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Previous: NCS HEALTHCARE INC, 424B3, 2000-05-09 |
Next: VIRGINIA RETIREMENT SYSTEMS ET AL, 13F-HR, 2000-05-09 |
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 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 April 1, 2000
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________to _________
Commission file number 0-27422
ARTHROCARE CORPORATION (Exact name of Registrant as specified in its Charter)
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595 North Pastoria Avenue
Sunnyvale, California 94086
(Address of Principal Executive Offices including Zip Code)
(408) 736-0224
(Registrant's Telephone Number, Including Area Code)
(Former name, former address and former fiscal year if changed
since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ]
The number of shares outstanding of the registrant's common stock as of April 14, 2000 was 10,916,309.
ARTHROCARE CORPORATION
FORM 10-Q
INDEX
PART I. Financial Information
Item 1. Financial Statements (unaudited)
Condensed Consolidated Balance Sheets as of April 1, 2000 and January 1, 2000
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosure about Market Risks
PART II. Other Information
Item 1: Legal Proceedings
Item 2: Changes in Securities
Item 3: Defaults Upon Senior Securities
Item 4: Submission of Matters to a Vote of Security Holders
Item 5: Other Information
Item 6: Exhibits and Reports on Form 8-K
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
ARTHROCARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
April 1, January 1,
2000 2000
------------- -------------
(unaudited)
ASSETS
Current assets:
Cash and cash equivalents..................... $48,251 $47,875
Available-for-sale securities................. 12,749 22,582
Accounts receivable, net of allowances........ 17,129 13,917
Inventories, net.............................. 8,758 6,960
Prepaid expenses and other current assets..... 677 719
------------- -------------
Total current assets 87,564 92,053
Available-for-sales securities.................. 21,125 9,150
Property and equipment, net..................... 7,975 7,366
Related party receivables....................... 1,205 1,205
Other assets.................................... 265 265
------------- -------------
Total assets............................... $118,134 $110,039
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.............................. $3,133 $2,930
Accrued liabilities........................... 1,798 1,256
Accrued compensation.......................... 2,888 2,689
Capital lease obligation, current portion..... 60 60
------------- -------------
Total current liabilities 7,879 6,935
Capital lease obligation, less
current portion.............................. 67 87
Deferred rent................................... 130 134
------------- -------------
Total liabilities..................... 8,076 7,156
------------- -------------
Stockholders' equity:
Common stock.................................. 11 11
Additional paid in capital.................... 127,860 125,200
Notes receivable from stockholders............ -- (273)
Accumulated other comprehensive (loss)........ (255) (151)
Accumulated deficit........................... (17,558) (21,904)
------------- -------------
Total stockholders' equity............ 110,058 102,883
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Total liabilities and stockholders' equity. $118,134 $110,039
============= =============
The accompanying notes are an integral part of these condensed consolidated financial statements
ARTHROCARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(unaudited)
Three Months Ended
-----------------------
April 1, April 3,
2000 1999
----------- -----------
Revenues:
Product sales................ $15,691 $9,077
License fees and royalties... 2,069 625
----------- -----------
Total revenues............ 17,760 9,702
Cost of product sales..... 6,364 3,876
----------- -----------
Gross profit.............. 11,396 5,826
----------- -----------
Operating expenses:
Research and development..... 1,757 1,024
Sales and marketing.......... 4,896 3,336
General and administrative... 1,239 1,349
----------- -----------
Total operating expenses.. 7,892 5,709
----------- -----------
Income from operations.. 3,504 117
Interest and other income, net.. 1,071 134
----------- -----------
Income before taxes............. 4,575 251
Income tax provision............ 229 11
----------- -----------
Net income ..................... $4,346 $240
=========== ===========
Basic net income per
share....................... $0.40 $0.03
=========== ===========
Diluted net income per
share....................... $0.36 $0.03
=========== ===========
Shares used in computing basic
net income per share........... 10,918 8,973
=========== ===========
Shares used in computing
diluted net income per share... 11,944 9,505
=========== ===========
The accompanying notes are an integral part of these condensed consolidated financial statements
ARTHROCARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(unaudited)
Three Months Ended
--------------------------
April 1, April 3,
2000 1999
------------ ------------
Cash flows from operating activities:
Net income ....................................... $4,346 $240
Adjustments to reconcile net income
to net cash provided by operating activities:
Depreciation and amortization................ 851 470
Amortization of deferred stock
compensation and stock compensation expense 364 40
Provision for doubtful accounts receivable
and product returns........................ (93) 93
Provision for excess and obsolete inventory.. (636) 525
Deferred rent................................ (4) (2)
Changes in operating assets and liabilities:
Accounts receivable (3,120) (552)
Inventory.................................. (1,162) (666)
Prepaid expenses and other current assets.. 42 636
Accounts payable........................... 203 (566)
Accrued liabilities........................ 741 (167)
Deferred revenue........................... -- 605
Other assets............................... -- 59
------------ ------------
Net cash provided by operating activities 1,532 715
------------ ------------
Cash flows from investing activities:
Purchases of property and equipment............... (1,460) (1,130)
Purchases of available-for-sale securities........ (22,851) (347)
Sale or maturities of available-for-sale
securities...................................... 20,624 1,001
------------ ------------
Net cash used in investing
activities...................................... (3,687) (476)
------------ ------------
Cash flows from financing activities:
Issuance of notes receivable to related
parties......................................... -- (11)
Repayment of capital leases....................... (20) (19)
Repayment of notes receivable from related
parties......................................... 273 148
Proceeds from exercise of options
to purchase common stock........................ 2,296 406
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Net cash provided by financing
activities............................ 2,549 524
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Effect of exchange rate on changes in cash (18) (36)
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Net increase in cash and cash equivalents............ 376 727
Cash and cash equivalents, beginning of period....... 47,875 2,826
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Cash and cash equivalents, end of period............. $48,251 $3,553
============ ============
The accompanying notes are an integral part of these condensed consolidated financial statements
ARTHROCARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Basis of Presentation:
In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (all of which are normal and recurring in nature) necessary to present fairly the financial position, results of operations and cash flows of ArthroCare Corporation and its subsidiaries ("ArthroCare," "we," "us" or "our") for the periods indicated. Interim results of operations are not necessarily indicative of the results to be expected for the full year or any other interim periods. The notes to the financial statements contained in our Form 10-K for the year ended January 1, 2000 should be read in conjunction with these condensed consolidated financial statements. The balance sheet at January 1, 2000 was derived from audited financial statements; however, the financial statements in this report do not include all disclosures required by generally accepted accounting principles.
2. Computation of Net Income Per Share:
Basic net income per share is computed using the weighted average number of shares of common stock outstanding during the period. Diluted net income per share is computed using the weighted average number of shares of common stock outstanding and common equivalent shares outstanding during the period. Common equivalent shares consist of stock options and are excluded from the computation if their effect is anti-dilutive.
The following is a reconciliation of the computation for basic and diluted net income per share (in thousands, except per share data):
Three Months Ended
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April 1, April 3,
2000 1999
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Net income ..................... $4,346 $240
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Shares calculation:
Weighted average basic
shares outstanding.......... 10,918 8,973
Options...................... 1,026 532
----------- -----------
Total shares used to
compute diluted net
income per share.......... 11,944 9,505
=========== ===========
Net income per share:
Basic........................ $0.40 $0.03
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Diluted...................... $0.36 $0.03
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Options to purchase 316,481 shares of common stock at prices ranging from $17.25-$24.25 per share were outstanding during the three month period ended April 3, 1999, but were not included in the computation of diluted earnings per share because the option's exercise price was greater than the average market price of the common stock during the period.
3. Comprehensive Income:
Comprehensive income is comprised of net income and other comprehensive income such as foreign currency translation gain/loss and unrealized gains or losses on available-for-sale marketable securities. Our total comprehensive income was as follows (in thousands):
Three Months Ended
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April 1, April 3,
2000 1999
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Net income ..................... $4,346 $240
Other comprehensive income:
Change in unrealized gain and
losses in available for sale
marketable securities........ (85) --
Foreign translation
adjustment................... (18) (36)
----------- -----------
Comprehensive net income........ $4,243 $204
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4. Balance Sheet Detail (in thousands):
April 1, January 1,
2000 2000
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(unaudited)
Inventory:
Raw materials......................... $3,478 $2,870
Work-in-process....................... 1,967 1,280
Finished goods........................ 3,313 2,810
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Total.................................... $8,758 $6,960
============ ============
Other accrued liabilities:
Accrued professional fees............. $30 $30
Accrued warranty...................... 248 174
Other................................. 1,520 1,052
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Total.................................... $1,798 $1,256
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5. Line of Credit:
In June 1999, we entered into a $7.0 million revolving line of credit that expires in June 2000. Available borrowings under this line of credit are contingent upon and collateralized by our assets and are subject to covenants related to financial ratios and profits. Borrowings under the line of credit bear interest at the bank's prime rate plus one-quarter of one percentage point. At April 1, 2000, we were in compliance with these covenants and no borrowings were outstanding.
