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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
----------
FORM 10-Q
----------
Mark One
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ________ TO ________
Commission File Number: 0-20127
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ESCALON MEDICAL CORP.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
PENNSYLVANIA 33-0272839
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
565 EAST SWEDESFORD ROAD, SUITE 200
WAYNE, PA 19087
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(610) 688-6830
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
N/A
FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer (as defined in Rule
12b-2 of the Exchange Act).
Large accelerated filer Yes [ ] No [ ] Accelerated filer Yes [ ] No [ ]
Non-accelerated filer 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]
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date: 6,344,657 shares of common
stock, $0.001 par value, outstanding as of November 6, 2006.
================================================================================
ESCALON MEDICAL CORP.
FORM 10-Q QUARTERLY REPORT
TABLE OF CONTENTS
Part I. Financial Information
Item 1. Condensed Consolidated Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets as of September 30, 2006
(Unaudited) and June 30, 2006 2
Condensed Consolidated Statements of Income for the three-
month periods ended September 30, 2006 and 2005 (Unaudited)
Condensed Consolidated Statements of Cash Flows for the three-month
periods ended September 30, 2006 and 2005 (Unaudited) 4
Condensed Consolidated Statement of Shareholders' Equity for the
three-month period ended September 30, 2006 (Unaudited) 5
Condensed Consolidated Statement of Other Comprehensive Income (Loss)
for the three-month periods ended September 30, 2006 and 2005 (Unaudited) 6
Notes to the Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations 22
Item 3. Quantitive and Qualitative Disclosures about Market Risk 32
Item 4. Controls and Procedures 33
Part II. Other Information
Item 1. Legal Proceedings 33
Item 1A Risk Factors 33
Item 6. Exhibits 33
1
PART I. FINANCIAL STATEMENTS
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
ESCALON MEDICAL CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, JUNE 30,
2006 2006
------------- ------------
(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents $ 2,149,040 $ 3,379,710
Available for sale securities 59,130 50,220
Accounts receivable, net 4,252,165 3,996,243
Inventory, net 7,693,453 7,122,916
Other current assets 365,785 362,160
------------ ------------
TOTAL CURRENT ASSETS 14,519,573 14,911,249
------------ ------------
Furniture and equipment, net 925,750 969,956
Goodwill 21,072,260 21,072,260
Trademarks and trade names, net 620,106 620,106
Patents, net 289,355 313,702
Covenant not to compete and customer list, net 399,346 420,073
Other assets 545,284 337,421
------------ ------------
TOTAL ASSETS $ 38,371,674 $ 38,644,767
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt $ 240,480 $ 232,837
Accounts payable 1,702,095 1,558,501
Accrued expenses 2,627,314 2,503,771
------------ ------------
TOTAL CURRENT LIABILITIES 4,569,889 4,295,109
------------ ------------
Long-term debt, net of current portion 95,239 162,551
Accrued post-retirement benefits 1,087,000 1,087,000
------------ ------------
TOTAL LIABILITIES 5,752,128 5,544,660
------------ ------------
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 share authorized; 6,344,657
issued and outstanding at September 30, 2006 and June 30, 2006,
respectively 6,345 6,345
Common stock warrants 1,601,346 1,601,346
Additional paid-in capital 65,797,782 65,699,370
Retained earnings (34,836,544) (34,122,427)
Accumulated other comprehensive income (loss) 50,617 (84,527)
------------ ------------
TOTAL SHAREHOLDERS' EQUITY 32,619,546 33,100,107
------------ ------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 38,371,674 $ 38,644,767
============ ============
See notes to condensed consolidated financial statements
2
ESCALON MEDICAL CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
THREE MONTHS ENDED SEPTEMBER 30,
2006 2005
------------- --------------
NET REVENUES:
Product revenue $ 6,543,586 $ 7,123,354
Other revenue $ 624,574 670,180
----------- -----------
REVENUES, NET 7,168,160 7,793,534
----------- -----------
COSTS AND EXPENSES:
Cost of goods sold $ 3,630,380 4,105,653
Research and development $ 713,605 756,160
Marketing, general and administrative $ 3,555,900 3,284,051
----------- -----------
TOTAL COSTS AND EXPENSES 7,899,885 8,145,864
----------- -----------
LOSS FROM OPERATIONS (731,725) (352,330)
----------- -----------
OTHER (EXPENSE) AND INCOME:
Gain on sale of available for sale securities 0 1,157,336
Equity in Ocular Telehealth Management, LLC (18,543) (18,429)
Interest income 45,436 4,847
Interest expense (9,285) (10,677)
----------- -----------
TOTAL OTHER INCOME 17,608 1,133,077
----------- -----------
NET (LOSS) INCOME BEFORE TAXES (714,117) 780,747
----------- -----------
Provision for income taxes 0 66,400
----------- -----------
NET (LOSS) INCOME $ (714,117) $ 714,347
=========== ===========
BASIC NET (LOSS) INCOME PER SHARE $ (0.11) $ 0.12
=========== ===========
DILUTED NET (LOSS) INCOME PER SHARE $ (0.11) $ 0.11
=========== ===========
WEIGHTED AVERAGE SHARES - BASIC 6,344,657 5,964,292
=========== ===========
WEIGHTED AVERAGE SHARES - DILUTED 6,344,657 6,372,742
=========== ===========
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,
2006 2005
------------- -------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income $ (714,117) $ 714,347
Adjustments to reconcile net (loss) income to net cash (used in)
operating activities:
Depreciation and amortization 135,279 107,752
Gain on sale of available for sale securities 0 (1,157,336)
Loss on Ocular Telehealth Management, LLC 18,543 18,429
Change in operating assets and liabilities:
Accounts receivable, net (237,802) (289,009)
Inventory, net (553,845) (169,880)
Other current and long-term assets (181,490) (260,772)
Accounts payable, accrued and other liabilities 251,364 285,845
----------- -----------
NET CASH (USED IN) OPERATING ACTIVITIES (1,282,068) (750,624)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from the sale of available for sale securities 0 1,157,336
Purchase of fixed assets (36,966) (144,649)
----------- -----------
NET CASH PROVIDED BY/(USED IN) INVESTING ACTIVITIES (36,966) 1,012,687
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Principal payments on term loans (59,669) (59,539)
Issuance of common stock - stock options 10,876
Refund of income taxes related to exercise of stock options 98,412 0
----------- -----------
NET CASH PROVIDED BY/(USED IN) FINANCING ACTIVITIES 38,743 (48,663
----------- -----------)
Effect of exchange rate changes on cash and cash equivalents 49,620 (3,475)
----------- -----------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (1,230,671) 209,925
----------- -----------
Cash and cash equivalents, beginning of period 3,379,710 5,115,772
----------- -----------
Cash and cash equivalents, end of period $ 2,149,040 $ 5,325,697
=========== ===========
SUPPLEMENTAL SCHEDULE OF CASH FLOW INFORMATION:
Interest paid $ 7,939 $ 10,667
=========== ===========
Income taxes paid $ 0 $ 93,000
=========== ===========
(Decrease)/increase in unrealized appreciation on available for sale securities $ 8,910 $(1,163,187)
