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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
X Annual report pursuant to Section 13 or 15(d) of the Securities Exchange
- ---- Act of 1934.
For the fiscal year ended January 1, 1999 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
0-27880
CardioThoracic Systems, Inc.
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(Exact Name of Registrant as Specified in Its Charter)
Delaware 94-3228757
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(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
10600 N. Tantau Ave., Cupertino, CA 95014-0739
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(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone, including area code: (408) 342-1700
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.001 par value
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Preferred Share Purchase Rights
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(Title of class)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
requirements for the past 90 days. Yes X No
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Indicate by check mark if disclosures of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
The aggregate value of voting stock held by nonaffiliates of the Registrant
was approximately $74,368,000 as of March 15, 1999 based upon the closing
price of the Registrant's common stock reported for such date on the Nasdaq
National Market. Shares of common stock held by each executive officer and
director and by each person who owns 5% or more of the outstanding common
stock have been excluded in that such persons may be deemed affiliates. The
determination of affiliate status is not necessarily a conclusive
determination for other purposes. As of March 15, 1999, the Registrant had
outstanding 14,321,933 shares of the Common Stock.
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DOCUMENTS INCORPORATED BY REFERENCE
Parts of the Annual Report to stockholders for Registrant's 1998 fiscal year,
filed as an exhibit hereto, are incorporated by reference into Parts II and
IV hereof; and parts of the Proxy Statement for Registrant's 1999 Annual
Meeting of Stockholders, to be filed with the Commission on or before 120
days after the end of the 1998 fiscal year, are incorporated by reference
into Part III hereof.
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PART I
ITEM 1. BUSINESS
OVERVIEW
This annual report on Form 10-K contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section
21E of the Securities Exchange Act of 1934. The Company's future results
could differ materially from those anticipated by such forward-looking
statements as a result of certain factors including those set forth in this
section and in the section entitled "Other Risk Factors".
CardioThoracic Systems, Inc. ("CTS" or the "Company") develops,
manufactures, and markets proprietary, disposable instruments and systems
for performing minimally invasive cardiac surgery ("MICS"). The Company's
current products are designed to enable the majority of cardiothoracic
surgeons, using their existing skills coupled with Company sponsored
training, to perform MICS on a beating heart. The OPCAB-TM- (Off Pump
Coronary Artery Bypass) and MIDCAB-TM- (Minimally Invasive Direct Coronary
Artery Bypass) procedures eliminate the need for a heart-lung machine, and
recent studies indicate that the MICS procedures reduce the trauma,
procedural costs and post-surgical complications associated with conventional
coronary artery bypass graft ("CABG") surgery while providing long-term
procedural success rates comparable to CABG surgery.
The main components of the CTS OPCAB-TM- Procedure and MIDCAB-TM-
Procedure family of products include the Access Platform, which is designed
to maximize access to the chest cavity through a mid-line or mini-thoracotomy
incision, the Stabilizer, which is designed to isolate and minimize the
motion of the diseased artery and the CTS-Registered Trademark- Access MP-TM-
Lift, which is designed to offset the ribs to provide a window into the chest
cavity so the surgeon can harvest the internal mammary artery (IMA) through a
mini-thoracotomy. In 1998 the Company also introduced the CTS-Registered
Trademark- FloCoil Shunt which is inserted into the coronary artery to create
a near bloodless field and to provide myocardial protection during off-pump
beating heart CABG.
BACKGROUND
Heart disease is the leading cause of death in America, with the
American Heart Association reporting in the 1999 Heart and Stroke Statistical
Update that an estimated 13.9 million Americans have a history of coronary
artery or other heart disease. The report went on to project that in 1999 an
estimated 1.1 million Americans will have a new or recurrent coronary attack,
of whom about one third will die. Each year, approximately 1.4 million
patients undergo a revascularization procedure to treat coronary artery
disease. Coronary artery disease (atherosclerosis) is caused by cholesterol
and other fatty materials becoming deposited on the walls of blood vessels,
which form a build-up known as plaque. The heart needs a constant supply of
oxygen and nutrients, which are carried by the blood in the coronary
arteries. The accumulation of plaque narrows the interior of the blood
vessels, thereby reducing blood flow to the heart muscle (the myocardium).
When blood flow to the heart muscle becomes insufficient, an injury occurs,
which may result in a heart attack (myocardial infarction) and often death.
The heart has three main branches of coronary arteries: the left
anterior descending artery ("LAD"), which descends from the left across the
heart; the right coronary artery ("RCA"), which extends from the right of the
heart around to the back of the heart; and the left circumflex artery, which
extends from the left of the heart around to the back of the heart. The LAD
is the primary blood supply to the heart and supplies blood to a large amount
of the myocardium. Studies indicate that restoring blood flow to the LAD is
the single most important determinant of long-term, event-free survival.
Traditional treatments for
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coronary artery disease include drug therapy, coronary artery bypass
graft ("CABG") surgery and catheter-based treatments, including balloon
angioplasty, atherectomy and coronary stenting. CABG bypass surgery is highly
invasive and traumatic to the patient, but is considered the most effective
and long-lasting treatment for severe coronary artery disease. While
catheter-based treatments are less invasive, the procedures are limited by
high rates of restenosis, a renarrowing of the treated coronary artery, which
generally requires reintervention. Catheter-based treatments have been
increasingly adopted because they are a less invasive treatment alternative.
There are approximately 1.0 million catheter-based procedures performed
annually worldwide. Notwithstanding the introduction of less invasive
catheter-based treatments, the Company believes that the number of patients
treated by CABG surgery has continued to grow each year and that more than
650,000 CABG procedures are performed annually worldwide. The Company
believes that many of the patients currently undergoing CABG surgery or
catheter-based treatments are candidates for the MIDCAB or OPCAB procedure.
DRUG THERAPY
Drug therapy is a non-invasive treatment to improve blood flow and
alleviate some of the symptoms associated with angina (chest pain). However,
while some drug therapies may inhibit continued plaque build-up in the
arteries, drug therapy is not a cure for heart disease. The various drugs
utilized include nitroglycerin, beta blockers, calcium channel blockers and
cholesterol lowering drugs. Although drug therapy is the least invasive
treatment currently available, it is typically expensive because it must be
chronically administered. Some patients suffer from side effects as well as
require future interventional procedures.
CORONARY ARTERY BYPASS GRAFT SURGERY
CABG surgery is a treatment for severe cases of coronary artery disease
in which blood vessel grafts are used to bypass the site of the blocked
artery. This procedure restores blood flow by routing around a blockage using
a healthy blood vessel from another part of the body. Although CABG surgery
is highly effective in treating coronary artery disease, it is a highly
invasive, traumatic and expensive procedure. In the United States the cost of
undergoing CABG is approximately $36,000. The average post-operative hospital
stay for a person undergoing a CABG procedure in the United States in 1994
was five to seven days, and the average recuperation period following
discharge from the hospital was approximately eight to ten weeks.
The CABG procedure involves sawing the patient's sternum or breast bone
in half, creating a twelve inch incision (sternotomy) for the purpose of
exposing the patient's heart. The two halves are spread approximately six
inches apart with a steel sternal retractor, and the heart is exposed.
Cannulae (plastic tubes) are inserted into the aorta and right atrium of the
heart, a clamp is placed on the aorta to stop blood flow, and the heart is
connected to a heart-lung machine (going "on pump") to be slowly cooled and
eventually stopped before the grafting can occur. The heart-lung machine is a
series of interconnected specialty medical devices that together function as
the patient's heart and lungs by temporarily circulating and oxygenating
blood while the patient's own heart and lungs are rendered inactive. The
patient's blood is circulated through plastic tubes to reservoirs in the
heart-lung machine where carbon dioxide is removed, oxygen is replaced, and
temperature is controlled. The patient's circulation is maintained on the
external equipment throughout much of the CABG procedure, which averages
three to six hours, depending on the patient's condition and number of grafts
that must be created. Often patients undergo multiple vessel procedures,
which may involve harvesting a saphenous vein from the leg and bypassing
several blockages to achieve revascularization. When a saphenous vein is used
as a graft, typically a continuous incision is made from the ankle to the
thigh of a patient's leg, the saphenous vein is dissected and removed, and
the wound is sutured closed. A study involving over 1,000 patients indicates
that the open harvesting
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of the saphenous vein (saphenectomy) results in wound healing impairment in
approximately 24% of patients. As an alternative to bypassing the blockage
with a saphenous vein graft, an internal mammary artery ("IMA") can be
grafted directly on the coronary artery, bypassing the blocked section. At
the conclusion of the CABG procedure, cannulae and the heart-lung machine are
removed, the sternal halves are tied together with steel wire, and the skin
is closed with suture material.
Despite the invasiveness and trauma of the procedure, CABG is considered
the most effective and long lasting treatment for severe coronary artery
disease. Over 85% of bypass grafts formed from saphenous veins are patent
(open) one year after surgery and over 60% are patent ten years after
surgery. Grafts using the internal mammary arteries have patency rates of
over 85% ten years after surgery and are well documented as being highly
resistant to atherosclerosis.
While every effort is made to minimize potential adverse effects from a
procedure as traumatic as CABG surgery, published studies have shown that
approximately 68% of all CABG surgeries have some complications. Some of the
most severe complications can be attributed to the heart-lung machine,
including strokes, multiple organ dysfunction, inflammatory complications,
respiratory failure and post-operative internal bleeding complications. It is
estimated that stroke, which can have devastating functional consequences,
occurs in approximately 5% to 8% of all CABG procedures. Another common
complication of the use of the heart-lung machine is cognitive dysfunction,
with patients experiencing significant loss of memory, attention span, verbal
fluency, and psychomotor speed, even as long as six months after CABG
surgery, regardless of attempts to mitigate or decrease the heart-lung
machine time and trauma.
Severe complications related to CABG procedures can also result from the
sternotomy. Significant post-operative sternal infection usually requires
reoperation and excision of the sternum and muscle flap. The rate of wound
complications after sternotomy in a major study was 1.1% overall (72 patients
out of 6,504), with 10 of those 72 dying before being discharged from the
hospital. The patients with wound complications had a median length of
hospital stay of 43 days, and triple the hospital costs of patients without
such complications.
CATHETER-BASED THERAPIES
Catheter-based therapies, such as balloon angioplasty, atherectomy and
coronary stenting, have become increasingly popular and effective over the
last ten years. Balloon angioplasty is a procedure in which a balloon-tipped
intravascular catheter is inserted into the femoral artery through a small
incision in the upper thigh, is guided to the lesion (site of plaque) and
is inflated and deflated several times to reshape the plaque and increase
blood flow. Additional interventional devices for coronary artery disease
include atherectomy devices (devices that cut or ablate and remove plaque
from the arterial wall), laser catheter devices (devices that use laser
energy to reduce plaque in arteries) and coronary stents (expandable metal
frames that are positioned within the diseased area in the coronary artery to
maintain the vessel opening). These treatments occur in a catheterization
laboratory and are performed on a beating heart so they do not require a
heart-lung machine. As a result, the length of stay and recuperation period
are substantially less than those required with conventional CABG. Currently,
a common form of catheter-based treatment involves the use of balloon
angioplasty followed by the placement of a coronary stent in the diseased
artery. As a result of these minimally invasive approaches, patients are
typically discharged within 24 to 48 hours and can return to a normal
lifestyle within several days.
While less invasive and traumatic than CABG, catheter-based therapies may
not offer prolonged efficacy. Studies have indicated that within three to six
months after a balloon angioplasty, between 25% and 45% of patients experience
restenosis (a renarrowing of the treated coronary artery). In addition, 5%
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to 7% of coronary balloon angioplasty patients experience abrupt reclosure of
the treated vessel, which may be caused in part by flaps or tears of plaque
that occur in the course of such treatment. In patients with multi-vessel
coronary artery disease, a randomized study has shown that within three years
of receiving treatment, only 7% of patients receiving CABG surgery required
reintervention while 40% of patients receiving balloon angioplasty required
reintervention. Additional studies have confirmed that approximately 20% of
balloon angioplasty patients with multi-vessel disease will undergo CABG
surgery within one year of receiving balloon angioplasty. However, the
efficacy of catheter-based treatments may be improving. Recent multi-center
studies indicated that restenosis rates after treatment with stents can be
reduced by approximately 30% as compared to balloon angioplasty alone. Future
advancements in stents or other catheter-based treatments may further reduce
restenosis rates.
The average cost of a balloon angioplasty procedure in the United States
is approximately $15,000 or less than one-half of the average cost of CABG
surgery. In a recent study, the cost of balloon angioplasty was equivalent to
that of CABG three years after the procedure, primarily due to the expense of
reintervention for the balloon angioplasty patient. In addition, the use of
stenting greatly increases the cost of a catheter-based procedure. One study
indicated that the average cost per procedure for elective stenting was
approximately twice the cost of balloon angioplasty treatment without
stenting (or nearly equal to the cost of CABG surgery).
THE MIDCAB PROCEDURE
A procedure known as Minimally Invasive Direct Coronary Artery Bypass
("MIDCAB") applies the techniques of minimally invasive intervention to CABG
surgery. The Company believes that this procedure will provide patients with
minimally invasive advantages similar to those of catheter-based procedures
and clinical benefits comparable to those of CABG procedures. The Company
believes the MIDCAB procedure offers the following benefits:
ELIMINATES HEART-LUNG MACHINE (OFF PUMP). Surgery is performed on the
beating heart, eliminating the need for a heart-lung machine. The heart-lung
machine is a major contributing factor to the post-operative complications of
CABG, which include stroke, bleeding and respiratory complications.
MINIMALLY INVASIVE. Access to the heart is provided through a small
incision called a mini-thoracotomy, eliminating the need for a sternotomy, in
which a twelve inch incision is made by sawing through the sternum or
breastbone and spreading the ribcage apart to expose the heart. The healing
of the sternum adds to the recovery time for a CABG procedure, even in
procedures without complications.
PROVIDES DIRECT ACCESS. Placement of the mini-thoracotomy provides
access to the heart and the internal mammary arteries, permitting grafts to
be performed under the surgeon's direct vision without the need for
endoscopic equipment.
REDUCES COSTS. Studies indicate that fewer complications result in
shorter hospital stays (approximately two to three days), less recuperation
time (approximately two weeks) and reduced patient trauma relative to CABG
surgery. The Company believes that the MIDCAB procedure represents a
significant advancement in the delivery of coronary revascularization and
provides patients, payors and providers with a cost-effective alternative to
existing interventional procedures.
In the CTS MIDCAB procedure, the patient is placed under general
anesthesia and a mini-thoracotomy is made just below the patient's breast,
between the ribs. The procedure takes advantage of the fact that the heart
and the LAD artery are located directly under the incision. The Access MP-TM-
Lift is inserted into the mini-thoracotomy and expanded to create an opening
and offset the ribs. Under direct vision,
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without the need for endoscopic equipment, the surgeon then dissects the IMA
from the chest wall. The IMA branches are gently exposed and are then clipped
and cauterized. After the IMA is harvested to a satisfactory length the
Access MP-TM- Lift is removed and the Access Platform is inserted into the
chest opening. A small incision is then made in the pericardium (a fibrous,
fluid filled sac that holds the heart in place in the chest cavity) and the
LAD artery is exposed. The CTS MIDCAB procedure requires only a small
pericardial incision, which allows the pericardium to continue to provide
some support to the heart. The surgeon positions the Stabilizer at the
grafting site isolating it and rendering it motionless. A small incision is
made in the LAD artery at the site of the grafting, and the IMA artery is
grafted, under the surgeon's direct vision, onto the beating heart. After the
grafting is finished, the chest is sewn shut and the procedure is complete.
Despite the potential benefits of the MIDCAB procedure for the treatment
of coronary heart disease, it is regularly performed by only a limited number
of cardiothoracic surgeons. The Company believes that many cardiothoracic
surgeons have been reluctant to attempt or have stopped performing the MIDCAB
procedure because of, among other things, the difficulties of performing
surgery on the beating heart including harvesting the IMA and in most cases
its limitation to the LAD artery or branches off the LAD. Of the MIDCAB
procedures performed to date, virtually all have been performed on the LAD or
branches off the LAD. During 1998 the Company believes that approximately 17
percent of the units shipped by the Company were used in a MIDCAB procedure.
THE OPCAB PROCEDURE
A procedure known as Off Pump Coronary Artery Bypass ("OPCAB") has been
developed that offers the same benefits of MIDCAB except that it is done
through a mid-line incision (mini-sternotomy or sternotomy). This procedure
provides surgeons the ability to do multi-vessel bypass procedures on a
beating heart since it allows greater visualization of the heart and more
freedom in lifting and rotating the heart. During 1998 the Company believes
that approximately 83 percent of the units shipped by the Company were used
in an OPCAB procedure.
Despite the potential benefits of the OPCAB procedure for the treatment
of coronary heart disease, it is currently performed by a limited number of
cardiothoracic surgeons. The Company believes that some cardiothoracic
surgeons maybe reluctant to attempt the OPCAB procedure because of, among
other things, the difficulties of performing surgery on the beating heart and
the difficulties of positioning the heart to bypass certain arteries. The
Company is unable to predict how quickly, if at all, the OPCAB procedure will
be adopted by the medical community or, if it is adopted, the number of OPCAB
procedures that will be performed.
Although the Company believes that the CTS OPCAB and MIDCAB procedures have
significant advantages over competing procedures, broad-based clinical adoption
of the procedures will not occur until physicians determine that the procedures
are an attractive alternative to current treatments for coronary artery disease.
The Company believes that physician endorsements are essential for clinical
adoption of these procedures, and there can be no assurance that physicians
currently endorsing off-pump CABG will continue to do so. Clinical adoption will
also depend upon the Company's ability to facilitate training of cardiothoracic
surgeons to perform CABG on a beating heart, and the willingness of such
surgeons to perform such a procedure. Patient acceptance of the procedures will
depend in part upon physician recommendations as well as other factors,
including the degree of invasiveness, the effectiveness of the procedures and
rate and severity of complications associated with the procedures as compared to
other treatments. Even if the clinical efficacy of the OPCAB and MIDCAB
procedures are established, physicians may elect not to recommend the procedures
unless acceptable reimbursement from health care
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payors is available. Health care payor acceptance may require evidence of the
cost effectiveness of the OPCAB and MIDCAB procedures as compared to other
currently available treatments. There can be no assurance that the OPCAB or
MIDCAB procedures will gain significant clinical adoption. Failure of the
OPCAB and MIDCAB procedures to achieve significant clinical adoption would
have a material adverse effect on the Company's business, financial condition
and results of operations.
CTS PRODUCTS
The majority of the Company's products are disposable surgical
instruments designed to facilitate the OPCAB and MIDCAB procedures. The
Company has seen the adoption of the off-pump beating heart CABG grow as it
continues to develop products that enable the majority of cardiothoracic
surgeons, using their existing skills coupled with Company sponsored
training, to perform the OPCAB and MIDCAB procedures. The Company's
current and future products can be placed into one of four groups: beating
heart products, stopped heart products, harvesting products and ancillary
products.
Beating Heart Products - OPCAB Procedures
In April and June of 1998 the Company shipped its first products
specifically designed for the OPCAB procedure. The OPCAB Access Systems
(Access MV2-TM- was first shipped in April 1998 and Access Plus-TM- was first
shipped in June 1998) enable off-pump beating heart CABG procedures utilizing
a conventional mid-sternal approach.
