<PAGE>
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2000
OR
[_] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE TRANSITION PERIOD FROM _________________ TO
_______________.
COMMISSION FILE NO. 000-23275
SOMNUS MEDICAL TECHNOLOGIES, INC.
(Exact name of registrant as specified in its charter)
Delaware 77-0423465
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
285 N. Wolfe Road
Sunnyvale, California 94086
(address of principal executive offices, including zip code)
(408) 773-9121
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [_]
As of November 8, 2000 14,680,131 shares of the Registrant's Common Stock were
outstanding.
1
<PAGE>
SOMNUS MEDICAL TECHNOLOGIES, INC.
INDEX
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION Page
----------------------------- ----
<S> <C>
Item 1. Financial Statements (unaudited)
Condensed Consolidated Balance Sheets as of
September 30, 2000 and December 31, 1999 ......................... 3
Condensed Consolidated Statements of Operations for the
Three and Nine month periods ended September 30, 2000
and 1999 ......................................................... 4
Condensed Consolidated Statements of Cash Flows for the
Nine month periods ended September 30, 2000 and 1999 ............. 5
Notes to Condensed Consolidated Financial Statements ............. 6
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations .................... 8
Item 3. Quantitative and Qualitative Disclosures of
Market Risk ...................................................... 19
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K ................................. 19
Signatures ................................................................ 20
</TABLE>
2
<PAGE>
Item 1. Financial Statements
SOMNUS MEDICAL TECHNOLOGIES, INC.
Condensed Consolidated Balance Sheets
(In thousands)
<TABLE>
<CAPTION>
September 30, December 31,
2000 1999
(Unaudited) (*)
------------ ------------
<S> <C> <C>
Assets
Current assets:
Cash and cash equivalents $ 9,405 $ 14,888
Short-term equivalents -- 4,972
Accounts receivable, net 1,867 1,906
Inventories 1,694 1,181
Other current assets 179 164
-------- --------
Total current assets 13,145 23,111
Property and equipment net 2,168 1,603
Other assets 89 84
-------- --------
$ 15,402 $ 24,798
======== ========
Liabilities and stockholders' equity
Current liabilities:
Accounts payable $ 1,997 $ 1,623
Accrued liabilities 1,168 1,442
Accrued compenstion 1,632 2,167
Accrued warranty 877 907
Accrued clinical cost 532 547
Deferred revenue 535 1,287
-------- --------
Total current liabilities 6,741 7,973
Stockholders' equity
Common stock 16 14
Additional paid-in capital 65,559 65,332
Deferred stock compensation (22) (189)
Accumulated deficit (56,892) (48,332)
-------- --------
Total stockholders' equity 8,661 16,825
-------- --------
$ 15,402 $ 24,798
======== ========
</TABLE>
(*) Derived from audited financial statements
See accompanying notes
3
<PAGE>
SOMNUS MEDICAL TECHNOLOGIES, INC.
Condensed Consolidated Statement of Operations
(Unaudited)
(In thousands, except per share data)
<TABLE>
<CAPTION>
For the Three Months For the Nine Months
Ended Ended
--------------------- --------------------
Sept. 30, Sept. 30, Sept. 30, Sept. 30,
2000 1999 2000 1999
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Product revenue* $ 2,937 $ 3,175 $ 9,141 $ 8,484
Cost of sales 1,412 1,541 5,091 4,713
-------- -------- -------- --------
Gross margin 1,525 1,634 4,050 3,771
Operating expenses:
Research and development 1,459 878 4,377 4,248
Selling, general and administrative 2,942 3,843 8,850 11,015
-------- -------- -------- --------
Total operating expenses 4,401 4,721 13,227 15,263
-------- -------- -------- --------
Loss from operations (2,876) (3,087) (9,177) (11,492)
Interest and other income, net* 163 307 617 1,129
-------- -------- -------- --------
Net loss $ (2,713) $ (2,780) $ (8,560) $(10,363)
Net loss per share, basic and diluted $ (0.19) $ (0.19) $ (0.59) $ (0.73)
======== ======== ======== ========
Shares used in computing net loss per share, basic
and diluted 14,589 14,324 14,511 14,215
======== ======== ======== ========
</TABLE>
* Revenue for the three and nine months ended September 30, 1999 included
related party revenue of $95,000 and $445,000, respectively. Interest and
other income, net for the three and nine months ended September 30, 1999,
includes nonrecurring technology and documentation fees from a related
party of $133,000.
See accompanying notes
4
<PAGE>
SOMNUS MEDICAL TECHNOLOGIES, INC.