=========== ===========
See notes to condensed consolidated financial statements
4
ESCALON MEDICAL CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2006
(UNAUDITED)
ACCUMULATED
COMMON STOCK COMMON ADDITIONAL OTHER TOTAL
-------------------- STOCK PAID-IN ACCUMULATED COMPREHENSIVE SHAREHOLDERS'
SHARES AMOUNT WARRANTS CAPITAL DEFICIT INCOME (LOSS) EQUITY
--------- -------- ------------ ------------ -------------- ------------- ------------
BALANCE AT JUNE 30, 2006 6,344,657 $ 6,345 $ 1,601,346 $ 65,699,370 $ (34,122,427) $ (84,527) $ 33,100,107
Net (loss) 0 0 0 (714,117) 0 (714,117)
Refund of income taxes
related to exercise
of stock options 98,412 98,412
Change in unrealized
gains on 0
available for sale
securities 0 0 0 0 8,910 8,910
Foreign currency
translation 0 0 0 0 126,234 126,234
--------- -------- ------------ ------------ ------------- ----------- ------------
BALANCE AT SEPTEMBER 30,
2006 6,344,657 $ 6,345 $ 1,601,346 $ 65,797,782 $ (34,836,544) $ 50,617 $ 32,619,546
========= ======== ============ ============ ============== =========== ============
See notes to condensed consolidated financial statements
5
ESCALON MEDICAL CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF OTHER COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)
THREE MONTHS ENDED SEPTEMBER 30,
2006 2005
------------- -------------
Net income (loss) $ (714,117) $ 714,347
Change in unrealized gains on
available for sale securities 8,910 (1,163,187)
Foreign currency translation 126,234 (57,132)
----------- -----------
COMPREHENSIVE (LOSS) INCOME $ (578,973) $ (505,972)
=========== ===========
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 ("EME"), Escalon Digital Vision, Inc. ("EMI"), Escalon
Pharmaceutical, Inc. ("Pharmaceutical"), Escalon Holdings, Inc. ("EHI") and Drew
Scientific Company, Ltd ("Drew"), including its subsidiaries. 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") and other regulatory
authorities. 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 2006 Annual Report on
Form 10-KSB 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.
In connection with the presentation of the current period condensed
unaudited consolidated financial statements, certain prior period balances have
been reclassified to conform with the current period presentation.
2. ACQUISITIONS
DREW ACQUISITION
On July 23, 2004, the Company acquired approximately 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. The results of Drew's
operations have been included in the consolidated financial statements, and the
Company has been operating Drew as an separate business unit 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).
The Company accounted for the purchase under FAS 141. Under FAS 141, the
Company paid a premium (i.e., goodwill) over the fair value of the net tangible
and identified intangible assets. The Company acquired Drew as part of its
strategy to diversify its business into the diagnostic medical devices
7
market. Drew afforded the Company a combined capital equipment product with a
continuing revenue stream product in the form of disposables. The application of
purchase accounting under FAS 141 requires that the total purchase price be
allocated to the fair value of assets acquired and liabilities assumed based on
their fair values at the acquisition date, with amounts exceeding the fair
values being recorded as goodwill. The allocation process requires an analysis
of acquired fixed assets, contracts, customer lists and relationships,
trademarks, patented technology, service markets, contractual commitments, legal
contingencies and brand value to identify and record the fair value of all
assets acquired and liabilities assumed. The Company engaged a third-party to
value the assets acquired and liabilities assumed. In valuing acquired assets
and assumed liabilities, fair values were based on expected discounted cash
flows, current replacement cost or other techniques as deemed appropriate.
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
===========
MRP ACQUISITION
On January 30, 2006 EMI acquired substantially all of the assets of MRP
Group, Inc. ("MRP") in exchange for 250,000 shares of the Company's common stock
and approximately $47,000 in cash. The MRP business consists of ophthalmic
technology solutions offering two retinal imaging systems. Approximately 200 of
these systems have been installed at leading medical and retinal care centers.
The operating results of MRP are included as part of the Medical/Trek/EMI
business unit as of January 30, 2006.
The Company accounted for the purchase under FAS 141. Under FAS 141, the
Company paid a premium (i.e., goodwill) over the fair value of the net tangible
and identified intangible assets acquired to obtain a leading edge technology
platform in the digital imaging marketplace. The application of purchase
accounting under FAS 141 requires that the total purchase price be allocated to
the fair value of assets acquired and liabilities assumed based on their fair
values at the acquisition date, with amounts exceeding the fair values being
recorded as goodwill in the amount of $1,086,737. The allocation process
requires an analysis of acquired fixed assets, contracts, customer lists and
relationships, trademarks, patented technology, service markets, contractual
commitments, legal contingencies and brand value to identify and record the fair
value of all assets acquired and liabilities assumed. The values of certain
assets and liabilities are based on preliminary valuations and are subject to
adjustment as additional information is obtained. Business unit disclosures and
pro forma statement of operations data for 2006 and 2005 do not include MRP
operations and assets as they are not material in relation to the consolidated
financial statements.
3. STOCK-BASED COMPENSATION
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,
8
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
optionee provides service in exchange for the award. The Company was 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.
For the three months ended September 30, 2005, the Company accounted for
its stock-based awards to employees using the intrinsic value method under
Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued
to Employees and related Interpretations. Stock-based awards to non-employees
were recorded using the fair value method in accordance with SFAS No. 123,
Accounting for Stock-Based Compensation .
If the computed fair value of the awards had been amortized to expense
over the vesting period of the awards under SFAS No. 123, net income would have
been as follows for the period ended:
SEPTEMBER 30,
2005
-------------
Net income, as reported $ 714,347
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects (305,199)
----------
PRO FORMA NET INCOME $ 409,148
==========
EARNINGS PER SHARE:
BASIC - AS REPORTED $ 0.12
==========
BASIC - PRO FORMA $ 0.07
==========
DILUTED - AS REPORTED $ 0.11
==========
DILUTED - PRO FORMA $ 0.06
==========
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 periods. No
options were granted during the three-month period ended September 30, 2006.
The Company accelerated the vesting of all of its outstanding options
effective June 30, 2006, as such, as of September 30, 2006, there was $0 of
total unrecognized compensation cost related to non-vested share based
compensation.