These systems are made up of an access platform, stabilizer and internal
mammary artery ("IMA") clip. The access platform is designed to maximize
access to the chest cavity through a mid-line incision, providing a full
one-inch wider opening of the sternum than the previous CTS product. The
stabilizer incorporates an articulating foot that is attached by a mounting
system to the access platform. The stabilizer is designed to apply slight
pressure to the myocardium and thereby isolate the diseased artery, minimize
the motion of the beating heart and permit the surgeon to complete the graft.
The IMA clip is designed to hold the IMA while the surgeon is sewing the
graft. The Access Plus differs from the Access MV2 in that it has an
additional two places to mount the stabilizer, increasing the surgeon's
flexibility to access the target arteries without repositioning the access
platform.
In January 1999 the Company started shipping the CTS-Registered
Trademark- Access Ultima-TM- System, its next generation OPCAB procedure
system. The access platform provides a rail system for mounting the
stabilizer, pericardial suture holders and a multi-use drive mechanism. The
stabilizer mounting system was enhanced to provide a greater range of motion
for the stabilizer. This system further improves the surgeon's flexibility
to access the target arteries.
Beating Heart Products - MIDCAB Procedures
The CTS-Registered Trademark- Access MV-TM- Stabilizer Set and the
CTS-Registered Trademark- Access MP-TM- Lift make up a system designed to
provide the necessary access to the chest cavity through a mini-thoracotomy,
simplify the harvesting of the internal mammary artery, and optimize the
conditions necessary for a quality graft to be performed on a beating heart.
In addition to the access platform and stabilizer, this system also provides a
unique spreading device that offsets the ribs to provide a window into the
chest cavity so the surgeon can harvest the IMA without using an endoscope.
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Stopped Heart Products
During the second quarter of 1999 the Company expects to start shipping
the CTS-Registered Trademark- Aurora-TM- MultiTrac System. The system is
designed to optimize the working space and organization of a less invasive
valve surgery. The system includes an access platform with suture holders and
a multi-use drive mechanism and an integrated tissue retractor and valve
retainer.
During 1999, upon receiving Federal Drug Administration ("FDA")
clearance, the Company expects to start shipping the CTS-Registered
Trademark- Voyager-TM-Quad Cannula. This device is designed to offer a less
traumatic way of eliminating blood flow to the heart during less invasive
valve surgery and conventional CABG surgery. Through a single incision into
the aorta this device provides arterial perfusion, intra-aortic occlusion,
antegrade cardioplegia delivery and aortic venting.
Harvesting Products
In the third and fourth quarters of 1998 the Company had a limited
launch of the CTS-Registered Trademark- Ceres-TM- SV System. The system is
designed to minimize patient trauma by endoscopic harvesting of the saphenous
vein from just a few small incisions. The Company is not currently shipping
this product and with the experienced gained from this limited launch, CTS
plans to develop its second-generation saphenous vein harvesting system.
Ancillary Products
In the first quarter of 1998, the Company commenced shipments of the
CTS-Registered Trademark- FloCoil-TM- Shunt. The FloCoil is inserted into
the coronary artery to provide myocardial protection and create a near
bloodless field during the suturing of the coronary anastomosis.
In the fourth quarter of 1998, the Company commenced shipments of
Cardioflon-Registered Trademark- and Cardionyl-Registered Trademark- sutures
under a distribution agreement with Peters Laboratories, a corporation of
France. These sutures have been designed for use in various cardiac surgery
procedures.
In February of 1999, the Company commenced shipments of the
CTS-Registered Trademark- Aries-TM- CO2 Blower/Mister. The Aries provides
controlled delivery of CO2 and saline to improve visibility during the
anastomosis by keeping blood away from the anastomotic site.
In February of 1999, the Company commenced shipments of the
CTS-Registered Trademark- Coronary FloMeter System under a distribution
agreement with Transonic Systems, Inc. The CTS Coronary FloMeter System
allows the surgeon to confirm acute graft patency and is made up of a
FloMeter and FloProbes. The FloMeter contains the electronics, printer and
LED display showing blood flow measurement in millimeters per minute and
provides a hard copy record of real time diastolic flow pattern. The
FloProbe is placed on the artery and using ultrasound technology captures the
information necessary for the FloMeter to determine and display the blood
flow rate of the artery being measured.
During the second quarter of 1999, the Company expects to start shipping
CTS-Registered Trademark- OPCAB-TM- Procedure Kits. These kits package
together essential accessories and devices for off-pump beating heart bypass
surgery. Included in the kits are an aortic punch, silastic tape, soft jaw
bulldog clamp, CTS Aries Blower/Mister and optional CTS FloCoil Shunts.
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SALES, MARKETING AND DISTRIBUTION
The Company markets its products principally to cardiac surgeons. The
Company's marketing strategy is to generate broad based market acceptance of
the OPCAB procedure, the MIDCAB procedure and other less invasive cardiac
surgery procedures by sponsoring educational programs and surgeon training
programs, and by cultivating relationships with opinion leaders in cardiac
surgery. The Company has established a Medical Advisory Board comprised of
cardiothoracic surgery opinion leaders, prominent surgeons and leading
interventional cardiologists. Some of the members of the Medical Advisory
Board as well as other key off-pump surgeons participate in
Company-sponsored educational and training sessions, thereby encouraging
acceptance of the OPCAB and MIDCAB procedures among cardiothoracic surgeons
and the integration of beating heart CABG into their hospital and surgical
practices.
The Company currently has a direct sales force of twenty-one people in
the United States which are supported by three clinical sales associates. For
most of 1998 the Company had CardioThoracic Systems, GmBH, a wholly owned
subsidiary, in Dusseldorf Germany which supported a direct sales and
marketing organization for Germany. In accordance with a restructuring plan,
during the fourth quarter of 1998 the Company closed its Germany subsidiary.
In the first quarter of 1999, CTS entered into a distribution agreement with
a distributor in Germany. In other international markets, the Company sells
its products through distributors.
The Company has a small sales and marketing organization when compared
to most of its competitors. There can be no assurance that the Company will
be able to build a larger direct sales force or marketing organization, that
maintaining a direct sales force or marketing organization will be cost
effective, or that the Company's sales and marketing efforts will be
successful. There can be no assurance that the Company will be able to
maintain agreements with distributors, or that such distributors will devote
adequate resources to selling the Company's products. Since the Company has
entered into distribution agreements for the sale of its products in certain
countries, it will be dependent upon the efforts of these third parties, and
there can be no assurance that such efforts will be successful. Failure to
maintain or grow an effective direct sales and marketing organization or to
maintain effective distributors could have a material adverse effect on the
Company's business, financial condition and results of operations.
CUSTOMER TRAINING
The Company believes that its CORriculum-SM- training and education
program plays a important role in the adoption of the OPCAB and MIDCAB
procedures. Through the CORriculum Institute of Education, CTS partners with
some of the country's top opinion leaders to train surgeons and their staff
members on the latest techniques in minimally invasive cardiac surgery. The
CORriculum continuum utilizes a multi-step process aimed at driving adoption.
This process begins with a sales inservicing call, and is followed by a
series of group and one-on-one training courses that combine lectures and
live cases. During 1998, nearly 1,300 surgical personnel were trained
through the Company's programs.
RESEARCH AND DEVELOPMENT
The Company directs its research efforts toward development of
proprietary surgical instruments and systems for cardiothoracic minimally
invasive procedures, including off-pump beating heart coronary artery bypass,
saphenous vein and other arterial conduit harvesting and on-pump less
invasive valve surgery and coronary procedures. Some of the products under
development will require regulatory clearance or approval prior to
commercialization. As of January 1, 1999, the Company's research and
development staff consisted of 45 full-time engineers, technicians,
machinists and managers who have substantial experience in the development of
medical devices, including expertise in the application of mechanical and
electrical design principles to devices for cardiovascular applications.
Research and
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development expenses for the years ended January 1, 1999, January 2, 1998 and
December 31, 1996 were $11.5 million, $10.8 million and $11.5 million,
respectively.
MANUFACTURING
To date, the Company's manufacturing activities have consisted of
assembling CTS' various products. The Company purchases most of the
components for its products from various independent suppliers that are
either standard components or are built or molded to the Company's
proprietary specifications. In addition, the Company contracts with third
parties for the performance of certain processes involved in the
manufacturing cycle, such as finished product sterilization. Some of these
components and processes may only be available from single-source vendors.
Any prolonged supply interruption or yield problems experienced by the
Company due to a single-source vendor could have a material adverse effect on
the Company's ability to manufacture its products until a new source of
supply is qualified. Many of the Company's components are molded parts that
require custom tooling which is manufactured and maintained by third party
vendors. Should such custom tooling be damaged it could result in a supply
interruption that could have a material adverse effect on the Company's
ability to manufacture its products until a new tool is manufactured. Also,
the Company's new product development efforts and the timeliness of new
product launches could be significantly affected by tooling vendors ability
to meet completion and quality commitments on the manufacture of custom
tooling. As the Company increases production, it may from time to time
experience lower than anticipated yields or production constraints, resulting
in delayed product shipments, which could have a material adverse effect on
the Company's business, financial condition and results of operation.
The Company's manufacturing facilities are subject to the FDA's Quality
System Regulations ("QSR"), (formerly referred to as Good Manufacturing
Practices, GMPs) international quality standards (ISO 9001) and other
regulatory requirements. The Company has received ISO 9001 certification, has
obtained its California Device Manufacturing license and has successfully
undergone a facility inspection by the FDA. Difficulties encountered by the
Company in maintaining its facilities in accordance with QSR regulations,
international quality standards or other regulatory requirements could entail
a delay or termination of production, which could have a material adverse
effect on the Company's business, financial condition and results of
operations.
The Company has no experience manufacturing its products in the volumes
that would be necessary for the Company to achieve profitable operations.
There can be no assurance that reliable, high-volume manufacturing can be
established or maintained at commercially reasonable costs. Companies often
encounter difficulties in scaling up production, including problems involving
production yield, quality control and assurance, and shortages of qualified
personnel. Difficulties encountered by the Company in manufacturing scale-up
could have a material adverse effect on the Company's business, financial
condition and results of operations.
PATENTS AND PROPRIETARY RIGHTS
The Company's ability to compete effectively will depend in part on its
ability to develop and maintain proprietary aspects of its technology. The
Company owns eleven issued United States patents, including one which
contains claims that cover certain aspects of the Company's FloCoil-TM-
Shunt. Additionally, the Company has fifty-three United States patent
applications and various foreign patent applications pending. The Company is
the licensee of a United States patent and several related pending
applications for a heart valve insertion and stapling device, and a United
States patent application for bipolar electrosurgical scissors.
Additionally, the Company has acquired exclusive rights to a United States
patent covering methods of minimally invasive harvesting.
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There can be no assurance that any issued patents or any patents which
may be issued as a result of the Company's licensed patent applications or
pending United States and foreign patent applications will provide any
competitive advantages for the Company's products or that they will not be
successfully challenged, invalidated or designed around in the future. In
addition, there can be no assurance that competitors, many of which have
substantial resources and have made substantial investments in competing
technologies, will not seek to apply for and obtain patents that will
prevent, limit or interfere with the Company's ability to make, use and sell
its products either in the United States or in international markets.
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. There can be no assurance that
the Company will not become subject to patent infringement claims or
litigation or interference proceedings declared by the USPTO to determine the
priority of inventions. The defense and prosecution of intellectual property
suits, USPTO interference proceedings and related legal and administrative
proceedings are both costly and time-consuming. Litigation may be necessary
to enforce patents issued to the Company, to protect trade secrets or
know-how owned by the Company or to determine the enforceability, scope and
validity of the proprietary rights of others. Any litigation or interference
proceedings will result in substantial expense to the Company and significant
diversion of effort by the Company's technical and management personnel. An
adverse determination in litigation or interference proceeding to which the
Company becomes a party could subject the Company to significant liabilities
to third parties or require the Company to seek licenses from third parties
or prevent the Company from selling its products in certain markets, or at
all. Costs associated with settlements, licensing and similar arrangements
may be substantial and could include ongoing royalties. Furthermore, there
can be no assurance that the necessary licenses would be available to the
Company on satisfactory terms, if at all. Adverse determinations in a
judicial or administrative proceeding or failure to obtain necessary licenses
could prevent the Company from manufacturing and selling its products, which
would have a material adverse effect on the Company's business, financial
condition and results of operations.
Congress enacted legislation, which became effective October 1, 1996,
that places certain restrictions on the ability of medical device
manufacturers to enforce certain patent claims, relating to surgical and
medical methods, against medical practitioners. Such limitations on the
enforceability of patent claims, relating to medical and surgical methods,
against medical practitioners could have a material adverse effect on the
Company's ability to protect its proprietary methods and procedures against
medical practitioners.
In addition to patents, the Company relies on trade secrets and
proprietary know-how, which it seeks to protect, in part, through
confidentiality and proprietary information agreements. There can be no
assurance that such confidentiality or proprietary information agreements
will not be breached, that the Company would have adequate remedies for any
breach, or that the Company's trade secrets will not otherwise become known
to or be independently developed by competitors.
COMPETITION
The Company believes that the principal competitive factors in the market
for treatment of cardiovascular disease are safety, efficacy, ease of use,
reliability and cost effectiveness. The Company believes that the OPCAB and
MIDCAB procedures performed with the Company's products will be substantially
less costly than highly-invasive, traditional surgical procedures and may
ultimately replace
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these procedures in some applications. The Company believes that its products
will enable surgeons to perform coronary bypass surgery less invasively, in a
shorter period of time and with reduced patient trauma, resulting in reduced
recuperation time in the ICU, shorter hospital stays and faster recovery, as
well as lower complication rates. As a result, the Company believes that its
products will compete favorably with respect to each of these factors,
although no assurance can be given that it will compete favorably.
The medical device industry and the market for treatment of
cardiovascular disease, in particular, are characterized by rapidly evolving
technology and intense competition. A number of companies, including Johnson
& Johnson, Boston Scientific Corporation, Guidant Corporation and Medtronic,
Inc., are currently marketing stents, catheters, lasers, drugs and other less
invasive means of treating cardiovascular disease. Many of these less
invasive treatments, as well as CABG surgery, are widely accepted in the
medical community and have a long history of safe and effective use. Many of
the Company's competitors have substantially greater capital resources, name
recognition and expertise in and resources devoted to research and
development, manufacturing and marketing and obtaining regulatory clearances
or approvals. Furthermore, competition in the emerging market for minimally
invasive cardiac surgery is intense and is expected to increase. Medtronic,
Inc., Genzyme Surgical Products Corp., Johnson & Johnson, Guidant
Corporation, Baxter International, Inc., Heartport, Inc. and United States
Surgical Corp. are marketing or have announced that they are developing
products to be used in MICS procedures. There can be no assurance that MICS
procedures will replace any current treatments. Additionally, even if MICS
procedures are widely adopted, there can be no assurance that the Company's
competitors will not succeed in developing or marketing alternative
procedures and technologies, competing devices to perform the same
procedures, or therapeutic drugs that are more effective than the Company's
products or that render the Company's products or technologies obsolete or
not competitive. In addition, there can be no assurance that existing
products for other surgical uses will not be used in MICS procedures.
Furthermore, sales of the Company's products could be adversely affected by
reuse, notwithstanding the instructions in the Company's clinical protocols
and product labeling indicating that certain components of the Company's
products are single-use devices. Such competition or reuse could have a
material adverse effect on the Company's business, financial condition and
results of operations.
GOVERNMENT REGULATION
The medical devices to be marketed and manufactured by the Company are
subject to extensive regulation by the FDA, and, in some instances, by
foreign governments. Pursuant to the Federal Food, Drug, and Cosmetic Act of
1976, as amended, and the regulations promulgated thereunder (the "FDC Act"),
the FDA regulates the clinical testing, manufacture, labeling, distribution,
and promotion of medical devices. Noncompliance with applicable requirements
can result in, among other things, fines, injunctions, civil penalties,
recall or seizure of products, total or partial suspension of production,
failure of the government to grant premarket clearance or premarket approval
for devices, withdrawal of marketing approvals, and criminal prosecution. The
FDA also has the authority to request repair, replacement or refund of the
cost of any device manufactured or distributed by the Company.
In the United States, medical devices are classified into three classes
(Class I, II or III), on the basis of the controls deemed necessary by the
FDA to reasonably assure their safety and effectiveness. Under FDA
regulations, Class I devices are subject to general controls (for example,
labeling, premarket notification and adherence to QSRs) and Class II devices
are subject to general and special controls (for example, performance
standards, postmarket surveillance, patient registries and FDA guidelines).
Generally, Class III devices are those which must receive premarket approval
by the FDA to ensure their safety and effectiveness (for example,
life-sustaining, life-supporting and implantable devices, or new devices
which have not been found substantially equivalent to legally marketed
devices).
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Before a new device can be introduced into the United States market, the
manufacturer must generally obtain marketing clearance through either a
510(k) premarket notification or a premarket approval ("PMA") application. A
510(k) clearance will be granted if the submitted information establishes
that the proposed device is "substantially equivalent" to a legally marketed
Class I or II medical device, or to a Class III medical device for which the
FDA has not called for a PMA. The FDA may determine that a proposed device is
not substantially equivalent to a legally marketed device, or that additional
information or data are needed before a substantial equivalence determination
can be made. A request for additional data may require that clinical studies
of the device's safety and efficacy be performed.
Commercial distribution of a device for which a 510(k) premarket
notification is required can begin only after the FDA issues an order finding
the device to be "substantially equivalent" to a predicate device. The FDA
has recently been requiring a more rigorous demonstration of substantial
equivalence than in the past. It generally takes from four to six months from
the date of submission to obtain a 510(k) clearance, but it may take longer.
The FDA may determine that a proposed device is not substantially equivalent
to a legally marketed device, or that additional information is needed before
a substantial equivalence determination can be made.
A "not substantially equivalent" determination, or a request for
additional information, could delay the market introduction of new products
that fall into this category and could have a materially adverse effect on
the Company's business, financial condition and results of operations. For
any of the Company's products that were cleared through the 510(k) process,
modifications or enhancements that could significantly affect the safety or
efficacy of the device or that constitute a major change to the intended use
of the device will require new 510(k) submissions.
A PMA application must be filed if a proposed device is not
substantially equivalent to a legally marketed Class I or Class II device, or
if it is a Class III device for which the FDA has called for PMAs. A PMA
application must be supported by valid scientific evidence which typically
includes extensive data, including human clinical trial data to demonstrate
the safety and effectiveness of the device. The PMA application must also
contain the results of all relevant bench tests, laboratory and animal
studies, a complete description of the device and its components, and a
detailed description of the methods, facilities and controls used to
manufacture the device. In addition, the submission must include the proposed
labeling, advertising literature and training methods (if required).
Upon receipt of a PMA application, the FDA makes a threshold
determination as to whether the application is sufficiently complete to
permit a substantive review. If the FDA determines that the PMA application
is sufficiently complete to permit a substantive review, the FDA will accept
the application for filing. Once the submission is accepted for filing, the
FDA begins an in-depth review of the PMA. An FDA review of a PMA application
generally takes one to two years from the date the PMA application is
accepted for filing, but may take significantly longer. The review time is
often significantly extended by the FDA asking for more information or
clarification of information already provided in the submission. During the
review period, an advisory committee, typically a panel of clinicians, will
likely be convened to review and evaluate the application and provide
recommendations to the FDA as to whether the device should be approved. The
FDA is not bound by the recommendations of the advisory panel. Toward the end
of the PMA review process, the FDA generally will conduct an inspection of
the manufacturer's facilities to ensure that the facilities are in compliance
with applicable QSR requirements.