Condensed Consolidated Statements of Cash Flows
(Unaudited, in thousands)
<TABLE>
<CAPTION>
For the Nine
Months Ended
---------------------
Sept. 30, Sept. 30,
2000 1999
-------- --------
<S> <C> <C>
Cash flows used in operating activities
Net loss $ (8,560) $(10,363)
Adjustments to reconcile net loss to net cash
used in operating activities:
Amortization of deferred compensation 47 463
Depreciation 632 677
Changes in operating assets and liabilities:
Accounts receivable 39 (641)
Inventories (513) (210)
Other current assets (15) 205
Other noncurrent assets (5) (5)
Accounts payable, accrued liabilities,
and accrued warranty 70 1,129
Accrued compensation (535) 694
Accrued clinical costs (15) (203)
Deferred revenue (752) 495
-------- --------
Net cash used in operating activities (9,607) (7,759)
-------- --------
Cash flows used in investing activities
Capital expenditures (1,197) (548)
Repurchase of common stock -- (285)
Maturity of Short-term investments 4,972 --
-------- --------
Net cash provided by (used in) investing activities 3,775 (833)
-------- --------
Cash flows provided by financing activities
Net proceeds from issuance of common stock 349 198
-------- --------
Net decrease in cash and cash equivalents (5,483) (8,394)
Cash and cash equivalents at beginning of period 14,888 32,280
-------- --------
Cash and cash equivalents at end of period $ 9,405 $ 23,886
======== ========
</TABLE>
See accompanying notes
5
<PAGE>
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1 - Summary of Significant Accounting Policies
---------------------------------------------------
Basis of Presentation
The condensed consolidated balance sheet as of September 30, 2000, the
condensed consolidated statements of operations for the three and nine month
periods ended September 30, 2000 and 1999, and the condensed consolidated
statements of cash flows for the nine month periods ended September 30, 2000 and
1999, have been prepared by management, without audit, in accordance with
generally accepted accounting principles, for interim financial information and
pursuant to instructions to Form 10-Q and Article 10 of Regulation S-X. In the
opinion of management, all adjustments (which include only normal recurring
adjustments) necessary to present fairly the financial position at September 30,
2000 and results of operations and cash flows for all periods presented have
been made. The condensed consolidated balance sheet at December 31, 1999 has
been derived from the audited financial statements at that date.
Certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted accounting
principles have been condensed or omitted pursuant to the Securities and
Exchange Commission's rules and regulations.
These condensed financial statements should be read in conjunction with
the audited consolidated financial statements as included in our Annual Report
on Form 10-K for the year ended December 31, 1999, as filed with the Securities
and Exchange Commission. The results of operations for the three and nine month
periods ended September 30, 2000 are not necessarily indicative of the results
to be expected for any subsequent quarter or for the entire fiscal year ending
December 31, 2000.
Revenue Recognition
We recognize revenue at the time products are shipped or, for sales
which are financed through third parties, upon acceptance from a third party
leasing company of a customer lease and the related equipment. For shipments to
distributors made under agreements that do not provide for right of return or
price protection, revenue for control units is recognized upon shipment to the
final customer. Allowances for product returns are provided for at the time of
revenue recognition.
New Accounting Standards
In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, "Revenue recognition in financial statements"
(SAB 101). SAB 101 summarizes the SEC's views in applying generally accepted
accounting principles to revenue recognition.
6
<PAGE>
The Adoption of SAB 101 had no significant impact on the Company's revenue
recognition policy or results of operations.
In June 1998, The Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 133, " Accounting for Derivative Financial
Instruments and Hedging Activities" ("SFAS 133") which provides a comprehensive
and consistent standard for the recognition and measurement of derivatives and
hedging activities. SFAS 133, as amended, is required to be adopted by the
Company effective January 1, 2001 and is not anticipated to have an impact on
the Company's results of operations or financial condition when adopted as the
Company holds no derivative financial instruments and does not currently engage
in hedging activities.
In March 2000, the Financial Accounting Standards Board issued
Interpretation 44, "Accounting for Certain Transactions Involving Stock
Compensation." The adoption of this Interpretation had no impact on the
Company's results of operations or financial condition.
NOTE 2 - Inventories
--------------------
(in thousands) September 30, December 31,
2000 1999
------ ------
Raw Materials $1,017 $ 406
Work in Process 201 214
Finished Goods 477 561
------ ------
$1,695 $1,181
====== ======
7
<PAGE>
Item 2. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the
attached condensed consolidated financial statements and notes thereto, and with
our audited financial statements and notes thereto for the fiscal year ended
December 31, 1999.
The information set forth below contains forward-looking statements,
(designated by a *) and our actual results could differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including those set forth below under "Factors That May Affect Future Results"
and those set forth under "Item 1" in our Annual Report on Form 10-K for the
fiscal year ended December 31, 1999.
Overview
We design, develop, manufacture and market innovative medical devices
that utilize our proprietary temperature, controlled radiofrequency technology
for the treatment of upper airway disorders. Our Somnoplasty(R) System provides
physicians with a suite of products designed to offer minimally invasive,
curative treatment alternatives for disorders of the upper airway, including
obstructive sleep apnea syndrome (OSAS), upper airway resistance syndrome,
(UARS), chronic turbinate hypertrophy, hypertrophic tonsils, and habitual
snoring.