6. Litigation:
We are currently involved in ongoing litigation. In June 1998, we announced that we had entered into an exclusive worldwide marketing and distribution agreement with Xomed Surgical Products for our products in the ENT surgery market. On February 4, 1999, Xomed Surgical Products of Jacksonville, Florida filed a complaint against us in the Fourth Judicial Circuit, Duval County Florida, alleging breach of contract by us. In the complaint, Xomed has demanded a full refund of the amounts paid for certain products bought by Xomed from us, and for a portion of an exclusive license fee paid by Xomed pursuant to an exclusive license and distribution agreement between Xomed and ArthroCare. This license and distribution agreement was terminated by us on February 5, 1999. We believe that the suit is without merit, and filed a Motion to Dismiss on February 24, 1999.
7. Recent Accounting Pronouncements:
In December 1999, the SEC issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). SAB 101 requires that license and other upfront fees from research collaborators be recognized over the term of the agreement unless the fee is in exchange for products delivered or services performed that represent the culmination of a separate earnings process. On March 24, 2000, the SEC issued Staff Accounting Bulletin No. 101A "Amendment: Revenue Recognition Financial Statements". SAB 101A allows companies to defer the reporting of a change in accounting principle, as required by SAB101, until the second quarter of the current year. Accordingly, we will report a change in accounting principle for the fiscal quarter ending July 1, 2000. We are still evaluating the application of SAB101 and believe that certain revenue previously recognized may be deferred to future periods. The cumulative effect of this change in accounting principle, which we anticipate adopting in the second quarter of 2000, may result in an increase of our accumulated deficit.
8. Segment Information:
We are organized into five business units based on product markets: arthroscopy, spinal and neurosurgery, ear nose and throat surgery, cosmetic surgery and cardiology. Our reportable segments are arthroscopy, and cosmetic surgery and other which includes spinal and neurosurgery, ear nose and throat surgery and cardiology. Total revenues for the three month period ended April 1, 2000 for the arthroscopy, cosmetic surgery and other business segments were $12.9 million ,4.6 million, and .03 million, respectively. Total revenues for the three month period ended April 3, 1999 for the arthroscopy cosmetic surgery and other business segments were $8.0 million, $1.5 million and $0.2 million respectively. Income (loss) from operations for the three month period ended April 1, 2000 for the arthroscopy, cosmetic surgery and other business segments was $3.8 million, $3.1 million and ($1.1) million, respectively. Income (loss) from operations for the three month period ended April 3, 1999, for the arthroscopy, cosmetic surgery and other business segments were $1.0 million, $0.8 million and ($2.0) million respectively. Our reportable segments do not include interest and other income and certain corporate expenses which amounted to $1.1 million and $2.3 million, respectively, for the three month periods ended April 1, 2000 and $0.1 million and $1.5 million, respectively, for the three month period ended April 3, 1999.
9. Stock Split:
On March 24, 2000 the Board of Directors approved a two-for-one stock split of our common stock, which is subject to shareholder approval. The following table sets out proforma basic and diluted net income per share as if the stock split had been effective from the begining of the periods indicated:
Three Months Ended
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April 1, April 3,
2000 1999
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Basic net income per share:
As reported.................... $0.40 $0.03
Proforma....................... $0.20 $0.01
Diluted net income per share:
As reported.................... $0.36 $0.03
Proforma....................... $0.18 $0.01
PART I. FINANCIAL INFORMATION
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
Statements in this Management's Discussion and Analysis of Financial Condition and Results of Operations which express that ArthroCare Corporation ("ArthroCare" "we," "us," or "our") "believes", "anticipates", "expects" or "plans to", as well as other statements which are not historical fact, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual events or results may differ materially as a result of the risks and uncertainties described herein and elsewhere including, in particular, those factors described under "Business" set forth in Part I of our Annual Report on Form 10-K for the year ended January 1, 2000 and "ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS" set forth below.
We are a medical device company that develops, manufactures and markets products based on our patented CoblationÒ technology. Our products allow surgeons to operate with increased precision and accuracy, limiting damage to surrounding tissue thereby potentially reducing pain and speeding recovery for the patient. Our products operate at lower temperatures than traditional electrosurgical or laser surgery tools and enable surgeons to ablate, sculpt, aspirate or shrink soft tissue and to seal bleeding vessels. Our soft-tissue surgery systems consist of a controller unit and an assortment of disposable devices that are specialized for specific types of surgery. We believe our Coblation technology can replace the multiple surgical tools traditionally used in soft-tissue surgery procedures with one multi-purpose surgical system.
Coblation technology is applicable across many soft-tissue surgical markets. Our systems are used to perform many types of arthroscopic surgery. Our strategy includes applying our patented Coblation technology to a broad range of other soft-tissue markets, including spinal surgery, neurosurgery, cosmetic surgery, ear nose and throat ("ENT") surgery, and various cardiology applications.
In April 1998, we announced that we had entered the cosmetic surgery market to commercialize Coblation technology in this field. In early 1999, we entered into a license and distribution agreement with Collagen Aesthetics, Inc., who has been purchased by Inamed Corporation. Under this agreement, Inamed Corporation acquired exclusive, worldwide, marketing rights for our cosmetic surgery line of products for the dermatology and cosmetic surgery markets.
In May 1998, we announced that we had entered the ear, nose and throat market and had formed a business unit called ENTec® to commercialize Coblation technology in this field. In June 1998, we entered into a license agreement with Xomed Surgical Products, Inc. to market Coblation products in the ear, nose and throat market. In February 1999, Xomed filed a suit against us alleging breach of contract and seeking monetary damages. We then terminated this agreement and have been marketing and selling the ENT surgery product line through a network of distributors supported by regional sales managers.
In early 1998, we formed a business unit, AngioCare™, for the purpose of further developing and for commercializing our technology in specific applications in the field of cardiology. As part of those efforts, in February 1998, we entered into a license agreement under which Boston Scientific Corporation will help develop, obtain regulatory approval for and market products based on Coblation technology for myocardial revascularization procedures.
In September 1999, we announced that we had entered the spinal surgery market. We are marketing and selling the spinal surgery products through a network of independent distributors supported by regional managers worldwide.
We have received 510(k) clearance to market our Arthroscopic System for use in arthroscopic surgery of the knee, shoulder, ankle, elbow, wrist and hip, and our Arthroscopic System is CE marked for use in arthroscopic surgery. Our Cosmetic Surgery System is CE marked for general dermatology, skin resurfacing for the purpose of wrinkle reduction procedures and we have received 510(k) clearance for use of our Cosmetic Surgery System in general dermatology procedures and for skin resurfacing for the purpose of wrinkle reduction in the United States. Our ENT Surgery System is CE marked, and we have received 510(k) clearances for use of our ENT Surgery System in general head, neck, oral and sinus, including snoring and tonsillectomy surgery procedures in the United States. Our Spinal Surgery System is CE marked and we have received 510(k) clearance in the United States to market this system for spinal surgery. Our neurosurgery products are CE marked. We have received 510(k) clearance to market Coblation technology for general surgery.
In December 1995, we introduced our Arthroscopic System commercially in the United States and have derived a significant portion of our sales from this system. Our strategy includes placing controller units, at substantial discounts, to generate future disposable revenue. Our strategy also includes applying our patented Coblation technology to a range of other soft-tissue surgical markets including the products we have introduced in the fields of spinal surgery, neurosurgery in Europe, cosmetic surgery and ear, nose and throat surgery. We have received 510(k) clearance for use of our technology in several fields. We cannot be sure that any of our clinical studies in other fields will lead to 510(k) applications or that the applications will be cleared by the FDA on a timely basis, if at all. In addition, we cannot be sure that the products, if cleared for marketing, will ever achieve commercial acceptance.