If the FDA's evaluations of both the PMA application and the manufacturing
facilities are favorable, the FDA will either issue an approval letter or an
approvable letter, which usually contains a number of conditions that must be
met in order to secure final approval of the PMA. When and if those
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conditions have been fulfilled to the satisfaction of the FDA, the agency
will issue a PMA approval letter, authorizing commercial marketing of the
device for certain indications. If the FDA's evaluation of the PMA
application or manufacturing facilities are not favorable, the FDA will delay
approval of the PMA application or issue a "not approvable letter." The FDA
may also determine that additional clinical trials are necessary, in which
case PMA approval may be delayed for several years while additional clinical
trials are conducted and submitted in an amendment to the PMA. The PMA
process is expensive, uncertain and lengthy and a number of devices for which
FDA approval has been sought by other companies have never been approved for
marketing. Modifications to a device that is the subject of an approved PMA,
its labeling, or manufacturing process may require approval by the FDA of PMA
supplements or new PMAs. Supplements to a PMA often require the submission of
the same type of information required for an initial PMA, except that the
supplement is generally limited to that information needed to support the
proposed change from the product covered by the original PMA.
If human clinical trials of a device are required in connection with
either a 510(k) premarket notification or a PMA, and the device presents a
"significant risk," the sponsor of the trial (usually the manufacturer or the
distributor of the device) is required to file an investigational device
exemption ("IDE") application prior to commencing human clinical trials. The
IDE application must be supported by data, typically including the results of
animal and laboratory testing. If the IDE application is reviewed and
approved by the FDA and one or more appropriate Institutional Review Boards
("IRBs"), human clinical trials may begin at a specific number of
investigational sites with a specific number of patients, as approved by the
FDA. If the device presents a "nonsignificant risk" to the patient, a sponsor
may begin the clinical trial after obtaining approval for the study by one or
more appropriate IRBs, but not the FDA. Sponsors of clinical trials are
permitted to sell those devices distributed in the course of the study
provided such compensation does not exceed recovery of the costs of
manufacture, research, development and handling. An IDE supplement must be
submitted to and approved by the FDA before a sponsor or an investigator may
make a change to the investigational plan that may affect its scientific
soundness or the rights, safety or welfare of human subjects.
Any products manufactured or distributed by the Company pursuant to the
FDA clearances or approvals are subject to pervasive and continuing
regulation by the FDA, including record keeping requirements and reporting of
adverse experiences with the use of the device. Device manufacturers are
required to register their establishments and list their devices with the FDA
and certain state agencies, and are subject to periodic inspections by the
FDA and certain state agencies. The FDC Act requires devices to be
manufactured in accordance with QSR regulations which impose certain
procedural and documentation requirements upon the Company with respect to
manufacturing and quality assurance activities. The FDA has recently
finalized changes to the QSR regulations, which will likely increase the cost
of complying with QSR requirements.
Labeling and promotion activities are subject to scrutiny by the FDA and
in certain instances, by the Federal Trade Commission. The FDA actively
enforces regulations prohibiting marketing of products for unapproved uses.
The Company and its products are also subject to a variety of state laws and
regulations in those states or localities where its products are marketed.
Any applicable state or local regulations may hinder the Company's ability to
market its products in those states or localities. Manufacturers are also
subject to numerous federal, state and local laws relating to such matters as
safe working conditions, manufacturing practices, environmental protection,
fire hazard control and disposal of hazardous or potentially hazardous
substances. There can be no assurance that the Company will not be required
to incur significant costs to comply with such laws and regulations now or in
the future or that such laws or regulations will not have a material adverse
effect upon the Company's ability to do business.
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Exports of products that have market clearance from the FDA do not
require export approval. However, some foreign countries require
manufacturers to provide an FDA certificate for products for export ("CPE")
which requires the device manufacturer to certify to the FDA that the product
has been granted premarket clearance in the United States and that the
manufacturing facilities appeared to be in compliance with QSRs at the time
of the last QSR inspection. The FDA will refuse to issue a CPE if significant
outstanding QSR violations exist.
Exports of products subject to the 510(k) notification requirements, but
not yet cleared to market, are permitted without FDA export approval provided
certain requirements are met. Unapproved products subject to the PMA
requirements must be approved by FDA for export. To obtain FDA export
approval certain requirements must be met and information must be provided to
the FDA, including documentation demonstrating that the product is approved
for import into the country to which it is to be exported and, in some
instances, safety data from animal or human studies. There can be no
assurance that the FDA will grant export approval when such approval is
necessary, or that countries to which the devices are to be exported will
approve the devices for import. Failure of the Company to obtain CPEs, meet
the FDA's export requirements, or obtain FDA export approval when required to
do so, could have a material adverse effect on the Company's business,
financial condition and results of operations.
The introduction of the Company's products in foreign markets will also
subject the Company to foreign regulatory clearances, registrations or
approvals which may impose additional substantial costs and burdens.
International sales of medical devices are subject to the regulatory
requirements of each country. The regulatory review process varies from
country to country. Many countries also impose product standards, packaging
requirements, labeling requirements and import restrictions on devices. In
addition, each country has its own tariff regulations, duties and tax
requirements. The approval by the FDA and foreign government authorities is
unpredictable and uncertain, and no assurance can be given that the necessary
clearances, registrations or approvals will be granted on a timely basis or
at all. Delays in receipt of, or a failure to receive, such clearances,
registrations or approvals, or the loss of any previously received,
clearances, registrations or approvals, could have a material adverse effect
on the business, financial condition and results of operations of the Company.
The European Union has promulgated rules that require that medical
products receive the right to affix the CE mark prior to their sale. The CE
mark is an international symbol of adherence to quality assurance standards
and compliance with applicable European medical device directives. In order
to maintain the right to affix the CE mark to its current and future
products, the Company must maintain processes that meet ISO 9000 quality
standards and have each individual product comply with the Medical Devices
Directive 93/42/EEC. In January 1997 the Company received ISO 9001
certification and CE Mark approval for the first generation MIDCAB products.
Subsequent products must conform to the Medical Devices Directive in order to
affix the CE mark.
The CTS Access Ultima System, CTS Access MV Stabilizer Set, CTS Access
MP Lift, CTS Aurora MultiTrac System and CTS Ceres SV System are Class I
devices which do not require marketing clearance from the FDA. The Company
also has the right to affix the CE Mark to these products. The CTS FloCoil
Shunt, CTS Bipolar Scissors and CTS Aries CO2 Blower/Mister received FDA
marketing clearance through the 510(k) process. The Company has also met the
necessary requirements to affix the CE Mark to these products. The
manufacturers of the CTS Coronary FloMeter System, CTS Coronary FloProbes,
Cardioflon Sutures, Cardionyl Sutures and other products in the CTS OPCAB
Procedure Kits have received FDA marketing clearance through the 510(k)
process. The Company is currently in the process of obtaining 510(k)
clearance for the CTS Voyager Quad Cannula. There can be no assurance that
the Company will obtain 510(k) clearance to market the CTS Voyager Quad
Cannula.
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There can be no assurance that the FDA will act favorably or quickly on
the Company's 510(k) submissions, and significant difficulties and costs may
be encountered by the Company in its efforts to obtain FDA clearance that
could delay or preclude the Company from selling its potential products in
the United States. Failure to receive, or delays in the receipt of FDA
clearances or approvals could have a material adverse effect on the Company's
business, financial condition and results of operations.
The Company's products are subject to continued and pervasive regulation
by the FDA and other foreign and domestic regulatory authorities. Changes in
existing requirements or adoption of new requirements or policies could
adversely affect the ability of the Company to comply with regulatory
requirements. Failure to comply with regulatory requirements could have a
material adverse effect on the Company's business, financial condition and
results of operations. There can be no assurance that the Company will not be
required to incur significant costs to comply with laws and regulations in
the future or that laws or regulations will not have a material adverse
effect upon the Company's business, financial condition or results of
operations.
Regulatory clearances or approvals, if granted, may include significant
limitations on the indicated uses for which the Company's products may be
marketed. FDA enforcement policy strictly prohibits the marketing of FDA
cleared or approved medical devices for unapproved uses. In addition, the
Company's manufacturing processes are required to comply with the QSR
regulations of the FDA. These regulations include design, testing,
production, control, documentation and other requirements. Enforcement of
QSRs has increased significantly in the last several years, and the FDA has
publicly stated that compliance will be more strictly scrutinized. The
Company's facilities and manufacturing processes, as well as those of any
future third-party suppliers, will be subject to periodic inspection by the
FDA, the California Department of Health Services and other agencies. The
Company has received ISO 9001 certification, has obtained its California
Device Manufacturing license and has successfully undergone a facility
inspection by the FDA. Failure to comply with these and other applicable
regulatory requirements could result in, among other things, warning letters,
fines, injunctions, civil penalties, recall or seizure of products, total or
partial suspension of production, refusal of the government to grant
premarket clearance or premarket approval for devices, withdrawal of
clearances or approvals and criminal prosecution, any of which could have a
material adverse effect on the Company's business, financial condition and
results of operations.
THIRD-PARTY REIMBURSEMENT
In the United States, health care providers, such as hospitals and
physicians, that purchase medical devices such as the Company's products,
generally rely on third-party payors, principally Medicare, Medicaid and
private health insurance plans, to reimburse all or part of the cost of the
procedure in which the medical device is being used. Reimbursement for
cardiovascular surgery, including CABG surgery, using devices that have
received FDA approval, has generally been available in the United States. In
addition, certain health care providers are moving toward a managed care
system in which such providers contract to provide comprehensive health care
for a fixed cost per person. The Company is unable to predict what changes,
if any, may be made in the reimbursement methods utilized by third-party
health care payors. The Company could be adversely affected by changes in
reimbursement policies of government or private health care payors,
particularly to the extent any such changes affect reimbursement for the
procedures in which the Company's products are intended to be used. Failure
by physicians, hospitals and other potential users of the Company's products
to obtain sufficient reimbursement from health care payors for the procedures
in which the Company's products are intended to be used or adverse changes in
government and private third-party payors' policies toward reimbursement for
such procedures could have a material adverse effect on the Company's
business, financial condition and results of operations.
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Market acceptance of the Company's products in international markets is
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. The Company intends
to seek international reimbursement approvals, although there can be no
assurance that any such approvals will be obtained in a timely manner, if at
all, and failure to receive international reimbursement approvals could have
a material adverse effect on market acceptance of the Company's products in
the international markets in which such approvals are sought.
PRODUCT LIABILITY AND INSURANCE
The development, manufacture and sale of medical products entail
significant risk of product liability claims and product recalls. The
Company's current product liability insurance coverage limits are $5,000,000
per occurrence and $5,000,000 in the aggregate, and there can be no assurance
that such coverage limits are adequate to protect the Company from any
liabilities it might incur in connection with the development, manufacture
and sale of its products. In addition, the Company may require increased
product liability insurance coverage as product sales increase. Product
liability insurance is expensive and in the future may not be available to
the Company on acceptable terms, if at all. A successful product liability
claim or series of claims brought against the Company in excess of its
insurance coverage, or a product recall, could have a material adverse effect
on the Company's business, financial condition and results of operations.
EMPLOYEES
As of January 1, 1999, the Company had 147 full-time employees.
Forty-five persons are engaged in research and development and regulatory
affairs activities, fifty-five persons are engaged in sales and marketing
activities, thirty-four persons are engaged in manufacturing and quality
assurance and thirteen persons are engaged in finance and administration. No
employees are covered by collective bargaining agreements, and the Company
believes it maintains good relations with its employees.
OTHER RISK FACTORS
This annual report on Form 10-K contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section
21E of the Securities and Exchange Act of 1934. The Company's future results
could differ materially from those anticipated by such forward-looking
statements as a result of certain factors including those set forth in the
following factors and elsewhere in this annual report on Form 10-K.
LIMITED OPERATING HISTORY; HISTORY OF LOSSES AND EXPECTATION OF FUTURE
LOSSES. The Company has a limited operating history upon which evaluation of
its prospects can be made. Such prospects must be considered in light of the
substantial risks, expenses and difficulties encountered by entrants into the
medical device industry, which is characterized by an increasing number of
participants, intense competition and a high failure rate. The Company began
commercial sales of its products in December 1996 and has limited experience in
manufacturing, marketing and selling its products. The Company has experienced
operating losses since its inception, and, as of January 1, 1999, the Company
had an accumulated deficit of approximately $62.0 million. The development and
commercialization of the Company's products will continue to require substantial
development, regulatory, sales and marketing, manufacturing and other
expenditures. The Company expects its operating losses to continue at least
through 1999 as it expends substantial resources to continue development of its
products, obtain additional regulatory clearances or approvals, continue to
market, sell and manufacture its products, support its
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finance and administrative organizations and conduct further research and
development. There can be no assurance that the Company's products will gain
enough commercial acceptance to allow the Company to generate the revenues
necessary to achieve profitability.
UNCERTAINTY OF CLINICAL ADOPTION OF MICS PROCEDURES. Most of the
Company's current products are designed to enable the majority of
cardiothoracic surgeons to perform minimally invasive cardiac surgery
("MICS") on a beating heart. Accordingly, the Company's success is dependent
upon acceptance of this procedure by the medical community as a reliable,
safe and cost effective alternative to existing treatments for
revascularizing blocked coronary arteries. The Company is unable to predict
how quickly, if at all, MICS will be adopted by the medical community or, if
it is adopted, the number of MICS procedures that will be performed. The
medical conditions that can be treated with MICS can also be treated with
widely accepted surgical procedures such as CABG surgery and catheter-based
treatments, including balloon angioplasty, atherectomy and coronary stenting.
Although the Company believes that MICS has significant advantages over
competing procedures, broad-based clinical adoption of MICS will not occur
until physicians determine that the approach is an attractive alternative to
current treatments for coronary artery disease. The Company believes that
continued physician endorsements will be essential for clinical adoption of
MICS, and there can be no assurance that such endorsements will be continued.
Clinical adoption will also depend upon the Company's ability to facilitate
training of cardiothoracic surgeons to perform MICS, and the willingness of
such surgeons to perform MICS procedures. Patient acceptance of MICS will
depend in part upon physician recommendations as well as other factors,
including the degree of invasiveness, the effectiveness of the procedure and
rate and severity of complications associated with MICS as compared to other
treatments. Even if the clinical efficacy of MICS is established, physicians
may elect not to recommend the procedure unless acceptable reimbursement from
health care payors is available. Health care payor acceptance may require
evidence of the cost effectiveness of the MICS as compared to other currently
available treatments. For all of these reasons, there can be no assurance
that MICS will gain clinical adoption. Failure of MICS to achieve significant
clinical adoption would have a material adverse effect on the Company's
business, financial condition and results of operations.
Most of the Company's current products are designed for beating heart
MICS and are expected to account for the great majority of the Company's
revenues in 1999. The Company manufactured and sold approximately 23,700
beating heart MICS systems in the two years ended January 1, 1999, but there
can be no assurance that demand for the Company's current or future products
will be sufficient to allow profitable operations. Failure of the Company's
current and future products to be successfully commercialized at
significantly higher volumes would have a material adverse effect on the
Company's business, financial condition and results of operations.
EARLY STAGE OF DEVELOPMENT AND COMMERCIALIZATION; NO ASSURANCE OF
ABILITY TO MANAGE GROWTH. The Company believes that the Company's products
could address a large potential market. There can be no assurance that the
Company's marketing efforts will result in significant demand for its
products, or that the current demand for the Company's products will grow.
Even if demand for the Company's products does grow, there can be no
assurance that the Company will be able to develop the necessary
manufacturing capability; build and train the necessary manufacturing, sales
and marketing teams; attract, retain and integrate the required key
personnel; or implement the financial and management systems to meet growing
demand for its products. Failure of the Company to successfully manage its
growth would have a material adverse effect on the Company's business,
financial condition and results of operations.
RISKS RELATING TO INTERNATIONAL OPERATIONS. The Company markets its
products in international markets. Changes in overseas economic conditions,
currency exchange rates, foreign tax laws, or tariffs or
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other trade regulations could have a material adverse effect on the Company's
business, financial condition and results of operations. The international
nature of the Company's business is also expected to subject it and its
distributors to laws and regulations of the foreign jurisdictions in which
they operate or the Company's products are sold. The regulation of medical
devices in a number of such jurisdictions, particularly in the European
Union, continues to develop and there can be no assurance that new laws or
regulations will not have an adverse effect on the Company's business,
financial condition and results of operations. In addition, the laws of
certain foreign countries do not protect the Company's intellectual property
rights to the same extent as do the laws of the United States.
POSSIBLE FUTURE CAPITAL REQUIREMENTS. The Company's capital
requirements, and the availability of product revenues, depend on numerous
factors, including the progress of the Company's product development
programs, the receipt of and the time required to obtain regulatory
clearances or approvals, the resources the Company devotes to developing,
manufacturing and marketing its products, the extent to which the Company's
products receive market acceptance, and other factors. The Company expects
to devote substantial capital resources to research and development, to
support a direct sales force and marketing operation in the United States and
to continue to support its manufacturing capacity and facilities.
Consequently, the Company may be required to raise additional funds through
public or private financing, collaborative relationships or other
arrangements. There can be no assurance that the Company will not require
additional funding or that such additional funding, if needed, will be
available on terms attractive to the Company, or at all, which could have a
material adverse effect on the Company's business, financial condition and
results of operations. Any additional equity financing may be dilutive to
stockholders, and debt financing, if available, may involve restrictive
convenants.
POTENTIAL VOLATILITY OF STOCK PRICE. The stock markets have experienced
price and volume fluctuations that have particularly affected medical
technology companies, resulting in changes in the market prices of the stocks
of many companies that may not have been directly related to the operating
performance of those companies. Such broad market fluctuations may adversely
affect the market price of the Company's Common Stock. In addition, the
market price of the Common Stock may be highly volatile. Factors such as
variations in the Company's financial results, comments by securities
analysts, announcements of technological innovations or new products by the
Company or its competitors, changing government regulations and developments
with respect to FDA submissions, patents, proprietary rights or litigation
may have a significant adverse effect on the market price of the Common Stock.
SIGNIFICANT RESTRICTIONS ON CHANGE OF CONTROL. The Company has adopted
a number of anti-takeover measures. The Company has adopted a Preferred
Shares Rights Agreement, sometimes referred to as a poison pill, designed to
prevent hostile takeovers not approved by the Board of Directors. In
addition, the Company is authorized to issue 5,000,000 shares of undesignated
Preferred Stock. Such shares of Preferred Stock may be issued by the Company
without stockholder approval upon such terms as the Company's Board of
Directors may determine. The issuance of Preferred Stock may have the effect
of delaying, deferring or preventing a change of control of the Company, may
discourage bids for the Company's Common Stock at a premium over the market
price of the Common Stock and may adversely affect the market price of the
voting and other rights of, the holders of Common Stock. At present, the
Company has no plans to issue any of the Preferred Stock.
The Company's Certificate of Incorporation and Bylaws provide for the
division of the Board of Directors into three classes of directors serving
staggered three-year terms. In addition, the Certificate of Incorporation
requires that any action required or permitted to be taken by the
stockholders must be taken at a meeting and may not be taken by written
consent in lieu of a meeting. The Bylaws provide that special meetings of
the stockholders may be called only by the board of directors, the chairman
of the board or the president of the Company, and not by the stockholders.