9
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:
THREE MONTHS ENDED SEPTEMBER 30,
2006 2005
------------- --------------
NUMERATOR:
Numerator for basic and diluted
earnings per share
NET (LOSS) INCOME $ (714,117) $ 714,347
----------- -----------
DENOMINATOR:
Denominator for basic earnings per
share - weighted average shares 6,344,657 5,964,292
Effect of dilutive securities:
Stock options and warrants 0 408,450
DENOMINATOR FOR DILUTED EARNINGS PER
SHARE - WEIGHTED AVERAGE AND
ASSUMED CONVERSION ----------- -----------
6,344,657 6,372,742
----------- -----------
BASIC (LOSS) EARNINGS PER SHARE $ (0.11) $ 0.12
=========== ===========
DILUTED (LOSS) EARNINGS PER SHARE $ (0.11) $ 0.11
=========== ===========
The impact of dilutive securities were omitted from the earnings per share
calculation in 2006 as they would reduce the loss per share (anti-dilutive).
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,
2006 2006
------------- -----------
(UNAUDITED)
Raw materials $ 4,964,886 $ 4,219,836
Work in process 848,434 809,807
Finished goods 2,177,986 2,345,985
----------- -----------
7,991,306 7,375,628
----------- -----------
Valuation allowance (297,853) (252,712)
----------- -----------
TOTAL INVENTORY $ 7,693,453 $ 7,122,916
=========== ===========
10
6. 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 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 $288,146 and $263,799 at September 30, 2006 and June 30, 2006,
respectively. Amortization expense for the three-month periods ended September
30, 2006 and 2005 was $24,347 and $25,030, 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.
COVENANT NOT TO COMPETE AND CUSTOMER LIST
The Company recorded the value of a covenant not to compete and a customer
list as intangible assets as part of the acquisition of MRP (See note 2). The
valuation was based on the fair market value of these assets at the time of
acquisition. These assets are amortized over their estimate useful lives, not
exceeding 5 years, on a straight-line basis from the date of acquisition.
Accumulated amortization was $43,623 and $22,986 at September 30, 2006 and June
30, 2006, respectively. Amortization expense for the three-month period ended
September 30, 2006 and 2005 was $20,637 and $0, respectively.
GOODWILL, TRADEMARKS AND TRADE NAMES
Goodwill, trademarks and trade names represent intangible assets obtained
from Escalon Opthalmics ("EOI"), Endologix, Inc. ("Endologix"), Sonomed, MRP
(See note 2) 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 unit. 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, 2006 and June 30, 2006:
11
SEPTEMBER 30, JUNE 30, 2006
NET CARRYING NET CARRYING
AMOUNT AMOUNT
------------- -------------
(UNAUDITED)
GOODWILL
Sonomed $ 9,525,550 $ 9,525,550
Drew 9,574,655 9,574,655
Vascular 941,218 941,218
Medical/Trek/EMI 1,030,837 1,030,837
----------- -----------
TOTAL $21,072,260 $21,072,260
=========== ===========
SEPTEMBER 30,
2006 JUNE 30, 2006
NET CARRYING NET CARRYING
AMOUNT AMOUNT
------------- ------------
(UNAUDITED)
UNAMORTIZED INTANGIBLE ASSETS
Sonomed $616,906 $616,906
Medical/Trek/EMI 3,200 3,200
-------- --------
TOTAL $620,106 $620,106
======== ========
The following table presents amortized intangible assets by business unit as of
September 30, 2006:
ADJUSTED
GROSS GROSS
CARRYING CARRYING ACCUMULATED NET CARRYING
AMOUNT IMPAIRMENT AMOUNT AMORTIZATION VALUE
-------- ---------- -------- ------------ ------------
(UNAUDITED)
AMORTIZED INTANGIBLE ASSETS
PATENTS
Drew $ 275,285 $ 0 $ 275,285 $(105,378) $ 169,907
Vascular 36,915 0 36,915 (23,072) 13,843
Medical/Trek/EMI 265,301 0 265,301 (159,696) 105,605
--------- --------- --------- --------- ---------
TOTAL $ 577,501 $ 0 $ 577,501 $(288,146) $ 289,355
========= ========= ========= ========= =========
CUSTOMER LIST/COVENANT NOT
TO COMPETE
Medical/Trek/EMI $ 442,969 $ 0 $ 442,969 $ (43,623) $ 399,346
--------- --------- --------- --------- ---------
TOTAL $ 442,969 $ 0 $ 442,969 $ (43,623) $ 399,346
========= ========= ========= ========= =========
12
The following table presents amortized intangible assets by business unit
as of June 30, 2006:
ADJUSTED
GROSS GROSS
CARRYING CARRYING ACCUMULATED NET CARRYING
AMOUNT IMPAIRMENT AMOUNT AMORTIZATION VALUE
-------- ---------- -------- ------------ ------------
AMORTIZED INTANGIBLE ASSETS
PATENTS
Drew $ 275,285 $ 0 $ 275,285 $ (90,955) $ 184,330
Vascular (pending issuance) 36,915 0 36,915 0 36,915
Medical/Trek/EMI 265,301 0 265,301 (172,844) 92,457
--------- --------- --------- --------- ---------
TOTAL $ 577,501 $ 0 $ 577,501 $(263,799) $ 313,702
========= ========= ========= ========= =========
CUSTOMER
LIST/COVENANT NOT
TO COMPETE
Medical/Trek/EMI $ 442,969 $ 0 $ 442,969 $ (22,896) $ 420,073
--------- --------- --------- --------- ---------
TOTAL $ 442,969 $ 0 $ 442,969 $ (22,896) $ 420,073
========= ========= ========= ========= =========
7. ACCRUED EXPENSES
The following table presents accrued expenses as of September 30, 2006 and
June 30, 2006:
SEPTEMBER 30,
2006 JUNE 30, 2006
------------ -------------
(UNAUDITED)
Accrued compensation $1,572,048 $1,260,139
Warranty accruals 255,740 255,740
Legal accruals 119,101 221,369
Other accruals 680,425 766,523
---------- ----------
TOTAL ACCRUED EXPENSES $2,627,314 $2,503,771
========== ==========
In addition to normal accruals, other accruals as of September 30, 2006
and June 30, 2006 relate to the remaining lease payments on a facility that
ceased manufacturing operations 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 accruals.
8. 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 debt
provided for interest at fixed rate of 8% per annum until July 1, 2005. The
interest rate was then adjusted to the prime rate plus 4% per annum. Each June
1, the rate will be adjusted to the prime rate plus 4% per annum. The debt has a
minimum interest rate of 8% per annum to a maximum interest rate of 18% per
annum. The interest rate on the Texas Mezzanine Fund was 12.0% per annum and
10.25% per annum as of September 30, 2006 and June 30, 2006, respectively. Drew
is required to pay the Texas Mezzanine Fund 1% of fiscal year revenues over
$11,500,000 as defined in a revenue participation agreement. The note is due in
June 2008 and is secured
13
by certain assets of Drew. The outstanding balance of the note was $244,056 and
$278,717 as of September 30, 2006 and June 30, 2006, 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% per annum. The outstanding balance of this note
was $91,663 and $116,671 as of September 30, 2006 and June 30, 2006,
respectively.