We have $9,405,000 of cash and cash equivalents at September 30,
2000. Based upon our current operations, this will not be sufficient capital
to support our operations for the next twelve months. We are in the process of
exploring alternatives in response to our cash situation, including raising
funds through the issuance of equity or debt securities in the public or
private markets.
Our operations in 1996 and 1997 consisted largely of research and
development, product engineering, seeking clearance of our products from the
Food & Drug Administration (FDA), development of a direct sales force in the
United States and distribution network, and training international distributor
employees for distribution of the Somnoplasty System in the European Union (EU),
Australia, Southeast Asia and certain other areas. We commercially introduced
the Somnoplasty System internationally beginning in June 1997. One month later,
after receiving 510(k) clearance from the FDA for the use of the Somnoplasty
System to treat habitual snoring, we began direct sales of the Somnoplasty
System in the United States. We received FDA clearance to treat chronic
turbinate hypertrophy in December 1997 and OSAS/UARS in November 1998. During
the third quarter of fiscal 1998, we established a European headquarters in The
Netherlands. In June 2000, we received clearance from the FDA for a new device
designed to significantly reduce enlarged tonsils. In addition, in June 2000, we
secured regulatory "shonin" approval to market the Somnoplasty System in Japan.
During 1998, we hired a Vice President and General Manager of European
Sales and Marketing to manage distributors in European countries. During 1999,
we continued to build our direct sales force in the United States. During the
fourth quarter of 1999, we hired a Director of International Sales to manage our
distributors in countries other than the United States and Europe.
Product shipments of control units and disposable devices are made
directly from our facility in Sunnyvale, California to domestic customers and
international distributors. As our installed base of control units has grown
we have continued to receive an increasing percentage of our sales from
disposable handpieces as opposed to from the sale of control units.
8
<PAGE>
Our personnel, sales and scope of operations place considerable
strain on our management, financial, manufacturing and other capabilities,
procedures and controls. There can be no assurance that any existing or
additional capabilities, procedures or controls will be adequate to support
our operations or that our capabilities, procedures or controls will be
designed, implemented or improved in a timely and cost-effective manner.
Failure to implement and improve and expand such capabilities, procedures and
controls in an efficient manner could have a material adverse effect on our
business, financial condition and results of operations.
As of September 30, 2000, we have incurred cumulative losses from
inception of $56,892,000. Moreover, we expect to incur significant additional
operating losses over the next couple of years primarily due to the development
of our manufacturing and sales and marketing capabilities along with ongoing
research and development efforts, including clinical studies and expenses
associated with our patent portfolio, as well as costs associated with the
implementation of the appropriate infrastructure to support the business
operations. * Our limited operating history makes accurate prediction of
future operating results difficult or impossible.
Future revenues and results of operations may fluctuate significantly
from quarter to quarter or year to year and will depend upon numerous factors,
including the extent to which our products gain market acceptance, the scale-up
of manufacturing capabilities, the expansion of sales and marketing activities,
competition, the timing and success of new product introductions by us or our
competitors, the timing of regulatory clearances or approvals of those new
products and our ability to market our products in the United States and
internationally. Accordingly, interim period comparisons of our operating
results are not necessarily meaningful and should not be relied upon as
indicators of likely future performance or annual operating results.
Our business and financial results could be materially adversely
affected in the event that we are unable to market the Somnoplasty System
effectively, anticipate customer demand, meet customer demand or effectively
manage new product launches, pricing and cost containment pressures in health
care. Our operations and financial results could also be significantly affected
by international factors, including oversight by numerous regulatory agencies,
changes in foreign currency exchange rates and foreign economic and political
conditions.
9
<PAGE>
Results of Operations
Net Revenue. Our revenues for the three and nine months ended
September 30, 2000 were derived primarily from sales of our Somnoplasty
system, consisting of control units and disposable devices to private
practices, hospitals, clinics, and sleep clinics. Net revenues for the three
and nine months periods ended September 30, 2000 were $2,937,000 and
$9,141,000 respectively, a decrease and increase over the prior year periods
of $238,000 or 7.5 percent, and $657,000, or 7.7 percent, respectively. The
decrease for the three month period ended September 30, 2000 as compared to
the prior year period is attributable to lower revenue from control units
offset by increased revenue from disposable handpieces driven off the higher
installed base. The slight increase for the nine month period ended September
30, 2000 as compared to the prior year period is attributable to increased
revenue from disposable handpieces driven off the higher installed base offset
by lower revenue from control units. During the three and nine month periods
ended September 30, 2000, 76.7 percent and 82.7 percent of our revenues
respectively were derived from sales to customers in the United States. During
the three and nine month periods ended September 30, 1999, 84.9 percent and
87.6 percent of our revenues respectively were derived from sales to customers
in the United States. As we implement sales programs that reduce the price of
control units, the revenue from products shipped has shifted from a mix of
approximately 48 percent control units and 52 percent disposable handpieces
for the three and nine month periods ended September 30, 1999 to a mix of
approximately 20 percent control units and 80 percent disposable handpieces
for the three and nine month periods ended September 30, 2000, respectively.