Advanced notice must be given by
20
<PAGE>
stockholders of any stockholder proposal or director nomination or other
business to be brought by stockholders at stockholders' meetings.
ITEM 2. PROPERTIES
The Company currently leases a 23,500 and a 4,125 square foot facility
in Cupertino, California. The facilities include an environmentally
controlled, Class 10,000 clean room for assembly together with laboratory,
machine shop, warehouse and office space. The leases expire on June 1, 2001.
The Company expects to enter into a sublease for approximately 17,000 square
foot of office and warehouse space in the second quarter of 1999. The
Company estimates that this additional space will be sufficient for the
Company's growth in 1999. The Company is currently evaluating its
requirements for 2000 and beyond.
ITEM 3. LEGAL PROCEEDINGS
The Company is not currently party to any legal proceeding.
Heartport, Inc. (formerly Stanford Surgical Technologies, Inc.), the
former employer of the Company's founder and Chief Technical Officer, Charles
S. Taylor, has alleged in certain correspondence in late 1995 and again in
September 1997 that Mr. Taylor and the Company may have misappropriated trade
secrets of the former employer and breached confidentiality obligations to
the former employer. The former employer has also claimed in such
correspondence an ownership interest in certain developments and products of
the Company. The Company has agreed to provide for the defense of Mr. Taylor
in the event that litigation is commenced. Litigation is subject to inherent
uncertainties, especially in cases where complex technical issues are decided
by a lay jury. Accordingly, no assurance can be given that if a lawsuit is
commenced it would not be decided against the Company. Such an adverse
determination could have a material adverse effect upon the Company's
business, financial condition and results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) A special meeting of stockholders was held on October 29, 1998.
(b) The matter voted upon at the meeting and results of the voting
with respect to that matter are as follows:
(1) Approve the adoption of the 1998 Employee Stock Purchase
Plan including the reservation of 250,000 shares of Common
Stock for sale thereunder and an annual increase in the
number of shares of Common Stock reserved for sale
thereunder by the lesser of 250,000 or 1.5% of the
outstanding shares of Common Stock.
For 7,385,692 Against 755,724 Abstain 32,655
--------- ------- ------
21
<PAGE>
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS.
The information required by this item is incorporated by reference to
the portion of the Registrant's 1998 annual report to stockholders entitled
"Market Price of Common Stock and Dividend Information" and included in
Exhibit 13.1 to this report.
The following information is provided as an amendment to the initial
report on Form SR, "Report of Sales and Securities and Use of Proceeds
Therefrom", regarding the use of proceeds from the sale of securities under
the Company's Registration Statement Form S-1 (333-1840), which was declared
effective on April 18, 1996 (CUSIP number 141907). The information provided
is for the period from April 18, 1996 through January 1, 1999.
<TABLE>
<CAPTION>
Use of Proceeds Amount
--------------- ------
<S> <C>
Construction of plant, building and facilities $ 0
Purchase and installation of machinery and equipment 6,416,000
Purchase of real estate 0
Acquisition of other businesses 0
Repayment of indebtedness 0
Working capital 4,242,000
Cost of operations 34,776,000
Temporary Investment
--------------------
Cash 240,000
Commercial paper, notes and bonds $38,602,000
</TABLE>
All amounts above represent estimates of direct or indirect payments to third
parties.
The amounts below were paid directly to officers of the Company.
<TABLE>
<CAPTION>
Use of Proceeds Amount
--------------- ------
<S> <C>
Loans to officers $ 655,000
</TABLE>
ITEM 6. SELECTED FINANCIAL DATA
The information required by this item is incorporated by reference to
the portion of the Registrant's 1998 annual report to stockholders entitled
"Selected Financial Data" and included in Exhibit 13.1 to this report.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The information required by this item is incorporated by reference to
the portion of the Registrant's 1998 annual report to stockholders entitled
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and included in Exhibit 13.1 to this report.
22
<PAGE>
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by this item is incorporated by reference to
the portion of the Registrant's 1998 annual report to stockholders entitled
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Financial Risk Management" and included in Exhibit 13.1 to this
report.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item is incorporated by reference to
the portion of the Registrant's 1998 annual report to stockholders entitled
"1998 Financial Review" and included in Exhibit 13.1 to this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
23
<PAGE>
PART III
Certain information required by Part III is omitted from this Report on
Form 10-K in that the Registrant will file a definitive proxy statement
within 120 days after the end of its fiscal year pursuant to Regulation 14A
with respect to the 1999 Annual Meeting of Stockholders (the "Proxy
Statement") to be held May 4, 1999 and certain information included therein
is incorporated herein by reference.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item relating to directors is
incorporated by reference to the information under the caption "Proposal No.
1 -- Election of Directors" in the Proxy Statement.
The executive officers of the Registrant, who are elected by the board
of directors, are as follows:
<TABLE>
<CAPTION>
Name Age Position
- ------------------ ----- ---------------------------------------------
<S> <C> <C>
Richard M. Ferrari 45 President, Chief Executive Officer and Director
Jeffrey G. Gold 51 Executive Vice President and Chief Operating
Officer
Steven M. Van Dick 44 Vice President, Finance and Administration and
Chief Financial Officer
Michael J. Billig 48 Vice President, Regulatory, Quality and Clinical
Research
Geoffrey D. Dillon 44 Vice President, Sales and Marketing
Richard A. Lotti 42 Vice President, Business Development
Charles S. Taylor 44 Vice President and Chief Technical Officer
</TABLE>
RICHARD M. FERRARI joined CTS as Chief Executive Officer and a Director
in June 1995 and was elected President in August 1995. From January 1991
until joining the Company, he was President and Chief Executive Officer of
CardioVascular Imaging Systems, Inc. ("CVIS"), a manufacturer of
intravascular ultrasound systems, which is currently a subsidiary of Boston
Scientific Corporation. From March 1990 until joining CVIS, he served as
President and Acting Chief Executive Officer of Medstone International, Inc.,
a manufacturer of lithotripsy equipment for treatment of gall and kidney
stones. From 1981 to February 1990, he was employed with ADAC Laboratories,
a supplier of diagnostic imaging equipment, serving most recently as
Executive Vice President and General Manager responsible for the Nuclear
Medicine, Digital Cardiology, Information Management and Radiation Therapy
business units. Mr. Ferrari currently serves on the boards of several
privately held companies. Mr. Ferrari holds an M.B.A. from the University of
South Florida.
JEFFREY G. GOLD joined the Company as Executive Vice President in March
of 1997 and was elected Chief Operating Officer in July of 1997. From 1978
through 1996 he held various positions with Cordis Corporation, a
manufacturer of cardiovascular devices. From 1993 to 1996 Mr. Gold was
President of Cordis Endovascular Systems, Inc., a supplier of devices for
interventional neuroradiology. Mr. Gold served Cordis as Vice President of
Research & Development from 1991 to 1993, and as Vice President of
Manufacturing from 1986 to 1991. Mr. Gold holds an Industrial Engineering
degree from Northeastern University and an MBA from the University of Florida.
24
<PAGE>
STEVE M. VAN DICK joined the Company as Vice President of Finance and
Administration and Chief Financial Officer in April 1996. From March 1995
until April 1996, Mr. Van Dick was Vice President of Finance and
Administration and Chief Financial Officer of Perclose, Inc., a manufacturer
of minimally invasive systems for the surgical closure of arterial access
sites in catheterization procedures. From September 1993 until March 1995,
he was Vice President of Finance and Chief Financial Officer of CVIS. From
1992 until joining CVIS, Mr. Van Dick was Vice President, Finance and Chief
Financial Officer of Imatron, Inc., a manufacturer of specialized medical
equipment. From 1987 until joining Imatron, he held various positions with
ADAC Laboratories, serving as Vice President of Finance since 1988 and as
Chief Financial Officer since 1991. Mr. Van Dick holds an M.B.A. from Santa
Clara University and is a Certified Public Accountant.
MICHAEL J. BILLIG joined CTS as Vice President of Regulatory, Clinical
and Quality in February 1996. From January 1989 until joining the Company,
Mr. Billig served as Vice President, Regulatory, Clinical and Quality of
Cardiometrics, Inc., a company that manufactures and markets intravascular
Doppler ultrasound systems for measuring blood flow. From June 1987 to
February 1989, he served as Director, Regulatory Affairs and Quality
Assurance of Cardiometrics, Inc.
GEOFFREY D. DILLON joined the Company as Vice President, Global Sales in
August 1997 and was made Vice President, Sales and Marketing in March 1998.
From February 1997 until joining the Company, Mr. Dillon was Vice President,
Sales and Marketing of Quest Medical Inc.'s Cardiovascular Systems Division,
a manufacturer of cardiac surgery specialty products. From May 1996 to
February 1997, Mr. Dillon was Vice President, Marketing of Quest Medical
Inc.'s Cardiovascular Systems Division. From May 1995 to May 1996, Mr.
Dillon was President of Dilstar, Inc., an exclusive sales and marketing
agency for H.D.N.A. of North America, a high definition television network.
From January 1994 to April 1995, Mr. Dillon was Director of Marketing for the
Micro-Endo Division of Sofamor-Danek Group, a manufacturer of spinal implants
and spinal endoscopy systems. From 1983 to December 1993, Mr. Dillon held
various positions with Storz Instrument Company, a manufacturer of various
medical devices, serving as Product Manager, Surgical Specialties Division
since 1990. Mr. Dillon holds a BA degree from Ashland University.
RICHARD A. LOTTI joined the Company as Vice President, Business
Development in December of 1997. From June 1994 to July 1997, Mr. Lotti was
a Vice President of the NeuroCare Group and the General Manager of Camino
NeuroCare, the market leader in intracranial neuromonitoring. From January
1990 to February 1994, Mr. Lotti held various product development management
positions with Sorin Biomedical, previously Pfizer-Shiley, a manufacturer of
cardiopulmonary bypass devices and heart valve implants. Mr. Lotti served as
director of the cardiopulmonary business since February 1992. Prior to 1990,
Mr. Lotti held positions in operations, product development and international
operations at Alcon Surgical and Johnson and Johnson. He holds a BSME and an
MBA from Rensselaer Polytechnic Institute.
CHARLES S. TAYLOR, the founder of CTS, has been with Informed Creation,
the predecessor company to CTS, since its inception in November 1993, and has
served as Vice President, Chief Technical Officer and Director since the
Company's incorporation in June 1995. From June 1992 until November 1993,
Mr. Taylor was a member of the research and development group at Stanford
Surgical Technologies, Inc., now Heartport, Inc., a public company that
develops and markets instruments for cardiac surgical procedures. From
January 1992 to May 1992, Mr. Taylor managed the establishment of a new
development group for Eli Lilly's Medical Instrument Systems division, the
Technology Development Center ("TDC"), which develops surgical devices for
vascular intervention procedures. From May 1986 to December 1991, he was an
Engineer and Manager for Advanced Cardiovascular Systems, Inc. where he
directed teams of engineers developing new manufacturing technologies and
custom research and development equipment.
25
<PAGE>
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference to
the information under the caption "Executive Compensation" in the Proxy
Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference to
the information under the caption "Share Ownership of Directors, Officers and
Certain Beneficial Owners" in the Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference to the
information under the caption "Certain Transaction" in the Proxy Statement.
26
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. Financial Statements
The following Consolidated Financial Statements of CardioThoracic
Systems, Inc. and Report of Independent Accountants are
incorporated by reference in the respective portions of the
Registrant's 1998 annual report to stockholders included in
Exhibit 13.1 to the report:
Consolidated Balance Sheets; January 1, 1999 and January 2,
1998
Consolidated Statements of Operations; Years ended January 1,
1999, January 2, 1998 and December 31, 1996
Consolidated Statements of Stockholders' Equity; Years ended
January 1, 1999, January 2, 1998 and December 31, 1996
Consolidated Statements of Cash Flows; Years ended January 1,
1999, January 2, 1998 and December 31, 1996
Notes to Consolidated Financial Statements
Report of Independent Accountants
2. Financial Statement Schedules
All financial statement schedules are omitted because they are
not applicable or the required information is shown in the
Consolidated Financial Statements or the notes thereto.
3. Exhibits
Refer to (c) below.
(b) Reports on Form 8 - K.
The Company was not required to and did not file any reports on Form
8-K during the three months ended January 1, 1999.
(c) Exhibits
<TABLE>
<CAPTION>
Exhibit
No. Description
----- ---------------------------------------------------------------
<S> <C>
3.2(1) Restated Certificate of Incorporation.
3.3(7) Bylaws (as amended).
3.4(4) Certificate of Designations of Rights, Preferences and
Privileges of Series A Participating Preferred Stock
</TABLE>
27
<PAGE>
<TABLE>
<S> <C>
3.5(4) Preferred Shares Rights Agreement, dated as of February 14,
1997.
3.6(7) Certificate of Amendment to Restated Certificate of
Incorporation.
4.1(1) Specimen Common Stock Certificate.
10.1(1) Form of Indemnification Agreement between the Company and
each of its directors and officers.
10.2(8) Incentive Stock Plan and forms of Agreements thereunder (as
amended).
10.3(1) Director Option Plan and form of Director Stock Option
Agreement thereunder.
10.4(1) Employee Stock Purchase Plan and forms of agreements
thereunder.
10.5(5) Nonstatutory Stock Option Plan and form of Nonstatutory Stock
Option Agreement thereunder (as amended).
10.6(1) Form of Employment, Confidential Information and Invention
Assignment Agreement.
10.8(1) Consulting Agreement, dated June 30, 1995, between the
Company and Federico Benetti, M.D.
10.9(1) Assignment Agreement, dated June 30, 1995 (as amended by
Amendment Agreement dated August 31, 1995), between the
Company and Federico Benetti, M.D.
10.10(1) Employment Letter Agreement, dated September 5, 1995, between
the Company and Charles S. Taylor.
10.11(1) Assignment Agreement, dated September 7, 1995, between the
Company and Charles S. Taylor.
10.12(1) Shareholder Rights Agreement dated September 8, 1995 (as
amended January 3, 1996) between the Company and certain
holders of the Registrant's securities.
10.13(1) Letter Agreement regarding Heartport trade secret
allegations, dated October 11, 1995, between the Company and
Charles S. Taylor.
10.14(1) Assignment, Assumption of Lease and Consent, dated November
9, 1995, between the Company and Cardiovascular Concepts,
Inc. ("CVC") for the premises located at 3260 Alpine Road,
Portola Valley, California 94028.
10.17(1) Consent to Assignment, dated December 22, 1995, among the
Company, Viking Partners, Inc. ("Viking"), CVC and Fogarty
Engineering, Inc. for the premises located at 3260 Alpine
Road, Portola Valley, California 94028.
10.19(1) First Amendment to Assignment, Assumption of Lease and
Consent, dated December 22, 1995, between the Company and CVC
for the premises located at 3260 Alpine Road, Portola Valley,
California 94028.
10.21(1) Consulting Agreement, dated February 21, 1996, between the
Company and Thomas J. Fogarty, M.D.
10.22(1) Development and License Agreement, dated February 19, 1996,
between the Company and Enable Medical Corp.
10.23(1) Employment Letter Agreement, dated March 15, 1996, between
the Company and Steve M. Van Dick.
10.24(1) Lease dated March 29, 1996 for space located at 10600 North
Tantau Avenue, Cupertino, California between the Company and
Spieker Properties,
</TABLE>
28
<PAGE>
<TABLE>
<S> <C>
L.P.
10.27(2) Employment Agreement, dated April 19, 1996, between the
Company and Steve Van Dick.
10.29(2) Promissory Note for $35,000 dated May 20, 1996, between the
Company and Michael Billig.
10.31(3) Promissory Note for $750,000 and Security Agreement dated
August 16, 1996, between the Company and Richard Ferrari.
10.32(5) Promissory Note for $200,000 dated December 3, 1996, between
the Company and Steve Van Dick.
10.33(6) Employment Letter Agreement, dated February 25, 1997, between
the Company and Jeffrey Gold.
10.34(7) Employment Letter Agreement, dated July 17, 1997, between the
Company and Geoffrey Dillon.
10.35(7) Employment Letter Agreement, dated November 24, 1997, between
the Company and Richard Lotti.
10.36(8) 1998 Nonstatutory Stock Option Plan and forms of Agreements
thereunder.
10.37(9) 1998 Employee Stock Purchase Plan and forms of agreements
thereunder.
13.1 Portions of Annual Report to Stockholders incorporated by
reference.
23.1 Consent of PricewaterhouseCoopers LLP, Independent
Accountants
27.1 Financial Data Schedule
</TABLE>
- ---------------------
(1) Incorporated herein by reference to the same-numbered exhibit previously
filed with the Company's Registration Statement on Form S-1 (Registration
No. 333-1840).
(2) Incorporated herein by reference to the same-numbered exhibit previously
filed with the Company's Form 10-Q for the period ended June 30, 1996.
(3) Incorporated herein by reference to the same-numbered exhibit previously
filed with the Company's Form 10-Q for the period ended September 30, 1996.
(4) Incorporated herein by reference to the Company's Registration Statement on
Form 8-A, filed with the Securities and Exchange Commission on February 28,
1997.
(5) Incorporated herein by reference to the same-numbered exhibit previously
filed with the Company's Form 10-K for the period ended December 31, 1996.
(6) Incorporated herein by reference to the same-numbered exhibit previously
filed with the Company's Form 10-Q for the period ended June 27, 1997.
(7) Incorporated herein by reference to the same-numbered exhibit previously
filed with the Company's Form 10-K for the period ended January 2, 1998.
(8) Incorporated herein by reference to the Company's Registration Statement on
Form S - 8, filed with the Securities and Exchange Commission on May 27,
1998.
(9) Incorporated herein by reference to the Company's Registration Statement on
Form S - 8, filed with the Securities and Exchange Commission on January
22, 1999.
29
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized.
Date: March 30, 1999 CARDIOTHORACIC SYSTEMS, INC.
/S/ Richard M. Ferrari
--------------------------------------
Richard M. Ferrari
President and Chief Executive Officer
30
<PAGE>
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Richard M. Ferrari and Steve M. Van
Dick, jointly and severally, his or her attorneys-in-fact, and each with the
power of substitution, for him or her in any and all capacities, to sign any
amendments to this Report on Form 10-K, and to file the same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that each of said
attorneys-in-fact, or his or her substitute or substitutes, may do or cause
to be done by virtue thereof.
Pursuant to the requirements of the Securities and Exchange Act of 1934,
this Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the date indicated.
<TABLE>
<S> <C> <C>
/S/ Richard M. Ferrari President, Chief Executive March 30, 1999
- ------------------------- Officer and Director
Richard M. Ferrari
/S/ Steven M. Van Dick Vice President of Finance and March 30, 1999
- ------------------------- and Administration and Chief
Steven M. Van Dick Financial Officer (Principal
Financial and Accounting Officer)
/S/ Charles S. Taylor Vice President and Chief Technical March 30, 1999
- ------------------------- Officer and Director
Charles S. Taylor
/S/ Thomas J. Fogarty, M.D. Director March 30, 1999
- ----------------------------
Thomas J. Fogarty, M.D.
/S/ Jack W. Lasersohn Director March 30, 1999
- ----------------------------
Jack W. Lasersohn
/S/ Thomas C. McConnell Director March 30, 1999
- ----------------------------
Thomas C. McConnell
/S/ Robert C. Bellas Director March 30, 1999
- ----------------------------
Robert C. Bellas, Jr.