The schedule below presents principal amortization for the next five years
under each of the Company's loan agreements as of September 30, 2006:
TWELVE MONTHS
ENDING TEXAS
SEPTEMBER 30, MEZZANINE SYMBIOTICS TOTAL
------------- --------- ---------- -----
(UNAUDITED)
2007 $148,817 $ 91,663 240,480
2008 95,239 0 95,239
-------- -------- --------
TOTAL $244,056 $ 91,663 335,719
======== ========
Current portion of long-term debt 240,480
--------
Long-term portion $ 95,239
========
9. 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 laser technology; and
(3) Royalty payments received from Bio-Rad Laboratories, Inc.
("Bio-Rad").
For the three-month periods ended September 30, 2006 and 2005, Silicone
Oil revenue totaled $0 and $203,000, respectively, IntraLase royalties totaled
approximately $555,000 and $392,000, respectively, and the Bio-Rad royalties
totaled approximately $70,000 and $75,000, respectively.
14
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 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 diagnostic
tests provided by Bio-Rad. If fewer 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 OEM 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.
15
10. 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, 2006 are as follows:
LEASE
TWELVE MONTHS ENDING OBLIGATIONS
-------------------- -----------
(UNAUDITED)
2007 $ 720,916
2008 411,226
2009 284,615
2010 292,710
2011 308,770
Thereafter 116,354
---------------
TOTAL $ 2,134,590
===============
Rent expense charged to operations during the three-month periods ended
September 30, 2006 and 2005 was $215,320 and $215,111, 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, as amended and
restated on November 9, 2005, for the right to sell formulations or products of
CDS, including reagents, controls and calibrators ("CDS products"), on a private
label basis. The agreement has a term of 15 years, may be terminated by Drew at
any time with 18 months written notice, and if not terminated 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.
11. LEGAL PROCEEDINGS
In October 1997, Escalon and IntraLase entered into a License Agreement
wherein Escalon granted IntraLase the exclusive right to use Escalon's laser
properties, including patented and non-patented technology, in exchange for
shares of IntraLase common stock 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 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 Condensed 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
16
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 also held that IntraLase must give Escalon an accounting of third-party
royalties. The court agreed with IntraLase that it is not required to pay
royalties on research grants.
The court also 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 United States Court of Appeals for
the Ninth Circuit. The parties have submitted briefs to the court. Escalon
believes that a decision by the court is unlikely in 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 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. On June 3, 2005, after having been served
with Escalon's Complaint filed in the Delaware Court of Chancery ("Delaware
Action," described below), IntraLase filed an Amended Complaint in the Second
Action. Escalon, not having been served with the Amended Complaint, filed a
motion to dismiss the Complaint in the Second Action on jurisdictional and
substantive grounds. On June 6, 2005, Escalon filed a Motion to Dismiss the
Amended Complaint on grounds virtually identical to its first motion to dismiss.
The court dismissed without prejudice the Second Action on the grounds that much
of IntraLase's lawsuit sought a ruling on issues already raised by Escalon in
Escalon's Delaware Action. Accepting Escalon's arguments for dismissal, the
California Court held that retaining jurisdiction would likely result in
duplicative litigation and an unnecessary entanglement between the federal and
state court actions.
As referenced above, on May 15, 2005, Escalon, not having been served with
IntraLase's Second Action, initiated the Delaware Action by filing a Complaint
against IntraLase 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. In the 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 February 21, 2006, Escalon again 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 as well as
IntraLase's refusal to permit Escalon to inspect IntraLase's records and books
of account in accordance with paragraph 5.3 of the License Agreement. IntraLase
had steadfastly refused to permit inspections reasonably requested by Escalon to
audit IntraLase's records and books of account and, instead, conditioned any
inspection by Escalon's auditors on unreasonable and unnecessary
17
confidentiality restrictions and unilateral limitations on the scope of records
and books of account that would be made available for inspection to Escalon. On
the same day, Escalon filed its First Amended Complaint in the Delaware Action
adding to its pending claims a claim for declaratory relief wherein Escalon
seeks a judgment declaring that the License Agreement terminated fifteen days
after IntraLase received Escalon's notice of defaults and intent to terminate
and failed to cure said defaults.
On February 28, 2006, Escalon agreed to suspend the cure periods applicable
to the alleged breaches set out in its February 21, 2006 letter while Escalon
and IntraLase engaged in mediation efforts. Mediation before Vice Chancellor
Donald F. Parsons, Jr. of the Delaware Court of Chancery, pursuant to Chancery
Court Rule 174, took place on May 5, 2006 and was unsuccessful. However, in
August 2006, the Parties entered into a Stipulation under which IntraLase agreed
to allow an independent auditor, retained by the Company, to inspect certain of
IntraLase's books and records as needed, in the opinion of the independent
auditor, to verify that the Company received the full value of royalty payments
to which it is entitled pursuant to the License Agreement. The Company sent its
auditor to IntraLase's headquarters in early September 2006 to commence the
audit. The auditor has informed the Company that it is awaiting responses and
documents from Intralase that are necessary for the audit to be completed.
The Company desires to conclude this audit in November 2006.
Separately, on April 22, 2005, Escalon, as beneficial 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. Shortly thereafter, Escalon Holdings, record holder of common
stock of IntraLase, made the same written demand. IntraLase rejected both
demands. Thereafter, Escalon and Escalon Holdings filed an action in the
Delaware Court of Chancery against IntraLase seeking to enforce their
shareholder rights to inspect IntraLase's books and records ("220 Action"). The
220 Case remains in the discovery stage and the Court has set a trial date of
January 4, 2007.
Escalon is cognizant of the legal expenses and costs associated with the
IntraLase matter. Escalon, however, is taking all necessary and appropriate
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 royalty payments based on its filings with the SEC and filings in
connection with the First Action.
CARVER LITIGATION-CONNECTICUT ACTION
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 ("Connecticut Action"). 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 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.
CDC Acquisitions and IV Diagnostics and the plaintiffs in the Connecticut
Action recently resolved their disputes as Acquisition Corp. paid the plaintiffs
the outstanding judgment amount, eighty-three thousand dollars ($83,000.00). The
Company's cross-claims against certain of the former principal shareholders of
CDC Technologies, Inc. ("Technology Defendants") remain pending. The Technology
18
Defendants also have a cross-claim pending against CDC Acquisition Corp.
However, even in the event that Technology Defendants would prevail, their
damages are limited to the amount of their settlement, $50,000. Technology
Defendants recently filed a Motion to Enforce Settlement Agreement with the
trial court, asserting that there was an understanding that Technology
Defendants would be included in a three-way agreement to resolve all claims
associated with this litigation. The Company is opposing the Motion of the
Technology Defendants and intends to preserve and proceed to enforce its rights
against the Technology Defendants.
INSTITUTE OF CHILD HEALTH
Drew entered into a license agreement with the Institute of Child Health
("ICH") on May 10, 1993 to use ICH's intellectual property to manufacture,
lease, sell, use and sublicense certain products and all related consumables
used therein in the testing of blood and fluids. Under the license agreement
Drew was to pay royalties to ICH on the products and consumables. On January 23,
2006, the Company received a letter from ICH alleging that Drew has failed to
remit certain moneys due under the license agreement and has sought an
accounting to determine such amount due. Drew is reviewing this matter with
legal counsel and disputes the allegations of nonpayment.