We expect disposable handpieces to fluctuate as a percentage of total revenue,
quarter over prior year quarter and year over year, as we implement sales
programs that reduce the price of control units.
Cost of sales and gross margin. Cost of sales consists of raw
materials, subassemblies and completed electronics, quality assurance and
warranty costs. Gross margin for the three and nine months periods ended
September 30, 2000 increased by 1 percent to 51 percent of sales and was
consistent at 44 percent of sales, compared to the prior year periods. We
anticipate that as sales increase cost of sales will increase but may
fluctuate as a percentage of sales depending on volume and product mix. *
Research and development expenses. Research and development expenses
are comprised of salaries, prototype development costs, costs associated with
intellectual property, and clinical trial and regulatory approval costs.
Research and development costs for the three and nine months ended September 30,
2000 were $1,459,000 and $4,377,000, a increase over the prior year periods of
$581,000 or 66.2 percent and $129,000 or 3 percent, respectively. The increase
for the three months ended September 30, 2000 as compared to the prior year
period was primarily attributable to increased prototype expenses and salaries
and wages related to the release of new products and the one-time reversal of a
clinical charge of $300,000 recorded during the third quarter of 1999. The
increase for the nine months ended September 30, 2000 as compared to the prior
year period was primarily attributable to increased prototype expenses and
salaries and wages related to the release of new products, and the one-time
reversal of a clinical charge of $300,000 recorded during the third quarter of
1999 offset by a one-time charge of $214,000 for severance for a former officer
of the Company during the first quarter of 1999.
Selling, general and administrative. Selling, general and
administrative expenses consist of executive salaries, professional fees,
facilities overhead, accounting, human resources, and general office
administration expenses such as rent and facility costs. Selling, general and
administrative expenses for the three and nine months ended September 30, 2000
were $2,942,000 and $8,850,000, a decrease over the prior year periods of
$901,000 or 23.4 percent and $2,165,000 or 19.7 percent, respectively. The
decrease in the three month period
10
<PAGE>
ended September 30, 2000 as compared to the prior year period is primarily
attributable to reduced bad debt, legal, and personnel related costs. The
decrease in the nine month period ended September 30, 2000 as compared to the
prior year period is primarily attributable to reduced bad debt, legal, and
personnel related costs as well as a one time charge of $214,000 for severance
for a former officer of the Company included in the prior year period.
Interest and other income. Interest and other income for the three and
nine months ended September 30, 2000 was $163,000 and $617,000, a decrease over
the prior year periods of $144,000 or 46.9 percent and $512,000 or 45.3 percent,
respectively. The decrease in the three month period ended September 30, 2000 as
compared to the prior year period is attributable to the reduction in interest
income earned on a decreasing balance of cash, cash equivalents, and short-term
investments. The decrease in the nine month period ended September 30, 2000 as
compared to the prior year period is attributable to both the reduction in
interest income earned on a decreasing balance of cash, cash equivalents, and
short-term investments as well as by nonrecurring technology and documentation
fees received from a related party during the prior year period not received
during the nine month period ended September 30, 2000.
Liquidity and Capital Resources
Since inception through September 30, 2000, Somnus has financed its
operations primarily through the private placement of equity securities, bank
loans, lease lines of credit, stockholder loans and our November, 1997 Initial
Public Offering. From inception, we raised approximately $16,400,000 in net
proceeds from private equity financing. We raised an additional $43,800,000 from
our Initial Public Offering net of costs of $4,500,000.
Cash and cash equivalents and short-term investments at September 30,
2000 were $9,405,000 compared to $19,860,000 at December 31, 1999.
Net cash used in operating activities was approximately $9,607,000 for
the nine months ended September 30, 2000, compared to $7,759,000 million for the
nine months ended September 30, 1999. The increase in cash used in operating
activities from the prior year quarter is primarily attributable to an increase
in inventories and a decrease in deferred revenue and accrued compensation
during the nine months ended September 30, 2000. This was partially offset by
the decrease in net loss from the prior year period.
Net cash provided by investing activities was approximately $3,776,000
for the nine months ended September 30, 2000, compared to net cash used in
investing activities of $833,000 for the nine months ended September 30, 1999.
The increase from the prior year period is attributable to the sale of short-
term investments partially offset by an increase in capital expenditures.
Net cash provided by financing activities was approximately $349,000
for the nine months ended September 30, 2000 as compared to $198,000 for the
nine months ended September 30, 1999. The increase from the prior year period is
attributable to an increase in stock option exercises during the nine months
ended September 30, 2000 as compared to the prior year period.
At September 30, 2000, our principal sources of liquidity consisted of
cash and cash equivalents. There were no other material unused sources of liquid
assets at September 30, 2000.
11
<PAGE>
We currently anticipate that our capital expenditure requirements will
be approximately $3.5 million for the next twelve months. * These requirements
relate primarily to the production of control units for placement with customers
under our placement sales program and the acquisition of computer hardware and
software to handle anticipated headcount additions.
