Although it is not possible to create a comprehensive list of all factors that
may cause actual results to differ from the Company's forward-looking
statements, the most important factors include, without limitation, the
following:
21
ANY ACQUISITIONS, STRATEGIC ALLIANCES, JOINT VENTURES AND DIVESTITURES
THAT THE COMPANY EFFECTS COULD RESULT IN FINANCIAL RESULTS THAT DIFFER
FROM MARKET EXPECTATIONS.
In the normal course of business, the Company engages in discussions with
third parties regarding possible acquisitions, strategic alliances, joint
ventures and divestitures. As a result of any such transactions, the Company's
financial results may differ from the investment community's expectations in a
given quarter. In addition, acquisitions and alliances may require the Company
to integrate a different company culture, management team, business
infrastructure, accounting systems and financial reporting systems, although
there is no assurance that any such acquisitions or alliances will occur. The
Company may have difficulty developing, manufacturing and marketing the products
of a newly acquired company in a way that enhances the performance of the
Company's combined businesses or product lines to realize the value from
expected synergies. Depending on the size and complexity of an acquisition, the
Company's successful integration of the entity depends on a variety of factors
including the retention of key employees and the management of facilities and
employees in separate geographical areas. These efforts require varying levels
of management resources, which may divert the Company's attention from other
business operations. The Company acquired Drew during the first quarter of
fiscal 2005. Drew does not have a history of producing positive operating cash
flows and, as a result, at the time of acquisition, was operating under
financial constraints and was under-capitalized and is expected to negatively
impact the Company's financial results in the short-term. As Drew is integrated
into the Company, management will be working to reverse the situation, while at
the same time seeking to strengthen Drew's market position. Escalon loaned
approximately $6,891,000 to Drew. The funds have been primarily used to procure
components to build up inventory to support the manufacturing process, to pay
off accounts payable and debt of Drew, and expand the sales and marketing and
research and development efforts. Escalon anticipates that further working
capital will likely be required by Drew. If the Company does not realize the
expected benefits or synergies of such transactions, the Company's consolidated
financial position, results of operations and stock price could be negatively
impacted. Also, the Company's results may be adversely impacted because of
acquisition-related costs, amortization costs for certain intangible assets and
impairment losses related to goodwill in connection with such transactions.
COSTS ASSOCIATED WITH INTRALASE LITIGATION MAY ADVERSELY IMPACT EARNINGS
IN THE NEAR TERM.
Escalon is cognizant of the escalating legal expenses and costs associated
with the IntraLase matter. Escalon, however, is taking all necessary actions to
protect its rights and interests under the License Agreement. Escalon expects
expenses associated with this litigation to adversely impact earnings in the
near term. If Escalon is successful in the litigation, there is a cure feature
written into the stipulation to the temporary restraining order, which would
enable IntraLase to continue to pay royalties Escalon believes are due under the
License Agreement. Escalon believes that IntraLase has sufficient funds to
support such payments based upon its filings with the Securities and Exchange
Commission and filings in connection with this litigation. If IntraLase is
successful in the litigation, they would continue to pay royalties under their
calculations.
THE COMPANY'S RESULTS FLUCTUATE FROM QUARTER TO QUARTER.
The Company has experienced quarterly fluctuations in operating results
and anticipates continued fluctuations in the future. A number of factors
contribute to these fluctuations:
- Acquisitions, such as Drew, and subsequent integration of the
acquired company, although there is no assurance that such
acquisitions will occur;
- The timing and expense of new product introductions by the Company
or its competitors, although there is no assurance that any new
products will be successfully developed or gain market acceptance;
- The cancellation or delays in the purchase of the Company's
products;
- Fluctuations in customer demand for the Company's products;
- Fluctuations in royalty income;
- The gain or loss of significant customers;
22
- Changes in the mix of products sold by the Company;
- Competitive pressures on prices at which the Company can sell its
products; and
- Announcements of new strategic relationships by the Company or its
competitors.
The Company sets its spending levels in advance of each quarter based, in
part, on the Company's expectations of product orders and shipments during that
quarter. A shortfall in revenue, therefore, in any particular quarter as
compared to the Company's plan could have a material adverse impact on the
Company's results of operations and cash flows. Also, the Company's quarterly
results could fluctuate due to general market conditions in the healthcare
industry or global economy generally, or market volatility unrelated to the
Company's business and operating results.
FAILURE OF THE MARKET TO ACCEPT THE COMPANY'S PRODUCTS COULD ADVERSELY
IMPACT THE COMPANY'S BUSINESS AND FINANCIAL CONDITION.
The Company's business and financial condition will depend in part upon
the market acceptance of the Company's products. The Company cannot assure that
the Company's products will achieve market acceptance. Market acceptance depends
on a number of factors including:
- The price of the products;
- The receipt of regulatory approvals for multiple indications;
- The establishment and demonstration of the clinical safety and
efficacy of the Company's products; and
- The advantages of the Company's products over those marketed by the
Company's competitors.
Any failure to achieve significant market acceptance of the Company's
products will have a material adverse impact on the Company's business.
THE COMPANY NO LONGER RECEIVES REVENUE FROM THE SALE OF SILICONE OIL BY
BAUSCH & LOMB WHICH EXPIRED ON AUGUST 12, 2005.
The Company received approximately 2.6% and 7.9% of its net revenue during
the three-month periods ended September 30, 2005 and 2004, respectively, from
Bausch & Lomb's sales of Silicone Oil. The Company was entitled to receive this
revenue from Bausch & Lomb, in varying amounts, through August 12, 2005. The
Company's agreement with Bausch & Lomb, which commenced on August 13, 2000, was
structured so that the Company received consideration from Bausch & Lomb based
on its adjusted gross profit from its sales of Silicone Oil on a quarterly
basis. The consideration was subject to a factor, which declined according to
the following schedule:
From 8/13/00 to 8/12/01 100%
From 8/13/01 to 8/12/02 82%
From 8/13/02 to 8/12/03 72%
From 8/13/03 to 8/12/04 64%
From 8/13/04 to 8/13/05 45%
The revenue associated with the sale of Silicone Oil by Bausch & Lomb had
no associated expense and consequently provided a gross margin of 100%. The
elimination of this revenue will have a significant negative impact on gross
margin. The Company will not receive any future revenue related to the Silicone
Oil royalty as the contract expired on August 12, 2005.
THE COMPANY'S PRODUCTS ARE SUBJECT TO STRINGENT ONGOING REGULATION
BY THE FDA AND SIMILAR HEALTH CARE REGULATORY AUTHORITIES, AND IF
THE FDA'S APPROVALS OR CLEARANCES OF THE COMPANY'S PRODUCTS ARE
RESTRICTED OR REVOKED, THE COMPANY COULD FACE DELAYS THAT WOULD
IMPAIR THE COMPANY'S ABILITY TO GENERATE FUNDS FROM OPERATIONS.
23
The FDA and similar health care regulatory authorities in foreign
countries extensively regulate the Company's activity. The Company must obtain
either 510(K) clearances or pre-market approvals and new drug application
approvals prior to marketing a product in the United States. Foreign regulation
also requires that the Company obtain other approvals from foreign government
agencies prior to the sale of products in those countries. Also, the Company may
be required to obtain FDA approval before exporting a product or device that has
not received FDA marketing clearance or approval.
The Company has received the necessary FDA approvals for all products that
the Company currently markets. Any restrictions on or revocation of the FDA
approvals and clearances that the Company has obtained, however, would prevent
the continued marketing of the impacted products and other devices. The
restrictions or revocations could result from the discovery of previously
unknown problems with the product. Consequently, FDA revocation would impair the
Company's ability to generate funds from operations.