/S/ Philip M. Young Director March 30, 1999
- ----------------------------
Philip M. Young
</TABLE>
31
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit
No. Description
----- ---------------------------------------------------------------
<S> <C>
13.1 Portions of Annual Report to Stockholders incorporated by
reference.
23.1 Consent of PricewaterhouseCoopers LLP, Independent
Accountants
27.1 Financial Data Schedule
</TABLE>
32
<PAGE>
1998 FINANCIAL REVIEW
----------------------------------------
TABLE OF CONTENTS
17 Selected Financial Data
18 Management's Discussion and Analysis of
Financial Condition and Results of Operations
24 Consolidated Balance Sheets
25 Consolidated Statements of Operations
26 Consolidated Statements of Stockholders' Equity
28 Consolidated Statements of Cash Flows
29 Notes to Consolidated Financial Statements
35 Report of Independent Accountants
16
<PAGE>
SELECTED FINANCIAL DATA
CardioThoracic Systems, Inc. and subsidiary
<TABLE>
<CAPTION>
Company Informed Creation
---------------------------------------------------------------------------------------------
June 15, 1995
(date of January 1,
YEAR ENDED Year Ended Year Ended inception) to 1995 to Year Ended
JANUARY 1, January 2, December 31, December 31, June 14, December 31,
1999 1998 1996 1995(1) 1995(1) 1994
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
STATEMENTS OF OPERATIONS DATA:
Net sales $ 16,149,000 $ 9,379,000 $ 141,000
Cost of sales and start-up
manufacturing costs 7,237,000 5,962,000 842,000
-----------------------------------------------
Gross profit (loss) 8,912,000 3,417,000 (701,000)
Operating expenses:
Research and development 11,496,000 10,806,000 11,475,000 $ 488,000 $ 2,808 $20,154
Sales, marketing, general
and administration 21,655,000 18,620,000 6,977,000 556,000 5,537 22,162
Restructuring costs 736,000
Interest income, net 2,413,000 3,645,000 3,075,000 47,000 24 63
---------------------------------------------------------------------------------------------
Net loss $(22,562,000) $(22,364,000) $(16,078,000) $ (997,000) $(8,321) $(42,253)
---------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------
Net loss per common share
and per common share --
assuming dilution $ (1.62) $ (1.66) $ (1.64) $ (0.36)
---------------------------------------------------------------
Shares used in computing
net loss per common share
and per common share --
assuming dilution 13,968,000 13,505,000 9,794,000 2,783,000
- -----------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
Company Informed Creation
---------------------------------------------------------------------------------------------
JANUARY 1, January 2, December 31, December 31, June 14, December 31,
1999 1998 1996 1995 1995 1994
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash, cash equivalents and
available-for-sale securities $ 40,253,000 $ 60,834,000 $ 78,457,000 $3,273,000 $ 6,146 $ 3,333
Working capital 25,750,000 54,871,000 54,512,000 3,149,000 4,528 2,228
Total assets 49,766,000 69,276,000 83,691,000 3,389,000 15,853 14,599
Accumulated deficit (62,001,000) (39,439,000) (17,075,000) (997,000)
Total sole proprietorship
capital or stockholders' equity 39,963,000 60,134,000 79,253,000 3,214,000 14,235 13,494
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) The periods beginning on or after June 15, 1995 reflects the data
of the Company. The periods to and including June 14, 1995 reflect
data of Informed Creation. The Company acquired all of the
intellectual property assets of Informed Creation for cash on
September 7, 1995.
17
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CardioThoracic Systems, Inc. and subsidiary
The following discussion of the financial condition and results of operations
of CardioThoracic Systems, Inc. ("CTS" or the "Company") should be read in
conjunction with the Consolidated Financial Statements and the related Notes
thereto included herein.
This report contains forward looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
and Exchange Act of 1934. The Company's future results of operations could
vary significantly from those anticipated by such statements as a result of
factors described in this Management's Discussion and Analysis of Financial
Condition and Results of Operations and under "Factors Affecting Results of
Operations."
OVERVIEW
The business of the Company was commenced in November 1993 as a sole
proprietorship, Informed Creation. In June 1995, the business was
incorporated and as part of the Company's initial financing in September
1995, the Company acquired all intellectual property assets of Informed
Creation. The Company has a limited operating history upon which evaluation
of its prospects can be made. Such prospects must be considered in light of
the substantial risks, expenses and difficulties encountered by entrants into
the medical device industry, which is characterized by an increasing number
of participants, intense competition and a high failure rate. The Company
began commercial sales of its products in December 1996 and has limited
experience in manufacturing, marketing and selling its products. The Company
has experienced operating losses since its inception, and, as of January 1,
1999, the Company had an accumulated deficit of approximately $62,001,000.
The development and commercialization of the Company's products will continue
to require substantial development, regulatory, sales and marketing,
manufacturing and other expenditures. The Company expects its operating
losses to continue at least through 1999 as it expends substantial resources
to continue development of its products, obtain additional regulatory
clearances or approvals, continue to market, sell and manufacture its
products, support its finance and administrative organizations and conduct
further research and development. There can be no assurance that the
Company's products will gain enough commercial acceptance to allow the
Company to generate the revenues necessary to achieve profitability.
Most of the Company's current products are designed to enable the majority
of cardiothoracic surgeons to perform minimally invasive cardiac surgery
("MICS") on a beating heart. Accordingly, the Company's success is dependent
upon acceptance of this procedure by the medical community as a reliable,
safe and cost effective alternative to existing treatments for
revascularizing blocked coronary arteries. The Company is unable to predict
how quickly, if at all, MICS will be adopted by the medical community or, if
it is adopted, the number of MICS procedures that will be performed. The
medical conditions that can be treated with MICS can also be treated with
widely accepted surgical procedures such as CABG surgery and catheter-based
treatments, including balloon angioplasty, atherectomy and coronary stenting.
Although the Company believes that MICS has significant advantages over
competing procedures, broad-based clinical adoption of MICS will not occur
until physicians determine that the approach is an attractive alternative to
current treatments for coronary artery disease. The Company believes that
continued physician endorsements will be essential for clinical adoption of
MICS, and there can be no assurance that such endorsements will be continued.
Clinical adoption will also depend upon the Company's ability to facilitate
training of cardiothoracic surgeons to perform MICS, and the willingness of
such surgeons to perform MICS procedures. Patient acceptance of MICS will
depend in part upon physician recommendations as well as other factors,
including the degree of invasiveness, the effectiveness of the procedure and
rate and severity of complications associated with MICS as compared to other
treatments. Even if the clinical efficacy of MICS is established, physicians
may elect not to recommend the procedure unless acceptable reimbursement from
health care payors is available. Health care payor acceptance may require
evidence of the cost effectiveness of the MICS as compared to other currently
available treatments. For all of these reasons, there can be no assurance
that MICS will gain clinical adoption. Failure of MICS to achieve significant
clinical adoption would have a material adverse effect on the Company's
business, financial condition and results of operations.
Most of the Company's current products are designed for beating heart MICS
and are expected to account for the great majority of the Company's revenues
in 1999. The Company manufactured and sold approximately 23,700 beating heart
MICS systems in the two years ended January 1, 1999, but there can be no
assurance that demand for the Company's current or future products will be
sufficient to allow profitable operations. Failure of the Company's current
and future products to be successfully commercialized at significantly higher
volumes would have a material adverse effect on the Company's business,
financial condition and results of operations.
Before the Company can market certain products under development in the
United States, the Company must obtain clearance or approval from the United
States Food and Drug Administration ("FDA"). The Company has filed or will be
filing 510(k) premarket notifications or premarket approval ("PMA")
applications with the FDA for clearance or approval to market current
products and certain products under development. There can be no assurance
that the FDA will act favorably or quickly on the Company's submissions, or
that significant difficulties and costs will not be encountered by the
Company in its efforts to obtain FDA clearance or approval for its products
under development. Any such difficulties could delay or preclude obtaining
regulatory clearance or approval. In addition, there can be no assurance that
the FDA will not impose strict labeling or other requirements as a condition
of its 510(k) clearance or PMA approval, any of which could limit the
Company's ability to market its products under development. Further, if the
Company wishes to modify a product after FDA clearance or approval, including
changes in indications or other modifications that could affect safety and
efficacy, additional clearances or approvals will be required from the FDA.
Failure to receive, or delays in receipt of, FDA clearances or approvals,
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including delays resulting from an FDA request for clinical trials or
additional data as a prerequisite to clearance or approval, or any FDA
conditions that limit the ability of the Company to market its products under
development, could have a material adverse effect on the Company's business,
financial condition and results of operations.
In order for the Company to market its products under development in
Europe and certain other international jurisdictions, the Company and its
distributors will have to obtain required regulatory registrations or
approvals and otherwise comply with extensive regulations regarding safety,
efficacy and quality. These regulations, including the requirements for
registrations or approvals and the time required for regulatory review, vary
from country to country. The Company has received ISO 9001 certification and
the CE Mark approval for sale of its current products. The CE Mark evidences
receipt of the regulatory approval necessary for commercialization in
European Union countries and eliminates the requirement to obtain individual
country approvals. There can be no assurance that the Company will obtain
future regulatory registrations or approvals in other such countries or that
it will not be required to incur significant costs in obtaining or
maintaining its foreign regulatory registrations or approvals. Delays in
receipt of these registrations or approvals, failure to receive these
clearances or approvals, or the loss of received registrations or approvals
could have a material adverse effect on the Company's business, financial
condition and results of operations.
RESULTS OF OPERATIONS
FOR THE YEAR ENDED JANUARY 1, 1999 COMPARED TO THE YEAR ENDED JANUARY 2, 1998.
Net sales increased 72% to $16.1 million in the year ended January 1, 1999
when compared to the year ended January 2, 1998. The increase in net sales
was due primarily to a 111% increase in unit shipments of the CTS MIDCAB-TM-
Procedure System and CTS OPCAB-TM- Procedure family of products for the year
ended January 1, 1999 over the previous year. The increase in unit shipments
was offset by a 16% drop in the average selling price per procedural unit in
the year ended January 1, 1999 from the previous year.
Gross profit increased to $8.9 million (55% of net sales) in the year
ended January 1, 1999 compared to $3.4 million (36% of net sales) in the
previous year. The improvement in gross profit as a percent of net sales is
primarily due to lower material costs per unit, higher production volumes
which resulted in increased manufacturing efficiencies and a smaller
percentage of international revenue which has lower selling prices and
consequently lower gross margins.
Research and development expenses in the year ended January 1, 1999 were
$11.5 million compared to $10.8 million in the year ended January 2, 1998.
This was a result of increased research and development staff, facility
costs, and expenditures related to the continuing development and prototyping
of the instruments associated with the Company's Access MV-TM- products,
Access Ultima,-TM- Modular MIDCAB-TM- System, Ceres-TM- Saphenous Vein
Harvesting System, Aurora-TM- MultiTrac System, cannulation systems and valve
attachment products. The Company expects that research and development
expenses will continue at current levels through 1999.
The Company has entered into development and licensing agreements, and may
enter into additional agreements in the future, that require milestone
payments which are tied to certain events. The timing of these milestone
payments is uncertain and could have a material impact on the operating
results in the quarter and year in which they are expensed. During 1998 the
Company expensed $1.3 million for licensing of certain intellectual property
and other milestone payments, compared to $1.3 million in 1997.
Sales, marketing, general and administrative expenses increased to $21.7
million in the year ended January 1, 1999 compared to $18.6 million in the
same period last year. This increase was due primarily to the addition of
sales and marketing personnel, the costs associated with the support of a
larger field sales organization and higher surgeon training costs. The
Company expects that sales and marketing and administrative expenses will
decrease somewhat in 1999 as the Company reduces its costs to sell product
internationally.
The Company has recorded deferred compensation of $14.6 million, less
cancellations of $2.1 million, for the difference between the option exercise
price or restricted stock purchase price and the deemed fair value of the
Company's Common Stock for options granted and restricted stock sold in 1995
and early 1996 and for the deemed fair value of the Company's Common Stock
for options granted to non-employees since inception. The deferred
compensation is being amortized to operating expenses over the related
vesting period of the shares (one to four years) and will, therefore,
continue to have an adverse effect on the Company's results of operations
through 2001. Amortization of deferred compensation charged to operating
expenses in the year ended January 1, 1999 totaled $1.8 million compared to
$2.2 million for the same period last year.
In the fourth quarter of fiscal 1998, the Company recorded a restructuring
charge of $736,000 in connection with the closure of its German subsidiary.
In accordance with the restructuring plan, this closure resulted in the
termination of four German employees which represented all the employees of
the German subsidiary. The charge associated with employee termination
benefits was $349,000. The balance of the restructuring charge was an $88,000
non-cash charge for the loss on property and equipment and the write-down of
other recorded assets, $235,000 for lease cancellation expenses and $64,000
for other exit related costs.
Interest income decreased to $2.8 million in the year ended January 1,
1999 compared to $4.0 million in the same period last year. This decrease was
primarily due to lower average cash and investment balances.
FOR THE YEAR ENDED JANUARY 2, 1998 COMPARED TO THE YEAR ENDED
DECEMBER 31, 1996.
Revenues were $9.4 million in the year ended January 2, 1998 compared to
$141,000 in the year ended December 31, 1996. The increase in revenues were
due primarily to the increase in shipments of the CTS MIDCAB System and
Access MV System. The year ended January 2, 1998 was the first full year of
product shipments, with shipments of the CTS MIDCAB System and Access MV
System beginning in December 1996 and September 1997, respectively.
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Cost of sales increased to $6.0 million for the year ended January 2, 1998
compared to $842,000 in the same period last year. This increase is primarily
the result of material costs associated with products sold, a significant
increase in personnel and other costs associated with the scale-up of
manufacturing and assembly operations, manufacturing engineering and support
functions, and a materials procurement and handling function.
Research and development expenses for the year ended January 2, 1998 were
$10.8 million compared to $11.5 million for the year ended December 31, 1996.
This decrease was due to a reduction in the charge for amortization of
deferred compensation allocated to research and development from $5.3 million
in 1996 to $689,000 in 1997, partially offset by an increase in research and
development staff, patent-related costs, facility costs, costs associated
with acquiring certain intellectual property and increased expenditures
related to the continuing development of the instruments associated with the
Access MV System, CTS Saphenous Vein Harvesting System and valve products.
The Company has entered into development and licensing agreements that
require milestone payments which are tied to certain events. During 1997 the
Company expensed $1.3 million for the right to acquire certain intellectual
property and a milestone payment related to a development agreement compared
to $1.5 million in 1996 for milestone payments related to development
agreements.
Sales, marketing, general and administrative expenses increased to $18.6
million for the year ended January 2, 1998 compared to $7.0 million for the
year ended December 31, 1996. This increase was due primarily to the hiring
of marketing and administrative personnel and consultants, the CTS
CORriculum-TM- training programs, promotional efforts to increase market
awareness of the Company and MICS, sales and marketing costs associated with
the Company's German subsidiary, higher facility costs and establishing the
Company's administrative infrastructure.
Net interest income increased to $3.7 million for the year ended January
2, 1998 compared to $3.1 million in the same period last year. The increase
is due to higher average cash and investment balances during 1997 compared to
1996 resulting from the Company's April 1996 initial public offering.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, the Company has financed its operations primarily from the
sale of equity securities. As of January 1, 1999, the Company had raised
approximately $90.9 million (net of stock issuance costs) from the sale of
equity securities. As of January 1, 1999, cash, cash equivalents and
available-for-sale securities totaled $40.3 million. The Company's cash used
in operations was $17.4 million for the year ended January 1, 1999,
reflecting expenditures made primarily to continue research and development
and sales and marketing activities, and to support its administrative
infrastructure. The Company also spent $1.7 million for the purchases of
property and equipment and $1.6 million for repayment of debt in the year
ended January 1, 1999.
The Company plans to finance its operations principally from existing
cash, cash equivalents and available-for-sale securities and interest
thereon, and product revenues. The Company believes that its existing cash
balances and available-for-sale securities and interest thereon, and product
revenues will be sufficient to fund its operations through 2000. The
Company's capital requirements, and the availability of product revenues,
depend on numerous factors, including the progress of the Company's product
development programs, the receipt of and the time required to obtain
regulatory clearances or approvals, the resources the Company devotes to
developing, manufacturing and marketing its products, the extent to which the
Company's products receive market acceptance, and other factors. The Company
expects to devote substantial capital resources to research and development,
to support a direct sales force and marketing operation in the United States
and to continue to support its manufacturing capacity and facilities.
Consequently, the Company may be required to raise additional funds through
public or private financing, collaborative relationships or other
arrangements. There can be no assurance that the Company will not require
additional funding or that such additional funding, if needed, will be
available on terms attractive to the Company, or at all, which could have a
material adverse effect on the Company's business, financial condition and
results of operations. Any additional equity financing may be dilutive to
stockholders, and debt financing, if available, may involve restrictive
convenants.
At January 1, 1999, the Company had approximately $48.3 million in federal
and $35.3 million in state net operating loss carryforwards, which will
expire in the years 2001 through 2018, if not utilized. In addition, the
Company has federal and state research and development credits of $1.4
million and $778,000, respectively. These credits expire in the years 2011
through 2018, if not utilized. Utilization of federal income tax
carryforwards is subject to certain limitations under Section 382 of the
Internal Revenue Code of 1986. These annual limitations may result in
expiration of net operating loss carryforwards and research and development
credits before they can be fully utilized.
IMPACT OF THE YEAR 2000 ISSUE
The year 2000 Issue is the result of computer programs written using two
digits rather than four to define the applicable year. Any of the Company's
computer programs that have date-sensitive software may recognize a date
using "00" as the year 1900 rather than the year 2000. This could result in a
system failure or miscalculations causing disruptions of operations,
including, among other things, a temporary inability to process transactions,
send invoices, or engage in similar normal business activities.
The Company is in the process of performing an inventory of all software
utilized by the Company and determining whether or not the software is year
2000 compliant. In late 1996 the Company acquired its manufacturing, order
entry, finance and network software from third party vendors that have
certified such software to be year 2000 compliant. The Company believes it
has no custom software in its manufacturing or development processes which
requires modification. The Company expects to complete this evaluation of
software in early 1999. The Company is not anticipating finding any
significant non-compliant software. If any such software is found it would
most likely be replaced by commercially available software that was year 2000
compliant.
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The Company is also surveying its major suppliers to determine their year
2000 readiness. It is expected that the survey will be completed in early
1999. The Company currently has no plans to contact its customers concerning
their year 2000 readiness. The Company's products have no date sensitive
software or embedded chip technology. The Company has sold its products to
over 500 hospitals and distributors worldwide and no one customer represents
more than 10% of the Company's revenue.
Virtually all of the computer hardware currently owned by the Company is
year 2000 compliant and in any event non-compliant computer hardware will
most likely be replaced before the year 2000.
Based on a preliminary assessment, the Company believes that there will be
no material impact on the operations of the Company due to the year 2000
issue. As a result the Company is not developing any formal contingency plans.
The costs incurred to date to determine the impact of the year 2000 issue
are immaterial and no significant future costs are anticipated.
FINANCIAL RISK MANAGEMENT
As a Company with international sales, CTS faces exposure to adverse
movements in foreign currency exchange rates. These exposures may change over
time as the Company's international business grows and the Company's business
practices evolve and could have a material adverse effect on the Company's
business, financial condition and results of operations. All of the Company's
international sales are currently denominated in U.S. dollars. An increase in
the value of the U.S. dollar relative to foreign currencies could make the
Company's products more expensive and therefore, reduce demand for the
products or force the Company to reduce its selling price. Reduced demand or
lower selling prices could have a material adverse effect on the Company's
business, financial condition and results of operations. Currently, the
Company does not hedge against any foreign currencies.