OTHER LEGAL PROCEEDINGS
The Company, 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.
19
12. SEGMENTAL INFORMATION
During the three-month periods ended September 30, 2006 and 2005, the
Company operations were classified into four principal reportable business units
that provide different products or services.
Separate management of each unit is required because each business unit is
subject to different marketing, production and technology strategies.
SEGMENTAL STATEMENTS OF OPERATIONS (IN THOUSANDS) - THREE MONTHS ENDED
SEPTEMBER 30, 2006 AND 2005
DREW SONOMED VASCULAR MEDICAL/TREK/EMI TOTAL
------------------ ------------------ ---------------- ---------------- ------------------
2006 2005 2006 2005 2006 2005 2006 2005 2006 2005
-------- -------- -------- -------- ------- ------- ------- ------- -------- --------
REVENUES, NET:
Product revenue $ 2,785 $ 4,071 $ 2,293 $ 1,798 $ 817 $ 931 $ 648 $ 323 $ 6,543 $ 7,123
Other revenue 70 75 0 0 0 0 555 595 625 670
-------- -------- -------- -------- ------- ------- ------- ------- -------- --------
TOTAL REVENUE, NET 2,855 4,146 2,293 1,798 817 931 1,203 918 7,168 7,793
-------- -------- -------- -------- ------- ------- ------- ------- -------- --------
COSTS AND EXPENSES:
Cost of goods sold 1,759 2,594 1,187 976 313 320 372 216 3,631 4,106
Operating expenses 1,841 1,792 884 1,040 552 529 992 679 4,269 4,040
-------- -------- -------- -------- ------- ------- ------- ------- -------- --------
TOTAL COSTS AND EXPENSES 3,600 4,386 2,071 2,016 865 849 1,364 895 7,900 8,146
-------- -------- -------- -------- ------- ------- ------- ------- -------- --------
(LOSS) INCOME FROM
OPERATIONS (745) (240) 222 (218) (48) 82 (161) 23 (732) (353)
-------- -------- -------- -------- ------- ------- ------- ------- -------- --------
OTHER (EXPENSE) AND
INCOME:
Gain on sale of available
for sale securities 0 0 0 0 0 0 0 1,157 0 1,157
Equity in OTM 0 0 0 0 0 0 (19) (18) (19) (18)
Interest income 0 0 0 0 0 0 45 5 45 5
Interest expense (8) (10) 0 0 0 (1) 0 0 (8) (11)
-------- -------- -------- -------- ------- ------- ------- ------- -------- --------
TOTAL OTHER (EXPENSE) AND
INCOME (8) (10) 0 0 0 (1) 26 1,144 18 1,133
-------- -------- -------- -------- ------- ------- ------- ------- -------- --------
(LOSS) AND INCOME BEFORE TAXES (753) (250) 222 (218) (48) 81 (135) 1,167 (714) 780
-------- -------- -------- -------- ------- ------- ------- ------- -------- --------
Income taxes 0 0 0 0 0 0 0 66 0 66
-------- -------- -------- -------- ------- ------- ------- ------- -------- --------
NET (LOSS) INCOME $ (753) $ (250) $ 222 $ (218) $ (48) $ 81 $ (135) $ 1,101 $ (714) $ 714
======== ======== ======== ======== ======= ======= ======= ======= ======== ========
Depreciation and
amortization $ 86 $ 55 $ 6 $ 5 $ 49 $ 17 $ 18 $ 28 $ 159 $ 105
Assets $ 17,404 $ 15,295 $ 13,784 $ 13,623 $ 3,944 $ 2,208 $ 3,092 $ 8,655 $ 38,224 $ 39,781
Expenditures for
long-lived assets $ 35 $ 88 $ 0 $ 0 $ 1 $ 13 $ 9 $ 11 $ 45 $ 112
13. SHAREHOLDERS' EQUITY
WARRANTS TO PURCHASE COMMON STOCK
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. The fair market
value of the warrants was determined under the Black Scholes model and recorded
to additional paid-in capital in accordance with Emerging Issues Task Force
Issue Number 00-19, "Accounting for Derivative Financial Instruments Indexed to,
and Potentially Settled in, a Company's Own Stock" ("EITF 00-19").
14. RELATED-PARTY TRANSACTIONS
The Company and a member of the Company's Board of Directors are founding
and equal members of 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
20
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, 2006, the Company had
invested $256,000 in OTM. As of September 30, 2006, Escalon owned 45% of OTM.
The members of OTM have agreed to review the operations of OTM after 24 months,
at which time the members each have the right to sell its membership interest
back to OTM at fair market value. The Company provides administrative support
functions to OTM. From inception through September 30, 2006, OTM had revenue of
approximately $16,200 and incurred expenses of approximately $213,500. This
investment is accounted for under the equity method of accounting and is
included in other assets.
Two relatives of a senior executive officer have provided legal services
as either an employee or a consultant to the Company. Richard DePiano, Jr. (son
of the Chief Executive Officer ("CEO")) is General Counsel to the Company, Mr.
DePiano's salary plus bonus for the three-month periods ended September 30, 2006
and 2005 were $31,364 and $30,900, respectively. Caryn Lindsey (daughter-in-law
of the CEO) acted as a consultant and employee for the Company in 2005. For the
three-month periods ended September 30, 2006 and 2005 Ms. Lindsey received
consulting fees and salary of $0 and $16,250, respectively.
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 as having 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 held by the
Company 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.
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
common stock at September 30, 2006 are classified as available-for-sale
securities and had a market value of $59,130.
16. ANKA CO-MARKETING AGREEMENT
On October 11, 2005 the Company signed a non-exclusive co-marketing
agreement with privately held 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. The
co-marketing agreement will enable the Company to jointly market its existing
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.
In connection with the co-marketing agreement, Company extended a $300,000
loan in October 2005 and an additional loan of $100,000 in January 2006,
pursuant to demand notes, to Anka. Under the terms of these notes, repayment is
due within six months after written demand or immediately upon an event of
default. On February 16, 2006, the Company demanded repayment in accordance with
the terms of the notes. The loan was paid in full in April 2006.
21
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD LOOKING STATEMENTS
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 FDA,
acquisitions, the development of joint venture opportunities, intellectual
property and patent protection and infringement, 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 list of such factors contained in its periodic report on Form
10-KSB for the year ended June 30, 2006 to be an exhaustive statement of all
risks, uncertainties or potentially inaccurate assumptions.
EXECUTIVE OVERVIEW - THREE-MONTH PERIOD ENDED SEPTEMBER 30, 2006
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 the Company's
performance and financial condition.