The FDA and comparable agencies in state and local jurisdictions and in
foreign countries impose substantial requirements upon the manufacturing and
marketing of pharmaceutical and medical device equipment and related
disposables, including the obligation to adhere to the FDA's Good Manufacturing
Practice regulations. Compliance with these regulations requires time-consuming
detailed validation of manufacturing and quality control processes, FDA periodic
inspections and other procedures. If the FDA finds any deficiencies in the
validation processes, for example, the FDA may impose restrictions on marketing
the specific products until such deficiencies are corrected.
The Company has received CE approval on several of the Company's products
that allows the Company to sell the products in the countries comprising the
European community. In addition to the CE mark, however, some foreign countries
may require separate individual foreign regulatory clearances. The Company
cannot assure that the Company will be able to obtain regulatory clearances for
other products in the United States or foreign markets.
The process for obtaining regulatory clearances and approvals underlying
clinical studies for any new products or devices and for multiple indications
for existing products is lengthy and will require substantial commitments of
Escalon's financial resources and Escalon's management's time and effort. Any
delay in obtaining clearances or approvals or any changes in existing regulatory
requirements would materially adversely impact the Company's business.
Escalon's failure to comply with the applicable regulations would subject
the Company to fines, delays or suspensions of approvals or clearances, seizures
or recalls of products, operating restrictions, injunctions or civil or criminal
penalties, which would adversely impact the Company's business, financial
condition and results of operations.
THE SUCCESS OF COMPETITIVE PRODUCTS COULD HAVE AN ADVERSE IMPACT ON THE
COMPANY'S BUSINESS.
The Company faces intense competition in the medical device and
pharmaceutical markets, which are characterized by rapidly changing technology,
short product life cycles, cyclical oversupply and rapid price erosion. Many of
the Company's competitors have substantially greater financial, technical,
marketing, distribution and other resources. The Company's strategy is to
compete primarily on the basis of technological innovation, reliability, quality
and price of the Company's products. Without timely introductions of new
products and enhancements, the Company's products will become technologically
obsolete over time, in which case the Company's revenues and operating results
would suffer. The success of the Company's new product offerings will depend on
several factors, including the Company's ability to:
- Properly identify customer needs;
- Innovate and develop new technologies, services and applications;
- Establish adequate product distribution coverage;
- Obtain and maintain required regulatory approvals from the FDA and
other regulatory agencies;
24
- Protect the Company's intellectual property;
- Successfully commercialize new technologies in a timely manner;
- Manufacture and deliver the Company's products in sufficient volumes
on time;
- Differentiate the Company's offerings from the offerings of the
Company's competitors;
- Price the Company's products competitively;
- Anticipate competitors' announcements of new products, services or
technological innovations; and
- Anticipate general market and economic conditions.
The Company cannot ensure that the Company will be able to compete
effectively in the competitive environments in which the Company operates.
THE COMPANY'S PRODUCTS EMPLOY PROPRIETARY TECHNOLOGY, AND THIS TECHNOLOGY
MAY INFRINGE ON THE INTELLECTUAL PROPERTY RIGHTS OF THIRD PARTIES.
The Company holds several United States and foreign patents for the
Company's products. Other parties, however, hold patents relating to similar
products and technologies. If patents held by others were adjudged valid and
interpreted broadly in an adversarial proceeding, the court or agency could deem
them to cover one or more aspects of the Company's products or procedures. Any
claims for patent infringements or claims by the Company for patent enforcement
would consume time, result in costly litigation, divert technical and management
personnel or require the Company to develop non-infringing technology or enter
into royalty or licensing agreements. The Company cannot be certain that the
Company will not be subject to one or more claims for patent infringement, that
the Company would prevail in any such action or that the Company's patents will
afford protection against competitors with similar technology.
If a court determines that any of the Company's products infringes,
directly or indirectly, on a patent in a particular market, the court may enjoin
the Company from making, using or selling the product. Furthermore, the Company
may be required to pay damages or obtain a royalty-bearing license, if
available, on acceptable terms.
LACK OF AVAILABILITY OF KEY SYSTEM COMPONENTS COULD RESULT IN DELAYS,
INCREASED COSTS OR COSTLY REDESIGN OF THE COMPANY'S PRODUCTS.
Although some of the parts and components used to manufacture the
Company's products are available from multiple sources, the Company currently
purchases most of the Company's components from single sources in an effort to
obtain volume discounts. Lack of availability of any of these parts and
components could result in production delays, increased costs, or costly
redesign of the Company's products. Any loss of availability of an essential
component could result in a material adverse change to Escalon's business,
financial condition and results of operations. Some of the Company's suppliers
are subject to the FDA's Good Manufacturing Practice regulations. Failure of
these suppliers to comply with these regulations could result in the delay or
limitation of the supply of parts or components to the Company, which would
adversely impact the Company's financial condition and results of operations.
THE COMPANY'S ABILITY TO MARKET OR SELL THE COMPANY'S PRODUCTS MAY BE
ADVERSELY IMPACTED BY LIMITATIONS ON REIMBURSEMENTS BY GOVERNMENT
PROGRAMS, PRIVATE INSURANCE PLANS AND OTHER THIRD PARTY PAYORS.
The Company's customers bill various third party payors, including
government programs and private insurance plans, for the health care services
provided to their patients. Third party payors may reimburse the customer,
usually at a fixed rate based on the procedure performed, or may deny
reimbursement if they determine that the use of the Company's products was
elective, unnecessary, inappropriate, not cost-effective, experimental or used
for a non-approved indication. Third party payors may deny reimbursement
notwithstanding FDA approval or clearance of a product and may challenge the
prices charged for the medical products and services. The Company's ability to
sell the Company's
25
products on a profitable basis may be adversely impacted by denials of
reimbursement or limitations on reimbursement, compared with reimbursement
available for competitive products and procedures. New legislation that further
reduces reimbursements under the capital cost pass-through system utilized in
connection with the Medicare program could also adversely impact the marketing
of the Company's products.
FUTURE LEGISLATION OR CHANGES IN GOVERNMENT PROGRAMS MAY ADVERSELY IMPACT
THE MARKET FOR THE COMPANY'S PRODUCTS.
In the past several years, the federal government and Congress have made
proposals to change aspects of the delivery and financing of health care
services. The Company cannot predict what form any future legislation may take
or its impact on the Company's business. Legislation that sets price limits and
utilization controls adversely impact the rate of growth of the markets in which
the Company participates. If any future health care legislation were to
adversely impact those markets, the Company's product marketing could also
suffer, which would adversely impact the Company's business.
THE COMPANY MAY BECOME INVOLVED IN PRODUCT LIABILITY LITIGATION, WHICH MAY
SUBJECT THE COMPANY TO LIABILITY AND DIVERT MANAGEMENT ATTENTION.
The testing and marketing of the Company's products entails an inherent
risk of product liability, resulting in claims based upon injuries or alleged
injuries or a failure to diagnose associated with a product defect. Some of
these injuries may not become evident for a number of years. Although the
Company is not currently involved in any product liability litigation, the
Company may be party to litigation in the future as a result of an alleged
claim. Litigation, regardless of the merits of the claim or outcome, could
consume a great deal of the Company's time and attention away from the Company's
core businesses. The Company maintains limited product liability insurance
coverage of $1,000,000 per occurrence and $2,000,000 in the aggregate, with
umbrella policy coverage of $5,000,000 in excess of such amounts. A successful
product liability claim in excess of any insurance coverage may adversely impact
the Company's financial condition and results of operations. The Company cannot
assure that product liability insurance coverage will continue to be available
to the Company in the future on reasonable terms or at all.