We anticipate that our existing resources will not be sufficient
capital to support our operations for the next twelve months. * We anticipate
that we will require additional funding prior to such time. * Our future capital
requirements will depend on many factors, including our ability to maintain
regulatory compliance, our ability to establish and maintain strategic
distributor relationships, the rate of market adoption of our products,
competing technological and market developments, the ability for us to produce
or procure enough product to most customer demand, the cost of manufacturing and
other factors. There can be no assurance that additional financing to meet our
funding requirements will be available as needed. If additional funds are raised
by issuing equity securities, substantial dilution to existing stockholders my
result. Insufficient funds may require us to delay, scale back or eliminate some
or all of our research or development programs or to relinquish rights to
products at an earlier stage of development or on less favorable terms than we
would otherwise seek to obtain or to scale back and eliminate certain sales and
marketing initiatives. Our failure to raise capital when needed would have a
material adverse effect on our business, financial condition and results of
operations.
FACTORS THAT MAY AFFECT FUTURE RESULTS
Our operating results may vary significantly depending on certain
factors, including market acceptance of products, the ability to anticipate and
meet customer demand, delays in the introduction or shipment of new products,
increased competition, delays in ongoing research and development programs,
litigation costs should we be involved in litigation, adverse changes in the
economic conditions in any of the several counties in which we do business, a
slower growth rate in our target markets, and the factors set forth in our
annual report on Form 10-K for the fiscal year ended December 31, 1999.
Our funds available for operations are low and we will need to raise additional
funds which will cause dilution to existing investors
We expect within the next six months we will raise additional funds
through the issuance of equity or debt securities in the public or private
markets in order to continue operations.* Additional financing may not be
available, or if available, may not be on favorable terms. The availability of
financing will depend, in part, on market conditions. Market volatility as of
late has been high and the risk of securing additional funding uncertain. If we
cannot raise sufficient new capital we may be unable to successfully promote or
produce products, continue supplying our services, or pay our employees, any of
which could seriously harm our business. If we do not raise additional funds
then we will be unable to continue our operations. Any future equity financing
would result in substantial dilution to our stockholders. If we raise
additional funds by issuing debt, we may be subject to limitations on our
operations, including limitations on the payment of dividends.
We may fail to meet continued Nasdaq listing standards which would result in a
listing on a lesser known market within Nasdaq or a delisting altogether. Any
change in market listing may adversely affect our ability to raise capital.
Under the continued listing standards for inclusion of our stock on
the Nasdaq National Market we are required to maintain net tangible assets of
$4.0 million. As of September 30, 2000, our net tangible assets decreased were
$8.7 million. We are uncertain as to whether we will be able to raise
sufficient capital or otherwise increase the assets we own
12
<PAGE>
through sales of our products or asset purchases to maintain minimum net
tangible assets. There are other Nasdaq maintenance standards as well,
including a requirement that our stock cannot close below $1.00 for 30
consecutive trading days. We can give no assurance that our stock will
continue to trade above $1.00. If we cannot maintain Nasdaq maintenance
standards we may be transferred from the Nasdaq National Market to the Nasdaq
SmallCap or the pink sheets or delisted altogether. If our stock is removed
from the Nasdaq National Market, the liquidity and price of our stock may be
adversely affected. As a result, there may be less demand for our stock and we
may be unable to raise sufficient capital to fund our operations.
We have limited experience in selling and marketing our Somnoplasty System. We
may be unable to generate significant revenue from the sale of our generators
and the revenue resulting from sales of our handpieces may not be significant
enough to make us profitable.
We have only limited experience selling and marketing the Somnoplasty
System for the treatment of turbinate hypertrophy (chronic nasal obstruction),
soft palate/uvula (habitual snoring), hypertrophic tonsils and base of tongue
(obstructive sleep apnea syndrome/upper airway resistance syndrome). The sale of
our disposable handpieces may not provide substantial revenue and we may
ultimately prove unsuccessful in selling the Somnoplasty System on a direct
basis in the United States in sufficient quantities for us to become profitable.
Market acceptance of the Somnoplasty System will require us to demonstrate that
the cost of our products and procedures are competitive with currently available
alternatives. There can be no assurance that we will successfully generate
sufficient demand for the Somnoplasty System at the prices at which we currently
offer our control units and disposable devices. In the event the required
investments were to preclude us from placing sufficient quantities of control
units, our ability to sell disposable devices would be limited, which would have
a material effect on our business, financial condition and results of
operations.
We have a history of operating losses and we expect those losses to continue.
We had significant operating losses since the commencement of our
operations in 1996. As of September 30, 2000, we have an accumulated deficit
of approximately $56.9 million. We expect those losses to continue based on
our current and projected increased sales and marketing, general and
administrative, and research and development expenses. * We may never become
profitable. Our ability to become profitable depends on many factors,
including our ability to achieve market acceptance for the Somnoplasty System,
our ability to produce our products consistent with government and regulatory
standards, and our ability to obtain reimbursement for both our products and
the procedure from healthcare payors.
13
<PAGE>
We are dependent upon the Somnoplasty System, which has not been available for
sufficient time for us to know if it is effective on a long term basis.
