UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q/A
(x) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2003
Commission File Number 1-13165
CRYOLIFE, INC.
(Exact name of registrant as specified in its charter)
--------------------
Florida 59-2417093
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
1655 Roberts Boulevard, NW
Kennesaw, Georgia 30144
(Address of principal executive offices)
(zip code)
(770) 419-3355
(Registrant's telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
YES X NO ____
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
YES X NO ____
The number of shares of common stock, par value $0.01 per share, outstanding on
July 31, 2003 was 19,699,510.
EXPLANATORY NOTE
The Company is filing this amendment to Form 10-Q to amend Items 1 and 2 of
Part I to restate its consolidated financial statements for the three and six
months ended June 30, 2003 to correct the income tax expense in those periods in
accordance with Accounting Principles Board Opinion No. 28, Interim Financial
Reporting. As a result, the financial statements as of and for the three and six
months ended June 30, 2003 have been restated from the amounts previously
reported. The effect of the restatement on the consolidated financial statements
is detailed in Note 15 to the consolidated financial statements. In addition, we
are supplementing Part I, Item 4.
All of the information in this Form 10-Q/A is as of August 5, 2003, the filing
date of the original Form 10-Q, and has not been updated for events subsequent
to that date other than the restatement of the financial statements discussed in
Note 15 to the consolidated financial statements and the reassessment of its
disclosure controls pursuant to Part I, Item 4. Although we have amended the
forward-looking statements to reflect the amendments referred to above, none of
the forward-looking information contained herein has been updated beyond that
date. This Form 10-Q/A does not contain Part I Item 3 or Part II Items 1
through 5 as those portions of the previously filed Form 10-Q have not changed.
2
Part I - FINANCIAL INFORMATION
Item 1. Financial statements
CRYOLIFE, INC. AND SUBSIDIARIES
SUMMARY CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------------- -----------------------------
2003 2002 2003 2002
As Restated As Restated
See Note 15 See Note 15
-------------------------------- --------------------------------
(Unaudited) (Unaudited)
Revenues:
Human tissue preservation services, net $ 8,615 $ 17,536 $ 17,745 $ 37,774
Products 6,932 5,473 13,531 10,538
Distribution and grant 166 255 357 423
-------------------------------- --------------------------------
15,713 23,264 31,633 48,735
Costs and expenses:
Human tissue preservation services
(including write-down of $10,023
for the three and six months ended
June 30, 2002 and $1,131 for the three
months and $1,428 for the six months
ended June 30, 2003) 5,160 17,203 7,603 25,266
Products 2,006 1,843 3,647 4,078
General, administrative, and marketing 23,539 11,447 35,131 20,925
Research and development 1,088 1,196 2,005 2,349
Interest expense 147 196 279 388
Interest income (116) (239) (247) (537)
Other expense (income), net 166 (16) 140 (72)
-------------------------------- --------------------------------
31,990 31,630 48,558 52,397
-------------------------------- --------------------------------
Loss before income taxes (16,277) (8,366) (16,925) (3,662)
Income tax expense (benefit) 3,644 (2,844) 3,430 (1,244)
-------------------------------- --------------------------------
Net loss $ (19,921) $ (5,522) $ (20,355) $ (2,418)
================================ ================================
Net loss per share:
Basic $ (1.01) $ (0.28) $ (1.04) $ (0.13)
================================ ================================
Diluted $ (1.01) $ (0.28) $ (1.04) $ (0.13)
================================ ================================
Weighted average shares outstanding:
Basic 19,675 19,538 19,654 19,318
================================ ================================
Diluted 19,675 19,538 19,654 19,318
================================ ================================
See accompanying notes to summary consolidated financial statements.
3
Item 1. Financial Statements
CRYOLIFE, INC.
SUMMARY CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
June 30, December 31,
2003 2002
As Restated
See Note 15
-------------------------------------
ASSETS (Unaudited)
Current Assets:
Cash and cash equivalents $ 16,147 $ 10,277
Marketable securities, at market 9,761 14,583
Trade receivables, net 8,260 6,930
Other receivables, net 1,766 11,824
Deferred preservation costs, net 9,559 4,332
Inventories 4,535 4,585
Prepaid expenses and other assets 3,769 2,182
Deferred income taxes 1,275 6,734
-------------------------------------
Total current assets 55,072 61,447
-------------------------------------
Property and equipment, net 35,852 38,130
Patents, net 5,313 5,324
Other, net 1,194 1,513
-------------------------------------
TOTAL ASSETS $ 97,431 $ 106,414
=====================================
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities:
Accounts payable $ 3,174 $ 3,874
Accrued expenses and other current
liabilities 15,071 6,823
Accrued compensation 1,695 1,627
Accrued procurement fees 3,499 3,769
Note payable 1,616 --
Current maturities of capital lease 1,957 2,169
obligations
Current maturities of long-term debt 4,800 5,600
-------------------------------------
Total current liabilities 31,812 23,862
-------------------------------------
Capital lease obligations, less current
maturities 863 971
Deferred income taxes -- 986
Other long-term liabilities 4,881 795
Total liabilities 37,556 26,614
Shareholders' equity:
Preferred stock -- --
Common stock (issued 21,045 shares in 2003
and 20,864 shares in 2002) 210 209
Additional paid-in capital 74,063 73,630
Retained (deficit) earnings (7,569) 12,786
Deferred compensation (15) (21)
Accumulated other comprehensive income 362 282
Less: Treasury stock at cost (1,370
shares in 2003 and 1,361 shares in 2002) (7,176) (7,086)
-------------------------------------
Total shareholder' equity 59,875 79,800
-------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 97,431 $ 106,414
=====================================
See accompanying notes to summary consolidated financial statements.
4
Item 1. Financial Statements
CRYOLIFE, INC.
SUMMARY CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
Six Months Ended
June 30,
-------------------------------
2003 2002
As Restated
See Note 15
-------------------------------
(Unaudited)
Net cash from operating activities:
Net loss $ (20,355) $ (2,418)
Adjustments to reconcile net loss to net cash
provided by operating activities:
(Gain) loss on sale of marketable equity securities (19) 228
Depreciation and amortization 2,774 2,526
Provision for doubtful accounts 48 48
Write-down of deferred preservation costs 1,428 10,023
Other non-cash adjustments to income 307 --
Deferred income taxes 4,410 (3,048)
Tax effect of nonqualified option exercises 19 481
Changes in operating assets and liabilities
Receivables 9,250 (1,450)
Deferred preservation costs and inventories (6,605) (7,956)
Prepaid expenses and other assets 856 (635)
Accounts payable, accrued expenses, and other liabilities 10,862 2,951
-------------------------------
Net cash flows provided by operating activities 2,975 750
-------------------------------
Net cash flows from investing activities:
Capital expenditures (333) (2,735)
Other assets 173 (1,980)
Purchases of marketable securities -- (11,725)
Sales and maturities of marketable securities 4,708 19,391
Proceeds from note receivable -- 1,169
-------------------------------
Net cash flows provided by investing activities 4,548 4,120
-------------------------------
Net cash flows from financing activities:
Principal payments of debt (800) (800)
Payment of obligations under capital leases (320) (300)
Principal payments on short-term note payable (827) --
Proceeds from exercise of stock options and
issuance of common stock 325 1,099
Net cash used in financing activities (1,622) (1)
Increase in cash 5,901 4,869
Effect of exchange rate changes on cash (31) 217
Cash and cash equivalents, beginning of period 10,277 7,204
-------------------------------
Cash and cash equivalents, end of period $ 16,147 $ 12,290
===============================
See accompanying notes to summary consolidated financial statements.
5
CRYOLIFE, INC. AND SUBSIDIARIES
NOTES TO SUMMARY CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1 - BASIS OF PRESENTATION
The accompanying unaudited summary consolidated financial statements have been
prepared in accordance with (i) accounting principles generally accepted in the
United States for interim financial information and (ii) the instructions to
Form 10-Q and Rule 10-01 of Regulation S-X of the United States Securities and
Exchange Commission ("SEC"). Accordingly, the statements do not include all of
the information and disclosures required by accounting principles generally
accepted in the United States for a complete presentation of financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Certain prior year balances have been reclassified to conform to the
2003 presentation. Operating results for the three and six months ended June 30,
2003 are not necessarily indicative of the results that may be expected for the
year ending December 31, 2003. For further information, refer to the
consolidated financial statements and notes thereto included in the CryoLife
Form 10-K for the year ended December 31, 2002, as amended.
The Company expects its liquidity to continue to decrease significantly over the
next twelve months due to 1) the anticipated decrease in preservation revenues
as compared to preservation revenues prior to the FDA Order as a result of
reported tissue infections, the FDA Order, and associated adverse publicity, 2)
the increase in cost of human tissue preservation services as a percent of
revenue as a result of lower tissue processing volumes and changes in processing
methods, which have increased the cost of processing human tissue and 3) an
expected use of cash due to the increased costs relating to the defense and
resolution of lawsuits (discussed in Note 13) and legal and professional costs
relating to the ongoing FDA compliance and the anticipated required Term Loan
pay off during 2003 (discussed in Note 6). The Company believes that anticipated
revenue generation, expense management, tax refunds of approximately $2.4
million resulting from tax loss carrybacks, savings resulting from the reduction
in the number of employees in September 2002 necessitated by the reduction in
revenues, and the Company's existing cash and marketable securities will enable
the Company to meet its liquidity needs through at least June 30, 2004.
The Company's long term liquidity and capital requirements will depend upon
numerous factors, including the Company's ability to return to the level of
demand and gross margins for its tissue services that existed prior to the FDA
Order, the outcome of litigation against the Company (discussed in Note 13), the
timing and amount of settlements or other outcomes of the product liability
claims (discussed in Note 13), the resolution of the dispute with its upper
layer excess product liability insurance carrier (discussed in Note 13), the
ability to arrange and fund a global settlement of outstanding claims for an
amount substantially below the amount accrued (discussed in Note 13), and the
Company's ability to find suitable funding sources to replace the Term Loan
(discussed in Note 6). The Company may require additional financing or seek to
raise additional funds through bank facilities, debt or equity offerings, or
other sources of capital to meet liquidity and capital requirements beyond June
30, 2004. Additional funds may not be available when needed or on terms
acceptable to the Company, which could have a material adverse effect on the
Company's business, financial condition, results of operations, and cash flows.