- On July 23, 2004, the Company 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 acquired all of the Drew shares
during the fiscal year ended June 30, 2005. The Company has been
operating Drew as a separate business unit since its acquisition, and
Drew's results of operations are included in the "Management's Discussion
and Analysis of Financial Condition and Results of Operations" 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. The Company's operational priorities with respect to
Drew is 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 six- month period ended December
31, 2004. The balance of the shares were issued in the six-month period
ended June 30, 2005.
- Revenue decreased approximately 8% during the three-month period ended
September 30, 2006 as compared to the same period last fiscal year. The
decrease is primarily related to decreases in the Drew and Vascular
business units. Revenue at Drew and Vascular decreased 32% and 12%,
respectively, during the three-month period ended September 30, 2006 when
compared to the same period last fiscal year. These decreases were offset
by strong sales in the Company's Sonomed and Medical/Trek/EMI business
units. Sales at Sonomed and Medical/Trek/EMI increased approximately 28%
and 100%, respectively, during the three-month period ended September 30,
2006 compared to the same period last fiscal year.
22
- During July 2005, the Company sold 58,555 shares of IntraLase common stock
that had originally been received by the Company in connection with the
license of its laser properties to IntraLase in 1997. (See note 15 of 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.
- Cost of goods sold as a percentage of product revenue decreased to
approximately 55.4% of revenues during the three-month period ended
September 30, 2006, as compared to approximately 57.6% of product revenue
for the same period last fiscal year. Gross margins in the Drew business
unit have historically been lower than those in the Company's other
business units. The aggregate cost of goods sold as a percentage of
product revenue of the Sonomed, Vascular and Medical/Trek/EMI business
units during the three-month period ended September 30, 2006 remained
steady at approximately 50.0% of product revenue in the same period last
fiscal year.
- Operating expenses increased approximately 5.5% during the three-month
period ended September 30, 2006 as compared to the same period in the
prior fiscal year. During the three-month period ended September 30, 2006,
the Company continued to experience a high amount of legal and accounting
fees primarily related to IntraLase litigation costs. While the Company
expects these legal and accounting 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.
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.
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 ultra fast laser systems
designed for the treatment of ophthalmic disorders. As a result of the EOI
acquisition, the Company changed its market focus and ceased 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 notes 9 and 15
of the notes to the condensed consolidated financial statements for further
information.) The Company is in dispute with IntraLase over royalty payments
owed to the Company. (See note 11 of the notes to the 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.
23
On July 23, 2004, the Company 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 acquired all of
the Drew shares during fiscal 2005. 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 2 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 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.
24
VALUATION OF INTANGIBLE ASSETS
The Company 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 and 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.
(LOSS)/INCOME PER SHARE
The Company computes net (loss)/income 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
(loss)/income per share is computed by dividing the net (loss)/income for the
period by the weighted average number of shares of common stock outstanding
during the period. The calculation of diluted net (loss)/income per share
excludes potential common shares if the effect is anti-dilutive. Basic earnings
per share are computed by dividing net (loss)/income 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 (loss)/income for financial statement purposes, management
must make certain estimates and judgments. These estimates and judgments occur
in the calculation of certain tax liabilities 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, 2006, 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
25
income prior to the expiration of the loss carry forwards. 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, 2006 AND 2005
The following table shows consolidated product revenue by business unit as
well as identifying trends in business unit product revenues for the three-month
periods ended September 30, 2006 and 2005. Table amounts are in thousands:
THREE-MONTH PERIOD ENDED
SEPTEMBER 30,
------------------------------
2006 2005 % CHANGE
-------- -------- --------
PRODUCT REVENUE:
Drew $ 2,785 $ 4,071 -31.6%
Sonomed 2,293 1,798 27.5%
Vascular 817 931 -12.2%
Medical/Trek/EMI 648 323 100.6%
-------- -------- -----
TOTAL $ 6,543 $ 7,123 -8.1%
======== ======== =====
Product revenue decreased approximately $584,000, or 8%, to $6,543,000
during the three-month period ended September 30, 2006 as compared to the same
period last fiscal year. In the Drew business unit, product revenue decreased
$1,280,000, or 32%, as compared to the same period last fiscal year. The
decrease is primarily due to the aging of Drew's product line and delays in
bringing its new products to market. Drew anticipates that it will release a new
product for sale in each of the second and third quarters of the current fiscal
year.
Product revenue increased $495,000, or 28%, at the Sonomed business unit
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 new Vumax II
ultrasound systems and an increase in export sales, which were partially offset
by a decrease in domestic sales and in demand for the Company's pachymeter
product.
Product revenue decreased $114,000, or 12%, to $817,000 in the Vascular
business unit during the three-month period ended September 30, 2006 as compared
to the same period last fiscal year. The decrease in product revenue in the
Vascular business unit was primarily caused by an decrease in direct sales to
end users by the Company's domestic sales team. The Company also saw a decrease
in revenue from the Company's distributor network. The Company terminated its
relationship with several of its distributors during the prior fiscal year.
In the Medical/Trek/EMI business unit, product revenue increased $325,000,
or 100%, to $648,000 during the three-month period ended September 30, 2006 as
compared to the same period last fiscal year. The increase in Medical/Trek/EMI
product revenue is primarily attributed to an increase in the EMI sales of
digital imaging systems.
Other revenue decreased by approximately $45,000, or 6.7%, to $625,000
during the three-month period ended September 30, 2006 as compared to the same
period last fiscal year. The decrease is primarily due to a decrease in
royalties received from Bausch & Lomb from $203,000 in the prior fiscal period
to $0 for the three-month period ended September 30, 2006. The Company's
contract with Bausch & Lomb ended in August 2005, and accordingly, the Company
received no royalties in the three-month period ended September 30, 2006 and
will receive no future royalties under this agreement. (See note 9 of the notes
to the condensed consolidated financial statements for a description of the
step-down provisions under the contract with Bausch & Lomb.) Royalties from
Bio-Rad related to an OEM agreement between Bio-Rad and Drew decreased by
approximately $5,000 to $70,000 due to lower sales of Drew's products in
26
covered areas. 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. Offsetting these decreases
was an increase in royalties received from Interlase of approximately $163,000
from $392,000 in the prior fiscal period to $555,000 in the three-month period
ended September 30, 2006. The Company continues to challenge the method of
calculating its royalty payments to the Company by Intralase and this issue
remains a subject of litigation. (See notes 9 and 11 of the notes to the
condensed consolidated financial statements.)
The following table presents consolidated cost of goods sold by reportable
business unit and as a percentage of related unit product revenues for the
three-month periods ended September 30, 2006 and 2005. Table amounts are in
thousands:
THREE-MONTH PERIOD ENDED SEPTEMBER 30,
--------------------------------------
2006 % 2005 %
-------- ---- -------- ----
COST OF GOODS SOLD:
Drew $ 1,759 63.2% $ 2,594 63.7%
Sonomed 1,187 51.8% 976 54.3%
Vascular 313 38.3% 320 34.4%
Medical/Trek/EMI 372 57.4% 216 66.9%
-------- ---- -------- ----
TOTAL $ 3,631 55.5% $ 4,106 57.6%
======== ==== ======== ====
Cost of goods sold totaled approximately $3,631,000, or 55% of product
revenue, for the three-month period ended September 30, 2006 as compared to
$4,106,000, or 57.6% of product revenue, for the same period last fiscal year.