Our success depends upon the market acceptance of the Somnoplasty
System for the treatment of turbinate hypertrophy (chronic nasal obstruction),
soft palate/uvula (habitual snoring), hypertrophic tonsils and base of tongue
(obstructive sleep apnea syndrome/upper airway resistance syndrome). Market
acceptance will depend, in the large part, upon the effectiveness of the
Somnoplasty System over time. There can be no assurance that the procedure will
provide a permanent, curative treatment for patients. Independent factors, such
as aging and weight gain, may, over time, lead to the enlargement of tissue in
areas previously treated by our procedure. This could result in the need for
further treatments, making the procedure a potentially less attractive
alternative to existing surgical and non-surgical procedures, which could have a
material adverse effect upon our business, financial condition and results of
operations.
We may experience design or production problems and delays as we transition the
manufacture of our S-2 control unit to an outside supplier.
We are in the process of outsourcing the manufacture of our S-2 control
unit to a qualified third party. We may experience design or production
problems and delays as a result. We have earned internal production of our S-2
control unit. There can be no assurance that we will be able to successfully
manage this transition without interrupting our ability to meet customer
demand. The new third party manufacturer of our S-2 control unit is our only
supplier for this product. The inability of this manufacturer to successfully
produce our S-2 control unit consistent with our quality standards and/or on a
timely basis may have a material adverse affect on our financial condition and
results of operations. In the event this supplier fails to fulfill our product
needs, we will be forced to locate alternative suppliers. We can give no
assurance that we will be able to locate suitable replacement suppliers. If we
are unable to secure adequate manufacturing capacity to meet our supply
requirements, our business will be materially harmed.
We may experience problems with regard to our disposable devices which we
manufacture ourselves.
Disposable devices are currently manufactured entirely by Somnus. We have
in the past experienced and we may in the future experience design or
production problems and delays as we manufacture these units. In addition,
certain parts may be discontinued or placed on allocation by their
manufacturers. We have had to qualify alternative vendors when parts could no
longer be obtained by the vendor we had been using. We may have to redesign
our products to use alternative parts when we switch vendors. These
transfers to new vendors can cause delays in our manufacturing operations.
Additionally, there can be no assurance that in the future we will be able to
have parts specifically manufactured, redesign our products to use other
available parts or, qualify alternative vendors, at all or without
interrupting our ability to meet customer demand. The inability to react to
design or production issues through the manufacturing of special parts,
redesign of our products, and the qualification of new vendors could have a
material adverse effect on, financial condition and results of operations.
If our vendors are unable to satisfy our manufacturing requirements our business
will be materially harmed
The S2 control unit and our disposable devices use electronic components.
The electronics industry is in a period of undersupply. Our vendors supply the
electronic components we require to much larger customers, with whom we have to
compete for the limited supply. If we or our third party manufacturer are
not able to obtain such components in a timely manner or in quantities necessary
to meet our requirements, we may be unable to fulfill orders and may lose
customers.
We have in the past and may in the future have vendors who are unable to
supply us with adequate quantities of components. In such a situation, we have
to identify and qualify one or more substitute suppliers for these components
needs. Incorporating new components or transferring existing components needs
to new vendors requires significant time and can cause products shipment delays.
In addition, the costs associated with manufacturing our products may increase
if we required to use third party vendors. If we fail to satisfy our
manufacturing requirements, our business would be materially harmed.
14
<PAGE>
Several factors will impact our ability to achieve market acceptance.
Temperature Controlled Radiofrequency tissue volume reduction in the
upper airway is a new and novel development. Market acceptance of this procedure
for the treatment of turbinate hypertrophy (chronic nasal obstruction), soft
palate/uvula (habitual snoring), hypertrophic tonsils and base of tongue
(obstructive sleep apnea syndrome/upper airway resistance syndrome) could be
adversely affected by numerous factors, including:
. the lack of availability of third-party reimbursement,
. cost of the procedure,
. clinical acceptance,
. differentiation of our temperature control feature,
. effective physician training and
. patient acceptance.
Third party reimbursement. Patients do not receive third-party
reimbursement for use of the Somnoplasty System in the treatment of
habitual snoring. Market acceptance of the Somnoplasty System for the
treatment of turbinate hypertrophy (chronic nasal obstruction),
hypertrophic tonsils and base of tongue (obstructive sleep apnea
syndrome/upper airway resistance syndrome) depends, in large part, upon
the availability and receipt of an acceptable level of third-party
reimbursement for each of those indications, which has not yet been
established on a consistent basis. Reimbursement for the treatment of
habitual snoring, turbinate hypertrophy (chronic nasal obstruction),
hypertrophic tonsils and base of tongue (obstructive sleep apnea
syndrome/upper airway resistance syndrome) varies significantly depending
on the third party payor involved, the region in the U.S. and type of
medical facility where the procedure is performed.