Results of Operations
Revenues:
Product sales for the three months ended April 1, 2000 were $15.7 million, an increase of $6.6 million or 73% from $9.1 million from the prior year period. The increase in product sales resulted primarily from an increase in the number of unit sales of both controllers and disposable devices. The higher unit volume of sales resulted primarily from increased activity for newly introduced models of disposable devices for arthroscopy, sales of disposable devices for new product lines, sales of controllers and disposable devices for our cosmetic surgery product line and increasing international sales. We attribute increasing disposable device sales both domestically and internationally to our strategic plan to build market share through continued promotional programs of controller placements.
International product sales for the three months ended April 1, 2000 increased to 10% of total product sales compared to 5% of product sales for the same period of the prior year. We believe that the increase in international sales is attributable to our increasing marketing presence overseas and the regulatory approval to market our arthroscopic products in Japan.
Based upon the estimated number of arthroscopic procedures performed each year, we believe that knee procedures represent the largest segment of the arthroscopic market, while shoulder procedures represent the fastest growing segment. To achieve increasing disposable device sales in arthroscopy over time, we believe we must continue to penetrate the market in knee procedures, expand physicians' education with respect to Coblation technology and continue to work on new product development efforts specifically for knee applications. We believe that, in our four years of product shipments, we have penetrated 30% to 35% of the hospitals that perform arthroscopic procedures in the United States. We believe that approximately 60% of our arthroscopy disposable device sales is being generated by the sale of disposables for use in knee procedures.
License fees and royalty income increased to $2.1 million for the three months ended April 1, 2000 from $0.6 million for the three months ended April 3, 1999. The increase in license fees and royalty revenue in the current three-month period is primarily due to the timing of licensing payments and milestones received from our business partners. In January 1999, we entered into a license and distribution agreement with Inamed Corporation, which was expanded in February 1999, whereby Inamed Corporation acquired exclusive, worldwide, marketing rights for our patented Coblation technology in the cosmetic surgery market. Under the terms of the agreement, Inamed Corporation pays us license fees based upon the achievement of certain milestones and royalties on sales of product to end-users. During the three months ended April 1, 2000, and April 3, 1999 the vast majority of license fees and royalties we recognized were in conjunction with this agreement.
We cannot assure you that we will be able to continue to be able to recognize future license fees, or that products will be developed, cleared for marketing and achieve sufficient commercial acceptance, so that we may continue to receive licensing and royalty revenues from our business partners.
Cost of Product Sales
Cost of product sales for the three months ended April 1, 2000 was $6.4 million or 41% of product sales, as compared with $3.9 million or 43% of product sales for the three months ended April 3, 1999. The increase in cost of product sales for the three-month periods ended April 1, 2000, compared to the same period of the prior year, is attributable to increasing unit sales of both controllers and disposable devices. The decrease in cost as a percentage of product sales for the three month period ended April 1, 2000, as compared to the prior year period is attributable to increased manufacturing efficiency for established product lines and increased production volume.
We cannot be sure that gross margins will remain at current levels or show improvement in the future due to the distribution channels used, product mix, and fluctuation in manufacturing production levels as new products are introduced. We believe our gross margin will depend upon the mix of disposable device sales versus controller sales and/or placements and the various distribution channels utilized to sell our products in all commercialized fields. There can be no assurance that we will be successful in maintaining the mix of disposable devices to controllers or in increasing demand for our disposable devices. In addition, inefficiencies in manufacturing new products and the distribution channels utilized to sell those products may adversely impact gross margin.
Operating Expenses
Research and development expense was $1.8 million for the three months ended April 1, 2000 as compared to $1.0 million for the same period of the previous fiscal year. In general, overall spending in research and development increased as we continued to develop new products in our currently commercialized markets, continued our development efforts for potential additional products and continued to maintain our patent position. Salaries and related compensation expenses continued to increase during the current year period, including non-cash charges for stock options awarded to non- employees, as we continued to increase headcount in order to support our increasing research and development efforts. Increases in research and development expense have been partially offset by funding received from business partners for continued product development and by a decrease in the expenditures associated with clinical trials. We believe continued investment in Coblation technology is essential for us to maintain our competitive position. We expect to increase the dollar amount of research and development spending through continued expenditures on new product development, regulatory affairs, clinical studies and patents, as well as increased non-cash charges for stock options granted to non- employees, but anticipate expenses to continue to decrease as a percentage of product sales.
Sales and marketing expense increased to $4.9 million or 31% of product sales during the three months ended April 1, 2000, as compared to $3.3 million or 37% of product sales during the same period of the previous fiscal year. The increase in spending in absolute dollars for the three-month periods was primarily due to higher dealer commissions resulting from increased sales, increased staffing and related expenditures as well as increased trade-show related activities including marketing studies.
We anticipate that sales and marketing spending will continue to increase in absolute dollars due to the expansion of our distribution capabilities to address the spinal surgery market, higher dealer commissions from increased sales, the additional cost of penetrating international markets, higher promotional, demonstration and sample expenses, additional investments in the sales, marketing and support staff necessary to market our current products and commercialize future products.
General and administrative expenses were $1.2 million or 8% of product sales during the three months ended April 1, 2000, as compared to $1.3 million or 15% of product sales during the same period of the previous fiscal year. The decrease in spending for the three months ended April 1, 2000 as compared to the three months ended April 3, 1999, is attributable to a reduction in legal fees offset by an increase in spending during the current year associated with international consulting and staffing and related expenditures. We expect that general and administrative expenses as a percentage of product sales will continue to decrease when compared to prior year periods as a result of the settlement of patent litigation, offset partially by an increase in additional business development activities.
Interest and Other Income, net
Interest and other income, net increased to $1.1 million during the three months ended April 1, 2000 from $0.1 million for the three months ended April 3, 1999. The $1.0 million increase during the current year period was attributable to the increase in our cash and investment balances as a result of our secondary offering and cash flow. We anticipate that interest and other income, net, will continue to increase due to our increased cash balances.
Income Tax Provision
The provision for income taxes was $229,000 and $11,000 for the three-month periods ended April 1, 2000 and April 3, 1999, respectively. Because we use net operating loss carryforwards generated in prior years, our tax rate is below the statutory rate. We have federal net operating loss carryforwards which expire in the years 2001 through 2018, and state net operating loss carryforwards which expire in the years 2001 through 2003. We are subject to certain alternative minimum tax requirements in the current year for which an estimate is made based on the anticipated effective tax rate at the end of the fiscal year.
Net Income
Net income was $4.3 million for the three months ended April 1, 2000 compared to $0.2 million for the period ended April 3, 1999. Net income for the current period reflects an increase in product sales, license fees and gross margin, partially offset by increased spending in operating expenses. Although we have experienced substantial revenue growth since inception and have been profitable on a quarterly basis since the quarter ended April 3, 1999, due to our short operating history and numerous other factors, we cannot be sure that we can sustain revenue growth or profitability.
Liquidity and Capital Resources
On April 1, 2000, we had $79.7 million in working capital. The principal sources of liquidity consisted of $61.0 million in cash, cash equivalents and available-for-sale securities. The cash and cash equivalents are highly liquid with original maturities of ninety days or less. In addition, we had $21.1 million in long-term investments respresenting cash investments with original maturity dates of greater than one year. We also had $7.0 million available under a line of credit. Available borrowings under this line of credit are contingent upon and collateralized by some of our asset balances and are subject to covenants related to financial ratios and profits. Borrowings under the line of credit bear interest at the bank's prime rate plus one-quarter of one percentage point. At April 1, 2000 we were in compliance with these covenants and had no borrowings outstanding.
Net cash provided by operating activities for the three months ended April 1, 2000 was $1.2 million as compared to $0.7 million for the three-month period ended April 3, 1999. The increase in cash provided by operating activities year-over-year was primarily due to the net income of $4.3 million for the 2000 period compared to $0.2 million in the prior year, partially offset by increases in accounts receivable and inventory.
Net accounts receivable increased to $17.2 million as of April 1, 2000 from $13.9 million as of January 1, 2000. The increase in accounts receivable is mainly attributable to the corresponding increase in product sales along with the timing of sales during the quarter.
Inventories increased to $8.8 million as of April 1, 2000 from $7.0 million at January 1, 2000, due to the need to support higher anticipated product sales activity. We expect future inventory levels to grow to support sales volume increases, as a result of our expansion into the markets of spinal surgery, ear, nose and throat surgery and cosmetic surgery.