In addition, if one or more of the product liability lawsuits in which the
Company is a defendant should be tried with a substantial verdict rendered in
favor of the plaintiff(s), there can be no assurance that such verdict(s) would
not exceed the Company's available insurance coverage and liquid assets. The
items described above are factors that indicate that the Company may be unable
to continue operations beyond June 30, 2004.
NOTE 2 - FDA ORDER ON HUMAN TISSUE PRESERVATION AND OTHER FDA CORRESPONDENCE
FDA ORDER
On August 13, 2002 the Company received an order from the Atlanta district
office of the U.S. Food and Drug Administration ("FDA") regarding the non-valved
cardiac, vascular, and orthopaedic tissue processed by the Company since October
3, 2001 (the "FDA Order"). The FDA Order followed an April 2002 FDA Form 483
Notice of Observations ("April 2002 483") and an FDA Warning Letter dated June
17, 2002, ("Warning Letter"). Revenue from human tissue preservation services
6
accounted for 78% of the Company's revenues for the six months ended June 30,
2002, (the last period ended prior to the issuance of the FDA Order) and of
those revenues 67%, or $26.9 million, were derived from preservation of tissues
subject to the FDA Order. The FDA Order contained the following principal
provisions:
o The FDA alleged that, based on its inspection of the Company's
facility on March 25 through April 12, 2002, certain human tissue
processed and distributed by the Company may be in violation of 21
Code of Federal Regulations ("CFR") Part 1270. (Part 1270 requires
persons or entities engaged in the recovery, screening, testing,
processing, storage, or distribution of human tissue to perform
certain medical screening and testing on human tissue intended for
transplantation. The rule also imposes requirements regarding
procedures for the prevention of contamination or cross-contamination
of tissues during processing and the maintenance of certain records
related to these activities.)
o The FDA alleged that the Company had not validated procedures for the
prevention of infectious disease contamination or cross-contamination
of tissue during processing at least since October 3, 2001.
o Non-valved cardiac, vascular, and orthopaedic tissue processed by the
Company from October 3, 2001 to September 5, 2002 must be retained
until it is recalled, destroyed, the safety is confirmed, or an
agreement is reached with the FDA for its proper disposition under the
supervision of an authorized official of the FDA.
o The FDA strongly recommended that the Company perform a retrospective
review of all tissue in inventory (i.e. currently in storage at the
Company) that was not referenced in the FDA Order to assure that it
was recovered, processed, stored, and distributed in conformance with
21 CFR 1270.
o The Center for Devices and Radiological Health ("CDRH"), a division of
the FDA, would evaluate whether there are similar risks that may be
posed by the Company's allograft heart valves, and would take further
regulatory action if appropriate.
Pursuant to the FDA Order, the Company placed non-valved cardiac, vascular, and
orthopaedic tissue subject to the FDA Order on quality assurance quarantine and
recalled the non-valved cardiac, vascular, and orthopaedic tissues subject to
the FDA Order (i.e. processed since October 3, 2001) that had been distributed
but not implanted. In addition, the Company ceased processing non-valved
cardiac, vascular, and orthopaedic tissues. On September 5, 2002 the Company
reached an agreement with the FDA (the "Agreement") that supplements the FDA
Order and allows non-valved cardiac and vascular tissues subject to recall
(processed between October 3, 2001 and September 5, 2002) to be released for
distribution after the Company completes steps to assure that the tissue is used
for approved purposes and that patients are notified of risks associated with
tissue use. Specifically, the Company must obtain physician prescriptions, and
tissue packaging must contain specified warning labels. The Agreement calls for
the Company to undertake to identify third-party records of donor tissue testing
and to destroy tissue from donors in whom microorganisms associated with an
infection are found. The Agreement had a 45-business day term and was renewed on
November 8, 2002, January 8, 2003, March 17, 2003, and June 13, 2003. This most
recent renewal expires on September 5, 2003. The Company is unable to predict
whether or not the FDA will grant further renewals of the Agreement. In
addition, pursuant to the Agreement, the Company agreed to perform additional
procedures in the processing of non-valved cardiac and vascular tissues and
subsequently resumed processing these tissues. The Agreement contained the
requirement that tissues subject to the FDA Order be replaced with tissues
processed under validated methods. The Company also agreed to establish a
corrective action plan within 30 days from September 5, 2002 with steps to
validate processing procedures. The corrective action plan was submitted on
October 5, 2002.
On December 31, 2002 the FDA clarified the Agreement noting that non-valved
cardiac and vascular tissues processed since September 5, 2002 are not subject
to the FDA Order. Specifically, for non-valved cardiac and vascular tissue
processed since September 5, 2002, the Company is not required to obtain
physician prescriptions, label the tissue as subject to a recall, or require
special steps regarding procurement agency records of donor screening and
testing beyond those required for all processors of human tissue. These
restrictions also do not apply to orthopaedic tissue processed by the Company
since September 5, 2002. A renewal of the Agreement that expires on September 5,
2003 is therefore not needed in order for the Company to continue to distribute
non-valved cardiovascular, vascular, and orthopaedic tissues processed since
September 5, 2002.
7
A new FDA 483 Notice of Observations ("February 2003 483") was issued in
connection with the FDA inspection in February 2003, but corrective action was
implemented on most of its observations during the inspection. The Company
believes the observations, most of which focus on the Company's systems for
handling complaints, will not materially affect the Company's operations. The
Company responded to the February 2003 483 in March 2003. The Company has met
with the FDA to review its response to the February 2003 483. No additional
comments regarding the adequacy of its response were issued at that time. The
Company continues to work with the FDA to review process improvements.
After receiving the FDA Order, the Company met with representatives of the FDA's
CDRH division regarding CDRH's review of the Company's processed allograft heart
valves, which are not subject to the FDA Order. On August 21, 2002 the FDA
publicly stated that allograft heart valves have not been included in the FDA
Order as these devices are essential for the correction of congenital cardiac
lesions in neonate and pediatric patients and no satisfactory alternative device
exists. However, the FDA published a public health web notification stating that
it had serious concerns regarding the Company's processing and handling of
allograft heart valves. On June 27, 2003 the FDA modified the notification by
labeling it "archived document - no longer current information - not for
official use." There have been no further conversations with the FDA's CDRH
division on this matter.
PROCUREMENT
As a result of the adverse publicity surrounding the FDA Order, FDA Warning
Letter, and reported tissue infections, the Company's procurement of cardiac
tissues during the three and six months ended June 30, 2003, from which heart
valves and non-valved cardiac tissues are processed, decreased 20% and 24%,
respectively, as compared to the three and six months ended June 30, 2002. The
Company's second quarter 2003 procurement of cardiac tissues increased 12% from
the first quarter of 2003. The Company has continued to process and distribute
heart valves since the receipt of the FDA Order, as these tissues are not
subject to the FDA Order.
During the first quarter of 2003 the Company limited its vascular procurement
until it addressed the observations detailed in the April 2002 483, most of
which were addressed in the first quarter of 2003, and due to resource
constraints as a result of the September 2002 employee force reduction. The
Company continued to limit its vascular procurement in the second quarter of
2003 and will continue to limit its vascular procurement until it can fully
evaluate the demand for its vascular tissues. The Company's procurement of
vascular tissue for the three and six months ended June 30, 2003 decreased 50%
and 57%, respectively, as compared to the three and six months ended June 30,
2002. The Company's second quarter 2003 procurement of vascular tissues
increased 53% from first quarter of 2003. The Company expects that vascular
procurement will continue to increase during 2003.
The Company resumed limited processing of orthopaedic tissues in late February
2003 following the FDA inspection of the Company's processing operations. The
Company's procurement of whole and partial knees during the three and six months
ended June 30, 2003 was approximately 43% and 26%, respectively, of whole and
partial knee procurement levels for the three and six months ended June 30,
2002. The Company's procurement of orthopaedic tendons during the three and six
months ended June 30, 2003 was approximately 14% and 8%, respectively, of
orthopaedic tendon procurement levels for the three and six months ended June
30, 2002. The Company resumed limited distribution of recently processed
orthopaedic tissues in the second quarter of 2003.
ACCOUNTING TREATMENT
As a result of the FDA Order the Company recorded a reduction to pretax income
of $12.6 million in the quarter ended June 30, 2002. The reduction was comprised
of a net $8.9 million increase to cost of human tissue preservation services, a
$2.4 million reduction to revenues (and accounts receivable) for the estimated
return of the tissues subject to recall by the FDA Order, and a $1.3 million
accrual recorded in general, administrative, and marketing expenses for
retention levels under the Company's product liability and directors' and
officers' insurance policies of $1.2 million (see Note 13), and for estimated
expenses of $75,000 for packaging and handling for the return of affected
tissues under the FDA Order. The net increase of $8.9 million to cost of
preservation services was comprised of a $10.0 million write-down of deferred
preservation costs for tissues subject to the FDA Order, offset by a $1.1
million decrease in cost of preservation services due to the estimated tissue
returns resulting from the FDA Order (the costs of such recalled tissue are
included in the $10.0 million write-down). The Company evaluated many factors in
determining the magnitude of impairment to deferred preservation costs as of
June 30, 2002, including the impact of the FDA Order, the possibility of
continuing action by the FDA or other United States and foreign government
agencies, and the possibility of unfavorable actions by physicians, customers,
procurement organizations, and others. As a result of this evaluation,
8
management believed that since all non-valved cardiac, vascular, and orthopaedic
allograft tissues processed since October 3, 2001 were under recall pursuant to
the FDA Order, and since the Company did not know if it would obtain a favorable
resolution of its appeal and request for modification of the FDA Order, the
deferred preservation costs for tissues subject to the FDA Order had been
significantly impaired. The Company estimated that this impairment approximated
the full balance of the deferred preservation costs of the tissues subject to
the FDA Order, which included the tissues stored by the Company and the tissues
to be returned to the Company, and therefore recorded a write-down of $10.0
million for these assets.