THE COMPANY'S INTERNATIONAL OPERATIONS COULD BE ADVERSELY IMPACTED BY
CHANGES IN LAWS OR POLICIES OF FOREIGN GOVERNMENTAL AGENCIES AND SOCIAL
AND ECONOMIC CONDITIONS IN THE COUNTRIES IN WHICH THE COMPANY OPERATES.
The Company derives a portion of its revenue from sales outside the United
States. Changes in the laws or policies of governmental agencies, as well as
social and economic conditions, in the countries in which the Company operates
could impact the Company's business in these countries and the Company's results
of operations. Also, economic factors, including inflation and fluctuations in
interest rates and foreign currency exchange rates, and competitive factors such
as price competition, business combinations of competitors or a decline in
industry sales from continued economic weakness, both in the United States and
other countries in which the Company conducts business, could adversely impact
the Company's results of operations.
THE COMPANY IS DEPENDENT ON ITS MANAGEMENT AND KEY PERSONNEL TO SUCCEED.
The Company's principal executive officers and technical personnel have
extensive experience with the Company's products, the Company's research and
development efforts, the development of marketing and sales programs and the
necessary support services to be provided to the Company's customers. Also, the
Company competes with other companies, universities, research entities and other
organizations to attract and retain qualified personnel. The loss of the
services of any of the Company's executive officers or other technical
personnel, or the Company's failure to attract and retain other skilled and
experienced personnel, could have a material adverse impact on the Company's
ability to maintain or expand businesses.
26
THE MARKET PRICE OF THE COMPANY'S STOCK HAS HISTORICALLY BEEN VOLATILE,
AND THE COMPANY HAS NOT PAID CASH DIVIDENDS.
The volatility of the Company's common stock imposes a greater risk of
capital losses on shareholders as compared to less volatile stocks. In addition,
such volatility makes it difficult to ascribe a stable valuation to a
shareholder's holdings of the Company's common stock. The following factors have
and may continue to have a significant impact on the market price of the
Company's common stock:
- Any acquisitions, strategic alliances, joint ventures and divestitures
that the Company effects;
- Announcements of technological innovations;
- Changes in marketing, product pricing and sales strategies or new products
by the Company's competitors;
- Changes in domestic or foreign governmental regulations or regulatory
requirements; and
- Developments or disputes relating to patent or proprietary rights and
public concern as to the safety and efficacy of the procedures for which
the Company's products are used.
Moreover, the possibility exists that the stock market, and in particular
the securities of technology companies such as Escalon, could experience extreme
price and volume fluctuations unrelated to operating performance.
The Company has not paid cash dividends on its common stock and does not
anticipate paying cash dividends in the foreseeable future.
THE IMPACT OF TERRORISM OR ACTS OF WAR COULD HAVE A MATERIAL ADVERSE
IMPACT ON THE COMPANY'S BUSINESS.
Terrorist acts or acts of war, whether in the United States or abroad,
could cause damage or disruption to the Company's operations, its suppliers,
channels to market or customers, or could cause costs to increase, or create
political or economic instability, any of which could have a material adverse
impact on the Company's business.
THE COMPANY'S CHARTER DOCUMENTS AND PENNSYLVANIA LAW MAY INHIBIT A
TAKEOVER.
Certain provisions of Pennsylvania law and the Company's Bylaws could
delay or impede the removal of incumbent directors and could make it more
difficult for a third party to acquire, or discourage a third party from
attempting to acquire, control of the Company. These provisions could limit the
share price that certain investors might be willing to pay in the future for
shares of the Company's common stock. The Company's Board of Directors is
divided into three classes, with directors in each class elected for three-year
terms. The Bylaws impose various procedural and other requirements that could
make it more difficult for shareholders to effect certain corporate actions. The
Company's Board of Directors may issue shares of preferred stock without
shareholder approval on such terms and conditions, and having such rights,
privileges and preferences, as the Board may determine. The rights of the
holders of common stock will be subject to, and may be adversely impacted by,
the rights of the holders of any preferred stock that may be issued in the
future. The Company has no current plans to issue any shares of preferred stock.
COMPANY OVERVIEW
The following discussion should be read in conjunction with interim
condensed consolidated financial statements and the notes thereto, which are set
forth elsewhere in this report.
The Company operates in the healthcare market specializing in the
development, manufacture, marketing and distribution of medical devices and
pharmaceuticals in the areas of ophthalmology, diabetes, hematology and vascular
access. The Company and its products are subject to regulation and inspection by
the FDA. The FDA requires extensive testing of new products prior to sale and
has jurisdiction over the safety, efficacy and manufacture of products, as well
as product labeling and marketing. The Company's Internet address is
www.escalonmed.com.
27
In February 1996, the Company acquired substantially all of the assets and
certain liabilities of EOI, a developer and distributor of ophthalmic surgical
products. Prior to this acquisition, the Company devoted substantially all of
its resources to the research and development of ultrafast laser systems
designed for the treatment of ophthalmic disorders. As a result of the EOI
acquisition, Escalon changed its market focus and is no longer developing laser
technology. In October 1997, the Company licensed its intellectual laser
property to IntraLase, in return for an equity interest and future royalties on
sales of products. IntraLase undertook responsibility for funding and developing
the laser technology through to commercialization. IntraLase began selling
products related to the laser technology during fiscal 2002 and announced its
initial public offering of its common stock in October 2004. See Note 10 to
Condensed Consolidated Financial Statements for further information. The Company
is in dispute with IntraLase over royalty payments owed to the Company. See Part
II, Item 1, "Legal Proceedings" and Note 11 of the Notes to Condensed
Consolidated Financial Statements for further information.
To further diversify its product portfolio, in January 1999, the Company's
Vascular subsidiary acquired the vascular access product line from Endologix,
formerly Radiance Medical Systems, Inc. Vascular's products use Doppler
technology to aid medical personnel in locating arteries and veins in difficult
circumstances. Currently, this product line is concentrated in the cardiac
catheterization market. In January 2000, the Company purchased Sonomed, a
privately held manufacturer of ophthalmic ultrasound diagnostic equipment.
On July 23, 2004, Escalon acquired 67% of the outstanding ordinary shares
of Drew, a United Kingdom company, pursuant to the Company's exchange offer for
all of the outstanding ordinary shares of Drew, and since that date has acquired
all of the Drew shares. Drew is a diagnostics company specializing in the
design, manufacture and distribution of instruments for blood cell counting and
blood analysis. Drew is focused on providing instrumentation and consumables for
the physician office and veterinary office laboratories. Drew also supplies the
reagent and other consumable materials needed to operate the instruments.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements requires management to make
estimates and assumptions that impact amounts reported therein. The most
significant of those involve the application for SFAS 142, discussed further in
Note 7 of the Notes to the Condensed Consolidated Financial Statements included
in this report. The financial statements are prepared in conformity with
accounting principles generally accepted in the United States of America, and,
as such, include amounts based on informed estimates and judgments of
management. For example, estimates are used in determining valuation
allowances for deferred income taxes, uncollectible receivables, obsolete
inventory, sales returns and rebates and purchased intangible assets. Actual
results achieved in the future could differ from current estimates. The
Company used what it believes are reasonable assumptions and, where applicable,
established valuation techniques in making its estimates.
REVENUE RECOGNITION
The Company recognizes revenue from the sale of its products at the time
of shipment, when title and risk of loss transfer. The Company provides products
to its distributors at agreed wholesale prices and to the balance of its
customers at set retail prices. Distributors can receive discounts for accepting
high volume shipments. The discounts are reflected immediately in the net
invoice price, which is the basis for revenue recognition. No further material
discounts are given.