Net property and equipment increased to $8.0 million as April 1, 2000 from $7.4 million at January 1, 2000. The increase is primarily attributable to the capitalization of controllers placed under various promotional programs along with an increase of computer software and equipment.
We believe that our current cash balances, cash equivalents, short and long term investments and cash generated from our operations will be sufficient to meet our operating and capital requirements at least through the end of 2001. As of April 1, 2000, we had committed to capital expenditures of approximately $0.4 million. Our future liquidity and capital requirements will depend on numerous factors, including our success in commercializing our products, development and commercialization of products in fields other than arthroscopy, the ability of our suppliers to continue to meet our demands at current prices, obtaining and enforcing patents important to our business, the status of regulatory approvals and competition.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard 133, (SFAS No. 133), "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments, embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. We must adopt this standard no later than fiscal year 2001. To date, we do not engage in hedging activities.
In December 1999, the SEC issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements ("SAB101")." SAB 101 requires that license and other upfront fees from research collaborators be recognized over the term of the agreement unless the fee is in exchange for products delivered or services performed that represent the culmination of a separate earnings process. On March 24, 2000, the SEC issued Staff Accounting Bulletin No. 101A "Amendment: Revenue Recognition Financial Statements". SAB 101A allows companies to defer the reporting of a change in accounting principle, as required by SAB101 until the second quarter of the current fiscal year. Accordingly, we may report a change in accounting principle for the fiscal quarter ending July 1, 2000. We are still evaluating the application of SAB101 and believe that certain revenue previously recognized may be deferred to future periods. The cumulative effect of this change in accounting principle, which we anticipate adopting in the second quarter of 2000, may result in an increase of our accumulated deficit.
ADDITIONAL FACTORS THAT MIGHT AFFECT FUTURE RESULTS
We became a public company in February 1996. Included here are risk factors as updated from our Annual Report on Form 10-K, filed March 31, 2000 for the year ended January 1, 2000. The following factors represent current challenges to us that create risk and uncertainty. Failure to adequately overcome any of the following challenges, either singularly or in combination, could have a material adverse effect on our results of operations, business, or financial position.
We are Dependent Upon Our Arthroscopic System.
We commercially introduced our Arthroscopic System in December 1995. Since our Arthroscopic System accounts for the majority of our product sales, we are highly dependent on its sales. Our spinal surgery, cosmetic surgery, and ENT surgery products have only recently become available, and to date, we have sold only a small number of units. We cannot assure you that we will be able to continue to manufacture arthroscopy products in commercial quantities at acceptable costs, or that we will be able to continue to market such products successfully.
To achieve increasing disposable device sales over time, we believe we must continue to penetrate the market in knee procedures, expand physicians' education with respect to Coblation technology and continue working on new product development efforts specifically for knee applications. Furthermore, in order to maintain and increase current market penetration we must be aggressive in increasing our installed base of controllers to generate increased disposable device revenue. To date, we have placed our arthroscopic controllers at substantial discounts in order to stimulate demand for our disposable devices.
We believe that surgeons will not use our products unless they determine, based on experience, clinical data and other factors, that these systems are an attractive alternative to conventional means of tissue ablation. There are only a few independently published clinical reports and limited long-term clinical follow-up to support the marketing efforts for our Arthroscopic System. We believe that continued recommendations and endorsements by influential arthroscopic surgeons are essential for market acceptance of our Arthroscopic System. If our Coblation technology does not continue to receive endorsement by influential surgeons or our long-term data does not support our current claims of efficacy, our business, financial condition, results of operations and future growth prospects could be materially adversely affected.
Commercial Success of Our Non-Arthroscopic Products Is Uncertain
We have developed several new applications for our Coblation technology in spinal and neurosurgery, cosmetic surgery and ENT surgery. Additionally we have established a program to explore the application of our Coblation technology in various areas within cardiology. Our products for these non-arthroscopic indications are in various stages of commercialization and development, and we may be required to undertake time-consuming and costly commercialization, development and additional regulatory approval activities. We are awaiting 510(k) clearance in the United States to market our Spinal Surgery System specifically for use in neurosurgery. If we do not receive this or future clearances we will be unable to market this and future products for specific indications and our business, financial condition, results of operations and future growth prospects could be materially adversely affected. We cannot assure you that product development will ever be successfully completed, that regulatory clearances or approvals, if applied for, will be granted by the FDA or foreign regulatory authorities on a timely basis, if at all, or that the products will ever achieve commercial acceptance.
We may have to make a significant investment in additional preclinical and clinical testing, regulatory, physician training and sales and marketing activities to further develop and commercialize the spinal surgery, neurosurgery, cosmetic surgery, ENT surgery and cardiology product lines. Although we believe that these products offer certain advantages, we cannot assure you that these advantages will be realized, or if realized, that these products will result in any meaningful benefits to physicians or patients.
Development and commercialization of our current and future non-arthroscopic products are subject to the risks of failure inherent in the development of new medical devices. These risks include the following: that such products will not be easy to use, will require extensive training or will not be cost-effective; that we will experience delays in testing or marketing; that such testing or marketing will result in unplanned expenditures or in expenditures above those anticipated by us; that our products will not be proven safe or effective; that third parties will develop and market superior or equivalent products; that such products will fail to receive necessary regulatory clearances or approvals; that such products will be difficult or uneconomical to manufacture on commercial scale; and that proprietary rights of third parties will preclude us and our collaborative partners from marketing such products.
In addition, the success of our non-arthroscopic products will depend on their adoption as alternatives to conventional means of tissue ablation. Clinical experience and follow-up data for our non- arthroscopic indications are limited, and we have sold only a small number of units to date. We believe that recommendations and endorsement of influential physicians are essential for market acceptance of our products.
We Have Limited Marketing and Sales Experience
We currently have limited experience in marketing and selling our products. To the extent that we have established or will enter into distribution arrangements for the sale of our products, we are and will be dependent upon the efforts of third parties. We are marketing and selling our arthroscopic surgery, spinal surgery and ENT surgery product lines in the United States through a network of independent distributors supported by regional sales managers and a small direct sales force. These distributors sell arthroscopy, spinal surgery and ENT surgery devices for a number of other manufacturers. In addition, we are marketing and selling our neurosurgery products internationally and will market in the United States after the receipt of 510(k) clearance. We plan to utilize existing spinal surgery distributors, for the commercialization of these products both domestically and internationally. We cannot assure you that these distributors will commit the necessary resources to effectively market and sell our arthroscopic surgery, spinal surgery, neuro- surgery or ENT surgery product lines, or that they will be successful in selling our products.
We have recently established a marketing presence in various countries and we cannot assure you that these newly established operations will be successful. In order to successfully market our products internationally, we will need to address many issues with which we have little or no experience, including the securing of necessary regulatory approvals in international markets and the potential reuse of our disposable devices by our customers. Even if we are able to successfully deal with these issues, we cannot assure you that we will be able to establish successful distribution capabilities internationally or receive favorable pricing for our products. In addition, we may face currency exchange risks as part of our international expansion. To the extent our marketing and sales efforts are unsuccessful, our business, financial condition, results of operations and future growth prospects may be materially adversely affected.
We Have Limited Manufacturing Experience
To be successful, we must manufacture our products in commercial quantities in compliance with regulatory requirements at acceptable costs. At the present time, we have limited manufacturing experience. Our manufacturing operations consist of an in-house assembly operation for the manufacture of disposable devices and controllers. We currently produce 44 models of disposable devices utilizing different functionalities, including suction and fluid management. As we increase the number of product designs for our disposable devices, the complexity of our manufacturing processes will increase. We manufacture three different controller models. Although the manufacturing processes for the controllers designed to date are substantially the same, we cannot be certain that we will be able to continue to manufacture these controllers without additional expense and capabilities. We could also encounter difficulties in manufacturing our current or future products which could reduce yields, result in supply disruptions and adversely affect our gross margins. If we have delays in manufacturing, we will not have adequate finished inventory to meet our needs. If our quality assurance programs do not continue to meet the demands of the complexity and capacity of the products we manufacture, we may experience product returns.
We Are Dependent on Key Suppliers
We depend on several sole source suppliers for some of our product components, including one component that we include in substantially all of our disposable devices. If the supply of materials from a sole source supplier were interrupted, replacement or alternative sources might not be readily obtainable due to the regulatory requirements applicable to our manufacturing operations. In addition, a new or supplemental filing with applicable regulatory authorities may require clearance prior to our marketing a product containing new material. This clearance process may take a substantial period of time and we cannot assure you that we would be able to obtain the necessary regulatory approval for the new material to be used in our products on a timely basis, if at all. This could create supply disruptions that would materially adversely affect our business, financial condition, results of operations and future growth prospects.