Cost of the procedure and clinical acceptance. Market acceptance also
is impacted by our ability to demonstrate that the Somnoplasty System is an
attractive alternative to other procedures, which depends upon physicians'
evaluations of the clinical safety and efficacy, ease of use, reliability
and cost-effectiveness of the Somnoplasty System. Recommendations and
endorsements by influential physicians have been and we believe, will
continue to be, essential to market acceptance. * There can be no assurance
that such recommendations or endorsements will continue to be obtained.
Competition and Differentiation of our technology. There can be no
assurance that we will be able to successfully differentiate our technology
from competing products. In the treatment of habitual snoring, the
Somnoplasty System is subject to intense competition from existing
products, such as nasal dilators and oral appliances, and surgical
procedures, such as LAUP. The U.S. market for the treatment of enlarged
turbinates is dominated by pharmacological treatments, such as nasal
sprays, and surgical procedures, such as turbinectomies. The U.S. market
for products for the treatment of OSA is currently dominated by CPAP
products produced by Healthdyne Technologies Inc, Nellcor Puritan Bennett,
Inc., a wholly owned subsidiary of Mallinckrodt Inc., ResMed Inc. and
Respironics, Inc. The U.S. market for the treatment of hypertrophic tonsils
is currently dominated by
15
<PAGE>
surgical procedures such as tonsillectomies and other procedures which
remove tonsil tissue. There can be no assurance that the Somnoplasty System
will successfully compete with or replace any existing products for these
or other indications. Other companies offer products which use
radiofrequency for the treatment of upper airway disorders. There can be no
assurance of our ability to differentiate our products with temperature
control feature from these products.
Physician training. Broad adoption of the Somnoplasty System will
require us to train physicians on how to perform the Somnoplasty procedure
and educating physicians regarding the advantages of the Somnoplasty System
over currently available surgical and non-surgical approaches. The time
required to complete such training and education could extend the sales
cycle for our products and delay or preclude commercial sales and market
acceptance. If we are unable to achieve broad market acceptance of the
Somnoplasty System for our current and anticipated indications, our
business, financial condition and results of operations would be materially
adversely affected.
Patient acceptance. Patient acceptance has been and we believe will
continue to be affected by numerous factors, including the possibility that
the Somnoplasty procedure may require multiple treatments, which would be
not only inconvenient for the patient, but also more costly if not covered
by insurance. Patient acceptance of the Somnoplasty System for the
treatment of turbinate hypertrophy (chronic nasal obstruction), soft
palate/uvula (habitual snoring), hypertrophic tonsils and base of tongue
(obstructive sleep apnea syndrome/upper airway resistance syndrome) also
depend in part upon physician recommendations as well as other factors,
including the effectiveness and reliability of the procedure as compared to
existing surgical and non-surgical procedures. We have not yet obtained
broad acceptance of the Somnoplasty System by the patient community, and
there can be assurance that we will achieve such broad acceptance, or that
market demand for our system will be sufficient to allow us to achieve
profitable operations. In addition, publicity arising from any adverse
outcome or other problem occurring in the treatment of a Somnoplasty
patient for any reason could materially adversely affect patient demand for
the procedure. Failure of the Somnoplasty System, for whatever reason, to
achieve significant patient acceptance would have a material adverse effect
on our business, financial condition and results of operations.
16
<PAGE>
Our products could infringe the intellectual property rights of others and lead
to costly litigation and/or substantial royalty payments.
Our competitors or licensors may assert that our products infringe upon
their intellectual property. We may be forced to arbitrate or litigate to
protect our products from claims of infringement. Litigation and arbitration are
costly pursuits and they consume time that management would otherwise dedicate
to building our business. In the event that our products infringe on the
intellectual property of others we may be required to pay significant damages.
We also may have to pay substantial royalties on existing agreements in order to
continue to market our products.
We need to develop successful distributor relationships for international sales.
Our future success will depend, in part, on our ability to enter into
and successfully develop strategic and distributor relationships with other
parties with respect to the marketing and distribution of our products.
In Europe our distributors are managed from the European headquarters
in The Netherlands. Our distributors in the rest of the world are coordinated by
the Director of International Sales, hired in 1999 and based in Sunnyvale. We
may add additional sales personnel, representative groups, and distributors as
necessary to further penetrate markets in the United States and around the
world. *
The success of our future strategic or distributor relationships will
depend on the other parties' ability to perform the role contemplated by us. We
may have limited or no control over the resources that any particular strategic
party or distributor devotes to our relationship with us. There can be no
assurance that we will be successful in locating or finalizing agreements with
further qualified parties with whom to enter into additional strategic or
distributor relationships or that any such relationships can be maintained or
will ultimately prove beneficial to us. In the event we are not successful in
developing such additional relationships, or if such relationships do not prove
to be successful, our business, financial condition and results of operations
would be materially adversely affected.