Cost of goods sold in the Drew business unit totaled $1,759,000, or 63% of
product revenue, for the three-month period ended September 30, 2006 as compared
to $2,594,000, or 64% of product revenue, for the same period last fiscal year.
The decrease in the cost of goods sold of 32% corresponds to a like decrease in
sales of 32%. Drew's instrument and OEM 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 $1,187,000, or 52%
of product revenue, for the three-month period ended September 30, 2006 as
compared to $976,000, or 54% of product revenue, for the same period last fiscal
year. The primary reason for the decrease in cost of goods sold as a percentage
of product revenue was an increase in sales of higher margin Vumax II's during
the three months ended September 30, 2006.
Cost of goods sold in the Vascular business unit totaled $313,000, or 38%
of product revenue, for the three-month period ended September 30, 2006 as
compared to $320,000, or 34% of product revenue, for the same period last fiscal
year. The Company experienced higher overtime and lower production efficiencies
in the current period as compared to the prior period.
Cost of goods sold in the Medical/Trek/EMI business unit totaled $372,000,
or 57% of product revenue, during the three-month period ended September 30,
2006 as compared to $216,000, or 67% of product revenue, during the same period
last fiscal year. Fluctuations in Medical/Trek/EMI cost of goods sold primarily
emanates from product mix. The large increase in high margin EMI products in the
current year accounts for the decrease in cost of goods sold as a percent of
product revenue.
27
The following table presents consolidated marketing, general and
administrative expenses as well as identifying trends in business unit
marketing, general and administrative expenses for the three-month periods ended
September 30, 2006 and 2005. Table amounts are in thousands:
THREE-MONTH PERIOD ENDED
SEPTEMBER 30,
--------------------------------
2006 2005 % CHANGE
-------- ------- --------
MARKETING, GENERAL AND
ADMINISTRATIVE:
Drew $ 1,841 $ 1,792 2.7%
Sonomed 884 1,040 -15.0%
Vascular 552 529 4.4%
Medical/Trek/EMI 992 679 46.1%
-------- -------- -----
TOTAL $ 4,269 $ 4,040 5.7%
======== ======== =====
Marketing, general and administrative expenses increased $260,000, or 8%,
to $3,551,000 during the three-month period ended September 30, 2006 as compared
to the same period last fiscal year. Marketing, general and administrative
expenses in the Drew business unit increased $14,000 or 1%, to $1,383,000 as
compared to the same period last fiscal year. The increase is primarily due to
increased legal fees related to the ICH matter in the United Kingdom (see
footnote 11).
Marketing, general and administrative expenses in the Sonomed business
unit decreased by $47,000, or 6%, to $797,000 as compared to the same period
last fiscal year. This decrease is related to higher expenses in the prior year
for marketing and travel expenses related to the Company's focus on increasing
domestic and foreign revenues and exhibits and brochures advertising the
Company's Ultrasound Biomicrosopes instrument.
Marketing, general and administrative expenses in the Vascular business
unit increased $37,000, or 8%, to $530,000 as compared to the same period last
fiscal year. The increase is related primarily to an increase of $11,000 in
legal fees for logo and patent registrations and $18,000 in administrative and
sales salaries incurred in the three month period ended September 30, 2006.
Marketing, general and administrative expenses in the Medical/Trek/EMI
business unit increased $256,000, or 44% to $841,000 as compared to the same
period last fiscal year. Legal fees, related mainly to the Interlase litigation,
increased by $281,000 in the period ended September 30, 2006 as compared to the
same period last year. The Company still anticipates these litigation costs will
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.) The remainder of the increase is related to sales and marketing
expenses related to the EMI product lines, and the joint marketing and
integration of the Company's product line with Anka Systems as part of a
co-marketing agreement.
Research and development expenses decreased $31,000, or 4%, to $718,000
during the three-month period ended September 30, 2006 as compared to the same
period last fiscal year. Research and development expenses were primarily
expenses associated with the planned introduction of new and or enhanced
products in the Drew and EMI business units. Research and development expenses
in the Drew business unit increased $35,000, or 8%, to $458,000 as compared to
the same period last fiscal year. The increase is primarily due to additional
salaries and benefits and consulting fees associated with the development of
several new hematology and diabetic instruments. Research and development
expenses in the Medical/Trek/EMI business unit increased $57,000 to $151,000 as
compared to the same period last fiscal year. The increase is primarily due to
higher prototype expenses (approximately $13,000) and salary expenses
(approximately $40,000) for the development of the Company's new digital
ophthalmic platform.
28
Gain on sale of available for sale securities was decreased approximately
$1,157,000 in the three-month period ended September 30, 2006. The decrease 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.) There
were no sales of available for sale securities during the three-month period
ended September 30, 2006.
The Company recognized a loss of $19,000 and $18,000 related to its
investment in OTM during the three-month periods ended September 30, 2006 and
2005, respectively. Commencing July 1, 2005, the Company began recognizing all
of the losses of OTM in its consolidated financial statements. OTM is an early
stage privately held company. Prior to July 1, 2005, the share of OTM's loss
recognized by the Company was 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 $45,000 and $5,000 for the three-month periods ended
September 30, 2006 and 2005, respectively. The increase was due to a combination
of higher effective yields on investments and higher investable balances.
Interest expense was $9,000 and $11,000 for the three-month periods ended
September 30, 2006 and 2005, respectively. The decrease reflects the reduction
in outstanding debt balance as of September 30, 2006 as compared to the prior
period.
LIQUIDITY AND CAPITAL RESOURCES
Changes in overall liquidity and capital resources from continuing
operations during the three-month period ended September 30, 2006 are reflected
in the following table (in thousands):
SEPTEMBER 30, JUNE 30,
2006 2006
------------- ----------
CURRENT RATIO:
Current assets $ 14,520 $ 14,911
Less: Current liabilities 4,570 4,295
--------- ---------
WORKING CAPITAL $ 9,950 $ 10,616
========= =========
CURRENT RATIO 3.2 TO 1 3.5 TO 1
========= =========
DEBT TO TOTAL CAPITAL RATIO:
Notes payable and current maturities $ 240 $ 233
Long-term debt 1,182 1,250
--------- ---------
Total debt $ 1,422 $ 1,483
--------- ---------
Total equity 32,620 33,100
========= =========
TOTAL CAPITAL $ 34,042 $ 33,100
========= =========
TOTAL DEBT TO TOTAL CAPITAL 4.2% 4.5%
========= =========
WORKING CAPITAL POSITION
Working capital decreased approximately $666,000 as of September 30, 2006
and the current ratio decreased to 3.2 to 1 from 3.5 to 1 when compared to June
30, 2006. The decrease in working capital was caused primarily by the loss from
operations of approximately $714,000 and cash used to fund fixed asset additions
of approximately $60,000. Partially offsetting these uses of working capital
were proceeds of
29
approximately $98,000 realized by the Company for the income tax benefit from
the exercise of stock options.