The Company maintains an investment portfolio of various issuers, types
and maturities. These securities are classified as available-for-sale, and
consequently, are recorded on the balance sheet at fair value with unrealized
gains or losses reported as a separate component of stockholders' equity. At
any time, a sharp rise in interest rates could have a material adverse effect
on the fair value of the Company's investment portfolio. Conversely, declines
in interest rates could have a material adverse effect on the interest
earnings of the Company's investment portfolio. Currently, the Company does
not hedge these interest rate exposures.
RECENT ACCOUNTING PRONOUNCEMENT
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities," ("SFAS 133"). SFAS 133 establishes new
standards of accounting and reporting for derivative instruments and hedging
activities. SFAS 133 requires that all derivatives be recognized at fair
value in the statement of financial position, and that the corresponding
gains or losses be reported either in the statement of operations or as a
component of comprehensive income, depending on the type of hedging
relationship that exists. SFAS 133 will be effective for fiscal years
beginning after June 15, 1999. Currently, the Company does not hold
derivative instruments or engage in hedging activities.
FACTORS AFFECTING RESULTS OF OPERATIONS
HIGHLY COMPETITIVE MARKET; RISK OF ALTERNATIVE THERAPIES; RISK OF REUSE.
The medical device industry and the market for treatment of cardiovascular
disease, in particular, are characterized by rapidly evolving technology and
intense competition. A number of companies, including Johnson & Johnson,
Boston Scientific Corporation, Guidant Corporation and Medtronic, Inc., are
currently marketing stents, catheters, lasers, drugs and other less invasive
means of treating cardiovascular disease. Many of these less invasive
treatments, as well as CABG surgery, are widely accepted in the medical
community and have a long history of safe and effective use. Many of the
Company's competitors have substantially greater capital resources, name
recognition and expertise in and resources devoted to research and
development, manufacturing and marketing and obtaining regulatory clearances
or approvals. Furthermore, competition in the emerging market for minimally
invasive cardiac surgery is intense and is expected to increase. Medtronic,
Inc., Genzyme Surgical Products Corp., Johnson & Johnson, Guidant
Corporation, Baxter International, Inc., Heartport, Inc. and United States
Surgical Corp. are marketing or have announced that they are developing
products to be used in MICS procedures. There can be no assurance that MICS
procedures will replace any current treatments. Additionally, even if MICS
procedures are widely adopted, there can be no assurance that the Company's
competitors will not succeed in developing or marketing alternative
procedures and technologies, competing devices to perform the same
procedures, or therapeutic drugs that are more effective than the Company's
products or that render the Company's products or technologies obsolete or
not competitive. In addition, there can be no assurance that existing
products for other surgical uses will not be used in MICS procedures.
Furthermore, sales of the Company's products could be adversely affected by
reuse, notwithstanding the instructions in the Company's clinical protocols
and product labeling indicating that certain components of the Company's
products are single-use devices. Such competition or reuse could have a
material adverse effect on the Company's business, financial condition and
results of operations.
LIMITED SALES, MARKETING AND DISTRIBUTION EXPERIENCE.
The Company currently has a small sales and marketing organization when
compared to most of its competitors. The Company sells its products in the
United States through a direct sales force. In certain international markets,
the Company sells its products through distributors. There can be no
assurance that the Company will be able to build a larger direct sales force
or marketing organization, that maintaining a direct sales force or marketing
organization will be cost effective, or that the Company's sales and
marketing efforts will be successful. There can be no assurance that the
Company will be able to maintain agreements with distributors, or that such
distributors will devote adequate resources to selling the Company's
products. Since the Company has entered into distribution agreements for the
sale of its products in certain countries, it will be dependent upon the
efforts of these third parties, and there can be no assurance that such
efforts will be successful. Failure to maintain or grow an effective direct
sales and marketing organization or to maintain effective distributors could
have a material adverse effect on the Company's business, financial condition
and results of operations.
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DEPENDENCE ON LICENSES, PATENTS AND PROPRIETARY TECHNOLOGY.
The Company's ability to compete effectively will depend in part on its
ability to develop and maintain proprietary aspects of its technology. The
Company owns eleven issued United States patents, including one which
contains claims that cover certain aspects of the Company's FloCoil-TM-
Shunt. Additionally, the Company has fifty-three United States patent
applications and various foreign patent applications pending. The Company is
the licensee of a United States patent and several related pending
applications for a heart valve insertion and stapling device, and a United
States patent application for bipolar electrosurgical scissors. Additionally,
the Company has acquired exclusive rights to United States Patent Number RE
36,043 covering methods of minimally invasive harvesting.
There can be no assurance that any issued patents or any patents which may
be issued as a result of the Company's licensed patent applications or
pending United States and foreign patent applications will provide any
competitive advantages for the Company's products or that they will not be
successfully challenged, invalidated or designed around in the future. In
addition, there can be no assurance that competitors, many of which have
substantial resources and have made substantial investments in competing
technologies, will not seek to apply for and obtain patents that will
prevent, limit or interfere with the Company's ability to make, use and sell
its products either in the United States or in international markets.
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. There can be no assurance that the Company will
not become subject to patent infringement claims or litigation or
interference proceedings declared by the USPTO to determine the priority of
inventions. The defense and prosecution of intellectual property suits, USPTO
interference proceedings and related legal and administrative proceedings are
both costly and time-consuming. Litigation may be necessary to enforce
patents issued to the Company, to protect trade secrets or know-how owned by
the Company or to determine the enforceability, scope and validity of the
proprietary rights of others. Any litigation or interference proceedings will
result in substantial expense to the Company and significant diversion of
effort by the Company's technical and management personnel. An adverse
determination in litigation or interference proceeding to which the Company
becomes a party, including any litigation that may arise against the Company
as described in "Potential Litigation" below, could subject the Company to
significant liabilities to third parties or require the Company to seek
licenses from third parties or prevent the Company from selling its products
in certain markets, or at all. Costs associated with settlements, licensing
and similar arrangements may be substantial and could include ongoing
royalties. Furthermore, there can be no assurance that the necessary licenses
would be available to the Company on satisfactory terms, if at all. Adverse
determinations in a judicial or administrative proceeding or failure to
obtain necessary licenses could prevent the Company from manufacturing and
selling its products, which would have a material adverse effect on the
Company's business, financial condition and results of operations.
Congress enacted legislation, which became effective October 1, 1996, that
places certain restrictions on the ability of medical device manufacturers to
enforce certain patent claims, relating to surgical and medical methods,
against medical practitioners. Such limitations on the enforceability of
patent claims, relating to medical and surgical methods, against medical
practitioners could have a material adverse effect on the Company's ability
to protect its proprietary methods and procedures against medical
practitioners.
In addition to patents, the Company relies on trade secrets and
proprietary know-how, which it seeks to protect, in part, through
confidentiality and proprietary information agreements. There can be no
assurance that such confidentiality or proprietary information agreements
will not be breached, that the Company would have adequate remedies for any
breach, or that the Company's trade secrets will not otherwise become known
to or be independently developed by competitors.
CONTINUING GOVERNMENT REGULATION.
Regulatory clearances or approvals, if granted, may include significant
limitations on the indicated uses for which the Company's products may be
marketed. FDA enforcement policy strictly prohibits the marketing of FDA
cleared or approved medical devices for unapproved uses. In addition, the
Company's manufacturing processes are required to comply with the Good
Manufacturing Practices ("GMP") regulations of the FDA which are currently
referred to as Quality System Regulations. These regulations include design,
testing, production, control, documentation and other requirements.
Enforcement of Quality System Regulations has increased significantly in the
last several years, and the FDA has publicly stated that compliance will be
more strictly scrutinized. The Company's facilities and manufacturing
processes, as well as those of any future third-party suppliers, will be
subject to periodic inspection by the FDA, the California Department of
Health Services and other agencies. The Company has received ISO 9001
certification, has obtained its California Device Manufacturing license and
has successfully undergone a facility inspection by the FDA. Failure to
comply with these and other applicable regulatory requirements could result
in, among other things, warning letters, fines, injunctions, civil penalties,
recall or seizure of products, total or partial suspension of production,
refusal of the government to grant premarket clearance or premarket approval
for devices, withdrawal of clearances or approvals and criminal prosecution,
any of which could have a material adverse effect on the Company's business,
financial condition and results of operations.
POTENTIAL LITIGATION.
Heartport, Inc. (formerly Stanford Surgical Technologies, Inc.), the former
employer of the Company's founder and Chief Technical Officer, Charles S.
Taylor, has alleged in certain correspondence in late 1995 and again in
September 1997 that Mr. Taylor and the Company may have misappropriated trade
secrets of the former employer and breached confidentiality obligations to
the former employer. The former employer has also claimed in such
correspondence an ownership interest in certain developments and products of
the Company. The Company has agreed to provide for the defense of Mr. Taylor
in the event that litigation is commenced. Litigation is subject to inherent
uncertainties, especially in cases where complex technical issues are decided
by a lay jury. Accordingly, no assurance can be given that if a lawsuit is
commenced it would not be decided against the Company. Such an adverse
determination could have a material adverse effect upon the Company's
business, financial condition and results of operations.
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POTENTIAL COMPONENT SHORTAGES; DEPENDENCE ON SOLE SOURCES OF SUPPLY.
The Company contracts with third parties for the manufacture of certain
components or the performance of certain processes involved in the
manufacturing cycle. Some of these components and processes may only be
available from single-source vendors. Any prolonged supply interruption or
yield problems experienced by the Company due to a single-source vendor could
have a material adverse effect on the Company's ability to manufacture its
products until a new source of supply is qualified. Many of the Company's
components are molded parts that require custom tooling which is manufactured
and maintained by third party vendors. Should such custom tooling be damaged
it could result in a supply interruption that could have a material adverse
effect on the Company's ability to manufacture its products until a new tool
is manufactured. Also, the Company's new product development efforts and the
timeliness of new product launches could be significantly affected by tooling
vendors ability to meet completion and quality commitments on the manufacture
of custom tooling. As the Company increases production, it may from time to
time experience lower than anticipated yields or production constraints,
resulting in delayed product shipments, which could have a material adverse
effect on the Company's business, financial condition and results of
operation.
LIMITED MANUFACTURING EXPERIENCE; SCALE-UP RISK.
The Company has no experience manufacturing its products in the volumes that
would be necessary for the Company to achieve profitable operations. There
can be no assurance that reliable, high-volume manufacturing can be
established or maintained at commercially reasonable costs. Companies often
encounter difficulties in scaling up production, including problems involving
production yield, quality control and assurance, and shortages of qualified
personnel. In addition, the Company's manufacturing facilities are subject to
GMP regulations, international quality standards and other regulatory
requirements. Difficulties encountered by the Company in manufacturing
scale-up or failure by the Company to implement and maintain its facilities
in accordance with GMP regulations, international quality standards or other
regulatory requirements could entail a delay or termination of production,
which could have a material adverse effect on the Company's business,
financial condition and results of operations.
UNCERTAINTY RELATING TO THIRD-PARTY REIMBURSEMENT.
In the United States, health care providers, such as hospitals and
physicians, that purchase medical devices such as the Company's products,
generally rely on third-party payors, principally Medicare, Medicaid and
private health insurance plans, to reimburse all or part of the cost of the
procedure in which the medical device is being used. Reimbursement for
cardiovascular surgery, including CABG surgery, using devices that have
received FDA approval, has generally been available in the United States. In
addition, certain health care providers are moving toward a managed care
system in which such providers contract to provide comprehensive health care
for a fixed cost per person. The Company is unable to predict what changes,
if any, may be made in the reimbursement methods utilized by third-party
health care payors. The Company could be adversely affected by changes in
reimbursement policies of government or private health care payors,
particularly to the extent any such changes affect reimbursement for the
procedures in which the Company's products are intended to be used. Failure
by physicians, hospitals and other potential users of the Company's products
to obtain sufficient reimbursement from health care payors for the procedures
in which the Company's products are intended to be used or adverse changes in
government and private third-party payors' policies toward reimbursement for
such procedures could have a material adverse effect on the Company's
business, financial condition and results of operations.
Market acceptance of the Company's products in international markets is
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. The Company intends
to seek international reimbursement approvals, although there can be no
assurance that any such approvals will be obtained in a timely manner, if at
all, and failure to receive international reimbursement approvals could have
a material adverse effect on market acceptance of the Company's products in
the international markets in which such approvals are sought.
PRODUCT LIABILITY RISK; LIMITED INSURANCE COVERAGE.
The development, manufacture and sale of medical products entail significant
risk of product liability claims and product recalls. The Company's current
product liability insurance coverage limits are $5,000,000 per occurrence and
$5,000,000 in the aggregate, and there can be no assurance that such coverage
limits are adequate to protect the Company from any liabilities it might
incur in connection with the development, manufacture and sale of its
products. In addition, the Company may require increased product liability
insurance coverage as product sales increase. Product liability insurance is
expensive and in the future may not be available to the Company on acceptable
terms, if at all. A successful product liability claim or series of claims
brought against the Company in excess of its insurance coverage, or a product
recall, could have a material adverse effect on the Company's business,
financial condition and results of operations.
23
<PAGE>
CONSOLIDATED BALANCE SHEETS
CardioThoracic Systems, Inc. and subsidiary
<TABLE>
<CAPTION>
JANUARY 1, 1999 January 2, 1998
- ------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 1,651,000 $ 4,681,000
Available-for-sale securities 27,513,000 52,105,000
Trade accounts receivable, net of allowances of $421,000 in 1998
and $225,000 in 1997 2,894,000 1,369,000
Notes receivable from officers -- 87,000
Inventories 963,000 641,000
Interest receivable 611,000 1,158,000
Prepaid expenses and other current assets 510,000 449,000
-----------------------------------------
Total current assets 34,142,000 60,490,000
Property and equipment, net 3,374,000 3,613,000
Available-for-sale securities 11,089,000 4,048,000
Notes receivable from officers 1,045,000 1,073,000
Other assets 116,000 52,000
-----------------------------------------
Total assets $ 49,766,000 $ 69,276,000
- ------------------------------------------------------------------------------------------------------------------------
LIABILITIES
Current liabilities:
Equipment note, current portion $ 500,000 $ 410,000
Accounts payable 1,871,000 779,000
Accrued liabilities 6,021,000 4,430,000
-----------------------------------------
Total current liabilities 8,392,000 5,619,000
Bank borrowings -- 1,557,000
Equipment note, less current portion 1,411,000 1,966,000
-----------------------------------------
Total liabilities 9,803,000 9,142,000
Commitments (Note 8)
STOCKHOLDERS' EQUITY
Preferred stock, par value $0.001:
Authorized: 5,000,000 shares
Issued and outstanding: none in 1998 and 1997 -- --
Common stock, par value $0.001:
Authorized: 60,000,000 shares in 1998 and 1997
Issued and outstanding: 14,219,178 shares in 1998 and 13,662,602 shares in 1997 14,000 14,000
Additional paid-in capital 103,317,000 103,156,000
Deferred compensation, net (1,460,000) (3,614,000)
Accumulated other comprehensive income 93,000 17,000
Accumulated deficit (62,001,000) (39,439,000)
-----------------------------------------
Total stockholders' equity 39,963,000 60,134,000
-----------------------------------------
Total liabilities and stockholders' equity $ 49,766,000 $ 69,276,000
- ------------------------------------------------------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
24
<PAGE>
CONSOLIDATED STATEMENTS OF OPERATIONS
CardioThoracic Systems, Inc. and subsidiary
<TABLE>
<CAPTION>
Year Ended
--------------------------------------------------------
JANUARY 1, 1999 January 2, 1998 December 31, 1996
- ---------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Net sales $ 16,149,000 $ 9,379,000 $ 141,000
Cost of sales and start-up manufacturing costs 7,237,000 5,962,000 842,000
-------------------------------------------------------
Gross profit (loss) 8,912,000 3,417,000 (701,000)
Operating expenses:
Research and development 11,496,000 10,806,000 11,475,000
Sales, marketing, general and administrative 21,655,000 18,620,000 6,977,000
Restructuring costs 736,000 -- --
-------------------------------------------------------
Total operating expenses 33,887,000 29,426,000 18,452,000
-------------------------------------------------------
Operating loss (24,975,000) (26,009,000) (19,153,000)
Interest income 2,802,000 3,976,000 3,103,000
Interest expense (313,000) (290,000) (28,000)
Other expense (76,000) (41,000)
-------------------------------------------------------
Net loss $(22,562,000) $(22,364,000) $(16,078,000)
- ---------------------------------------------------------------------------------------------------------
Net loss per common share and per
common share assuming dilution $ (1.62) $ (1.66) $ (1.64)
- ---------------------------------------------------------------------------------------------------------
Shares used in computing net loss per common
share and per common share assuming dilution 13,968,000 13,505,000 9,794,000
- ---------------------------------------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
25
<PAGE>
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
CardioThoracic Systems, Inc. and subsidiary
For the years ended January 1, 1999, January 2, 1998 and December 31, 1996
<TABLE>
<CAPTION>
Series A
Preferred Stock Common Stock
------------------------- -----------------------
Shares Amount Shares Amount
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Balances, December 31, 1995 4,025,000 $ 4,000 2,800,000 $ 3,000
Issuance of Series A preferred stock for cash at $1.00 per share
in January and February 1996, net of issuance costs of $1,000 1,000,000 1,000
Issuance of common stock through:
Initial public offering at $18.00 per share in April 1996,
net of issuance costs of $7,892,000 5,118,000 5,000
Conversion of preferred shares in connection with initial public
offering in April 1996 (5,025,000) (5,000) 5,025,000 5,000
Exercise of stock options 254,000
Exercise of purchase rights 6,000
Repurchase of common stock (89,000)
Deferred compensation related to issuance of common stock
and grants of stock options
Deferred compensation adjustment for cancellation of
stock options
Amortization of deferred compensation
Change in unrealized gain on available-for-sale securities
Net loss
----------------------------------------------------
Balances, December 31, 1996 13,114,000 13,000
Issuance of common stock through:
Exercise of stock options 504,000 1,000
Exercise of purchase rights 45,000
Deferred compensation related to issuance of common
stock and grants of stock options
Deferred compensation adjustment for cancellation of
stock options
Amortization of deferred compensation
Net loss
----------------------------------------------------
Balances, January 2, 1998 13,663,000 14,000
Issuance of common stock through:
Exercise of stock options 457,000 --