In addition, we use a single subcontractor to sterilize the disposable devices. Although this subcontractor has sterilzation facilities in several locations, we cannot assure you that we would be able identify and qualify an alternate sterilizer. Our inability to secure an alternative sterilizer, if required, would limit our ability to manufacture disposable devices and could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.
Our Operating Results Will Fluctuate
We only achieved profitability in the period ended April 3, 1999 and, as of April 1, 2000 had an accumulated deficit of $17.6 million. Results of operations may fluctuate significantly from quarter to quarter due to many factors, including the following: the introduction of new product lines; increased penetration in existing applications; product returns; achievement of research and development milestones; the amount and timing of receipt and recognition of license fees; manufacturing or supply disruptions; timing of expenditures; absence of a backlog of orders; receipt of necessary regulatory approvals; the level of market acceptance for our products; timing of the receipt of orders and product shipments; and promotional programs for our products.
We cannot assure you that future quarterly fluctuations will not adversely affect our business, financial condition, results of operations or future growth prospects. Revenues and profitability will be critically dependent on whether or not we can successfully continue to market our Coblation-based technology product lines. We cannot assure you that we will maintain or increase revenues or the level of profitability.
We Face Intense Competition
The markets for our current and potential products are intensely competitive. These markets include arthroscopy, spinal surgery, neurosurgery, ENT surgery, cosmetic surgery, and certain applications in the cardiology market. We cannot assure you that other companies will not succeed in developing technologies and products that are more effective than ours or that would render our technology or products obsolete or uncompetitive in these markets.
In arthroscopy, we compete against companies such as Johnson & Johnson, Smith & Nephew, Inc., Conmed Corporation, Stryker Corp. and Oratec Interventions, Inc. which market products to remove or shrink tissue. Specifically, Johnson & Johnson is currently marketing worldwide a bipolar electrosurgical system for tissue ablation. We are also aware of additional competitors that may commercialize products using technology similar to ours. In spinal surgery, we compete against companies which market products to remove tissue and treat spinal disorders. In ENT surgery, we compete against companies that offer manual instruments, such as Smith & Nephew, Inc., Stryker Corp., Conmed Corporation, and Xomed Surgical Products, Inc., which was recently acquired by Medtronic, Inc. In addition, we compete with companies that develop and market lasers for various ENT surgery applications, including ESC Medical Systems Ltd. Smaller companies, including Somnus Medical Technologies Inc., Elmed Inc. and Ellman International, Inc. also sell medical devices for the treatment of various ENT disorders including snoring and obstructive sleep apnea. In cosmetic surgery, we compete against companies such as Coherent Medical Group, and ESC Medical Systems Ltd. which market lasers for use in this field. In addition, other large companies manufacture and sell medical devices that use radio frequency energy for certain applications in dermatology and cosmetic surgery. In cardiology, we may compete with companies which use lasers to treat cardiovascular disease. Other approaches to alleviating cardiovascular disease, including drugs or other surgical approaches, may also be competitive.
Many of our competitors have significantly greater financial, manufacturing, marketing, distribution and technical resources than we do. Some of these companies offer broad product lines that they may offer as a single package and frequently offer significant discounts as a competitive tactic. For example, in order to compete successfully, we anticipate that we may have to continue to offer substantial discounts on our controllers in order to increase demand for our disposable devices, and that this competition could have a material adverse effect on our business, financial condition, results of operations and future growth prospects. Furthermore, some of our competitors utilize purchasing contracts that link discounts on the purchase of one product to purchases of other products in their broad product lines. Many of the hospitals in the United States have purchasing contracts with our competitors. Accordingly, customers may be dissuaded from purchasing our products rather than the products of these competitors to the extent the purchase would cause them to lose discounts on products.
We Face Uncertainty Over Reimbursement
Failure by physicians, hospitals and other users of our products to obtain sufficient reimbursement from health care payors for procedures in which our products are used or adverse changes in governmental and private third-party payors' policies toward reimbursement for such procedures would have a material adverse effect on our business, financial condition, results of operations and future growth prospects. Reimbursement for arthroscopic, spinal surgery and ENT surgery procedures performed using devices that have received FDA approval has generally been available in the United States. Typically, cosmetic surgery procedures are not reimbursed.
We are unable to predict what changes will be made in the reimbursement methods used by third-party health care payors. In addition, some health care providers are moving toward a managed care system in which providers contract to provide comprehensive health care for a fixed cost per person. Managed care providers are attempting to control the cost of health care by authorizing fewer elective surgical procedures. We anticipate that in a prospective payment system, such as the diagnosis related group system utilized by Medicare, and in many managed care systems used by private health care payors, the cost of our products will be incorporated into the overall cost of the procedure and that there will be no separate, additional reimbursement for our products. We anticipate that hospital administrators and physicians will justify the use of our products by the apparent cost savings and clinical benefits that we believe will be derived from the use of our products. However, we cannot assure you that this will be the case.
If we obtain the necessary international regulatory approvals, market acceptance of our products in international markets would be dependent, in part, upon the availability of reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country and include both government-sponsored health care and private insurance. We intend to seek international reimbursement approvals, although we cannot assure you that any such approvals will be obtained in a timely manner, if at all.
Our Business Depends on Attracting and Retaining Collaborators and Licensors
In order to successfully develop and commercialize certain products, we may enter into collaborative or licensing arrangements with medical device companies and other entities to fund and complete our research and development activities, pre-clinical and clinical testing, manufacturing, regulatory approval activities and to achieve successful commercialization of future products. We have signed an exclusive, worldwide distribution agreement with Inamed Corporation for our cosmetic surgery products. We have also entered into a license agreement under which Boston Scientific Corporation will help develop, obtain regulatory approval for and market products based on our Coblation technology for myocardial revascularization procedures.
Our participation in collaborative and licensing arrangements with third parties subjects us to a number of risks. Collaborative partners typically have significant discretion in electing whether to pursue any of the planned activities. We cannot control the amount and timing of resources our collaborative partners may devote to our products, and we cannot assure you that our partners will perform their obligations as expected. Business combinations or significant changes in a corporate partner's business strategy may adversely affect that partner's ability to meet its obligations under the arrangements. If a collaborative partner were to terminate or breach its agreement with us, or otherwise fail to complete its obligations in a timely manner, our business, financial condition, results of operations and future growth prospects would be materially adversely affected. To the extent that we are not able to establish further collaborative arrangements or that any or all of our existing collaborative arrangements are terminated, we would be required to seek new collaborative arrangements or to undertake commercialization at our own expense, which could significantly increase our capital requirements, place additional strain on our human resource requirements and limit the number of products which we would be able to develop and commercialize. In addition, we cannot assure you that our existing and future collaborative partners will not pursue alternative technologies or develop alternative products either on their own or in collaboration with others, including our competitors.
We cannot assure you that disputes will not arise in the future with respect to the ownership of rights to any technology or products developed with any collaborative partner. Lengthy negotiations with potential new collaborative partners or disagreements between established collaborative partners and us could lead to delays in or termination of the research, development or commercialization of certain products or result in litigation or arbitration that would be time consuming and expensive. Failure by any collaborative partner to commercialize successfully any product to which it has obtained rights from us, or the decision by a collaborative partner to pursue alternative technologies or commercialize or develop alternative products, either on its own or in collaboration with others, could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.
We May Be Unable to Effectively Protect Our Intellectual Property
Our ability to compete effectively depends in part on developing and maintaining the proprietary aspects of our Coblation technology. We believe that our issued patents are directed at, among other things, the core technology used in our soft-tissue surgery systems, including both multi-electrode and single-electrode configurations of our disposable devices, as well as the use of Coblation technology in specific surgical procedures.
We cannot assure you that the patents we have obtained, or any patents we may obtain as a result of our pending U.S. or international patent applications, will provide any competitive advantages for our products. We also cannot assure you that those patents will not be successfully challenged, invalidated or circumvented in the future. In addition, we cannot assure you that competitors, many of which have substantial resources and have made substantial investments in competing technologies, have not already applied for or obtained, or will not seek to apply for and obtain, patents that will prevent, limit or interfere with our ability to make, use and sell our products either in the United States or in international markets. Patent applications are maintained in secrecy for a period after filing. We may not be aware of all of the patents and patent applications potentially adverse to our interests.