In the quarter ended September 30, 2002 the Company recorded a reduction to
pretax income of $24.6 million as a result of the FDA Order. The reduction was
comprised of a net $22.2 million increase to cost of human tissue preservation
services, a $1.4 million write-down of goodwill, and a $1.0 million reduction to
revenues (and accounts receivable) for the estimated return of the tissues
shipped during the third quarter subject to recall by the FDA Order. The net
$22.2 million increase to cost of preservation services was comprised of a $22.7
million write-down of deferred preservation costs, offset by a $0.5 million
decrease in cost of preservation services due to the estimated and actual tissue
returns resulting from the FDA Order (the costs of such recalled tissue are
included in the $22.7 million write-down).
The Company evaluated multiple factors in determining the magnitude of
impairment to deferred preservation costs at September 30, 2002, including the
impact of the FDA Order, the possibility of continuing action by the FDA or
other United States and foreign government agencies, the possibility of
unfavorable actions by physicians, customers, procurement organizations, and
others, the progress made to date on the corrective action plan, and the
requirement in the Agreement that tissues subject to the FDA Order be replaced
with tissues processed under validated methods. As a result of this evaluation,
management believed that all tissues subject to the FDA Order, as well as the
majority of tissues processed prior to October 3, 2001, including heart valves,
which were not subject to the FDA Order, were fully impaired. Management
believed that most of the Company's customers would only order tissues processed
after the September 5, 2002 Agreement or tissues processed under future
procedures approved by the FDA once those tissues were available. The Company
anticipated that the tissues processed under the Agreement would be available
early to mid-November. Thus, the Company recorded a write-down of deferred
preservation costs for processed tissues in excess of the supply required to
meet demand prior to the release of these interim processed tissues.
As a result of the write-down of deferred preservation costs, the Company
recorded $6.3 million in income tax receivables and $4.5 million in deferred tax
assets as of December 31, 2002. Upon destruction or shipment of the remaining
tissues associated with the deferred preservation costs write-down, the deferred
tax asset will become deductible in the Company's related tax return assuming
there is future income to offset the tax asset. A refund of approximately $8.9
million related to 2002 federal income taxes was generated through a carry back
of operating losses and write-downs of deferred preservation costs. The Company
filed its 2002 federal income tax returns in April of 2003 and received its tax
refund during the second quarter of 2003. In addition, the Company recorded $2.5
million in income tax receivables as of December 31, 2002 related to estimated
tax payments for 2002. The Company received payment of the $2.5 million in
January of 2003.
On September 3, 2002 the Company announced a reduction in employee force of
approximately 105 employees. In the third quarter of 2002 the Company recorded
accrued restructuring costs of approximately $690,000, for severance and related
costs of the employee force reduction. The expense was recorded in general,
administrative, and marketing expenses and was included as a component of
accrued expenses and other current liabilities on the Summary Consolidated
Balance Sheet. During the year ended December 31, 2002 the Company utilized
$580,000 of the accrued restructuring costs, including $505,000 for salary and
severance payments, $64,000 for placement services for affected employees, and
$11,000 in other related costs. During the quarter ended March 31, 2003 the
Company utilized $64,000 of the accrued restructuring costs, including $57,000
for salary and severance payments and $7,000 in other related costs. In March
2003 the Company reversed the remaining accrual of $46,000 in unused
restructuring costs, which was primarily due to lower than anticipated medical
claims costs for affected employees. The Company has not incurred and does not
expect to incur any additional restructuring costs associated with the employee
force reduction subsequent to March 31, 2003.
In the quarter ended March 31, 2003 the Company recorded a favorable adjustment
of $848,000 to the estimated tissue recall returns due to lower actual tissue
returns under the FDA Order than were originally estimated in the second and
9
third quarters of 2002. The adjustment increased cardiac tissue revenues by
$92,000, vascular tissue revenues by $711,000, and orthopaedic tissue revenues
by $45,000 in the first quarter of 2003. As of June 30, 2003 approximately
$60,000 remains in the accrual for estimated return of tissues subject to recall
by the FDA Order.
During the three and six months ended June 30, 2003 the Company recorded $1.1
million and $1.4 million, respectively, as an increase to cost of preservation
services to write-down the value of certain deferred tissue preservation costs
from tissues processed in the three and six months ended June 30, 2003 that
exceeded market value. As of June 30, 2003 the balance of deferred preservation
costs was $4.3 million for allograft heart valve tissues, $452,000 for
non-valved cardiac tissues, $4.0 million for vascular tissues, and $738,000 for
orthopaedic tissues.
OTHER FDA CORRESPONDENCE
On February 20, 2003 the Company received a letter from the FDA stating that a
510(k) premarket notification should be filed for the Company's CryoValve(R) SG
and that premarket approval marketing authorization should be obtained for the
Company's CryoVein(R) SG when marketed or labeled as an arteriovenous ("A-V")
access graft. The agency's position is that use of the SynerGraft(R) technology
in the processing of allograft heart valves represents a modification to the
Company's legally marketed CryoValve allograft, and that vascular allografts
labeled for use as A-V access grafts are medical devices that require premarket
approval.
The Company is in discussions with the FDA about the type of submissions
necessary for these products. The Company advised the FDA that it has
voluntarily suspended use of the SynerGraft technology in the processing of
allograft heart valves and vascular tissue until the regulatory status of the
CryoValve SG and CryoVein SG is resolved. Additionally, the Company has
discontinued labeling its vascular grafts for use as A-V access grafts. The FDA
has not suggested that these tissues be recalled. Until such time as the issues
surrounding the SynerGraft tissue are resolved, the Company will employ its
traditional processing methods on these tissues. Distribution of allograft heart
valves and vascular tissue processed using the Company's traditional processing
protocols will continue. The outcome of the discussions with the FDA regarding
the use of the SynerGraft process on human tissue could result in an inability
to process tissues with the SynerGraft technology until further submissions and
FDA approvals are granted. The Company currently has nominal amounts of
SynerGraft processed cardiovascular and vascular tissue.
NOTE 3 - CASH EQUIVALENTS AND MARKETABLE SECURITIES
The Company maintains cash equivalents, which consist primarily of highly liquid
investments with maturity dates of 90 days or less at the time of acquisition,
and marketable securities in several large, well-capitalized financial
institutions, and the Company's policy disallows investment in any securities
rated less than "investment-grade" by national rating services.
Management determines the appropriate classification of debt securities at the
time of purchase and reevaluates such designations as of each balance sheet
date. Debt securities are classified as held-to-maturity when the Company has
the positive intent and ability to hold the securities to maturity.
Held-to-maturity securities are stated at amortized cost. Debt securities not
classified as held-to-maturity or trading and marketable equity securities not
classified as trading are classified as available-for-sale. At June 30, 2003 and
December 31, 2002 all marketable equity securities and debt securities were
designated as available-for-sale.
Available-for-sale securities are stated at their fair values, with the
unrealized gains and losses, net of tax, reported in a separate component of
shareholders' equity. Interest income, dividends, realized gains and losses, and
declines in value judged to be other than temporary are included in investment
income. The cost of securities sold is based on the specific identification
method.
10
The following is a summary of cash equivalents and marketable securities (in
thousands):
Unrealized Estimated
Holding Market
June 30, 2003 Cost Basis Gains/(Losses) Value
------------------------------------------------
Cash equivalents:
Money market funds $ 9,601 $ -- $ 9,601
Municipal obligations 5,000 -- 5,000
------------------------------------------------
$ 14,601 $ -- $ 14,601
================================================
Marketable securities:
Municipal obligations $ 9,549 $ 212 $ 9,761
================================================
Unrealized Estimated
Holding Market
December 31, 2002 Cost Basis Gains/(Losses) Value
------------------------------------------------
Cash equivalents:
Money market funds $ 52 $ -- $ 52
Municipal obligations 7,175 -- 7,175
------------------------------------------------
$ 7,227 $ -- $ 7,227
================================================
Marketable securities:
Municipal obligations $ 14,276 $ 307 $ 14,583
================================================
Differences between cost and market listed above, consisting of a net unrealized
holding gain less deferred taxes of $70,000 at June 30, 2003 and $104,000 as of
December 31, 2002, are included in the accumulated other comprehensive income
account of shareholders' equity.
The marketable securities of $9.8 million on June 30, 2003 and $14.6 million on
December 31, 2002 had maturity dates as follows: approximately zero and $1.2
million, respectively, of marketable securities had a maturity date of less than
90 days, approximately $6.5 million and $8.0 million, respectively, had a
maturity date between 90 days and 1 year, and approximately $3.3 million and
$5.4 million, respectively, had a maturity date between 1 and 5 years.
NOTE 4 - INVENTORIES
Inventories are comprised of the following (in thousands):
June 30, December 31,
2003 2002
-------------------------------
(Unaudited)
Raw materials $ 2,621 $ 2,341
Work-in-process 286 306
Finished goods 1,628 1,938
-------------------------------
$ 4,535 $ 4,585
===============================
NOTE 5 -INCOME TAXES
Deferred income taxes reflect the net tax effect of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and tax return purposes. The Company generated deferred tax assets
primarily as a result of net operating losses in 2002 and 2003, primarily due to
reductions in revenues, write-downs of deferred preservation costs, additional
professional fees, and accruals for product liability claims, as a result of the
FDA Order, FDA Warning Letter, and reported tissue infections. The Company
periodically assesses the recoverability of deferred tax assets and provides a
11
valuation allowance when management believes it is more likely than not that its
deferred tax assets will not be realized.
During the first quarter of 2003 the Company recorded a valuation allowance of
$658,000 for deferred tax assets generated by capital losses when management
determined that it was more likely than not that these deferred tax assets would
not be realized in future periods. During the second quarter of 2003, the
Company evaluated several factors to determine if a valuation allowance relative
to its deferred tax assets was necessary. The Company reviewed its historic
operating results, including the reasons for its operating losses in 2002 and
2003, uncertainties regarding projected future operating results due to the
effects of the adverse publicity resulting from the FDA Order, FDA Warning
Letter, and reported tissue infections and the changes in processing methods
resulting from the FDA Order, and the uncertainty of the outcome of product
liability claims (see Note 13). Based on the results of this analysis, the
Company has determined that it is more likely than not that $9.7 million of the
Company's $11.0 million in deferred tax assets will not be realized. Therefore,
the Company recorded an additional valuation allowance of $9.0 million against
its net deferred tax assets during the second quarter of 2003. As of June 30,
2003 the Company had a total of $9.7 million in valuation allowances against
deferred tax assets and a net deferred tax asset balance of $1.3 million. This
remaining $1.3 million of deferred tax assets was not subject to valuation as it
is expected to become recoverable by the end of the year. This amount along with
$1.1 million in income tax receivable, totaling $2.4 million, represents
expected tax refunds resulting from 2003 tax losses which can be carried back to
offset taxes paid in prior years.