Exercise of purchase rights 99,000 --
Deferred compensation adjustment for cancellation of
stock options
Amortization of deferred compensation
Change in unrealized gain on available-for-sale securities
Net loss
----------------------------------------------------
BALANCES, JANUARY 1, 1999 -- $ -- 14,219,000 $ 14,000
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
26
<PAGE>
<TABLE>
<CAPTION>
Additional
Paid-In Deferred Accumulated Other
Capital Compensation Comprehensive Income
- -------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Balances, December 31, 1995 $ 6,006,000 $ (1,802,000)
Issuance of Series A preferred stock for cash at $1.00 per share
in January and February 1996, net of issuance costs of $1,000 998,000
Issuance of common stock through:
Initial public offering at $18.00 per share in April 1996,
net of issuance costs of $7,892,000 84,218,000
Conversion of preferred shares in connection with initial public
offering in April 1996
Exercise of stock options 54,000
Exercise of purchase rights 92,000
Repurchase of common stock
Deferred compensation related to issuance of common stock
and grants of stock options 11,950,000 (11,950,000)
Deferred compensation adjustment for cancellation of
stock options (1,278,000) 1,278,000
Amortization of deferred compensation 6,732,000
Change in unrealized gain on available-for-sale securities $ 17,000
Net loss
----------------------------------------------------
Balances, December 31, 1996 102,040,000 (5,742,000) 17,000
Issuance of common stock through:
Exercise of stock options 649,000
Exercise of purchase rights 375,000
Deferred compensation related to issuance of common
stock and grants of stock options 621,000 (621,000)
Deferred compensation adjustment for cancellation of
stock options (529,000) 529,000
Amortization of deferred compensation 2,220,000
Net loss
----------------------------------------------------
Balances, January 2, 1998 103,156,000 (3,614,000) 17,000
Issuance of common stock through:
Exercise of stock options 91,000
Exercise of purchase rights 395,000
Deferred compensation adjustment for cancellation of
stock options (325,000) 325,000
Amortization of deferred compensation 1,829,000
Change in unrealized gain on available-for-sale securities 76,000
Net loss
----------------------------------------------------
BALANCES, JANUARY 1, 1999 $103,317,000 $ (1,460,000) $ 93,000
- -------------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
Total
Accumulated Stockholders'
Deficit Equity
- -----------------------------------------------------------------------------------------------
<S> <C> <C>
Balances, December 31, 1995 $ (997,000) $ 3,214,000
Issuance of Series A preferred stock for cash at $1.00 per share
in January and February 1996, net of issuance costs of $1,000 999,000
Issuance of common stock through:
Initial public offering at $18.00 per share in April 1996,
net of issuance costs of $7,892,000 84,223,000
Conversion of preferred shares in connection with initial public
offering in April 1996 --
Exercise of stock options 54,000
Exercise of purchase rights 92,000
Repurchase of common stock
Deferred compensation related to issuance of common stock
and grants of stock options --
Deferred compensation adjustment for cancellation of
stock options --
Amortization of deferred compensation 6,732,000
Change in unrealized gain on available-for-sale securities 17,000
Net loss (16,078,000) (16,078,000)
---------------------------
Balances, December 31, 1996 (17,075,000) 79,253,000
Issuance of common stock through:
Exercise of stock options 650,000
Exercise of purchase rights 375,000
Deferred compensation related to issuance of common
stock and grants of stock options --
Deferred compensation adjustment for cancellation of
stock options --
Amortization of deferred compensation 2,220,000
Net loss (22,364,000) (22,364,000)
---------------------------
Balances, January 2, 1998 (39,439,000) 60,134,000
Issuance of common stock through:
Exercise of stock options 91,000
Exercise of purchase rights 395,000
Deferred compensation adjustment for cancellation of
stock options --
Amortization of deferred compensation 1,829,000
Change in unrealized gain on available-for-sale securities 76,000
Net loss (22,562,000) (22,562,000)
---------------------------
BALANCES, JANUARY 1, 1999 $(62,001,000) $ 39,963,000
- -----------------------------------------------------------------------------------------------
</TABLE>
27
<PAGE>
CONSOLIDATED STATEMENTS OF CASH FLOWS
CardioThoracic Systems, Inc. and subsidiary
<TABLE>
<CAPTION>
Year Ended
--------------------------------------------------------
JANUARY 1, 1999 January 2, 1998 December 31, 1996
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss $(22,562,000) $(22,364,000) $(16,078,000)
Adjustments to reconcile net loss to net cash used
in operating activities:
Depreciation and amortization 1,895,000 1,144,000 251,000
Amortization of notes receivable from officer 71,000 112,000 68,000
Amortization of deferred compensation 1,829,000 2,220,000 6,732,000
Allowances for product returns 56,000 140,000 25,000
Allowances for doubtful accounts 140,000 60,000
Provision for restructuring 736,000 -- --
Changes in operating assets and liabilities:
Accounts receivable (1,721,000) (1,436,000) (158,000)
Inventories (322,000) (421,000) (220,000)
Prepaid expenses and other current assets 26,000 (325,000) (93,000)
Accrued interest on available-for-sale securities 547,000 (212,000) (925,000)
Other assets (27,000) (7,000) (45,000)
Accounts payable 1,092,000 (52,000) 744,000
Accrued liabilities 855,000 2,087,000 2,255,000
----------------------------------------------------
Net cash used in operating activities (17,385,000) (19,054,000) (7,444,000)
Cash flows from investing activities:
Purchases of property and equipment (1,656,000) (2,263,000) (2,682,000)
Purchases of available-for-sale securities (58,187,000) (73,105,000) (78,266,000)
Sales or maturities of available-for-sale securities 75,814,000 90,225,000 7,572,000
Issuance of notes receivable to officers (80,000) -- (1,339,000)
----------------------------------------------------
Net cash provided by (used in) investing activities 15,891,000 14,857,000 (74,715,000)
Cash flows from financing activities:
Bank borrowings 1,200,000 425,000
Proceeds from equipment note 1,785,000 849,000
Repayment of bank borrowings (1,557,000) (68,000)
Repayment of equipment note (465,000) (248,000) (11,000)
Proceeds from issuance of Series A preferred stock, net 999,000
Proceeds from issuance of common stock 486,000 1,025,000 84,369,000
----------------------------------------------------
Net cash provided by (used in) financing activities (1,536,000) 3,694,000 86,631,000
----------------------------------------------------
Net increase (decrease) in cash and cash equivalents (3,030,000) (503,000) 4,472,000
Cash and cash equivalents, beginning of year 4,681,000 5,184,000 712,000
----------------------------------------------------
Cash and cash equivalents, end of year $ 1,651,000 $ 4,681,000 $ 5,184,000
- -------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND
FINANCING ACTIVITIES:
Conversion of preferred stock to common stock in connection
with the Company's initial public offering $ 5,025,000
Reclass of officers notes receivable to notes receivable $ 124,000
- -------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest $ 312,000 $ 290,000 $ 27,000
- -------------------------------------------------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
28
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CardioThoracic Systems, Inc. and subsidiary
NOTE 1. FORMATION AND BUSINESS OF THE COMPANY:
CardioThoracic Systems, Inc. (the Company) was incorporated in the state of
California on June 15, 1995. The Company designs, develops, manufactures and
markets surgical products and systems for minimally invasive cardiac surgery.
The Company's principal operations commenced in December 1996, at which time it
emerged from the development stage.
On March 29, 1996, the Company was reincorporated in the state of Delaware
with the associated exchange of shares of each class and series of stock of the
predecessor company for one share of each identical class and series of stock of
the Delaware successor company having a par value of $0.001 per share for both
common stock and preferred stock.
In the course of its development activities, the Company has sustained
operating losses and expects such losses to continue through 1999. The Company
plans to continue to finance its operations with proceeds from the sale of
capital stock, such as its initial public offering, borrowings, and revenues
from product sales.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
CHANGE IN FISCAL YEAR-END:
In January 1997, the Company changed its financial reporting year from a fiscal
year of twelve calendar months ending on December 31 to a fiscal year of 52 or
53 weeks ending on the Friday closest to December 31. Accordingly, fiscal year
1998 and 1997 ended on January 1, 1999 and January 2, 1998, respectively.
BASIS OF CONSOLIDATION:
The Company had a wholly owned subsidiary in Germany, CardioThoracic Systems,
GmbH (see note 3). The consolidated financial statements include the accounts of
the Company and its wholly owned subsidiary. All intercompany balances and
transactions have been eliminated.
USE OF ESTIMATES:
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS AND AVAILABLE-FOR-SALE SECURITIES:
The Company considers all highly liquid investments purchased with original
maturities of three months or less to be cash equivalents. Cash and cash
equivalents include money market funds and various deposit accounts.
The Company has classified its investments as "available-for-sale." Such
investments are recorded at fair value and unrealized gains and losses, if
material, are recorded as a separate component of equity until realized.
Interest income is recorded using an effective interest rate, with associated
premium or discount amortized to "investment income." The cost of securities
sold is based upon the specific identification method.
INVENTORIES:
Inventories are stated at the lower of cost or market value. Cost is computed
using standard cost, which approximates actual cost on a first-in, first-out
basis.
DEPRECIATION AND AMORTIZATION:
Property and equipment are stated at cost and are depreciated on a straight-line
basis over their estimated useful lives of three to five years. Leasehold
improvements are amortized over their estimated useful lives, or the lease term,
if shorter. Upon sale or retirement of assets, the cost and related accumulated
depreciation or amortization are removed from the balance sheet, and the
resulting gain or loss is reflected in operations.
REVENUE RECOGNITION:
The Company recognizes revenue upon shipment of product to the customer, upon
fulfillment of acceptance terms, if any, and when no significant contractual
obligations remain outstanding.
RESEARCH AND DEVELOPMENT:
Research and development costs are charged to operations as incurred.
CONCENTRATION OF CREDIT RISK AND OTHER RISKS AND UNCERTAINTIES:
The Company's cash and cash equivalents are maintained at three financial
institutions. Deposits in these institutions may exceed the amount of insurance
provided on such deposits.
For accounts receivable, management of the Company performs ongoing credit
evaluations of its customers. At January 1, 1999 and January 2, 1998, no
individual customer accounted for more than 10% of net accounts receivable or
total revenues. For the year ended December 31, 1996, one customer accounted for
13% of total revenues.
The Company's products require approvals from the Food and Drug
Administration (FDA) and international regulatory agencies prior to the
commencement of commercialized sales. There can be no assurance that the
Company's products will receive any of these required approvals. If the Company
was denied such approvals, or such approvals were delayed, it would have a
materially adverse impact on the Company.
FOREIGN CURRENCY TRANSLATION:
The Company's international subsidiary used its local currency as its functional
currency. Assets and liabilities were translated at exchange rates in effect at
the balance sheet date and income and expense accounts at average exchange rates
during the year. Resulting translation adjustments were recorded directly to a
separate component of stockholders' equity, if material.
INCOME TAXES:
The Company accounts for income taxes under Statement of Financial Accounting
Standard (SFAS) No. 109, "Accounting for Income Taxes," which prescribes the use
of the liability method whereby deferred tax asset or liability account balances
are calculated at the balance sheet date using current tax laws and rates in
effect for the year in which the differences are expected to affect taxable
income. Valuation allowances are established when necessary to reduce deferred
tax assets to the amounts expected to be realized.
29
<PAGE>
RECLASSIFICATION:
Certain amounts in the financial statements have been reclassified to conform
with the current year's presentation. The reclassifications had no impact on
previously reported net loss.
NET LOSS PER SHARE:
Effective January 2, 1998, the Company adopted the Financial Accounting
Standards Board No. 128 "Earnings Per Share" and accordingly all prior periods
have been restated. Net loss per common share and per common share-assuming
dilution, on an historical basis, are computed using the weighted average number
of shares of Common Stock outstanding. Common equivalent shares from stock
options and preferred stock are excluded from the computation of net loss per
common share-assuming dilution as their effect is antidilutive. Pursuant to the
Securities and Exchange Commission Staff Accounting Bulletin No. 98, issued in
February 1998, common and common equivalent shares issued at prices below the
anticipated public offering price during the 12 months immediately preceding the
initial filing date have not been included in the calculations.
FAIR VALUE OF FINANCIAL INSTRUMENTS:
Carrying amounts of certain of the Company's financial instruments including
cash and cash equivalents, accounts receivable, accounts payable and other
accrued liabilities approximate fair value due to their short maturities. Based
on borrowing rates currently available to the Company for loans with similar
terms, the carrying value of notes payable and long-term debt approximates fair
value. Estimated fair values for marketable securities, which are separately
disclosed elsewhere, are based on quoted market prices for the same or similar
instruments.
COMPREHENSIVE INCOME (LOSS):
The Company has adopted the provisions of Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income," effective January 3, 1998.
This statement requires the disclosure of comprehensive income and its
components in a full set of general-purpose financial statements. Comprehensive
income is defined as net income (loss) plus revenues, expenses, gains and losses
that, under generally accepted accounting principles, are excluded from net
income (loss). The Company's unrealized gains on investments represent the only
component of comprehensive income excluded from net loss as it is not
significant, individually or in aggregate, and therefore, no separate statement
of comprehensive income has been presented.
RECENT ACCOUNTING PRONOUNCEMENTS:
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities," ("SFAS 133"). SFAS 133 establishes new standards of
accounting and reporting for derivative instruments and hedging activities. SFAS
133 requires that all derivatives be recognized at fair value in the statement
of financial position, and that the corresponding gains or losses be reported
either in the statement of operations or as a component of comprehensive income,
depending on the type of hedging relationship that exists. SFAS 133 will be
effective for fiscal years beginning after June 15, 1999. Currently, the Company
does not hold derivative instruments or engage in hedging activities.
NOTE 3. RESTRUCTURING:
In the fourth quarter of fiscal 1998, the Company recorded a restructuring
charge of $736,000 in connection with the closure of its German subsidiary. In
accordance with the restructuring plan, this closure resulted in the termination
of four German employees which represented all the employees of the German
subsidiary. The charge associated with employee termination benefits was
$349,000. The balance of the restructuring charge was an $88,000 non-cash charge
for the loss on property and equipment and the write-down of other recorded
assets, $235,000 for lease cancellation expenses and $64,000 for other exit
related costs.
NOTE 4. AVAILABLE-FOR-SALE SECURITIES:
The following summarizes the Company's available-for-sale securities:
<TABLE>
<CAPTION>
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
- ------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
January 1, 1999
U.S. government notes and bonds $ 967,000 $ -- $ -- $ 967,000
Government agencies' notes and bonds 12,777,000 77,000 -- 12,854,000
Corporate notes and bonds 24,765,000 20,000 (4,000) 24,781,000
------------------------------------------------------------------------
$ 38,509,000 $ 97,000 $ (4,000) $ 38,602,000
- ------------------------------------------------------------------------------------------------------------------------
January 2, 1998
Government agencies' notes and bonds $ 10,759,000 $ 8,000 $ (1,000) $ 10,766,000
Corporate notes and bonds 45,377,000 12,000 (2,000) 45,387,000
------------------------------------------------------------------------
$ 56,136,000 $ 20,000 $ (3,000) $ 56,153,000
- ------------------------------------------------------------------------------------------------------------------------
</TABLE>
30
<PAGE>
Available-for-sale debt securities by contractual maturities at January 1,
1999, are shown below.
<TABLE>
<CAPTION>
Amortized Market
Cost Value
- --------------------------------------------------------------------------------
<S> <C> <C>
Less than one year $27,471,000 $27,513,000
Due in one to two years 11,038,000 11,089,000
-------------------------------
$38,509,000 $38,602,000
- --------------------------------------------------------------------------------
</TABLE>
NOTE 5. INVENTORIES:
<TABLE>
<CAPTION>
JANUARY 1, 1999 January 2, 1998
- --------------------------------------------------------------------------------
<S> <C> <C>
Raw materials $503,000 $188,000
Work in progress 146,000 203,000
Finished goods 314,000 250,000
----------------------------
$963,000 $641,000
- --------------------------------------------------------------------------------
</TABLE>
NOTE 6. PROPERTY AND EQUIPMENT:
<TABLE>
<CAPTION>
JANUARY 1, 1999 January 2, 1998
- --------------------------------------------------------------------------------
<S> <C> <C>
Furniture and fixtures $ 574,000 $ 475,000
Leasehold improvements 1,267,000 1,228,000
Computer and office equipment 1,516,000 1,298,000
Machinery and equipment 3,309,000 2,009,000
-------------------------------
6,666,000 5,010,000
Less accumulated depreciation
and amortization (3,292,000) (1,397,000)
-------------------------------
$ 3,374,000 $ 3,613,000
- --------------------------------------------------------------------------------
</TABLE>
NOTE 7. ACCRUED LIABILITIES:
<TABLE>
<CAPTION>
JANUARY 1, 1999 January 2, 1998
- --------------------------------------------------------------------------------
<S> <C> <C>
Accrued payables $3,619,000 $3,249,000
Restructuring costs (note 3) 736,000 --
Accrued compensation 1,666,000 1,181,000
------------------------------
$6,021,000 $4,430,000
- --------------------------------------------------------------------------------
</TABLE>
NOTE 8. COMMITMENTS:
OPERATING LEASES:
The Company leases its facilities under three separate operating leases, which
expire in August 2000, May 2001 and May 2001. In addition to the base rentals,
the Company is responsible for certain taxes, insurance and maintenance costs.
Two of the lease terms include annual rent adjustments under which the base rent
is increased in accordance with the published Consumer Price Index for the area.
At January 1, 1999, future minimum facility lease payments are as follows:
<TABLE>
<S> <C>
1999 $ 633,000
2000 635,000
2001 255,000
----------
$1,523,000
- -----------------------------------------------------------------------------
</TABLE>
In August 1996, the Company entered into a noncancelable agreement to assign
the lease for one of its facilities through its expiration. The minimum facility
lease payments, disclosed above, have not been reduced by minimum noncancelable
rentals of $109,000, due in the future under the sublease agreement. The Company
received payments of $65,000, $65,000 and $56,000 under a sublease for the years
ended January 1, 1999, January 2, 1998 and December 31, 1996.
Rent expense for the years ended January 1, 1999, January 2, 1998 and
December 31, 1996 was $550,000, $497,000 and $387,000, respectively, net of
sublease income.
DEVELOPMENT AND LICENSE AGREEMENTS:
In February and March 1996, the Company entered into development and license
agreements with companies to develop minimally invasive cardiothoracic surgical
products. Under the development program agreements, the Company will make
development payments totaling $3.9 million upon the completion of certain
milestones. During fiscal 1998, 1997 and 1996 none, $1.0 million and $1.5
million has been charged to research and development expense in connection with
these agreements, respectively.
NOTE 9. BORROWINGS:
BANK BORROWINGS:
The Company had a $5.0 million line of credit agreement, the proceeds of which
were used for leasehold improvements and equipment purchases. The principal,
plus all accrued interest, advanced against this line of credit was paid in its
entirety in September 1998.
EQUIPMENT NOTE:
The Company had a revolving $2.5 million equipment loan credit facility with a
financial institution which expired on December 31, 1997. Borrowings under this
agreement are collateralized by the assets purchased under this equipment
facility. Three separate equipment notes had been drawn against this facility
for principal amounts of $849,000, $851,000 and $934,000, bearing interest at
11.97%, 12.27% and 11.75%, respectively. As of January 1, 1999, principal
outstanding under each of these notes was $545,000, $614,000 and $752,000, and
the final payment date is November 8, 2001, June 4, 2002 and November 11, 2002,
respectively.
At January 1, 1999, the future minimum payments under the equipment facility
are as follows:
<TABLE>
<S> <C>
1999 $ 500,000
2000 558,000
2001 605,000
2002 248,000
----------
$1,911,000
- -----------------------------------------------------------------------------
</TABLE>
NOTE 10. STOCKHOLDERS' EQUITY:
PREFERRED STOCK:
Under the Company's Articles of Incorporation, the Company's preferred stock is
issuable in series. As of January 1, 1999, 5,000,000 shares of preferred stock
were authorized and no preferred stock was issued or outstanding.
COMMON STOCK:
The Company issued shares of common stock to certain employees which contain
repurchase provisions in the event of termination of employment. These shares
are generally released from the repurchase provision ratably over 48 months
beginning on certain vesting dates. At January 1, 1999, 254,055 shares are
subject to repurchase under these stock purchase agreements.