A number of medical device and other companies and universities and research institutions have filed patent applications or have issued patents relating to monopolar and/or bipolar electrosurgical methods and apparatus. We have received, and we may receive in the future, notifications of potential conflicts of existing patents, pending patent applications and challenges to the validity of existing patents. In addition, we have become aware of, and may become aware of in the future, patent applications and issued patents that relate to our products and/or the surgical applications and issued patents and, in some cases, have obtained internal and/or external opinions of counsel regarding the relevance of certain issued patents to our products. We do not believe that our products currently infringe any valid and enforceable claims of the issued patents that we have reviewed. However, if third-party patents or patent applications contain claims infringed by our technology and such claims are ultimately determined to be valid, we may not be able to obtain licenses to those patents at a reasonable cost, if at all, or be able to develop or obtain alternative technology. Our inability to do either would have a material adverse effect on our business, financial condition, results of operations and prospects. We cannot assure you that we will not have to defend ourselves in court against allegations of infringement of third-party patents, or that such defense would be successful.
In addition to patents, we rely on trade secrets and proprietary know-how which we seek to protect, in part, through confidentiality and proprietary information agreements. We require our key employees and consultants to execute confidentiality agreements upon the commencement of an employment or consulting relationship with us. These agreements generally provide that all confidential information, developed or made known to the individual during the course of the individual's relationship with us, is to be kept confidential and not disclosed to third parties. These agreements also generally provide that inventions conceived by the individual in the course of rendering services to us shall be our exclusive property. We cannot assure you that employees will not breach such agreements, that we would have adequate remedies for any breach or that our trade secrets will not otherwise become known to or be independently developed by competitors.
We May Become Subject to Patent Litigation
The medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights, and companies in the medical device industry have employed intellectual property litigation to gain a competitive advantage. We cannot assure you that we will not become subject to patent infringement claims or litigation or interference proceedings declared by the United States Patent and Trademark Office, the USPTO, to determine the priority of inventions. On February 13, 1998, we filed a lawsuit against Ethicon, Inc., Mitek Surgical Products, a division of Ethicon, Inc., and GyneCare, Inc. alleging, among other things, infringement of several of our patents. The parties subsequently settled this lawsuit. Under the terms of the settlement, Ethicon, Inc. has licensed our U.S. patents for current products in the arthroscopy and gynecology markets. The settlement agreement also established a procedure for resolution of certain potential intellectual property disputes in these two markets without litigation. Under this procedure, the licenses granted in the Ethicon settlement have been extended to Australia and Canada in February 2000.
Defending and prosecuting intellectual property suits, USPTO interference proceedings and related legal and administrative proceedings are costly and time-consuming. Further litigation may be necessary to enforce our patents, to protect our trade secrets or know-how or to determine the enforceability, scope and validity of the proprietary rights of others. Any litigation or interference proceedings will be costly and will result in significant diversion of effort by technical and management personnel. An adverse determination in any of the litigation or interference proceedings to which we may become a party could subject us to significant liabilities to third parties, require us to license disputed rights from third parties or require us to cease using such technology, which would have a material adverse effect on our business, financial condition, results of operations and future growth prospects. Patent and intellectual property disputes in the medical device area have often been settled through licensing or similar arrangements, and could include ongoing royalties. We cannot assure you that we can obtain the necessary licenses on satisfactory terms, if at all.
The Market Price of Our Stock May Be Highly Volatile
Within the last 12 months, our common stock closing price has traded between a range of $14.94 and $123.50 per share. The market price of our common stock could continue to fluctuate substantially due to a variety of factors, including: quarterly fluctuations in results of our operations; our ability to successfully commercialize our products; announcements regarding results of regulatory approval filings, clinical studies or other testing, technological innovations or new commercial products by us or our competitors; developments concerning government regulations, proprietary rights or public concern as to the safety of technology; the execution of new collaborative agreements and material changes in our relationships with our business partners; market reaction to acquisitions and trends in sales, marketing, and research and development; changes in earnings estimates by analysts; sales of common stock by existing stockholders; and economic and political conditions.
The market price for our common stock may also be affected by our ability to meet analysts' expectations. Any failure to meet such expectations, even slightly, could have an adverse effect on the market price of our common stock. In addition, the stock market is subject to extreme price and volume fluctuations. This volatility has had a significant effect on the market prices of securities issued by many companies for reasons unrelated to the operating performance of these companies. In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been instituted against the company. If similar litigation were instituted against us, it could result in substantial costs and a diversion of our management's attention and resources, which could have an adverse effect on our business, results of operations and financial condition.
We Are Involved In Legal Proceedings
We are currently involved in ongoing litigation. In June 1998, we announced that we had entered into an exclusive worldwide marketing and distribution agreement with Xomed Surgical Products Inc. ("Xomed") for our products in the ENT surgery market. On February 4, 1999, Xomed filed a complaint against us alleging breach of contract. On February 5, 1999, we terminated this agreement. If legal proceedings are adversely adjudicated or settled, they could have an adverse effect on the financial condition, results of operations and future growth prospects. The defense of this type of action is expensive and may divert management's attention from the core business.
Delaware Law, Provisions in Our Charter and Our Stockholder Rights Plan Could Make the Acquisition of Our Company By Another Company More Difficult
Our stockholder rights plan and certain provisions of our certificate of incorporation and bylaws may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of our company. This could limit the price that certain investors might be willing to pay in the future for shares of our common stock. Some provisions of our certificate of incorporation and bylaws allow us to issue preferred stock without any vote or further action by the stockholders, to eliminate the right of stockholders to act by written consent without a meeting, to specify procedures for director nominations by stockholders and submission of other proposals for consideration at stockholder meetings, and to eliminate cumulative voting in the election of directors. Some provisions of Delaware law applicable to us could also delay or make more difficult a merger, tender offer or proxy contest involving us, including Section 203, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless certain conditions are met. Our stockholder rights plan, the possible issuance of preferred stock, the procedures required for director nominations and stockholder proposals and Delaware law could have the effect of delaying, deferring or preventing a change in control of ArthroCare, including without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of our common stock.
We Must Obtain Governmental Clearances Or Approvals Before We Can Sell Our Products; We Must Continue To Comply With Applicable Laws and Regulations.
United States
Our products are considered medical devices and are subject to extensive regulation in the United States. We must obtain premarket clearance or approval by the FDA for each of our products and indications before they can be commercialized. FDA regulations are wide ranging and govern, among other things: product design and development; product testing; product labeling; product storage; premarket clearance or approval; advertising and promotion; and product sales and distribution.
Noncompliance with applicable regulatory requirements can result in enforcement action, which may include: warning letters; fines, injunctions and civil penalties against us; recall or seizure of our products; operating restrictions, partial suspension or total shutdown of our production; refusing our requests for premarket clearance or approval of new products; withdrawing product approvals already granted; and criminal prosecution.
Unless an exemption applies, generally, before we can introduce a new medical device into the United States market, we must obtain FDA clearance of a 510(k) premarket notification or approval of a premarket approval application, or PMA application. If we can establish that our device is "substantially equivalent" to a "predicate device," i.e., a legally marketed Class I or Class II device or a preamendment Class III device (i.e., one that was in commercial distribution before May 28, 1976) for which the FDA has not called for PMAs, we may seek clearance from the FDA to market the device by submitting a 510(k) premarket notification. The 510(k) premarket notification will need to be supported by appropriate data, including, in some cases, clinical data, establishing the claim of substantial equivalence to the satisfaction of the FDA.
We have received 510(k) clearance to market our Arthroscopic System for surgery of the knee, shoulder, elbow, wrist, hip and ankle joints. We have received 510(k) clearance in the United States to market our Spinal Surgery System. In addition, we have received 510(k) clearance to market our Cosmetic Surgery System in general dermatology procedures and for skin resurfacing for the purpose of wrinkle reduction. We have received 510(k) clearance to market the ENT Surgery System in general head and neck surgical procedures as well as snoring, minimally-invasive sinus surgery and tonsill treatments. We cannot assure you that we will be able to obtain necessary clearances or approvals to market any other products, or existing products for new intended uses, on a timely basis, if at all. Delays in receipt or failure to receive clearances or approvals, the loss of previously received clearances or approvals, or failure to comply with existing or future regulatory requirements could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.