As a result of recording a valuation allowance, the Company has reported an
income tax expense of $3.6 million and $3.4 million for the three and six months
ended June 30, 2003, respectively.
NOTE 6 - DEBT
On April 25, 2000 the Company entered into a loan agreement permitting the
Company to borrow up to $8 million under a line of credit during the expansion
of the Company's corporate headquarters and manufacturing facilities. Borrowings
under the line of credit accrued interest equal to Adjusted LIBOR plus 2%
adjusted monthly. On June 1, 2001 the line of credit was converted to a term
loan (the "Term Loan") to be paid in 60 equal monthly installments of principal
plus interest computed at Adjusted LIBOR plus 1.5% (2.82% at June 30, 2003). At
June 30, 2003 the principal balance of the Term Loan was $4.8 million. The Term
Loan is secured by substantially all of the Company's assets. The Term Loan
contains certain restrictive covenants including, but not limited to,
maintenance of certain financial ratios, a minimum tangible net worth
requirement, and the requirement that no materially adverse event has occurred.
The lender has notified the Company that the FDA Order, as described in Note 2,
and the inquiries of the SEC, as described in Note 13, have had a material
adverse effect on the Company that constitutes an event of default.
Additionally, as of June 30, 2003, the Company is in violation of the debt
coverage ratio and net worth financial covenants. Therefore, all amounts due
under the Term Loan as of June 30, 2003 are reflected as a current liability on
the Summary Consolidated Balance Sheets. The Company and the lender are
currently in the process of negotiating specific terms of a forbearance
agreement, which if entered into would increase the interest rate charged on the
Term Loan effective August 1, 2003 to Adjusted LIBOR plus 4% (5.32% at June 30,
2003), accelerate the principal payments on the Term Loan by requiring a balloon
payment to pay off the outstanding balance by October 31, 2003, and cause the
Company to pay a $12,000 modification fee and the lender's attorneys costs,
which have yet to be determined. As of August 4, 2003 the Company has sufficient
cash and cash equivalents to pay the remaining outstanding balance of the Term
Loan.
In the quarter ended June 30, 2003 the Company entered into two agreements to
finance $2.9 million in insurance premiums associated with the yearly renewal of
certain of the Company's insurance policies. The amount financed accrues
interest at a 3.75% rate and is payable in equal monthly payments through
January 2004. As of June 30, 2003 the outstanding balance of the agreements was
$1.6 million.
NOTE 7 - DERIVATIVES
The Company's Term Loan, which accrues interest computed at Adjusted LIBOR plus
1.5%, exposes the Company to changes in interest rates going forward. On March
16, 2000 the Company entered into a $4.0 million notional amount
12
forward-starting interest swap agreement, which took effect on June 1, 2001 and
expires in 2006. This swap agreement was designated as a cash flow hedge to
effectively convert a portion of the Term Loan balance to a fixed rate basis,
thus reducing the impact of interest rate changes on future income. This
agreement involves the receipt of floating rate amounts in exchange for fixed
rate interest payments over the life of the agreement, without an exchange of
the underlying principal amounts. The differential to be paid or received is
recognized in the period in which it accrues as an adjustment to interest
expense on the Term Loan.
On January 1, 2001 the Company adopted SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133") as amended. SFAS 133 requires
the Company to recognize all derivative instruments on the balance sheet at fair
value, and changes in the derivative's fair value must be recognized currently
in earnings or other comprehensive income, as applicable. The adoption of SFAS
133 impacts the accounting for the Company's forward-starting interest rate swap
agreement. Upon adoption of SFAS 133, the Company recorded an unrealized loss of
approximately $175,000 related to the interest rate swap, which was recorded as
part of long-term liabilities and accumulated other comprehensive income as the
cumulative effect of adopting SFAS 133 within the Statement of Shareholders'
Equity.
In August 2002 the Company determined that changes in the derivative's fair
value could no longer be recorded in other comprehensive income, as a result of
the uncertainty of future cash payments on the Term Loan caused by the lender's
ability to declare an event of default as discussed in Note 6. Beginning in
August 2002 the Company started recording all changes in the fair value of the
derivative currently in other expense/income on the Summary Consolidated
Statements of Operations, and amortizing the amounts previously recorded in
other comprehensive income into other expense/income over the remaining life of
the agreement.
During the quarter ended June 30, 2003 the Company became aware of the lender's
intention to accelerate the payment of the Term Loan, as discussed in Note 6
above. Therefore, the Company recorded an expense of $222,000, to reclass the
unamortized portion of the other comprehensive loss to other expense/income on
the Summary Consolidated Statements of Operations. The Company and the lender
are currently in the process of negotiating the specific terms of a forbearance
agreement, which, if entered into, is expected to require the Company to pay the
lender by October 31, 2003 an amount equal the fair value of the swap agreement.
For the three and six months ended June 30, 2003 the Company recorded a total
expense of $216,000 and $207,000, respectively, on the interest rate swap.
As of June 30, 2003 the notional amount of this swap agreement was $2.4 million,
and the fair value of the interest rate swap agreement, as estimated by the bank
based on its internal valuation models, was a liability of $227,000. The fair
value of the swap agreement is recorded as part of short-term liabilities. The
unamortized value of the swap agreement, recorded in the accumulated other
comprehensive income account of shareholders' equity, was zero at June 30, 2003.
NOTE 8 - COMPREHENSIVE LOSS
Components of comprehensive loss consist of the following, net of tax (in
thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------ ------------------------------
2003 2002 2003 2002
------------------------------ ------------------------------
(Unaudited) (Unaudited)
Net loss $ (19,921) $ (5,522) $ (20,355) $ (2,418)
Unrealized (loss)/gain on investments (27) 128 (61) 42
Change in fair value of interest rate swap
(including cumulative effect of adopting
SFAS 133 in 2001) 159 15 172 23
Translation adjustment 127 250 (31) 217
------------------------------ ------------------------------
Comprehensive loss $ (19,662) $ (5,129) $ (20,275) $ (2,136)
============================== ==============================
13
The tax effect on the change in unrealized gain/loss on investments is a benefit
of $17,000 and an expense of $66,000 for the three months ended June 30, 2003
and 2002, respectively. The tax effect on the change in unrealized gain/loss on
investments is a benefit of $34,000 and an expense of $27,000 for the six months
ended June 30, 2003 and 2002, respectively. The tax effect on the change in fair
value of the interest rate swap is $82,000 and $7,000 for the three months ended
June 30, 2003 and 2002, respectively. The tax effect on the change in fair value
of the interest rate swap is $88,000 and $2,000 for the six months ended June
30, 2003 and 2002, respectively. The tax effect on the translation adjustment is
zero for the three months ended June 30, 2003 and 2002, respectively. The tax
effect on the translation adjustment is $110,000 and zero for the six months
ended June 30, 2003 and 2002, respectively.
NOTE 9 - LOSS PER SHARE
The following table sets forth the computation of basic and diluted earnings per
share (in thousands, except per share data):
Three Months Ended Six Months Ended
June 30, June 30,
--------------------------------- ------------------------------
2003 2002 2003 2002
--------------------------------- ------------------------------
(Unaudited) (Unaudited)
Numerator for basic and diluted earnings
per share - loss available to common
shareholders $ (19,921) $ (5,522) $ (20,355) $ (2,418)
================================= ==============================
Denominator for basic earnings per share -
weighted-average basis 19,675 19,538 19,654 19,318
Effect of dilutive stock options -- -- -- --
--------------------------------- ------------------------------
Denominator for diluted earnings per share -
adjusted weighted-average shares 19,675 19,538 19,654 19,318
================================= ==============================
Net loss per share:
Basic $ (1.01) $ (0.28) $ (1.04) $ (0.13)
================================= ===============================
Diluted $ (1.01) $ (0.28) $ (1.04) $ (0.13)
================================= ===============================
The effect of stock options of 529,000 and 674,000 shares for the three months
ended June 30, 2003 and 2002, respectively, was excluded from the calculation
because these amounts are antidilutive for the periods presented. The effect of
stock options of 446,000 and 692,000 shares for the six months ended June 30,
2003 and 2002, respectively, was excluded from the calculation because these
amounts are antidilutive for the periods presented.
On July 23, 2002 the Company's Board of Directors authorized the purchase of up
to $10 million of its common stock. As of August 13, 2002 the Company had
repurchased 68,000 shares of its common stock for $663,000. No further purchases
are anticipated in the near term.
NOTE 10 - STOCK-BASED COMPENSATION
On December 31, 2002 the Company was required to adopt SFAS No. 148, "Accounting
for Stock-Based Compensation - Transition and Disclosure" ("SFAS 148"). SFAS 148
amends SFAS No. 123, "Accounting for Stock-Based Compensation" to provide
alternative methods of transition for companies that voluntarily elect to adopt
the fair value recognition and measurement methodology prescribed by SFAS 123.
In addition, regardless of the method a company elects to account for
stock-based compensation arrangements, SFAS 148 requires additional disclosures
in the footnotes of both interim and annual financial statements regarding the
method the Company uses to account for stock-based compensation and the effect
of such method on the Company's reported results. The adoption of SFAS 148 did
not have a material effect on the financial position, results of operations, and
cash flows of the Company.
14
The Company has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" and related interpretations ("APB
25") in accounting for its employee stock options because, as discussed below,
the alternative fair value accounting provided for under SFAS 123 requires use
of option valuation models that were not developed for use in valuing employee
stock options. Under APB 25, because the exercise price of the Company's
employee stock options equals the market price of the underlying stock on the
date of the grant, no compensation expense is recognized.