CASH USED IN OPERATING ACTIVITIES
During the three-month periods ended September 30, 2006 and 2005, the
Company used approximately $1,282,000 and $751,000 of cash for operating
activities. The net increase in cash used for operating activities of
approximately $531,000 for the three-month period ended September 30, 2006 as
compared to the same period in the prior fiscal year is due primarily to the
following factors:
The Company had a net loss of $714,000 and experienced net cash out flows
from increases in accounts receivable, inventory and other current and long-term
assets of approximately $238,000, $554,000 and $181,000, respectively. These
cash out flows were partially offset by and increase in accounts payable of
$251,000 and non-cash expenditures on depreciation and amortization of $135,000.
In the prior fiscal period the cash used in operating activities of $531,000 was
related to net income in the prior year of $714,000 offset by a gain on sale of
marketable securities in the amount of $1,157,000.
CASH FLOWS PROVIDED BY (USED IN) INVESTING AND FINANCING ACTIVITIES
Cash flows used in investing activities of $40,000 is related to fixed
asset purchases during the three-month period ended September 30, 2006. The
decrease in cash flows from investing activities from the prior fiscal period
was $1,013,000. The change relates 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 of 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.
Cash flows provided by financing activities were approximately $39,000
during the three-month period ended September 30, 2006. During the period, the
Company made scheduled long-term debt repayments of approximately $60,000 and
received an income tax benefit of $98,000 by amending its fiscal 2006 state tax
returns to deduct the exercise of stock options during fiscal 2006.
DEBT HISTORY
At the time of the acquisition of Drew by the Company, 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 debt provides for interest at
fixed rate of 8% per annum until July 1, 2005. The interest rate was then
adjusted to the prime rate plus 4% per annum. Each June 1, the rate will be
adjusted to the prime rate plus 4% per annum. The debt has a minimum interest
rate of 8% per annum to a maximum interest rate of 18% per annum. The interest
rate on the Texas Mezzanine Fund was 10.25% per annum and 8% per annum as of
September 30, 2006 and June 30, 2006, respectively. Drew is required to pay the
Texas Mezzanine Fund 1% of fiscal year revenues over $11,500,000 as defined in a
revenue participation agreement. The note is due in June 2008 and is secured by
certain assets of Drew. The outstanding balance as of September 30, 2006 was
approximately $244,000. 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% per
annum. The outstanding balance as of March 31, 2006 was approximately $92,000.
30
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 $113,000 net difference from the
amounts reported in the Company's Form 10-Q for the quarter ended December 31,
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
The Company was not a party to any off-balance sheet arrangements during
the three-month periods ended September 30, 2006 and 2005.
The following table presents the Company's contractual obligations as of
September 30, 2006 (interest is not included in the table as it is immaterial):
LESS THAN 4-5
TOTAL 1 YEAR 1-3 YEARS YEARS
---------- ---------- ---------- ----------
Long-term debt $ 335,719 $ 240,480 $ 95,239 $ 0
Operating lease agreements 2,134,590 720,916 988,550 425,124
---------- ---------- ---------- ----------
TOTAL $2,470,309 $ 961,396 $1,083,789 $ 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 acquired all of the
Drew shares during 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. 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.
31
As of September 30, 2006, the Company has loaned approximately $11,023,000 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, to fund new product development and underwrite operating losses
incurred since acquisition. The Company anticipates that further working
capital will likely be required by Drew.
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. The Company has incurred and anticipates continuing to incur
higher than normal legal expenses related primarily to protecting its rights and
interests in intellectual property licensed to IntraLase. (See note 11 of the
notes to the condensed consolidated financial statements.) These higher costs
are likely to unfavorably impact operating income and cash flows in future
periods.
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
The table below provides information about the Company's financial
instruments consisting of both variable and 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, 2006 were variable at prime plus 4%, currently 10.25% per annum,
on the Texas Mezzanine Fund debt, and were fixed at 5.00% per annum, on the
Symbiotics, Inc. term debt. (See note 8 of the notes to the condensed
consolidated financial statements for further information regarding the
Company's debt obligations.)
2006 2007
---------- -------------
Texas Mezzanine Fund Note $ 148,817 $ 95,239
Interest rate 10.25% Prime Plus 4%
Symbiotics, Inc. Note $ 91,663 $ 0
Interest rate 5.00% 5.00%
---------- -------------
TOTAL $ 240,480 $ 95,239
========== =============
EXCHANGE RATE RISK
Prior to the 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
periods ended September 30, 2006 and 2005, Drew recorded approximately $321,000
and $87,000 respectively, of revenue denominated in United Kingdom Pounds and
Euros, respectively.
Drew incurs a portion of its expenses denominated in United Kingdom
Pounds. During the three-month periods ended September 30, 2006 and 2005, Drew
incurred approximately $1,265,000 and $1,368,000, respectively, of expense
denominated in United Kingdom Pounds. The Company's Sonomed and Vascular
business units incur an immaterial portion of their marketing expenses in the
European market, the majority of which are transacted in Euros.
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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 4. 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 Principal Financial and Accounting Officer, have
established disclosure controls and procedures to ensure that material
information relating to the Company, including its consolidated subsidiaries, is
made known to the officers who certify the Company's financial reports and to
other members of senior management and the Board of Directors.
Based on their evaluation of the effectiveness of the Company's disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Exchange Act) as of September 30, 2006, the Chief Executive Officer and
Principal Financial and Accounting Officer of the Company have concluded that
such disclosure controls and procedures are effective to ensure that the
information required to be disclosed by the Company in reports that it files or
submits under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in SEC rules and forms, and that information
required to be disclosed in the reports that the Company files or submits under
the Exchange Act is accumulated and communicated to the Company's management,
including its Chief Executive Officer and Principal Financial and Accounting
Officer, to allow timely decisions regarding required disclosure.
(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, 2006 that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See note 11 of the notes to the condensed consolidated financial
statements for further information regarding the Company's legal proceedings.
ITEM 1A. RISK FACTORS
There are no material changes from the risks previously disclosed in our
Annual Report on Form 10-K for the period ended June 30, 2006.
ITEM 6. EXHIBITS
31.1 Certificate of Chief Executive Officer under Rule 13a-14(a).
31.2 Certificate of Principal Financial and Accounting 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 Principal Financial and Accounting Officer under Section 1350 of Title 18 of the United States Code.
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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, 2006 By: /s/ Richard J. DePiano
--------------------------------
Richard J. DePiano
Chairman and Chief
Executive Officer
Date: November 14, 2006 By: /s/ Robert O'Connor
--------------------------------
Robert O'Connor
Chief Financial Officer
34