The Company's considerations for recognizing revenue upon shipment of
product to a distributor are based on the following:
- Persuasive evidence that an arrangement (purchase order and sales invoice)
exists between a willing buyer (distributor) and the Company that outlines
the terms of the sale (company
28
information, quantity of goods, purchase price and payment terms). The
buyer (distributor) does not have an immediate right of return.
- Shipping terms are ex-factory shipping point. At this point the buyer
(distributor) takes title to the goods and is responsible for all risks
and rewards of ownership, including insuring the goods as necessary.
- The Company's price to the buyer (distributor) is fixed and determinable
as specifically outlined on the sales invoice. The sales arrangement does
not have customer cancellation or termination clauses.
- The buyer (distributor) places a purchase order with the Company; the
terms of the sale are cash, COD or credit. Customer credit is determined
based on the Company's policies and procedures related to the buyer's
(distributor's) creditworthiness. Based on this determination, the Company
believes that collectibility is reasonably assured.
The Company assesses collectibility based on creditworthiness of the
customer and past transaction history. The Company performs ongoing credit
evaluations of its customers and does not require collateral from its customers.
For many of the Company's international customers, the Company requires an
irrevocable letter of credit to be issued by the customer before the purchase
order is accepted.
VALUATION OF INTANGIBLE ASSETS
Escalon annually evaluates for impairment its intangible assets and
goodwill in accordance with SFAS 142, "Goodwill and Other Intangible Assets," or
whenever events or changes in circumstances indicate that the carrying value may
not be recoverable. These intangible assets include goodwill, trademarks and
trade names. Factors the Company considers important that could trigger an
impairment review include significant under-performance relative to historical
or projected future operating results or significant negative industry or
economic trends. If these criteria indicate that the value of the intangible
asset may be impaired, an evaluation of the recoverability of the net carrying
value of the asset is made. If this evaluation indicates that the intangible
asset is not recoverable, the net carrying value of the related intangible asset
will be reduced to fair value. Any such impairment charge could be significant
and could have a material adverse impact on the Company's financial statements
if an when an impairment charge is recorded. No impairment losses were recorded
for goodwill, trademarks and trade names during any of the periods presented
based on these evaluations.
INCOME/(LOSS) PER SHARE
The Company computes net income/(loss) per share under the provisions of
SFAS No. 128, Earnings per Share (SFAS 128), and Staff Accounting Bulletin, No.
98 (SAB 98).
Under the provisions of SFAS 128 and SAB 98, basic and diluted net
income/(loss) per share is computed by dividing the net income/(loss) for the
period by the weighted average number of shares of common stock outstanding
during the period. The calculation of diluted net income/(loss) per share
excludes potential common shares if the effect is anti-dilutive. Basic earnings
per share are computed by dividing net income/(loss) by the weighted average
number of shares of common stock outstanding during the period. Diluted earnings
per share are determined in the same manner as basic earnings per share, except
that the number of shares is increased by assuming exercise of dilutive stock
options and warrants using the treasury stock method.
TAXES
Estimates of taxable income of the various legal entities and
jurisdictions are used in the tax rate calculation. Management uses judgment in
estimating what the Company's income will be for the year. Since judgment is
involved, there is a risk that the tax rate may significantly increase or
decrease in any period.
In determining income (loss) for financial statement purposes, management
must make certain estimates and judgments. These estimates and judgments occur
in the calculation of certain tax liabilities
29
and in the determination of the recoverability of certain of the deferred tax
assets, which arise from temporary differences between the tax and financial
statement recognition of revenue and expense. SFAS 109 also requires that the
deferred tax assets be reduced by a valuation allowance, if based on the
available evidence, it is more likely than not that all or some portion of the
recorded deferred tax assets will not be realized in future periods.
In evaluating the Company's ability to recover the Company's deferred tax
assets, management considers all available positive and negative evidence
including the Company's past operating results, the existence of cumulative
losses and near-term forecasts of future taxable income that is consistent with
the plans and estimates management is using to manage the underlying businesses.
Through September 30, 2005, the Company has recorded a full valuation
allowance against the Company's net operating losses due to the uncertainty of
their realization as a result of the Company's earnings history, the number of
years the Company's net operating losses and tax credits can be carried forward,
the existence of taxable temporary differences and near-term earnings
expectations. The amount of the valuation allowance could decrease if facts and
circumstances change that materially increase taxable income prior to the
expiration of the loss carryforwards. Any reduction would reduce (increase) the
income tax expense (benefit) in the period such determination is made by the
Company.
THREE-MONTH PERIODS ENDED SEPTEMBER 30, 2005 AND 2004
The following table shows consolidated product revenue by business segment
as well as identifying trends in business segment product revenues for the
three-month periods ended September 30, 2005 and 2004.
Three-Month Period Ended September 30,
--------------------------------------------------
2005 2004 % Change
----------- --------- --------
Product revenue:
Drew $ 4,071 $ 1,904 138.13%
Sonomed 1,798 1,644 9.37%
Vascular 931 695 33.96%
Medical/Trek/EMI 323 393 (17.81)%
----------- --------- --------
$ 7,123 $ 4,636 53.65%
=========== ========= ========
Product revenue increased approximately $2,487,000, or 53.65%, to
$7,123,000 during the three-month period ended September 30, 2005 as compared to
the same period last fiscal year. In the Drew business unit, product revenue
increased $2,167,000 or 138.13% as compared to the same period last fiscal year.
The increase is due primarily to the increased sale in both domestic and
international markets of diabetics and hematology instruments. Sales of
instruments increased by approximately $1,400,000 in the three-month period
ended September 30, 2005 as compared to the same period last prior year. Sales
of spare parts and reagents and controls, which are used to operate the
instruments, also increased during the period to support the increase in the
installed base of the related instruments. In the Sonomed business unit, product
revenue increased $154,000 or 9.4% as compared to the same period last fiscal
year The increase in product revenue was primarily caused by an increase in
sales of the Company's EZ AB scan ultrasound systems and an increase in export
sales, which were partially offset by a decrease in demand for the Company's
pachymeter product. The domestic market for pachymeters had previously expanded
due to enhanced techniques in glaucoma screening performed by optometrists.
Historically, the typical optometrist had not been a user of the pachymeter.
Domestic demand for the pachymeter returned to historic levels during the fourth
quarter of fiscal 2004 due to market saturation and increased price competition
within the marketplace. In the Vascular business unit, revenue increased
$236,000, or 34.0%, to $931,000 during the three-month period ended September
30, 2005 as compared to the same period last fiscal year. The increase in
product revenue in the Vascular business unit was primarily caused by an
increase in direct sales to end users by the Company's domestic sales team and,
to a lesser extent, increases in the European market. These increases were
partially offset by decreases in revenue from the Company's distributor network.
The Company terminated its relationship with several of its distributors during
the
30
prior fiscal year. In the Medical/Trek/EMI business unit, product revenue
decreased $70,000, or 17.81%, to $323,000 during the three-month period ended
September 30, 2005 as compared to the same period last fiscal year. The decrease
in Medical/Trek/EMI product revenue is primarily attributed to a decrease in OEM
revenue from Bausch & Lomb.
Other revenue increased $14,000, or 2%, to $670,000 during the three-month
period ended September 30, 2005 as compared to the same period last fiscal year.