Pro forma information regarding net income and earnings per share is required by
SFAS 123, which requires that the information be determined as if the Company
has accounted for its employee stock options granted under the fair value method
of that statement. The fair values for these options were estimated at the dates
of grant using a Black-Scholes option pricing model with the following
weighted-average assumptions:
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2003 2002 2003 2002
------------------------------- ------------------------------
(Unaudited) (Unaudited)
Expected dividend yield 0% 0% 0% 0%
Expected stock price volatility .605 .630 .615 .630
Risk-free interest rate 2.13% 3.67% 2.41% 3.67%
Expected life of options 3.3 Years 5.3 Years 3.9 Years 5.3 Years
The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition option valuation models require the input of highly
subjective assumptions, including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different from those of traded options and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair values of the options
are amortized to expense over the options' vesting periods. The Company's pro
forma information follows (in thousands, except per share data):
Three Months Ended Six Months Ended
June 30, June 30,
--------------------------------- --------------------------------
2003 2002 2003 2002
--------------------------------- --------------------------------
(Unaudited) (Unaudited)
Net loss--as reported $ (19,921) $ (5,522) $ (20,355) $ (2,418)
Deduct: Total stock-based employee
compensation expense determined
under the fair value based method
for all awards, net of tax 544 572 672 732
--------------------------------- --------------------------------
Net loss--pro forma $ (20,465) $ (6,094) $ (21,027) $ (3,150)
================================= ================================
Net loss per share--as reported:
Basic $ (1.01) $ (0.28) $ (1.04) $ (0.13)
================================= ================================
Diluted $ (1.01) $ (0.28) $ (1.04) $ (0.13)
================================= ================================
Net loss per share--proforma:
Basic $ (1.04) $ (0.31) $ (1.07) $ (0.16)
================================= ================================
Diluted $ (1.04) $ (0.31) $ (1.07) $ (0.16)
================================= ================================
15
NOTE 11 - ACCOUNTING PRONOUNCEMENTS
The Company was required to adopt SFAS No. 143, "Accounting for Asset Retirement
Obligations" ("SFAS 143") on January 1, 2003. SFAS 143 addresses accounting and
reporting for retirement costs of long-lived assets resulting from legal
obligations associated with acquisition, construction, or development
transactions. The adoption of SFAS 143 did not have a material effect on the
results of operations or financial position of the Company.
The Company was required to adopt SFAS No. 145, "Rescission of FASB Statements
4, 44 and 64, Amendment to FASB Statement 13, and Technical Corrections" ("SFAS
145"), on January 1, 2003. SFAS 145 rescinds SFAS No.s 4, 44 and 64, which
required gains and losses from extinguishments of debt to be classified as
extraordinary items. SFAS 145 also amends SFAS No. 13 eliminating
inconsistencies in certain sale-leaseback transactions. The provisions of SFAS
145 are effective for fiscal years beginning after May 15, 2002. The adoption of
SFAS 145 did not have a material effect on the results of operations or
financial position of the Company.
The Company was required to adopt SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities" ("SFAS 146") on January 1, 2003. SFAS 146
requires that costs associated with exit or disposal activities be recorded at
their fair values when a liability has been incurred. Under previous guidance,
certain exit costs were accrued upon management's commitment to an exit plan,
which is generally before an actual liability has been incurred. The adoption of
SFAS 146 did not have a material effect on the results of operations or
financial position of the Company.
NOTE 12 - SEGMENT INFORMATION
The Company has two reportable segments: Human Tissue Preservation Services and
Implantable Medical Devices. The Company's segments are organized according to
services and products.
The Human Tissue Preservation Services segment includes external revenue from
cryopreservation services of cardiac, vascular, and orthopaedic allograft
tissues. The Implantable Medical Devices segment includes external revenue from
product sales of BioGlue(R) Surgical Adhesive, bioprosthetic devices, including
stentless porcine heart valves, SynerGraft treated porcine heart valves, and
SynerGraft treated bovine vascular grafts, and Cerasorb(R) Ortho bone graft
substitute. There are no intersegment revenues.
The primary measure of segment performance, as viewed by the Company's
management, is segment gross margin, or net external revenues less cost of
preservation services and products. The Company does not segregate assets by
segment, therefore, asset information is excluded from the segment disclosures
below.
16
The following table summarizes revenues, cost of preservation services and
products, and gross margins for the Company's operating segments (in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2003 2002 2003 2002
------------------------------- ------------------------------
(Unaudited) (Unaudited)
Revenue:
Human tissue preservation services, net 8,615 17,536 17,745 37,774
Implantable medical devices 6,932 5,473 13,531 10,538
All other a 166 255 357 423
------------------------------- -------------------------------
$ 15,713 $ 23,264 $ 31,633 $ 48,735
------------------------------- -------------------------------
Cost of Preservation Services and Products:
Human tissue preservation services 5,160 17,203 7,603 25,266
Implantable medical devices 2,006 1,843 3,647 4,078
All other a -- -- -- --
------------------------------- -------------------------------
7,166 19,046 11,250 29,344
------------------------------- -------------------------------
Gross Margin (Loss):
Human tissue preservation services 3,455 333 10,142 12,508
Implantable medical devices 4,926 3,630 9,884 6,460
All other a 166 255 357 423
------------------------------- -------------------------------
$ 8,547 $ 4,218 $ 20,383 $ 19,391
------------------------------- -------------------------------
(a) The "All other" designation includes 1) grant revenue and 2) distribution
revenue.
The following table summarizes net revenues by product (in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2003 2002 2003 2002
------------------------------- ------------------------------
(Unaudited) (Unaudited)
Revenue:
Human tissue preservation services, net
Cardiovascular tissue $ 5,036 $ 7,336 $ 9,761 $ 14,644
Vascular tissue 3,299 4,641 7,554 11,658
Orthopaedic tissue 280 5,559 430 11,472
------------------------------- ------------------------------
Total preservation services 8,615 17,536 17,745 37,774
------------------------------- ------------------------------
BioGlue surgical adhesive 6,839 5,251 13,333 10,124
Other implantable medical devices 93 222 198 414
Distribution and grant 166 255 357 423
------------------------------- ------------------------------
$ 15,713 $ 23,264 $ 31,633 $ 48,735
=============================== ==============================
NOTE 13 - COMMITMENTS AND CONTINGENCIES
In the normal course of business as a medical device and services company, the
Company has product liability complaints filed against it. Following the FDA
Order, a greater number of lawsuits than has historically been the case have
been filed. As of August 1, 2003 approximately 21 lawsuits were open that were
filed against the Company between May 18, 2000 and May 23, 2003. The lawsuits
are currently in the pre-discovery or discovery stages. Of these lawsuits, 15
allege product liability claims arising out of the Company's orthopaedic tissue
services, five allege product liability claims arising out of the Company's
allograft heart valve tissue services, and one alleges product liability claims
arising out of the non-tissue products made by Ideas for Medicine, when it was a
subsidiary of the Company.
17
Of the 21 open lawsuits, two lawsuits were filed in the 2000/2001 insurance
policy year, four were filed in the 2001/2002 insurance policy year, 14 were
filed in the 2002/2003 insurance policy year and one was filed in the 2003/2004
policy year. For the 2000/2001 and 2001/2002 insurance policy years, the Company
maintained claims-made insurance policies, which the Company believes to be
adequate to defend against the suits filed during this period. For the 2002/2003
insurance policy year, the Company maintained claims-made insurance policies
with three carriers. Two of the three insurance companies who issued policies
for the 2002/2003 year have confirmed coverage for the first two layers of
coverage totaling $15 million; however, most of this coverage has already been
used in the settlement of other lawsuits. A third insurance company, covering
the $10 million of remaining insurance, has indicated that it intends to exclude
eleven matters under its policy, which is expected to have the effect of
substantially decreasing the total coverage available. The Company is currently
evaluating all of its alternatives in connection with resolving the dispute with
its upper layer excess carrier concerning the restrictions on the matters it has
excluded from coverage. Additionally, the Company has called a meeting with the
plaintiffs' attorneys to determine the feasibility of obtaining a global
settlement of the outstanding claims. However, based on the analysis of the
product liability lawsuits now pending against the Company, settlement
negotiations to date, the position taken by the upper layer excess carrier and
advice from counsel, during the second quarter of 2003 the Company has recorded
a liability of $9.0 million in the accrued expenses and other current
liabilities line of the Summary Consolidated Balance Sheet and a related expense
of $9.0 million in general, administrative, and marketing expenses for the
potential expense of resolving these lawsuits and reflecting the uninsured
portion of the estimated liability. The amounts recorded are reflective of
potential legal fees and settlement costs related to these lawsuits, and do not
reflect actual settlement arrangements or final judgments, which could include
punitive damages. The Company's product liability insurance policies do not
include coverage for any punitive damages, which may be assessed at trial. If
the Company is unsuccessful in arranging settlements of product liability claims
for an amount substantially below the amount accrued, there may not be
sufficient insurance coverage and liquid assets to meet these obligations, even
if the Company satisfactorily resolves the restrictions on the upper layer
excess insurance coverage. Additionally, if the Company is unable to settle the
outstanding claims for amounts within its ability to pay and one or more of the
product liability lawsuits in which the Company is a defendant should be tried
and a substantial verdict rendered in favor of the plaintiffs(s), there can be
no assurance that such verdict(s) would not exceed the Company's available
insurance coverage and liquid assets. If the Company is unable to meet required
future cash payments to resolve the outstanding product liability claims, it
will have a material adverse effect on the financial position, results of
operations, and cash flows of the Company.
Claims-made insurance policies generally cover only those asserted claims and
incidents that are reported to the insurance carrier while the policy is in
effect. Thus, a claims-made policy does not generally represent a transfer of
risk for claims and incidents that have been incurred but not reported to the
insurance carrier during the policy period. The Company periodically evaluates
its exposure to unreported product liability claims, and records accruals as
necessary for the estimated cost of unreported claims related to services
performed and products sold. As of December 31, 2002 the Company had accrued
$3.6 million for estimated costs for unreported product claims. On May 2, 2003
the insurance carrier for the 2003/2004 policy altered the policy effective
April 1, 2003 to be a first year claims made policy, i.e. only claims incurred
and reported during the policy period April 1, 2003 through March 31, 2004 are
covered by this policy. During the second quarter of 2003 the Company engaged an
independent actuarial firm to update the analysis of the unreported product
claims as of June 30, 2003. As a result the Company accrued an additional $3.9
million during the second quarter of 2003 to increase the total accrual to $7.5
million for estimated costs for unreported product liability claims related to
services performed and products sold prior to June 30, 2003. The $3.9 million
expense was recorded in the second quarter of 2003 in general, administrative,
and marketing expenses. The $7.5 million balance is included as a component of
accrued expenses and other current liabilities of $3.5 million and other
long-term liabilities of $4.0 million on the Summary Consolidated Balance
Sheets.