After a device receives 510(k) clearance, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in the intended use of the device, requires a new 510(k) clearance. The FDA requires each manufacturer to make this determination in the first instance, but the FDA can review any such decision. If the FDA disagrees with a manufacturer's decision not to seek a new 510(k) clearance, the agency may retroactively require the manufacturer to submit a premarket notification requesting 510(k) clearance. The FDA also can require the manufacturer to cease marketing and/or recall the modified device until 510(k) clearance is obtained. We have modified some of our marketed devices, but have determined that, in our view, new 510(k) clearances are not required. No assurance can be given that the FDA would agree with any of our decisions not to seek 510(k) clearance. If the FDA requires us to seek 510(k) clearance for any modification, the FDA also may require us to cease marketing and/or recall the modified device until we obtain a new 510(k) clearance.
If we cannot establish that a proposed device is substantially equivalent to a legally marketed device, we must seek premarket approval through submission of a PMA application. A PMA application must be supported by extensive data, including, in many instances, preclinical and clinical trial data, as well as extensive literature to prove the safety and effectiveness of the device. If necessary, we will file a PMA application for approval to sell our potential products. The PMA process can be expensive, uncertain and lengthy. We cannot assure you that we will be able to obtain PMA approvals on a timely basis, if at all, and delays in receipt or failure to receive approvals, could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.
We are also required to demonstrate and maintain compliance with the Quality System Regulation, or QSR. The QSR incorporates the requirements of Good Manufacturing Practice and relates to product design, testing, and manufacturing quality assurance, as well as the maintenance of records and documentation. The FDA enforces the QSR through inspections. We cannot assure you that we or our key component suppliers are or will continue to be in compliance, will not encounter any manufacturing difficulties, or that we or any of our subcontractors or key component suppliers will be able to maintain compliance with regulatory requirements. Failure to do so will have a material adverse effect on our business, financial condition, results of operations and future growth prospects.
We may not promote or advertise our products for uses not within the scope of our clearances or approvals or make unsupported safety and effectiveness claims. These determinations can be subjective. We cannot assure you that the FDA would agree that all of our promotional claims are permissible or that the FDA will not require us to revise our promotional claims or take enforcement action against us based upon our labeling and promotional materials.
International
International sales of our products are subject to strict regulatory requirements. The regulatory review process varies from country to country. We have obtained regulatory clearance to market the Arthroscopic System in Europe, Japan, Australia, Taiwan, Korea, Canada and Mexico, to market our cosmetic surgery products in Europe and Canada and to market our ENT surgery products and our spinal surgery and neurosurgery products in Europe, but we have not obtained any other international regulatory approvals in other international markets. We cannot assure you that we will obtain such clearances and approvals on a timely basis, or at all.
For European distribution, we have received ISO 9001/EN46001 certification and the EC Certificate pursuant to the European Union Medical Device Directive 93/42/EEC, allowing us to CE mark our products after assembling appropriate documentation. ISO 9001/EN46001 certification standards for quality operations have been developed to ensure that companies know the standards of quality on a worldwide basis. Failure to maintain the CE Mark will preclude us from selling our products in Europe. We cannot assure you that we will be successful in maintaining certification requirements.
We Face Product Liability Risks and May Not Be Able to Obtain Adequate Insurance
The development, manufacture and sale of medical products involves significant risk of product liability claims. Our current product liability insurance coverage limits are $10.0 million per occurrence and $10.0 million in the aggregate. We cannot assure you that such coverage limits are adequate to protect us from any liabilities we might incur in connection with the development, manufacture and sale of our products. In addition, we may be required to increase our product liability coverage as potential products are successfully commercialized. Product liability insurance is expensive and may not be available to us in the future on acceptable terms, if at all. We have not received any product liability claims to date. However, a successful product liability claim or series of claims brought against us in excess of our insurance coverage could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.
We May Be Unable to Attract and Retain Personnel
We are dependent upon a number of key management and technical personnel. The loss of the services of one or more key employees or consultants could have a material adverse effect on our business, financial condition, results of operations and future growth prospects. Our success will also depend on our ability to attract and retain additional highly qualified management and technical personnel. We face intense competition for qualified personnel, many of whom are often subject to competing employment offers, and we cannot assure you we will be able to attract and retain such personnel. Furthermore, our scientific advisory board members are all otherwise employed on a full-time basis. As a result, the scientific advisory board members are not available to devote their full time or attention to our business.
Future Sales By Current Stockholders Could Cause Our Common Stock Price to Decline
The market price of our common stock could decline as a result of sales of a large number of shares in the market after this offering or the perception that such sales could occur. These sales could also make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate to raise funds through future offerings of common stock.
Lack of Dividends
We have not paid any dividends and do not anticipate paying any dividends in the foreseeable future.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We have an investment portfolio of fixed income securities that are classified as "available-for-sale securities." These securities, like all fixed income instruments, are subject to interest rate risk and will fall in value if market interest rates increase. We attempt to limit this exposure by investing primarily in short-term securities.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
On February 4, 1999, Xomed Surgical Products, Inc. ("Xomed") of Jacksonville, Florida filed a complaint against us in the Fourth Judicial Circuit, Duval County, Florida, alleging breach of contract by us. In the complaint, Xomed has demanded a full refund of the amounts paid for certain products bought by Xomed from us, and for a portion of an exclusive license fee paid by Xomed pursuant to an exclusive license and distribution agreement between Xomed and us. We terminated this license and distribution agreement on February 5, 1999. We believe the suit is without merit, and filed a Motion to Dismiss and Answer to the Complaint on May 3, 1999. In addition, we filed two counterclaims against Xomed for damages caused by Xomed's failure to perform under the contract and for a certain milestone payment owed to us by Xomed.
Item 2. Changes in Securities and Use of Proceeds
None
Item 3. Defaults upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits.
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Number |
Desription |
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3.1 |
Restated Certificate of Incorporation of the Registrant. (Incorporated herein by reference to the same-numbered exhibit filed previously with the Registrant's Registration Statement on Form 8-A (Registration No. 000-27422)). |
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3.2 |
Amended and Restated Bylaws of the Registrant. (Incorporated herein by reference to the same-numbered exhibit filed previously with the Registrant's Quarterly Report on Form 10-Q for the period ended October 3, 1998). |
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4.1 |
Specimen Common Stock Certificate. (Incorporated herein by reference to the same-numbered exhibit filed previously with the Registrant's Registration Statement on Form 8-A (Registration No. 000-27422)). |
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10.1 |
Form of Indemnification Agreement between the Registrant and each of its directors and officers. (Incorporated herein by reference to the same-numbered exhibit filed previously with the Registrant's Registration Statement on Form S-1 (Registration No. 33.80453)). |
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10.2 |
Incentive Stock Plan and form of Stock Option Agreement thereunder. (Incorporated herein by reference to the same-numbered exhibit filed previously with the Registrant's Registration Statement on Form S-1 (Registration No. 33.80453)). |
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10.3 |
Director Option Plan and form of Director Stock Option Agreement thereunder. (Incorporated herein by reference to the same-numbered exhibit filed previously with the Registrant's Registration Statement on Form S-1 (Registration No. 33.80453)). |