The increase is primarily attributed to a $153,000 increase in royalty payments
received from IntraLase related to the licensing of the Company's intellectual
laser technology. IntraLase royalties increased partially due to a court order
amending IntraLase's method of calculating its royalty payments to the Company
(see notes 10 and 11 to the condensed consolidated financial statements). An
increase in royalties of $75,000 from Bio-Rad related to an OEM agreement
between Bio-Rad and Drew also contributed to the increase. While this agreement
terminated as of May 15, 2005, the parties have continued to operate under the
terms of the expired agreement pending negotiation of a potential extension
and/or revision. These increases were partially offset by a $214,000 decrease in
royalties received from Bausch & Lomb in connection with their sales of Silicone
Oil. The Company's contract with Bausch & Lomb called for annual step-downs in
the calculation of Silicone Oil revenue to be received by the Company from 64%
from August 13, 2003 to August 12, 2004 to 45% from August 13, 2004 to August
12, 2005. The Company's contract with Bausch & Lomb ended in August 2005,
accordingly, the Company will receive no future royalties under this agreement.
See note 10 of the notes to the condensed consolidated financial statements for
a description of the step-down provisions under the contract with Bausch & Lomb.
The following table presents consolidated cost of goods sold by reportable
business segment and as a percentage of related segment product revenues for the
three-month periods ended September 30, 2005 and 2004.
Three-Month Period Ended September 30,
-------------------------------------------
Cost of goods 2005 2004
-------------------------------------------
sold: Dollars % Dollars %
------------ ------ --------- -----
(in (in
thousands) thousands)
Drew $ 2,594 63.72% $ 1,251 65.65%
Sonomed 976 54.28% 859 52.25%
Vascular 320 34.37% 320 46.04%
Medical/Trek/EMI 216 66.87% 242 61.58%
------------ ----- --------- -----
$ 4,106 57.64% $ 2,672 57.61%
============ ===== ========= =====
Cost of goods sold totaled approximately $4,106,000, or 57.64% of product
revenue, for the three-month period ended September 30, 2005, as compared to
$2,672 000 or 57.61% of product revenue for the same period last fiscal. The
increase is primarily due to the corresponding increase in revenues of 53.65%.
Cost of goods sold in the Drew business unit totaled $2,594,000 or 63.72%
of product revenue for the three-month period ended September 30, 2005 as
compared to $1,251,000, or 65.65% of product revenue for the same period last
fiscal year. The decrease is due to a decrease in material costs resulting from
the easing of pre acquisition liquidity constraints at Drew following its
acquisition by Escalon and operating efficiencies gained through both
manufacturing changes implemented post-acquisition and higher production volumes
during the three-month period ended September 30, 2005 as compared to the same
period last fiscal year. These benefits were partially offset by a change in
product mix, with sales of instruments representing a higher percentage of total
sales in current fiscal year period. Instrument sales historically have lower
margins than the sales of reagents and controls which are used to operate the
instruments.
Cost of goods sold in the Sonomed business unit totaled $976,000 or 54.38%
of product revenue for the three-month period ended September 30, 2005 as
compared to $859,000 or 52.25% of product revenue for the same period last
fiscal year. The primary reason for the decrease was an increase in the
percentage of sales during the period which were international sales. The
Company historically
31
experiences a lower selling price per unit on its international product sales.
Cost of goods sold in the Vascular business unit totaled $320,000, or 34.37% of
product revenue, for the three-month period ended September 30, 2005 as compared
to $320,000, or 46.04% of product revenue for the same period last fiscal year.
The primary factor affecting the decrease in cost of goods sold as a percentage
of product revenue was the increase in direct sales to end users and
corresponding decrease in sales through the Company's distributor network where
the Company generally experiences lower price per unit on its products. Cost of
goods sold in the Medical/Trek/EMI business unit totaled $216,000, or 66.87% of
product revenue, during the three-month period ended September 30, 2005 as
compared to $242,000, or 61.58% of product revenue, during the same period last
fiscal year. Fluctuations in Medical/Trek/EMI cost of goods sold primarily
emanates from product mix, which was primarily controlled by market demand.
The following table presents consolidated marketing, general and
administrative expenses as well as identifying trends in business segment
marketing, general and administrative expenses for the three-month periods ended
September 30, 2005 and 2004.
Three-Month Period Ended September 30,
------------------------------------------
2005 2004 % Change
----------- --------- --------
(in (in
thousands) thousands)
Marketing, general and
administrative expenses:
Drew $ 1,399 $ 792 76.64%
Sonomed 516 324 59.26%
Vascular 420 339 23.89%
Medical/Trek/EMI 949 727 30.54%
----------- --------- -----
$ 3,284 $ 2,182 50.50%
=========== ========= =====
Marketing, general and administrative expenses increased $1,102,000, or
50.5 %, to $3,284,000 during the three-month period ended September 30, 2005 as
compared to the same period last fiscal year. While marketing, general and
administrative expenses increased $1,102,000 between periods, it decreased as a
percentage of product revenue to 46.1% for the three-month period ended
September 30, 2005 from 47.1% in the corresponding prior year period.
Marketing, general and administrative expenses in the Drew business unit
increased $ 607,000, or 76.64%, to $1,399,000 as compared to the same period
last fiscal year. The increase is primarily due to higher personnel
(approximately $308,000) and travel and trade show costs (approximately $99,000)
related to improving the image of the Drew brand with both customers and
distributors and improving the product distributor network, which ultimately
contributed to the 138% increase in product revenue when compared to the
corresponding prior year period. Marketing, general and administrative expenses
in the Sonomed business unit increased $192,000, or 59.26%, to $516,000 as
compared to the same period last fiscal year. Marketing and sales salaries,
commissions and other personnel-related expenses, including amounts paid to
independent agents utilized primarily in Europe, increased approximately
$107,000 as a result of increased headcount related primarily to the Company's
goal of increasing international revenues. Sales meeting and trade show
expenses, travel and lodging, and advertising increased by a combined $34,000
related primarily to the focus on growing international sales. Rent and
utilities expense increased $18,000 due to the relocation of Sonomed's facility
and the corresponding new lease entered into during fiscal 2005. Legal expenses
increased by $27,000 due fees incurred to resolve a dispute with a supplier and
fees related to researching intellectual property ownership issues for
intellectual property currently being evaluated for licensing for use in
potential new products. Marketing, general and administrative expenses in the
Vascular business unit increased $81,000, or 23.89%, to $420,000 as compared to
the same period last fiscal year. Salaries and other personnel-related expenses
increased $24,000 and the expense for customer samples increased by $17,000 when
compared to the prior fiscal period. Both increases were related to supporting a
higher volume of business during the current period as compared to the same
period in the prior fiscal year. Marketing, general and administrative expenses
in the Medical/Trek/EMI business unit increased $222,000, or 30.54%, to
$949,000 as compared to the same period last fiscal year. Legal and accounting
fees and personnel related costs increased by approximately $137,000 and
$62,000, respectively. Legal fees increased due to litigation costs with
Intralase, which the Company expects will
32
continue to impact earnings in the near term (see note 11 of the notes to the
condensed consolidated financial statements for a description of Legal
Proceedings). Accounting fees increased due to increased auditor's fees in
proportion to the increase in the Company's size due to the acquisition of Drew
on July 23, 2004 and initial costs incurred related to compliance with the
Sarbanes-Oxley Act of 2002. Personnel costs increased due to personnel additions
to support the overall growth of the Company
Research and development expenses increased $440,000, or 139.24%, to
$756,000 during the three-month period ended September 30, 2005 as compared to
the same period last fiscal year. The increase in research and development
expenses was attributed higher personnel, consultant and prototype costs related
to planned introductions of new and or enhanced products in the Drew and Sonomed
business units. In addition, approximately $92,000 of the increase was related
to the addition of a senior level person involved in evaluating various
technologies for potential use in new products or product enhancements.