At June 30, 2003 there was $150,000 accrued for required insurance retention
payments for the Company's product liability insurance policies claims related
to the 2000/2001 and 2001/2002 policy year. There were no amounts accrued for
required insurance retention payments for the Company's product liability and
directors' and officers' insurance policies claims related to the 2002/2003
policy year as the Company had met its retention levels under these insurance
policies.
18
Several putative class action lawsuits were filed in July through September 2002
against the Company and certain officers of the Company, alleging violations of
Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 based on a
series of purportedly materially false and misleading statements to the market.
The suits were consolidated, and a consolidated amended complaint filed, which
principally alleges that the Company failed to disclose its alleged lack of
compliance with certain FDA regulations regarding the handling and processing of
certain tissues and other product safety matters. The consolidated complaint
seeks certification of a class of purchasers between April 2, 2001 and August
14, 2002, compensatory damages, and other expenses of litigation. The Company
and the other defendants filed a motion to dismiss the consolidated complaint on
February 28, 2003, which motion the United States District Court for the
Northern District of Georgia denied in part and granted in part on May 27, 2003.
The discovery phase of the case commenced on July 16, 2003. The Company carries
directors' and officers' liability insurance policies, which the Company
presently believes to be adequate to defend against this action. Nonetheless, an
adverse judgment in excess of the Company's insurance coverage could have a
material adverse effect on the Company's financial position, results of
operations, and cash flows.
On August 30, 2002 a purported shareholder derivative action was filed by
Rosemary Lichtenberger against Steven G. Anderson, Albert E. Heacox, John W.
Cook, Ronald C. Elkins, Virginia C. Lacy, Ronald D. McCall, Alexander C.
Schwartz, and Bruce J. Van Dyne in the Superior Court of Gwinnett County,
Georgia. The suit, which names the Company as a nominal defendant, alleges that
the individual defendants breached their fiduciary duties to the Company by
causing or allowing the Company to engage in certain inappropriate practices
that caused the Company to suffer damages. The complaint was preceded by one day
by a letter written on behalf of Ms. Lichtenberger demanding that the Company's
Board of Directors take certain actions in response to her allegations. On
January 16, 2003 another purported derivative suit alleging claims similar to
those of the Lichtenberger suit was filed in the Superior Court of Fulton County
by complainant Robert F. Frailey. As in the Lichtenberger suit, the filing of
the complaint in the Frailey action was preceded by a purported demand letter
sent on Frailey's behalf to the Company's Board of Directors. Both complaints
seek undisclosed damages, costs and attorney's fees, punitive damages, and
prejudgment interest against the individual defendants derivatively on behalf of
the Company. The Company's Board of Directors has established an independent
committee to investigate the allegations of Ms. Lichtenberger and Mr. Frailey.
The independent committee engaged independent legal counsel to assist in the
investigation and has concluded its investigation. The committee's report
concludes that no officer or director breached any fiduciary duty and recommends
that the Board of Directors seek to have the lawsuits dismissed. The Company
anticipates responding to the complaint in August of 2003.
On August 19, 2002 the Company issued a press release announcing that on August
17, 2002, the Company received a letter from the Atlanta District Office of the
SEC inquiring into certain matters relating to the Company's August 14, 2002
announcement of the recall order issued by the FDA. Since that time, the Company
has been cooperating with the SEC in its inquiry, which as the SEC notified the
Company in July 2003, became a formal investigation in June 2003. The Company
plans to continue to cooperate with the SEC in its investigation.
NOTE 14 - SUBSEQUENT EVENTS
On August 4, 2003 the Company approved a buyback of employee stock options with
an exercise price of $23 or greater. The option buyback was approved for an
aggregate of up to $350,000 using a Black Scholes valuation model. The Company
anticipates making the offer to employees in third quarter of 2003.
NEITHER THE ABOVE STATEMENT NOR THIS QUARTERLY REPORT ON FORM 10-Q IS AN OFFER
TO PURCHASE, OR A SOLICITATION OF AN OFFER TO SELL, OPTIONS TO PURCHASE SHARES
OF COMMON STOCK OF CRYOLIFE, INC. SUCH AN OFFER WILL BE MADE ONLY BY AN "OFFER
TO PURCHASE OPTIONS" AND RELATED "LETTER OF TRANSMITTAL" TO BE DISSEMINATED TO
OPTIONHOLDERS AT A LATER DATE. OPTIONHOLDERS INVITED TO PARTICIPATE IN THE
BUYBACK DESCRIBED IN THE ABOVE STATEMENT SHOULD READ THESE DOCUMENTS, AS WELL AS
CRYOLIFE'S TENDER OFFER STATEMENT ON SCHEDULE TO, WHEN THEY ARE AVAILABLE
BECAUSE THEY CONTAIN IMPORTANT INFORMATION. THESE AND OTHER FILED DOCUMENTS WILL
BE AVAILABLE FOR FREE FROM THE SEC'S WEBSITE AT WWW.SEC.GOV AND CRYOLIFE. THE
OFFER WILL NOT BE MADE TO, NOR WILL TENDERS BE ACCEPTED FROM OR ON BEHALF OF,
OPTIONHOLDERS IN ANY JURISDICTION IN WHICH MAKING OR ACCEPTING THE OFFER WOULD
VIOLATE THAT JURISDICTION'S LAWS.
19
NOTE 15 - RESTATEMENT
Subsequent to the issuance of the Company's consolidated financial statements
for the three and six month periods ended June 30, 2003, the Company determined
that there were $2.4 million in tax loss carrybacks available to the Company at
June 30, 2003. Therefore, the entire deferred tax asset balance need not have a
valuation allowance. As a result, the consolidated financial statements as of
and for the three and six months ended June 30, 2003 have been restated from the
amounts previously reported as follows (in thousands, except per share data):
Three Months Ended Six Months Ended
June 30, 2003 June 30, 2003
----------------------------------- ----------------------------------
As Previously As As Previously As
Reported Restated Reported Restated
----------------------------------- ----------------------------------
(Unaudited) (Unaudited)
Income tax expense $ 6,069 $ 3,644 $ 5,855 $ 3,430
----------------------------------- ----------------------------------
Net loss $ (22,346) $ (19,921) $ (22,780) $ (20,355)
=================================== ==================================
Net loss per share:
Basic $ (1.14) $ (1.01) $ (1.16) $ (1.04)
=================================== ==================================
Diluted $ (1.14) $ (1.01) $ (1.16) $ (1.04)
=================================== ==================================
June 30, 2003
-----------------------------------
As Previously As
Reported Restated
-----------------------------------
(Unaudited)
Other receivables, net $ 616 $ 1,766
Deferred income taxes -- 1,275
Total current assets 52,647 55,072
TOTAL ASSETS 95,006 97,431
Retained deficit (9,994) (7,569)
Total shareholders' equity 57,450 59,875
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 95,006 $ 97,431
20
PART I - FINANCIAL INFORMATION
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
RECENT EVENTS
A new FDA 483 Notice of Observations ("February 2003 483") was issued in
connection with the FDA inspection in February 2003, but corrective action was
implemented on most of its observations during the inspection. The Company
believes the observations, most of which focus on the Company's systems for
handling complaints, will not materially affect the Company's operations. The
Company responded to the February 2003 483 in March 2003. The Company has met
with the FDA to review its response to the February 2003 483. No additional
comments regarding the adequacy of its response were issued at that time. The
Company continues to work with the FDA to review process improvements.
On February 20, 2003 the Company received a letter from the FDA stating that a
510(k) premarket notification should be filed for the Company's CryoValve SG and
that premarket approval marketing authorization should be obtained for the
Company's CryoVein SG when used for arteriovenous ("A-V") access. The agency's
position is that use of the SynerGraft technology in the processing of allograft
heart valves represents a modification to the Company's legally marketed
CryoValve allograft, and that vascular allografts labeled for use as A-V access
grafts are medical devices that require premarket approval.
The Company is in discussions with the FDA about the type of submissions
necessary for these products. The Company advised the FDA that it has
voluntarily suspended use of the SynerGraft technology in the processing of
allograft heart valves and vascular tissue until the regulatory status of the
CryoValve SG and CryoVein SG is resolved. Additionally, the Company has
discontinued labeling its vascular grafts for use as A-V access grafts. The FDA
has not suggested that these tissues be recalled. Until such time as the issues
surrounding the SynerGraft tissue are resolved, the Company will employ its
traditional processing methods on these tissues. Distribution of allograft heart
valves and vascular tissue processed using the Company's traditional processing
protocols will continue. The outcome of the discussions with the FDA regarding
the use of the SynerGraft process on human tissue could result in an inability
to process tissues with the SynerGraft technology until further submissions and
FDA approvals are granted. The Company currently has nominal amounts of
SynerGraft processed cardiovascular and vascular tissue, and as such, revenues
and gross margins will be adversely affected in the third and fourth quarters of
2003.
During the second quarter of 2003, the Company's upper layer excess product
liability insurance carrier, which covers $10 million of insurance, indicated
that it intends to exclude eleven matters under its policy, which is expected to
have the effect of substantially decreasing the total coverage available. The
Company is currently evaluating all of its alternatives in connection with
resolving the dispute with its upper layer excess carrier concerning the
restrictions on the matters it has excluded from coverage. See further
discussion regarding product liability claims in Part II. Item 1. Legal
Proceedings.
The Company and the lender are currently in the process of negotiating specific
terms of a forbearance agreement, which, if entered into, would increase the
interest rate charged on the Term Loan effective August 1, 2003 to Adjusted
LIBOR plus 4% (5.32% at June 30, 2003), accelerate the principal payments on the
Term Loan by requiring a balloon payment to pay off the outstanding balance by
October 31, 2003, and cause the Company to pay a $12,000 modification fee and
the lender's attorneys costs, which have yet to be determined. As of August 4,
2003 the Company has sufficient cash and cash equivalents to pay the remaining
outstanding balance of the Term Loan.