|
10.4 |
Employee Stock Purchase Plan and forms of agreements thereunder. (Incorporated herein by reference to the same-numbered exhibit filed previously with the Registrant's Registration Statement on Form S-1 (Registration No. 33.80453)). |
|
10.5 |
Form of Exclusive Distribution Agreement, (Incorporated herein by reference to the same-numbered exhibit filed previously with our Registration Statement on Form S-1 (Registration No. 33-80453)) |
|
10.6 |
Form of Exclusive Sales Representative Agreement. (Incorporated herein by reference to the same-numbered exhibit filed previously with the Registrant's Registration Statement on Form S-1 (Registration No. 33.80453)). |
|
10.7 |
Consulting Agreement, dated May 10, 1993, between the Registrant and Philip E. Eggers, and amendment thereto. (Incorporated herein by reference to the same-numbered exhibit filed previously with the Registrant's Registration Statement on Form S-1 (Registration No. 33.80453)). |
|
10.8 |
Consulting Agreement, dated May 20, 1993, between the Registrant and Eggers & Associates, Inc., and amendment thereto. (Incorporated herein by reference to the same-numbered exhibit filed previously with the Registrant's Registration Statement on Form S-1 (Registration No. 33.80453)). |
|
10.9 |
Lease Agreement, dated September 15, 1994, between Registrant and The Arrillaga Foundation and the Perry Foundation for the Registrant's facility located at 595 North Pastoria Avenue, Sunnyvale, California 94086. (Incorporated herein by reference to Exhibit 10.10 filed previously with the Registrant's Registration Statement on Form S-1 (Registration No. 33.80453)). |
|
10.10 |
Employment Letter Agreement, dated July 18, 1995, between the Registrant and Robert T. Hagan. (Incorporated herein by reference to Exhibit 10.16 filed previously with the Registrant's Registration Statement on Form S-1 (Registration No. 33.80453)). |
|
10.11 |
Restricted Stock Purchase and Security Agreement, dated August 1, 1995, between the Registrant and Robert T. Hagan. (Incorporated herein by reference to Exhibit 10.17 filed previously with the Registrant's Registration Statement on Form S-1 (Registration No. 33.80453)). |
|
10.12+ |
Radiation Services Agreement, dated September 13, 1995, between the Registrant and SteriGenics International. (Incorporated herein by reference to Exhibit 10.19 filed previously with the Registrant's Registration Statement on Form S-1 (Registration No. 33.80453)). |
|
10.13 |
Amended and Restated Stockholder Rights Agreement, dated October 16, 1995, between the Registrant and certain holders of the Registrant's securities. (Incorporated herein by reference to Exhibit 10.20 filed previously with the Registrant's Registration Statement on Form S-1 (Registration No. 33.80453)). |
|
10.14 |
Contribution Agreement, dated March 31, 1995, by and among Philip E. Eggers, Robert S. Garvie, Anthony J. Manlove, Hira V. Thapliyal and the Registrant. (Incorporated herein by reference to Exhibit 10.21 filed previously with the Registrant's Registration Statement on Form S-1 (Registration No. 33.80453)). |
|
10.15 |
Amended and Restated Stockholder Rights Agreement, dated October 2, 1998, between the Registrant and Norwest Bank Minnesota, N.A. (Incorporated herein by reference to Exhibit 10.20 filed previously with the Registrant's Registration Statement on Form 8-A filed October 21, 1998 (Registration No. 000-27422)). |
|
10.16 |
Exclusive Distributor Agreement, dated April 15, 1997, between the Registrant and Arthrex, GmbH. and Amendment dated October 2, 1998. (Incorporated herein by reference to Exhibit 10.20 filed previously with the Registrant's Quarterly Report on Form 10-Q for the period ended April 3, 1999). |
|
10.17 |
Employment Letter Agreement, dated June 20, 1997, between the Registrant and Michael A. Baker. (Incorporated herein by reference to Exhibit 10.24 filed previously with the Registrant's Quarterly Report on Form 10-Q for the period ended June 28, 1997). |
|
10.18+ |
Exclusive Distributor Agreement, dated August 21, 1997, between the Registrant and Kobayashi Pharmaceutical Company, Ltd. (Incorporated herein by reference to Exhibit 10.25 filed previously with the Registrant's Quarterly Report on Form 10-Q for the period ended September 27, 1997). |
|
10.19+ |
License Agreement dated February 9, 1998, between the Registrant and Boston Scientific Corporation. (Incorporated herein by reference to Exhibit 10.26 filed previously with the Registrant's Annual Report on Form 10-K for the period ended January 3, 1998). |
|
10.20+ |
Development and Supply Agreement dated February 9, 1998, between the Registrant and Boston Scientific Corporation. (Incorporated herein by reference to Exhibit 10.27 filed previously with the Registrant's Annual Report on Form 10-K for the period ended January 3, 1998). |
|
10.21 |
Lease Agreement date March 25, 1998 between the Registrant and Aetna Life Insurance Company for the Registrant's facility located at 840 Del Rey Avenue, Sunnyvale, California 94086. (Incorporated herein by reference to Exhibit 10.28 filed previously with the Registrant's Annual Report on Form 10-K for the period ended January 3, 1998). |
|
10.22+ |
Term sheet for License and Distribution Agreement between Xomed Surgical Products and the Registrant dated June 25, 1998. (Incorporated herein by reference to Exhibit 10.29 filed previously with the Registrant's Quarterly Report on Form 10-Q for the period ended October 3, 1998). |
|
10.23+ |
License Agreement dated February 9, 1999 between the Registrant and Collagen Aesthetics. (Incorporated herein by reference to Exhibit 10.27 filed previously with the Registrant's Annual Report on Form 10-K for the period ended January 2, 1999). |
|
10.24 |
Change of Control Agreement between the Registrant and the CEO. (Incorporated herein by reference to Exhibit 10.28 filed previously with the Registrant's Annual Report on Form 10-K for the period ended January 2, 1999). |
|
10.25 |
The Form of "VP Continuity Agreement" between the Registrant and its Vice Presidents. (Incorporated herein by reference to Exhibit 10.29 filed previously with the Registrant's Annual Report on Form 10-K for the period ended January 2, 1999). |
|
10.26 |
Letter Agreement dated February 9, 1999 between the Registrant and Collagen Aesthetics. (Incorporated herein by reference to Exhibit 10.30 filed previously with the Registrant's Annual Report on Form 10-K/A for the period ended January 2, 1999). |
|
10.27 |
Employment Letter Agreement, between the Registrant and John R. Tighe dated January 26,1999. (Incorporated herein by reference to Exhibit 10.30 filed previously with the Registrant's Quarterly Report on Form 10-Q for the period ended April 3, 1999). |
|
10.28 |
Employment Letter Agreement, between the Registrant and Christine Hänni amended May 19, 1999. (Incorporated herein by reference to Exhibit 10.31 filed previously with the Registrant's Quarterly Report on Form 10-Q for the period ended April 3, 1999). |
|
10.29 |
Employment Letter Agreement, between the Registrant and Bruce Prothro amended May 19, 1999. (Incorporated herein by reference to Exhibit 10.32 filed previously with the Registrant's Quarterly Report on Form 10-Q for the period ended April 3, 1999). |
|
10.30+ |
Litigation Settlement Agreement, between the Registrant and ETHICON, Inc. dated June 24, 1999 (Incorporated herein by reference to Exhibit 10.33 previously filed with the Registrant's Quarterly Report on Form 10-Q for the period ended July 3, 1999). |
|
10.31 |
Relocation Loan Agreement, between the Registrant and John R. Tighe dated 5/1/99. (Incorporated herein by reference to Exhibit 10.34 previously filed with the Registrant's Quarterly Report on Form 10-Q for the period ended July 3, 1999). |
|
10.32 |
Line of Credit Agreement with Silicon Valley Bank dated June 11, 1999 filed herewith. Incorporated herein by reference to Exhibit 10.35 previously filed with the Registrant's Quarterly Report on Form 10-Q for the period ended July 3, 1999.) |
|
10.33++ |
Amendment to License Agreement between ArthroCare Corporation and Inamed Corporation dated October 1, 1999. (Incorporated herein by reference to Exhibit 10.33 previously filed with the Registrant's Registration Statement on Form S-3. (Registration No. 333-87187)) |
|
10.34 |
First Amendment to Rights Agreement between the ArthroCare Corporation and Norwest Bank Minnesota, N.A. (the "Rights Agent") dated March 10, 2000. (Incorporated herein by reference to Exhibit 99.1 previously file with the Registrant's Form 8-K filed March 10, 2000.) |
|
10.35 |
Nonstatuatory Stock Option Plan and form of Stock Option Agreement thereunder. (Incorporated herein by reference to the same-numbered exhibit filed previously with this the Registrant's Annual Report on Form 10-K for the period ended January 1, 2000.) |
|
27.1 |
Financial Data Schedule. |
+ Confidential treatment granted.
++ Confidential treatment requested.
(b) Reports on Form 8-K.
The Company filed a Current Report on Form 8-K on March 10,
2000, reporting under Item 5 the amendment to its stockholders'
rights plan.
ARTHROCARE CORPORATION
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.
Dated: May 8, 2000
|
ARTHROCARE CORPORATION a Delaware corporation |
| (Registrant) |
Date: May 8, 2000
| By: | /s/ CHRISTINE HANNI |
|
| |
| Christine Hanni | |
| Vice President of Finance, Chief Financial Officer and Assistant Secretary | |
| (Principal Financial Officer and Accounting Officer) |
Date: May 8, 2000
| By: | /s/ MICHAEL A. BAKER |
|
| |
| Michael A. Baker | |
| President, Chief Executive Officer and Director | |
| Officer and Director (Principal Executive Officer) |
EXHIBIT INDEX
|
Number |
Desription |
|
27.1 |
Financial Data Schedule. |
|
|