Gain on sale of available for sale securities was approximately
$1,157,000 in the three-month period ended September 30, 2005. The increase
was due to the sale of 58,585 shares of IntraLase common stock in July 2005
(see note 15 of the notes to the condensed consolidated financial statements).
Escalon recognized a loss of $18,000 and $29,000 related to its investment
in OTM during the three-month periods ended September 30, 2005, respectively.
The share of OTM's loss recognized by the Company is in direct proportion to the
Company's ownership equity in OTM. OTM began operations during the three-month
period ended September 30, 2004. (See note 14 of the notes to the condensed
consolidated financial statements).
Interest income was $5,000 and $32,000 for the three-month periods ended
September 30, 2005 and 2004, respectively. The decrease relates to lower average
cash balances due the repayment of approximately $6,348,000 of debt in the
second quarter of fiscal 2005.
Interest expense was $11,000 and ($3,000) for the three-month periods
ended September 30, 2005 and 2004, respectively. The Company paid off several of
its debt facilities to several entities in advance of their maturities during
the fiscal year ended June 30, 2005. Additionally, the Company reversed accrued
loan commitment fees as a result of the satisfaction of the debt and the release
by the lender of those fees. The fees were originally accrued based on contract
terms. The increase in interest expense during the three-month period ended
September 30, 2005 when compared to the same prior year period is due to the
non-recurring reversal of loan commitment fees in the prior fiscal period.
LIQUIDITY AND CAPITAL RESOURCES
Changes in overall liquidity and capital resources from continuing
operations during the three-month period ended September 30, 2005 are reflected
in the following table:
September 30, June 30,
(Dollars are in thousands) 2005 2005
------------- ---------
Current assets $ 17,257 $ 17,665
Less: Current liabilities 4,340 4,052
------------ ---------
Working capital $ 12,917 $ 13,613
Current ratio 4.0 to 1 4.4 to 1
Notes payable and current maturities $ 233 $ 230
Long-term debt 330 392
------------ ---------
Total debt 563 $ 622
Total equity 34,024 34,519
------------ ---------
Total capital $ 34,587 $ 35,141
Total debt to total capital 1.63% 1.77%
33
WORKING CAPITAL POSITION
Working capital decreased $696,000 as of September 30, 2005 and the
current ratio decreased to 4.0 to 1 from 4.4 to 1 when compared to June 30,
2005. The decrease in working capital was caused primarily by the loss from
operations of approximately $352,000 and cash used to fund fixed asset additions
of approximately 145,000 during the three month period ended September 30, 2005.
CASH USED IN OPERATING ACTIVITIES
During the three-month periods ended September 30, 2005 and 2004, the
Company used approximately $751,000 and $1,935,000 of cash for operating
activities. The net decrease in cash generated from operating activities of
approximately $1,184,000 for the three-month period ended September 30, 2005 as
compared to the same period in the prior fiscal year is due primarily to the
following factors:
- The Company employed significantly less cash to fund working capital
requirements during the three months ended September 30, 2005 than it
employed in the same period in the prior fiscal year. Total working
capital employed was approximately $434,000 and $2,171,000, respectively,
during the three-month periods ended September 30, 2005 and 2004,
respectively. The decrease is due to the fact that in the prior year
period, the Company utilized approximately $1,500,000 in cash to begin to
alleviate the liquidity constraints that Drew was experiencing prior to
its acquisition by the Company. The cash was utilized to support
increases in inventory and receivables and reduce payables and
outstanding draws on Drew's line of credit.
- The reduction in cash utilized to fund working capital was partially
offset by a reduction in operating income of approximately $475,000 for
the three-month period ended September 30, 2005 when compared to the same
prior year period.
CASH FLOWS PROVIDED BY (USED IN) INVESTING AND FINANCING ACTIVITIES
Cash flows generated by investing activities were approximately $1,013,000
during the three-month period ended September 30, 2005 and relate primarily to
the net proceeds of approximately $1,157,000 realized from the sale of a
majority of the remaining shares of the IntraLase securities held by the Company
as available for sale securities (see note 15 to the notes to the condensed
consolidated financial statements). Partially offsetting the cash realized from
the securities sale was cash utilized for fixed asset additions of approximately
$145,000. Any necessary capital expenditures have generally been funded out of
cash from operations, and the Company is not aware of any factors that would
cause historical capital expenditure levels to not be indicative of capital
expenditures in the future and, accordingly, does not believe that the Company
will have to commit material resources to capital investment for the foreseeable
future.
Cash flows used in financing activities were approximately $49,000 during
the three month period ended September 30, 2005. During the period, the Company
made scheduled long-term debt repayments of approximately $60,000. Partially
offsetting the debt repayments was approximately $11,000 received by the Company
from the exercise of stock options by employees of the Company.
DEBT HISTORY
On December 23, 2002, a lender acquired the Company's bank debt, which
consisted of term debt of $5,850,000 and $1,475,000 outstanding on a $2,000,000
available line of credit. On February 13, 2003, the Company entered into an
amended agreement with the lender. The primary amendments of the amended loan
agreement were to reduce quarterly principal payments, extend the term of the
repayments and to alter the covenants of the original bank agreement. On
September 30, 2004, the Company paid off and terminated both the remaining term
debt and the outstanding balance on the line of credit. In
34
November 2001, the Company issued 60,000 warrants to purchase the Company's
common stock at $3.66 per share in connection with this debt. The warrants were
exercised in December 2004.
On January 21, 1999, the Company's Vascular subsidiary and Endologix
entered into an Assets Sale and Purchase Agreement. Pursuant to this agreement,
the Company acquired for cash the assets of Endologix's vascular access business
in exchange and also agreed to pay royalties to Endologix based on future sales
of the vascular access business for a period of five years following the close
of the sale, with a guaranteed minimum of $300,000 per year. On February 1,
2001, the parties amended the agreement to eliminate any future royalty payments
to Endologix. Pursuant to this amendment, the Company paid $17,558 in cash to
Endologix, delivered a short-term note in the amount of $64,884 that was
satisfied in January 2002, delivered a note in the amount of $717,558 payable in
eleven quarterly installments that commenced on April 15, 2002, and issued
50,000 shares of its common stock to Endologix. On September 30, 2004, the
Company paid off the balance of the term debt.
At the time of the acquisition of Drew by Escalon, Drew had two lines of
credit aggregating approximately $2,700,000, one of which was with a domestic
financial institution, and one with a United Kingdom financial institution. At
the time of the acquisition, outstanding draws on the lines aggregated
approximately $1,643,000. The lines were paid off and terminated during the
quarter ended December 31, 2004.
Drew has long-term debt facilities through the Texas Mezzanine Fund and
through Symbiotics, Inc. The Texas Mezzanine Fund term debt is payable in
monthly installments of $14,200, which includes interest at a fixed rate of
8.00%. The note is due in April 2008 and is secured by certain assets of Drew.
The outstanding balance as of September 30, 2005 was $370,930. The Symbiotics,
Inc. term debt, which originated from the acquisition of a product line from
Symbiotics, Inc., is payable in monthly principal installments of $8,333 plus
interest at a fixed rate of 5.00%. The outstanding balance as of September 30,
2005 was $191,688.
BALANCE SHEET
The components of the balance sheet of the Company were increased as of
July 23, 2004 by the acquisition of Drew as follows:
Cash $ 150,849
Accounts receivable 1,439,120
Inventory 2,069,146
Other current assets 351,505
Furniture and equipment 868,839
Goodwill 9,574,655
Patents 297,246
Other long-term assets 7,406
Line of credit 1,617,208
Current liabilities 3,392,286
Long-term debt 1,072,457
Exchange of common stock 7,430,439
These amounts represents approximately a $952,000 net difference from the
amounts reported in the Company's Form 10-Q for the quarter ended September 30,
2004, which has been recorded as an increase in goodwill. The difference is the
result of additional facts obtained since the acquisition which impacted the
valuation of the assets acquired and liabilities assumed.
OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS
Escalon was not a party to any off-balance sheet arrangements as of and
for the three-month periods ended September 30, 2005 and 2004.
35
The following table presents the Company's contractual obligations as of
September 30, 2005 (interest is not included in the table as it is immaterial):
Less than 3-5 More than
Total 1 Year 1-3 Years Years 5 Years
----------- ----------- ----------- -------- ------------
Long-term debt $ 562,598 $ 233,033 $ 329,565 $ - $ -
Operating lease agreements 3,024,462 889,749 1,132,264 577,325 425,124
----------- ----------- ----------- -------- ------------
$ 3,587,060 $ 1,122,782 $ 1,461,829 $577,325 $ 425,124
=========== =========== =========== ======== ============
FORWARD-LOOKING STATEMENT ABOUT SIGNIFICANT ITEMS LIKELY TO IMPACT LIQUIDITY
On July 23, 2004, the Company acquired approximately 67% of the
outstanding ordinary shares of Drew, pursuant to the Company's exchange offer
for all of the outstanding ordinary shares of Drew, and since that date has
acquired all of the Drew shares. Drew does not have a history of producing
positive operating cash flows and, as a result, at the time of acquisition, was
operating under financial constraints and was under-capitalized. As Drew is
integrated into the Company, management will be working to reverse the
situation, while at the same time seeking to strengthen Drew's market position.
As of September 30, 2005, Escalon has loaned approximately $6,891,000 to Drew.
The funds have been primarily used to procure components to build up inventory
to support the manufacturing process as well as to pay off accounts payable and
debt of Drew. Escalon anticipates that further working capital will likely be
required by Drew.
Escalon realized approximately 2.60% and 7.88%, of its net revenue during
the three-month periods ended September 30, 2005 and 2004, respectively, from
Bausch & Lomb's sale of Silicone Oil. This agreement expired in August 2005 and
the Company will not receive any future royalties from this contract. Silicone
Oil revenue was based on sale of the product by Bausch & Lomb multiplied by a
contractual factor that declines on an annual basis due to a contractual
step-down provision through its expiration date which was August 12, 2005. As
there were no costs associated with this revenue, the expiration of the
agreement will negatively impact gross margins, operating income and cash flows
in future periods. See Note 10 of the notes to the condensed consolidated
financial statements for a description of the step-down provisions under the
contract with Bausch & Lomb.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
The table below provides information about the Company's financial
instruments, consisting primarily of fixed interest rate debt obligations. For
debt obligations, the table represents principal cash flows and related interest
rates by expected maturity dates. Interest rates as of September 30, 2005 were
fixed at 8.00% on the Texas Mezzanine Fund term debt, and were fixed at 5.00% on
the Symbiotics, Inc. term debt. See Note 9 of the notes to the condensed
consolidated financial statements for further information regarding the
Company's debt obligations.
2006 2007 2008 Thereafter Total
--------- --------- -------- ---------- ---------
Texas Mezzanine Fund Note $ 133,037 $ 156,868 $ 81,025 $ - $ 370,930
Interest rate 8.00% 8.00% 8.00% -
Symbiotics, Inc. Note $ 99,996 $ 91,672 - - $ 191,668
Interest rate 5.00% 5.00% 5.00% -
--------- --------- -------- ---------- ---------
$ 233,033 $ 248,540 $ 81,025 $ - $ 562,598
========= ========= ======== ========== =========
EXCHANGE RATE RISK
During the three-month periods ended September 30, 2005 and 2004,
approximately 37.2% and 35.9%, respectively, of the Company's consolidated net
revenue was derived from international sales. Prior to the
36
acquisition of Drew, the price of all product sold overseas was denominated in
United States Dollars and consequently the Company incurred no exchange rate
risk on revenue. However, a portion of Drew's product revenue is denominated in
United Kingdom Pounds and Euros. During the three-month period ended September
30, 200, Drew recorded approximately $411,000 and $96,000, respectively, of
revenue denominated in United Kingdom Pounds respectively and Euros,
respectively.
Drew incurs a portion of its expenses denominated in United Kingdom
Pounds. During the three-month periods ended September 30, 2005 and 2004, Drew
incurred approximately $1,368,000 and $632,000, respectively, of expense
denominated in United Kingdom Pounds. The Company's Sonomed business unit incurs
a portion of its marketing expenses in the European market, the majority of
which are transacted in Euros. For the three-month periods ended September 30,
2005 and 2004, these expenses totaled $64,000 and $41,000, respectively. The
Company's Vascular business unit began incurring marketing expenses in the
European market during the second quarter of fiscal 2004, the majority of which
are transacted in Euros. For the three-month periods ended September 30, 2005
and 2004, these expenses totaled $39,000 and $0, respectively.
The Company may begin to experience fluctuations, beneficial or adverse,
in the valuation of currencies in which the Company transacts its business,
namely the United States Dollar, the United Kingdom Pound and the Euro.
ITEM 3. CONTROLS AND PROCEDURES
(A) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
The Company's management, with the participation of the Company's Chief
Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of the Company's disclosure controls and procedures (as such term is defined in
Rule 13a-15(e) and 15(d)-15(e) under the Exchange Act) as of the end of the
period covered by this report. Based on such evaluation, the Company's Chief
Executive Officer and Chief Financial Officer have concluded that, as of the end
of such period, the Company's disclosure controls and procedures are effective
in recording, processing, summarizing and recording, on a timely basis,
information required to be disclosed by the Company in the reports that it files
or submits under the Exchange Act.
(B) INTERNAL CONTROL OVER FINANCIAL REPORTING
There have not been any changes in the Company's internal control over
financial reporting (as such term is defined in Rule 13a-15(f) under the
Exchange Act) during the first fiscal quarter ended September 30, 2005 that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
A control system, no matter how well-designed and operated, cannot provide
absolute assurance that the objectives of the control systems are met, and no
evaluation of internal control can provide absolute assurance that all control
issues and instances of fraud, if any, within a company have been detected.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
INTRALASE CORP. LEGAL PROCEEDINGS
In October 1997, Escalon and IntraLase entered into a License Agreement
wherein Escalon granted IntraLase the exclusive right to use Escalon's
intellectual laser properties, including patented and non-patented technology,
in exchange for an equity interest in IntraLase as well as royalties based on a
percentage of net sales of future products. The shares of common stock were
restricted for sale until April
37
6, 2005 and, according to a Fourth Amended Registration Right Agreement between
Escalon and IntraLase, are now able to be sold. See Management's Discussion and
Analysis of Financial Condition and Results of Operations and the Notes to
Consolidated Financial Statements for discussions on the Company's sales of
IntraLase common stock.
On June 10, 2004, Escalon gave IntraLase notice of its intention to
terminate the License Agreement due to IntraLase's failure to pay certain
royalties that Escalon believed were due under the License Agreement. On June
21, 2004, IntraLase sought a preliminary injunction and temporary restraining
order with the United States District Court for the Central District of
California, Southern District against Escalon to prevent termination of the
License Agreement. Contemporaneously, IntraLase filed an action for declaratory
relief asking the Court to validate its interpretation of certain terms of the
License Agreement relating to the amount of royalties owed to Escalon ("First
Action"). The parties mutually agreed to the entry of a temporary restraining
order which was entered by the Court shortly thereafter. At the close of
discovery, IntraLase and Escalon filed cross-motions for summary judgment. On
May 5, 2005, the District Court, having ruled on such motions, entered judgment
in the First Action.