CRITICAL ACCOUNTING POLICIES
A summary of the Company's significant accounting policies is included in Note 1
to the consolidated financial statements, as filed in the Form 10-K for the
fiscal year ended December 31, 2002, as amended. Management believes that the
consistent application of these policies enables the Company to provide users of
the financial statements with useful and reliable information about the
Company's operating results and financial condition. The consolidated financial
statements are prepared in accordance with accounting principles generally
accepted in the United States, which require the Company to make estimates and
assumptions. The following are accounting policies that management believes are
21
most important to the portrayal of the Company's financial condition and results
and may involve a higher degree of judgment and complexity.
DEFERRED PRESERVATION COSTS: Tissue is procured from deceased human donors by
organ and tissue procurement agencies, which consign the tissue to the Company
for processing and preservation. Preservation costs related to tissue held by
the Company are deferred until revenue is recognized upon shipment of the tissue
to the implanting facilities. Deferred preservation costs consist primarily of
laboratory and personnel expenses, tissue procurement fees, fringe benefits,
facility allocations, and freight-in charges, and are stated at the lower of
cost or market, net of reserve, on a first-in, first-out basis.
During 2002 the Company recorded a write-down of deferred preservation costs of
$8.7 million for valved cardiac tissues, $2.9 million for non-valved cardiac
tissues, $11.9 million for vascular tissues, and $9.2 million for orthopaedic
tissue, totaling $32.7 million. These write-downs were recorded as a result of
the adverse publicity surrounding the FDA Order as discussed at Note 2 to the
Summary Consolidated Financial Statements in this Form 10-Q. The amount of these
write-downs reflected managements' estimates based on information available to
it at the time the estimates were made. These estimates may prove inaccurate, as
the ultimate impact of the FDA Order is determined. Management continues to
evaluate the recoverability of these deferred preservation costs based on the
factors discussed in Note 2 to Summary Consolidated Financial Statements and
will record additional write-downs if it becomes clear that additional
impairments have occurred. The write-down created a new cost basis, which cannot
be written back up if these tissues become shippable. The cost of human tissue
preservation services may be favorably affected depending on the future level of
tissue shipments related to previously written-down deferred preservation costs.
The shipment levels of these written-down tissues will be affected by the amount
and timing of the release of tissues processed after September 5, 2002, as a
result of the Agreement with the FDA, since, under the Agreement, written-down
tissues may be shipped if tissues processed after September 5, 2002 are not
available for shipment.
The Company regularly evaluates its deferred preservation costs to determine if
the carrying value is appropriately recorded at the lower of cost or market
value. During the three and six months ended June 30, 2003 the Company recorded
$1.1 million and $1.4 million, respectively, as an increase to cost of
preservation services to write-down the value of certain deferred tissue
preservation costs from tissues processed in the three and six months ended June
30, 2003 that exceeded market value. The amount of these write-downs reflects
managements' estimates of market value based on information available to it at
the time the estimates were made and actual results may differ from these
estimates.
As of June 30, 2003 the balance of deferred preservation costs was $4.3 million
for allograft heart valve tissues, $452,000 for non-valved cardiac tissues, $4.0
million for vascular tissues, and $738,000 for orthopaedic tissues.
DEFERRED INCOME TAXES: Deferred income taxes reflect the net tax effect of
temporary differences between the carrying amounts of assets and liabilities for
financial reporting purposes and tax return purposes. The Company generated
deferred tax assets primarily as a result of net operating losses in 2002 and
2003, primarily due to reductions in revenues, write-downs of deferred
preservation costs, additional professional fees, and accruals for product
liability claims, as a result of the FDA Order, FDA Warning Letter, and reported
tissue infections. The Company periodically assesses the recoverability of
deferred tax assets and provides a valuation allowance when management believes
it is more likely than not that its deferred tax assets will not be realized.
During the first quarter of 2003 the Company recorded a valuation allowance of
$658,000 for deferred tax assets generated by capital losses when management
determined that it was more likely than not that these deferred tax assets would
not be realized in future periods. During the second quarter of 2003, the
Company evaluated several factors to determine if a valuation allowance relative
to its deferred tax assets was necessary. The Company reviewed its historic
operating results, including the reasons for its operating losses in 2002 and
2003, uncertainties regarding projected future operating results due to the
effects of the adverse publicity resulting from the FDA Order, FDA Warning
Letter, and reported tissue infections and the changes in processing methods
resulting from the FDA Order, and the uncertainty of the outcome of product
liability claims (see Note 13). Based on the results of this analysis, the
Company has determined that it is more likely than not that $9.7 million of the
Company's $11.0 million in deferred tax assets will not be realized. Therefore,
the Company recorded an additional valuation allowance of $9.0 million against
its net deferred tax assets during the second quarter of 2003. As of June 30,
2003 the Company had a total of $9.7 million in valuation allowances against
22
deferred tax assets and a net deferred tax asset balance of $1.3 million. This
remaining $1.3 million of deferred tax assets was not subject to valuation as it
is expected to become recoverable by the end of the year. This amount along with
$1.1 million in income tax receivable, totaling $2.4 million, represents
expected tax refunds resulting from 2003 tax losses which can be carried back to
offset taxes paid in prior years.
Management will continue to evaluate the recoverability of the deferred tax
assets and may remove the valuation allowance if it determines that it is more
likely than not that the deferred tax assets will be realized in future periods.
VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL: The Company assesses
the impairment of its long-lived, identifiable intangible assets and related
goodwill annually and whenever events or changes in circumstances indicate that
the carrying value may not be recoverable. Factors that management considers
important that could trigger an impairment review include the following:
o Significant underperformance relative to expected historical or
projected future operating results;
o Significant negative industry or economic trends;
o Significant decline in the Company's stock price for a sustained
period; and
o Significant decline in the Company's market capitalization relative to
net book value.
Statement of Financial Accounting Standards No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), requires the
write-down of a long-lived asset to be held and used if the carrying value of
the asset or the asset group to which the asset belongs is not recoverable. The
carrying value of the asset or asset group is not recoverable if it exceeds the
sum of the undiscounted future cash flows expected to result from the use and
eventual disposition of the asset or asset group. In applying SFAS 144, the
Company defined the specific asset groups used to perform the cash flow
analysis. The Company defined the asset groups at the lowest level possible, by
identifying the cash flows from groups of assets that could be segregated from
the cash flows of other assets and liabilities. Using this methodology, the
Company determined that its asset groups consisted of the long-lived assets
related to the Company's two reporting segments. As the Company does not
segregate assets by segment, the Company allocated assets to the two reporting
segments based on factors including facility space and revenues. The Company
used a fourteen-year period for the undiscounted future cash flows. This period
of time was selected based upon the remaining life of the primary assets of the
asset groups, which are leasehold improvements. The undiscounted future cash
flows related to these asset groups exceeded their carrying values as of June
30, 2003 and, therefore, management has concluded that there is not an
impairment of the Company's long-lived intangible assets and tangible assets
related to the tissue preservation business or medical device business. However,
depending on the Company's ability to rebuild demand for its tissue preservation
services, the outcome of discussions with the FDA regarding the shipping of
orthopaedic tissues, and the future effects of adverse publicity surrounding the
FDA Order and reported infections on preservation revenues, these assets may
become impaired. Management will continue to evaluate the recoverability of
these assets in accordance with SFAS 144.
Beginning with the Company's adoption of Statement of Financial Accounting
Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142")
on January 1, 2002 the goodwill resulting from business acquisitions is not
amortized, but is instead subject to periodic impairment testing in accordance
with SFAS 142. Patent costs are amortized over the expected useful lives of the
patents (primarily 17 years) using the straight-line method. Other intangibles,
which consist primarily of manufacturing rights and agreements, are amortized
over the expected useful lives of the related assets (primarily five years). As
a result of the FDA Order, the Company determined that an evaluation of the
possible impairment of intangible assets under SFAS 142 was necessary. The
Company engaged an independent valuation expert to perform the valuation using a
discounted cash flow methodology, and as a result of this analysis, the Company
determined that goodwill related to its tissue processing reporting unit was
fully impaired as of September 30, 2002. Therefore, the Company recorded a
write-down of $1.4 million in goodwill during the quarter ended September 30,
2002. Management does not believe an impairment exists related to the other
intangible assets that were assessed in accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144").
23
PRODUCT LIABILITY CLAIMS: In the normal course of business as a medical device
and services company, the Company has product liability complaints filed against
it. Following the FDA Order, a greater number of lawsuits than has historically
been the case have been filed. The Company maintains claims-made insurance
policies to mitigate its financial exposure to product liability claims.
Claims-made insurance policies generally cover only those asserted claims and
incidents that are reported to the insurance carrier while the policy is in
effect. Thus, a claims-made policy does not generally represent a transfer of
risk for claims and incidents that have been incurred but not reported to the
insurance carrier during the policy period. The Company periodically evaluates
its exposure to unreported product liability claims, and records accruals as
necessary for the estimated cost of unreported claims related to services
performed and products sold. As of December 31, 2002 the Company had accrued
$3.6 million in estimated costs for unreported product liability claims related
to services performed and products sold prior to December 31, 2002. The Company
retained an independent actuarial firm to estimate the unreported claims. During
the second quarter of 2003 the independent actuarial firm updated the analysis
of the unreported product claims as of June 30, 2003. The independent firm
estimated the unreported product loss liability using a frequency-severity
approach, whereby, projected losses were calculated by multiplying the estimated
number of claims by the estimated average cost per claim. The estimated claims
were calculated based on the reported claim development method and the
Bornhuetter-Ferguson method using a blend of the Company's historical claim
experience and industry data. The estimated cost per claim was calculated using
a lognormal claims model blending the Company's historical average cost per
claim with industry claims data. As a result of the actuarial valuation the
Company accrued an additional $3.9 million to increase the total accrual to $7.5
million for unreported product liability claims related to services performed
and products sold prior to June 30, 2003. The $3.9 million expense was recorded
in the second quarter of 2003 in general, administrative, and marketing
expenses. The $7.5 million balance is included as a component of accrued
expenses and other current liabilities of $3.5 million and other long-term
liabilities of $4.0 million on the Summary Consolidated Balance Sheets.