31
<PAGE>
STOCK OPTION PLANS:
In December 1995, the Company approved the Incentive Stock Plan under which
the officers of the Company are authorized and directed to enter into stock
option agreements with selected individuals. The Company reserved 1,200,000
shares of common stock for issuance under the Incentive Stock Plan. In
February 1996, the Company adopted the Nonstatutory Stock Option Plan and
reserved 900,000 shares of common stock for issuance. In March 1996, the
Company increased the shares reserved for the Nonstatutory Stock Option Plan
from 900,000 shares to 995,000 shares. In January 1998, the Company approved
the 1998 Nonstatutory Stock Option Plan and reserved 150,000 shares of common
stock for issuance. Under the Company's stock option plans, the Board of
Directors has the authority to determine to whom options will be granted, the
number of shares, the vesting period and the exercise price (which generally
cannot be less than fair market value at the date of the grant). The options
generally vest over four years and expire ten years from date of grant.
DIRECTOR OPTION PLAN:
In February 1996, the Company approved the Director Option Plan and reserved
200,000 shares of common stock for issuance.
Activity under the Plans is as follows:
<TABLE>
<CAPTION>
Outstanding Options
Shares ---------------------------------------------
Available Number Exercise Aggregate
for Grant of Shares Price Price
- ---------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Balances, December 31, 1995 740,000 460,000 $ 0.10 $ 46,000
Additional shares authorized 1,595,000
Options granted (2,121,250) 2,121,250 $0.001-$21.38 10,495,000
Options canceled 17,500 (17,500) $17.00-$20.88 (327,000)
Options exercised (254,300) $0.001-$11.00 (54,000)
---------------------------------------------------------------
Balances, December 31, 1996 231,250 2,309,450 $0.001-$21.38 10,160,000
Additional shares authorized 600,000
Options granted (1,370,200) 1,370,200 $ 4.78-$25.38 12,988,000
Options canceled 807,019 (807,019) $ 0.10-$25.38 (8,955,000)
Options exercised (503,504) $0.001-$11.00 (649,000)
---------------------------------------------------------------
Balances, January 2, 1998 268,069 2,369,127 $0.001-$21.13 13,544,000
Additional shares authorized 750,000
Options granted (1,476,525) 1,476,525 $ 3.50-$ 7.94 7,901,000
Options canceled 1,061,480 (1,061,480) $ 0.10-$21.13 (9,668,000)
Options exercised (457,249) $0.001-$ 5.75 (91,000)
---------------------------------------------------------------
Balances, January 1, 1999 603,024 2,326,923 $ 0.10-$14.88 $11,686,000
- ---------------------------------------------------------------------------------------------------------
</TABLE>
The weighted average fair value of options granted in 1998, 1997 and 1996 was
$3.88, $6.14 and $4.40, respectively.
EMPLOYEE STOCK PURCHASE PLANS:
In February 1996, the Company approved the Employee Stock Purchase Plan and
reserved 150,000 shares of common stock for issuance. As of January 1, 1999,
January 2, 1998 and December 31, 1996, 99,326, 44,626 and 6,009 shares of
common stock had been purchased under this plan at a weighted average of
$3.97, $8.42 and $15.30 per share, respectively. In October 1998, the
stockholders approved the adoption of the 1998 Employee Stock Purchase Plan
and the reservation of 250,000 shares of common stock for sale thereunder. As
of January 1, 1999 no shares of common stock had been purchased under this
plan. Under both plans eligible employees may purchase a limited number of
shares of the Company's stock at 85% of the fair market value at certain
plan-defined dates.
STOCK-BASED COMPENSATION:
The Company has adopted the disclosure-only provisions of Statement of
Financial Accounting Standards No. 123 (SFAS No. 123), "Accounting for
Stock-Based Compensation." Had compensation cost for the Director Option
Plan, the Incentive Stock Plan, the Nonstatutory Stock Option Plans and the
Employee Stock Purchase Plans been determined based on the fair value at the
grant date for awards subsequent to January 1, 1995, according to the
provisions of SFAS No. 123, the Company's net loss and net loss per share for
the years would have been increased to the pro forma amounts indicated below:
<TABLE>
<CAPTION>
JANUARY 1, 1999 January 2, 1998 December 31, 1996
- -----------------------------------------------------------------------------------
<S> <C> <C> <C>
Net loss--as reported $(22,562,000) $(22,364,000) $(16,078,000)
- -----------------------------------------------------------------------------------
Net loss--pro forma $(26,022,000) $(24,868,000) $(16,180,000)
- -----------------------------------------------------------------------------------
Net loss per common
share and per
common share
assuming dilution
-- as reported $ (1.62) $ (1.66) $ (1.64)
- -----------------------------------------------------------------------------------
Net loss per common
share and per
common share
assuming dilution
-- pro forma $ (1.86) $ (1.84) $ (1.65)
- -----------------------------------------------------------------------------------
</TABLE>
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes model with the following weighted average assumptions:
<TABLE>
<CAPTION>
1998 1997 1996
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Risk-free interest rate 4.04%-5.77% 5.71%-6.81% 5.57%-6.44%
Expected life 4 YEARS 4 years 4 years
Expected dividends -- -- --
Expected volatility 79.23% 73.57% 38.88%
</TABLE>
The expected life is based on the assumption that stock options on
average are exercised once they are fully vested. The risk-free interest rate
was calculated in accordance with the grant date and expected life.
32
<PAGE>
The options outstanding and currently exercisable by exercise price at
January 1, 1999 are as follows:
<TABLE>
<CAPTION>
Options Currently
Options Outstanding Exercisable
- ---------------------------------------------------------------------- -------------------------------
Weighted
Average Weighted Weighted
Remaining Average Average
Exercise Number Contractual Exercise Number Exercise
Price Outstanding Life Price Exercisable Price
- --------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$ 0.10 262,548 7.1 $ 0.10 129,005 $ 0.10
$ 3.50-$5.25 718,650 9.3 $ 4.88 147,250 $ 5.00
$ 5.28-$7.63 1,321,725 8.8 $ 5.94 466,734 $ 5.96
$ 8.00 9,000 8.8 $ 8.00 9,000 $ 8.00
$14.88 15,000 7.4 $14.88 15,000 $14.88
Total 2,326,923 766,989
- --------------------------------------------------------------------------------------------------------------
</TABLE>
Deferred compensation to be recognized as a result of stock options
granted and common stock issued subject to repurchase provisions as of
January 1, 1999 totals $1.4 million. Amortization of deferred compensation is
generally over vesting periods of one to four years, with compensation
expense recognized in the years ended January 1, 1999, January 2, 1998 and
December 31, 1996 being $1.8 million, $2.2 million and $6.7 million,
respectively.
NOTE 11. RELATED PARTIES:
In June 1995, the Company entered into a consulting and assignment agreement
with a surgeon who serves on the Company's Scientific Advisory Board. Under
the agreement, the surgeon will develop prototype instruments, participate in
developing any testing protocols, provide clinical input with respect to
current surgical procedures, provide evaluations of prototype products and
test prototype and production products. In consideration, the Company will
pay this surgeon $5,000 per month. Payments under this agreement totaled
$60,000, $60,000 and $60,000 in fiscal year 1998, 1997 and 1996,
respectively. The assignment agreement assigned to the Company all this
surgeon's rights, title and interest in and to a U.S. patent application
entitled "Method For Coronary Artery Bypass." Concurrent with this agreement,
the Company sold 103,060 shares of common stock for cash at $0.001 per share
and will pay a 3% royalty on the first $10 million of net sales, 2% on the
next $15 million of net sales and 1.5% on net sales above $25 million of
future products covered by future potential patents on which this surgeon is
the sole inventor. No royalty payments were made in 1998, 1997 and 1996.
In February 1996, the company entered into a consulting agreement with a
board member. The agreement requires this board member to provide consulting
services with respect to the conception, development and clinical evaluation
of devices, instruments and techniques for minimally invasive coronary artery
bypass graft surgery for four years. In consideration for these consulting
services, the Company granted, to partnerships of which this board member is
a general partner, nonstatutory options to purchase a total of 90,000 shares
of common stock of the Company at an exercise price of $0.10 per share. The
options were immediately fully exercisable, but subject to repurchase at cost
in the event that both the agreement is terminated in accordance with its
terms and this board member is no longer a member of the Company's Board of
Directors. The repurchase right will lapse at the rate of 1/48 of the shares
each month beginning in March 1996. The Company will also pay royalties of 3%
on the aggregate net sales of certain products sold by the Company until a
total of $25,000,000 has been paid. Thereafter, the Company will have no
further royalty obligations under this agreement. The partnerships exercised
the stock options to purchase a total of 90,000 shares in February 1996. No
royalties were paid during 1998, 1997 and 1996.
Also in February 1996, the Company entered into a development program
agreement with a medical device company. This company is currently developing
several minimally invasive cardiothoracic surgical products. Under the
development program agreement, the Company issued a purchase order in the
amount of $30,000 to this company for their current prototype products. The
Company made development payments totaling $500,000 and issued a nonstatutory
option to purchase 450,000 shares of common stock of the Company at an
exercise price of $0.001 per share. All of the shares subject to the option
were exercised as of January 1, 1999. Also, the Company will pay certain
royalties based on revenue from certain product sales and sublicenses. The
Company may terminate the agreement without cause on 90 days notice by paying
a termination fee to this company in addition to all payments owed through
the notice date. No royalty payments were made during 1998, 1997 and 1996.
NOTES RECEIVABLE FROM OFFICERS:
In May 1996, the Company loaned an officer $35,000. The resultant
promissory note bears interest at 6.36% per annum and is due on the earlier
of May 20, 2000 or termination of employment. At January 1, 1999 all
principal and interest is outstanding on this note. The loan is
collateralized by the officer's option to purchase common stock.
In August 1996, the Company loaned an officer $750,000 which is due and
payable on the earlier of August 16, 2000 or termination of employment. The
resultant promissory note does not bear interest and is collateralized by the
officer's holding of 75,000 shares of the Company's common stock. At January
1, 1999 principal of $750,000 is outstanding on this note.
In December 1996, the Company loaned an officer $200,000 pursuant to a
provision in the officer's employment agreement. The resultant promissory
note bears interest at 6.31% per annum and is due on the earlier of December
31, 2000 or termination of employment. At January 1, 1999 all principal and
interest is outstanding on this note.
In June 1998, the Company loaned an officer $80,000 pursuant to a
provision in the officer's employment agreement. The resultant promissory
note bears interest at 5.77% and is due on the earlier of four annual equal
installments starting December 1, 1998 or termination. Should the officer's
association with the Company continue through the due date of any installment
payment under this note, the Company agrees to forgive all principal and
interest due by the terms of the note for the installment. At January 1, 1999
$60,000 principal is outstanding on this note.
33
<PAGE>
NOTE 12. INCOME TAXES:
At January 1, 1999, the Company has approximately $48.3 million in federal
and $35.3 million in state net operating loss carryforwards to reduce future
taxable income. These carryforwards expire in the years 2001 through 2018, if
not utilized. In addition, the Company has federal and state research and
development credits of $1.4 million and $778,000, respectively. These
carryforwards expire in the years 2011 through 2018 if not utilized.
The Tax Reform Act of 1986 limits the use of net operating loss and tax
credit carryforwards in the case of an "ownership change" of a corporation.
Any ownership changes, as defined, may restrict utilization of carryforwards.
Temporary differences and carryforwards which gave rise to significant
portions of deferred tax assets and liabilities are as follows:
<TABLE>
<CAPTION>
JANUARY 1, 1999 January 2, 1998
- ---------------------------------------------------------------------------
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards $ 18,527,000 $ 10,724,000
Capitalized research and
development costs 72,000 83,000
Capitalized start-up costs 929,000 1,267,000
Research and development credits 1,898,000 947,000
Other 776,000 381,000
Less: valuation allowance (22,202,000) (13,402,000)
-----------------------------------
Net deferred tax assets $ -- $ --
- ---------------------------------------------------------------------------
</TABLE>
In accordance with generally accepted accounting principles, a valuation
allowance must be established for a deferred tax asset if it is more likely
than not that a tax benefit may not be realized from the asset in the future.
The Company has established a valuation allowance to the extent of its
deferred tax assets due to uncertainties that a benefit can be realized in
the future.
NOTE 13. EMPLOYEE BENEFIT PLAN:
The Company has a 401(k) Retirement Plan (the Plan) which covers
substantially all employees. Eligible employees may make salary deferral
(before tax) contributions up to a specified maximum. The Company, at its
discretion, may make additional matching contributions on behalf of the
participants of the Plan. To date, the Company has not made any contributions
to the Plan.
NOTE 14. INDUSTRY AND GEOGRAPHIC SEGMENT INFORMATION:
The Company has adopted the Financial Accounting Standards Board's Statement
of Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information," ("SFAS 131"), effective for fiscal years
beginning after December 31, 1997. SFAS 131 supercedes Statement of Financial
Accounting Standards, "Financial Reporting for Segments of a Business
Enterprise" ("SFAS 14"). SFAS 131 changes current practice under SFAS 14 by
establishing a new framework on which to base segment reporting and also
requires interim reporting of segment information.
Management uses one measurement of profitability for its business. The
Company's cardiac surgery products are developed and marketed to cardiac
surgeons and hospitals. The Company markets its products to customers in the
United States, Canada, Europe, South America, Middle East and Asia Pacific
and operates in one business segment. All of the Company's long-lived assets
are in the United States. Revenue information by geographic area is as
follows:
<TABLE>
<CAPTION>
Revenue
- -------------------------------------------------------------------------------
<S> <C>
January 1, 1999:
United States $ 14,125,000
International 2,024,000
--------------
Total $ 16,149,000
- -------------------------------------------------------------------------------
January 2, 1998:
United States $ 7,725,000
International 1,654,000
--------------
Total $ 9,379,000
- -------------------------------------------------------------------------------
December 31, 1996:
United States $ 141,000
International --
--------------
Total $ 141,000
- -------------------------------------------------------------------------------
</TABLE>
34
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
CardioThoracic Systems, Inc., and subsidiary
To the Board of Directors and Stockholders of
CardioThoracic Systems, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, stockholders' equity and of cash flows
present fairly, in all material respects, the financial position of
CardioThoracic Systems, Inc. and subsidiary at January 1, 1999 and January 2,
1998, and the results of their operations and cash flows for each of the
three years in the period ended January 1, 1999, in conformity with generally
accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express
an opinion on these financial statements based on our audits. We conducted
our audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
San Jose, California
January 22, 1999
35
<PAGE>
CORPORATE OFFICERS AND BOARD MEMBERS
CardioThoracic Systems, Inc.
CORPORATE OFFICERS
RICHARD M. FERRARI
President and Chief Executive Officer
JEFFREY G. GOLD
Executive Vice President and Chief Operating Officer
STEVEN M. VAN DICK
Vice President, Finance and Administration and Chief Financial Officer
MICHAEL J. BILLIG
Vice President, Regulatory, Quality and Clinical Research
GEOFFREY D. DILLON
Vice President, Sales and Marketing
RICHARD A. LOTTI
Vice President, Business Development
CHARLES S. TAYLOR
Vice President and Chief Technical Officer
BOARD MEMBERS
ROBERT C. BELLAS, JR.
General partner, Morgenthaler Ventures, a venture capital firm
RICHARD M. FERRARI
President and Chief Executive Officer, CTS
THOMAS J. FOGARTY, M.D.
Cardiovascular surgeon, Professor of Surgery, Stanford University School of
Medicine
JACK W. LASERSOHN
General partner, The Vertical Group, a venture capital firm
THOMAS C. MCCONNELL
General partner, New Enterprise Associates, a venture capital firm
CHARLES S. TAYLOR
Vice President and Chief Technical Officer, CTS
PHILIP M. YOUNG
General partner, U.S. Venture Partners, a venture capital firm
36
<PAGE>
CORPORATE INFORMATION
CardioThoracic Systems, Inc.
CORPORATE OFFICES
CardioThoracic Systems, Inc.
10600 North Tantau Avenue
Cupertino, CA 95014-0739
(408) 342-1700 phone
(408) 342-1717 fax
TRANSFER AGENT AND REGISTRAR
Northwest Bank Minnesota, N.A.
Shareowner Services
P.O. Box 64854
St. Paul, MN 55164
(612) 450-4084 or (800) 468-9716
(612) 450-4078 fax
GENERAL COUNSEL
Wilson Sonsini Goodrich & Rosati
Professsional Corporation
Palo Alto, CA
AUDITORS
PricewaterhouseCoopers LLP
San Jose, CA
ANNUAL MEETING
The Annual Meeting of Shareholders will be held May 4, 1999 at 2:00 p.m. at
the Company's corporate offices.
FORM 10-K
A copy of the Company's Form 10-K is available, without charge, upon written
request to the Company's Investor Relations department.
MARKET PRICE OF COMMON STOCK AND DIVIDEND INFORMATION
The Company's common stock is traded on the NASDAQ National Market under the
symbol "CTSI." There were approximately 295 holders of record of the
Company's common stock on February 9, 1999. The table below provides
quarterly high/low prices on the NASDAQ national market, as reported by
NASDAQ.
<TABLE>
<CAPTION>
1998 1997
Quarter High Low High Low
- ---------------------------------------------------
<S> <C> <C> <C> <C>
First $7 15/16 $5 1/2 $26 1/2 $18 5/8
Second 6 1/2 4 1/4 21 5/8 10 3/4
Third 5 5/16 3 3/8 14 1/8 6 3/4
Fourth 8 3/8 3 1/8 9 3/8 4 5/8
- ---------------------------------------------------
</TABLE>
No dividends have been paid on common stock to date, and the Company has no
current plans to do so.
<PAGE>
EXHIBIT 23.1
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the incorporation by reference in the registration statement of
CardioThoracic Systems, Inc., on Forms S-8 (File No. 333-53663 and File No.
333-71019) of our report dated January 22, 1999 on our audits of the
consolidated financial statements of CardioThoracic Systems, Inc. and
subsidiary as of January 1, 1999 and January 2, 1998, and the years ended
January 1, 1999, January 2, 1998 and December 31, 1996, which report is
included in the Company's Annual Report on Form 10-K.
PricewaterhouseCoopers LLP
San Jose, California
March 29, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> JAN-01-1999
<PERIOD-START> JAN-03-1998
<PERIOD-END> JAN-01-1999
<CASH> 1,651,000
<SECURITIES> 27,513,000
<RECEIVABLES> 3,315,000
<ALLOWANCES> (421,000)
<INVENTORY> 963,000
<CURRENT-ASSETS> 34,142,000
<PP&E> 6,666,000
<DEPRECIATION> (3,292,000)
<TOTAL-ASSETS> 49,766,000
<CURRENT-LIABILITIES> 8,392,000
<BONDS> 0
0
0
<COMMON> 103,331,000
<OTHER-SE> (63,368,000)
<TOTAL-LIABILITY-AND-EQUITY> 49,766,000
<SALES> 16,149,000
<TOTAL-REVENUES> 16,149,000
<CGS> 7,237,000
<TOTAL-COSTS> 7,237,000
<OTHER-EXPENSES> 33,887,000
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 313,000
<INCOME-PRETAX> (22,562,000)
<INCOME-TAX> 0
<INCOME-CONTINUING> (22,562,000)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (22,562,000)
<EPS-PRIMARY> (1.62)
<EPS-DILUTED> (1.62)
</TABLE>