The Court, in ruling on the parties' cross-motions for summary judgment,
did not agree with IntraLase's interpretation of certain terms and declared
that, under the terms of the License Agreement, IntraLase must pay Escalon
royalties on revenue from maintenance contracts and one-year warranties.
Further, the Court rejected IntraLase's argument that it is entitled to deduct
the value of non-patented components of its ophthalmic products, which it sells
as an integrated unit, from the royalties due Escalon. Non-patented components
of the products include computer monitors, joysticks, keyboards, universal power
supplies, microscope assemblies, installation kits and syringes. In addition,
the Court rejected IntraLase's assertion that accounts receivable are not
"consideration received" under the License Agreement and expressly ruled that
IntraLase must pay Escalon royalties on IntraLase's accounts receivable. The
Court agreed with IntraLase, however, holding that IntraLase is not required to
pay royalties on research grants. The Court also held that IntraLase must give
Escalon an accounting of third-party royalties.
Further, the Court agreed with Escalon in finding that royalties are
"monies" and the default in the payment of royalties must be remedied within 15
days of written notice of the default. The Court rejected IntraLase's position
concerning the effective date of the Amended and Restated License Agreement
holding that the effective date of such Agreement was dated October 17, 2000.
IntraLase has appealed the judgment to the Ninth Circuit Court of Appeals.
Currently, briefing is scheduled to occur in February/March, 2006.
Intralase, after entry of the Court's ruling, attempted to cure its
default under the License Agreement, but underpaid based upon a purported
interpretation of "accounts receivable" that discounts the receivables recorded
on the sales substantially, and in a manner that appears to directly contradict
Intralase's own published financial statements.
In May, 2005, IntraLase also filed a second suit against Escalon in the
Central District of California, case number SAVC 05-440-AHS ("Second Action"),
again for declaratory relief as well as for reformation of the License
Agreement. In this action, IntraLase has asked the Court to, among other things,
validate its interpretation of certain other terms of the License Agreement
relating to the amount of royalties owed to Escalon and a declaration concerning
Escalon's audit rights under the License Agreement. Escalon filed a motion to
dismiss the Second Action on jurisdictional and substantive grounds. The motion
has been fully briefed and is currently under consideration by the Court for the
Central District of California.
On May 15, 2005, Escalon, not having been served with IntraLase's Second
Action, filed a Complaint against IntraLase in the Delaware Court of Chancery
for, among other things, breach of contract, breach of fiduciary duty arising
out of IntraLase's bad faith conduct under, and multiple breaches of, the
License Agreement ("Delaware Action"). Escalon seeks declaratory relief,
specified damages, and specific performance of its rights under the License
Agreement, including its express right under the
38
Agreement to have independent certified accountants audit the books and records
of IntraLase to verify and compute payments due Escalon.
On June 3, 2005, IntraLase, after having been served with Escalon's
Complaint, filed its First Amended Complaint in the Second Action adding new
matters that had already been raised by Escalon in its Delaware Action.
IntraLase also filed a motion to dismiss Escalon's Delaware Action. In July,
2005, the parties agreed to postpone briefing on IntraLase's motion until after
the California Court has ruled on Escalon's motion to dismiss the Second Action.
Separately, on April 22, 2005, Escalon, as record holder of common stock
of IntraLase, made a formal written demand to inspect certain of IntraLase's
books and records pursuant to Section 220 of the Delaware General Corporation
Law. IntraLase rejected Escalon's demand. Escalon recently filed an action in
the Delaware Court of Chancery against IntraLase seeking to enforce its
shareholder rights to inspect IntraLase's books and records. The 220 Case is
currently in the discovery stage.
Escalon is cognizant of the legal expenses and costs associated with the
IntraLase matter. Escalon, however, is taking all necessary actions to protect
its rights and interests under the License Agreement. Escalon expects expenses
associated with this litigation to adversely impact earnings in the near term.
Escalon believes that IntraLase has sufficient funds to support such payments
based on its filings with the SEC and filings in connection with the First
Action.
DREW LEGAL PROCEEDINGS
CARVER LITIGATION
On December 17, 2002, Edward Carver, David DeCava and Diane Carver, former
principal shareholders of CDC Technologies, Inc., filed a complaint in the State
of Connecticut, Superior Court, Judicial District of Waterbury at Waterbury
against CDC Acquisition, IV Diagnostics and certain other principal shareholders
of CDC Technologies seeking a total of approximately $420,000 for, among other
things, repayment of loans made to CDC Technologies, payment of past wages and
reimbursement of business expenses. The Plaintiffs' claims arose out of a
certain asset purchase for stock transaction in which CDC Acquisition, a wholly
owned subsidiary of Drew, acquired the assets of CDC Technologies and IV
Diagnostics. CDC Acquisition and IV Diagnostics, also a subsidiary of Drew,
asserted counterclaims against the plaintiffs for, among other things, breach of
fiduciary duty, unfair trade and conversion. In addition, CDC Acquisition and IV
Diagnostics asserted cross-claims against its co-defendants for indemnification
pursuant to the transaction agreements. A bench trial was held in June, 2005. In
August, 2005 the Court rendered a decision resulting in the Court's award of
only $76,000 to Plaintiffs. CDC Acquisition and IV Diagnostics filed a motion
for reconsideration of certain issues ruled upon by the Court. The motion was
denied. Plaintiffs' counsel filed a motion for attorneys' fees seeking over
$181,000. The Court recently granted such motion but awarded only $3,000 to
plaintiffs' counsel. On November 1, 2005, CDC Acquisition and IV Diagnostics
timely appealed the Court's ruling that CDC Acquisitions and IV Diagnostics are
liable to the plaintiffs. Further, CDC Acquisition and IV Diagnostics are
presently negotiating with co-defendants over the companies' indemnification
claims.
On December 30, 2002, Source One, a distributor of CDC Technologies, Inc.
filed suit in state court in Minnesota, later removed to the United States
District Court in Minnesota, against CDC Technologies, Edward Carver and CDC
Acquisition, Inc. and IV Diagnostics, as successors in interest to CDC
Technologies. CDC Acquisition and IV Diagnostics asserted cross-claims against
Carver for indemnification. The court granted summary judgment to the plaintiff
against defendants and awarded plaintiff approximately $185,000 plus interest
and costs. The Court also found Carver liable to CDC Acquisition for
indemnification. Plaintiff agreed to accept $140,000 from CDC Acquisition in
settlement of its claims. CDC Acquisition settled its indemnification claim
against Carver for $75,000.
The Company does not believe that these matters have, had or are likely to
have a material adverse impact on the Company's business, financial condition or
future results of operations.
39
OTHER LEGAL PROCEEDINGS
Escalon, from time to time is involved in various legal proceedings and
disputes that arise in the normal course of business. These matters have
included intellectual property disputes, contract disputes, employment disputes,
and other matters. The Company does not believe that the resolution of any of
these matters has had or is likely to have a material adverse impact on the
Company's business, financial condition or results of operations.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 6. EXHIBITS
31.1 Certificate of Chief Executive Officer under Rule 13a-14(a).
31.2 Certificate of Chief Financial Officer under Rule 13a-14(a).
32.1 Certificate of Chief Executive Officer under Section 1350 of Title
18 of the United States Code.
32.2 Certificate of Chief Financial Officer under Section 1350 of Title
18 of the United States Code.
40
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
ESCALON MEDICAL CORP.
(Registrant)
Date: November 14, 2005 By: /s/ Richard J. DePiano
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Richard J. DePiano
Chairman and Chief
Executive Officer
Date: November 14, 2005 By: /s/ Mark H. Karsch
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Mark H. Karsch
CFO
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