International sales of the Somnoplasty System are subject to numerous
risks. Distribution, pricing and marketing structures, as well a regulatory
requirements, vary significantly from country to country. Additionally, such
sales can be adversely affected by:
. limitations or disruptions caused by the imposition of government
controls,
. difficulty in obtaining export licenses,
. political instability,
. trade restrictions,
. changes in foreign tax laws or tariffs or other trade
regulations,
. difficulties coordinating communications among and managing
international operations,
17
<PAGE>
. the risk that distributors will fail to effectively promote our
products
. the risk of financial instability of distributors
. fluctuations in overseas economic conditions and international
currency exchange rates,
. increase in duty rates and
. competition.
There can be no assurance that we will be able to successfully
commercialize the Somnoplasty System or any of our future products in any
international market, which would have a material adverse effect on our
business, financial condition and results of operations.
Compliance with Quality System regulations is costly and time consuming and our
failure to comply could lead to delays in filling product orders and loss of
sales revenues
Our facilities are subject to inspection by regulatory authorities,
including the FDA, for compliance with Quality System regulations. The FDA
completed an inspection of our manufacturing facility in April 2000 and the FDA
inspector provided a list of observations indicating he believed were not in
full compliance with applicable Quality System regulations. In addition, in July
2000, the FDA issued us a formal warning letter, which stated that the methods
used in, or the facilities or controls used for the manufacture,packaging,
storage, or installation of our devices are not in conformance with applicable
Quality System regulations. The issuance of a formal warning letter may
materially impact our business, because:
. Federal agencies are advised of the issuance and may take this
information into account when considering the award of contracts;
. The FDA will not clear pre-market submission for devices to which
Quality System violations are reasonably related until the violations
have been corrected; and
. The FDA will not approve a request for Certificate for Products to
Export which will prevent us from exporting to new foreign markets until
the violations have been corrected.
We implemented a plan to take corrective actions to address the FDA's
observations and submitted a written response to the FDA Warning Letter. In
August 2000, we commissioned an audit of the Quality System regulations as
required by the FDA. The findings of this audit were submitted to the FDA. We
are in the process of correcting deficiencies identified in the FDA Warning
Letter, in the audit, and in our ongoing internal review of product quality.
The FDA will likely initiate a reinspection to verify we have corrected the
deficiencies noted in the FDA Warning Letter and to further verify the results
of the audit that we submitted. The scope of any reinspection could be more
comprehensive than the initial inspection. Failure to achieve and maintain
compliance with Quality System regulations could have a significant adverse
effect on our ability to continue to manufacture and sell our products, and in
the most serious cases could result in the seizure or recall of products, and
injunction and/or civil fines.
We are dependent on single-source suppliers for components.
We purchase certain key components of our products from single-source
suppliers. We have in the past and may in the future encounter shortages from
one of our single source suppliers. * In such a situation, we have had to
identify and qualify one or more substitute suppliers for these component needs.
There can be no assurance that in the future components obtained from the
single-source suppliers will continue to be available in adequate quantities or,
if required, that we will be able to locate alternative sources of such
components on a timely and cost-effective basis. To date, we have not
experienced significant adverse effects resulting from any shortage of
components. However, there can be no assurance that the single-source suppliers
will meet our future requirements for timely delivery of components of
sufficient quality
18
<PAGE>
and in sufficient quantity. The components may take several months to procure,
and a significant increase of orders could lead to significant delays and
control unit or device shortages. Such delays or shortages, particularly as we
scale up our manufacturing activities in support of sales and distributor
orders, would have a material adverse effect on our business, financial
condition and results of operations.
We are dependent upon key personnel.
Our future success depends in significant part upon the continued
service of certain key scientific, technical and management personnel and our
continuing ability to attract and retain highly qualified scientific, technical
and managerial personnel. Competition for such personnel is intense, and there
can be no assurance that we can retain our key scientific, technical and
managerial personnel or that we can attract, assimilate or retain other highly
qualified scientific, technical and managerial personnel in the future. We have
taken steps to retain our key employees including the granting of stock options
that vest over time. The loss of key personnel, especially if without advanced
notice, or the inability to hire or retain qualified personnel could have a
material adverse effect upon our business, financial condition and results of
operations.
Due to the factors noted above, our future earnings and stock price may
be subject to significant volatility, particularly on a quarterly basis. Any
shortfall in revenues or earnings from levels expected by security analysts
could have an immediate and significant adverse effect on the trading price of
our common stock.
Item 3: Quantitative and Qualitative Disclosures of Market Risk
There have been no material changes in the reported market risks since
December 31, 1999.
PART II - OTHER INFORMATION
----------------------------
Item 6: Exhibits and Reports on Form 8-K
(a) There were no reports on Form 8-K during the quarter ended
September 30, 2000.
Exhibit 27.1 - Financial Data Schedule
19
<PAGE>
SOMNUS MEDICAL TECHNOLOGIES, INC
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SOMNUS MEDICAL TECHNOLOGIES, INC.
(Registrant)
Date: November 13, 2000 By: /s/ John G. Schulte
--------------------------
John G. Schulte
President and
Chief Executive Officer
By: /s/ Robert D. McCulloch
-----------------------------
Robert D. McCulloch
Vice President of Finance
Chief Financial Officer
(principal financial and accounting officer)
20