For the 2000/2001 and 2001/2002 insurance policy years, the Company maintained
claims-made insurance policies, which the Company believes to be adequate to
defend against the suits filed during this period. For the 2002/2003 insurance
policy year, the Company maintained claims-made insurance policies with three
carriers. Two of the three insurance companies who issued policies for the
2002/2003 year have confirmed coverage for the first two layers of coverage
totaling $15 million; however, most of this coverage has already been used in
the settlement of other lawsuits. A third insurance company, covering the last
$10 million of the remaining insurance, has indicated that it intends to exclude
eleven matters under its policy, which is expected to have the effect of
substantially decreasing the total coverage available. The Company is currently
evaluating all of its alternatives in connection with resolving the dispute with
its upper layer excess carrier concerning the restrictions on the matters it has
excluded from coverage. Additionally, the Company has called a meeting with the
plaintiffs' attorneys to determine the feasibility of obtaining a global
settlement of the outstanding claims. However, based on the analysis of the
product liability lawsuits now pending against the Company, settlement
negotiations to date, the position taken by the upper layer excess carrier and
advice from counsel, during the second quarter of 2003 the Company has recorded
a liability of $9.0 million in the accrued expenses and other current
liabilities line of the Summary Consolidated Balance Sheet and a corresponding
expense in general, administrative, and marketing expenses for the estimated
expense of resolving these lawsuits and reflecting the uninsured portion of the
estimated liability. The amounts recorded are reflective of potential legal fees
and settlement costs related to these lawsuits, and do not reflect actual
settlement arrangements or final judgments, which could include punitive
damages. The Company's product liability insurance policies do not include
coverage for any punitive damages, which may be assessed at trial. If the
Company is unsuccessful in arranging settlements of product liability claims for
an amount substantially below the amount accrued, there may not be sufficient
insurance coverage and liquid assets to meet these obligations, even if the
Company satisfactorily resolves the restrictions on the upper layer excess
insurance coverage. Additionally, if the Company is unable to settle the
outstanding claims for amounts within its ability to pay and one or more of the
product liability lawsuits in which the Company is a defendant should be tried
with a substantial verdict rendered in favor of the plaintiffs(s), there can be
no assurance that such verdict(s) would not exceed the Company's available
insurance coverage and liquid assets. If the Company is unable to meet required
future cash payments to resolve the outstanding product liability claims, it
will have a material adverse effect on the financial position, results of
operations, and cash flows of the Company.
24
NEW ACCOUNTING PRONOUNCEMENTS
The Company was required to adopt SFAS No. 143, "Accounting for Asset Retirement
Obligations" ("SFAS 143") on January 1, 2003. SFAS 143 addresses accounting and
reporting for retirement costs of long-lived assets resulting from legal
obligations associated with acquisition, construction, or development
transactions. The adoption of SFAS 143 did not have a material effect on the
results of operations or financial position of the Company.
The Company was required to adopt SFAS No. 145, "Rescission of FASB Statements
4, 44 and 64, Amendment to FASB Statement 13, and Technical Corrections" ("SFAS
145"), on January 1, 2003. SFAS 145 rescinds SFAS No.s 4, 44 and 64, which
required gains and losses from extinguishments of debt to be classified as
extraordinary items. SFAS 145 also amends SFAS No. 13, eliminating
inconsistencies in certain sale-leaseback transactions. The provisions of SFAS
145 are effective for fiscal years beginning after May 15, 2002. The adoption of
SFAS 145 did not have a material effect on the results of operations or
financial position of the Company.
The Company was required to adopt SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities" ("SFAS 146") on January 1, 2003. SFAS 146
requires that costs associated with exit or disposal activities be recorded at
their fair values when a liability has been incurred. Under previous guidance,
certain exit costs were accrued upon management's commitment to an exit plan,
which is generally before an actual liability has been incurred. The adoption of
SFAS 146 did not have a material effect on the results of operations or
financial position of the Company.
RESULTS OF OPERATIONS
(IN THOUSANDS)
REVENUES
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2003 2002 2003 2002
------------------------------- ------------------------------
Revenues as reported $ 15,713 $ 23,264 $ 31,633 $ 48,735
Estimated tissue recall returns -- 2,433 -- 2,433
Adjustment to estimated tissue
recall returns -- -- (848) --
------------------------------- ------------------------------
Adjusted revenues (a) $ 15,713 $ 25,697 $ 30,785 $ 51,168
=============================== ==============================
Revenues as reported decreased 32% and 35% for the three and six months ended
June 30, 2003, respectively, as compared to the three and six months ended June
30, 2002. Revenues as reported for the six months ended June 30, 2003 include
- -----------------------
(a) The measurement "adjusted revenues" is defined as revenues prior to
estimated tissue recall returns and adjustment to estimated tissue recall
returns. This measurement may be deemed to be a "non-GAAP" financial measure as
that term is defined in Regulation G and Item 10(e) of Regulation S-K and is
included for informational purposes to provide comparable disclosure in the
current and prior periods of revenues derived from services provided with
respect to tissues and products shipped in the normal course of business. The
estimated tissue recall returns have been excluded from revenues in the prior
year periods to exclude the effect of an estimated amount of tissues to be
returned subsequent to the period presented due to the FDA recall. Excluding
this unfavorable item from the prior periods was necessary to show a clearer
comparison to current year periods and to illustrate the magnitude of the
decrease in current year revenues. The adjustment to estimated tissue recall
returns has been excluded from revenues in the 2003 six month period to exclude
the effect of an adjustment to the estimated amount of tissues to be returned
due to the FDA recall. Excluding this favorable item from the current year
periods was necessary to show a clearer comparison to prior year periods and to
illustrate the magnitude of the decrease in current year revenues. The
presentation of revenue as reported without the presentation of adjusted
revenues might mislead investors with respect to the magnitude of the decrease
in the Company's current year revenues relative to the prior year.
25
$848,000 in favorable adjustments to the estimated tissue recall returns due to
lower actual tissue returns under the FDA Order than were originally estimated.
Revenues as reported for the three and six months ended June 30, 2002 were
adversely affected by the estimated effect of the return of tissues subject to
recall by the FDA Order, which resulted in an estimated decrease of $2.4 million
in preservation service revenues. As of June 30, 2003 approximately $60,000
remains in the accrual for estimated return of tissues subject to recall by the
FDA Order.
Adjusted revenues decreased 39% and 40% for the three and six months ended June
30, 2003, respectively, as compared to the three and six months ended June 30,
2002. This decrease in adjusted revenues for the three and six months ended June
30, 2003 was primarily due to a 57% and 58% decrease, respectively, of human
tissue preservation service revenues as a result of the FDA Order's restriction
on shipments of certain tissues, the Company's cessation of orthopaedic
processing until late February 2003, a decrease in 2003 processing levels
relative to processing levels prior to the issuance of the FDA Order in August
of 2002, and decreased demand as a result of the adverse publicity surrounding
the FDA Order, FDA Warning Letter, and reported tissue infections. These
decreases were partially offset by an increase in BioGlue Surgical Adhesive
revenues for the three and six months ended June 30, 2003 of 30% and 32%,
respectively, due to increased demand.
Management believes that revenues will exceed third quarter 2002 levels in the
third quarter of 2003, but will still show a significant decrease for the full
year 2003 compared to 2002. The ongoing corrective actions taken by the Company
regarding the FDA issues and the anticipated resolution of the FDA issues should
assist the Company in rebuilding demand for its preservation services. In the
event the Company is not successful in rebuilding demand for its preservation
services, future revenues can be expected to remain significantly below
historical levels prior to the issuance of the FDA Order. As discussed in Note 2
to the Summary Consolidated Financial Statements, the outcome of the discussions
with the FDA regarding the use of the SynerGraft process on human tissue could
result in a reduction in SynerGraft processed cardiovascular and vascular tissue
which would reduce revenue and the gross margins with respect to cardiovascular
and vascular tissues.
BIOGLUE SURGICAL ADHESIVE
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2003 2002 2003 2002
------------------------------- ------------------------------
Revenues as reported $ 6,839 $ 5,251 $ 13,333 $ 10,124
BioGlue revenues as reported as a
percentage of total revenue as reported 44% 23% 42% 21%
BioGlue revenues as reported as a
percentage of total adjusted revenues(a) 44% 20% 43% 20%
Revenues as reported from the sale of BioGlue Surgical Adhesive increased 30%
and 32%, respectively, for the three and six months ended June 30, 2003 as
compared to the three and six months ended June 30, 2002. The 30% increase in
revenues as reported for the three months ended June 30, 2003 was primarily due
to an increase in BioGlue sales volume due to an increase in demand in both
foreign and domestic markets which increased revenues by 28%, and by an increase
in average selling prices which increased revenues by 2%. The 32% increase in
revenues as reported for the six months ended June 30, 2003 was due to an
increase in BioGlue sales volume due to an increase in demand in both foreign
and domestic markets which increased revenues by 26%, and by an increase in
average selling prices which increased revenues by 6%. Volume increases in both
the three and six months ended June 30, 2003 were lead by increases in the
BioGlue 2ml and 5ml product sizes. Domestic revenues accounted for 77% and 78%
of total BioGlue revenues for the three and six months ended June 30, 2003,
respectively, and 77% and 79% of total BioGlue revenues for the three and six
months ended June 30, 2002, respectively.
There is a possibility that the Company's BioGlue manufacturing operations could
come under increased scrutiny from the FDA as a result of their review of the
Company's tissue processing laboratories.
26
CARDIOVASCULAR PRESERVATION SERVICES
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2003 2002 2003 2002
------------------------------- ------------------------------
Revenues as reported $ 5,036 $ 7,336 $ 9,761 $ 14,644
Estimated tissue recall returns -- 340 -- 340
Adjustment to estimated tissue recall
returns -- -- (92) --
------------------------------- ------------------------------
Adjusted revenues(a) $ 5,036 $ 7,676 $ 9,669 $ 14,984
=============================== ==============================
Cardiovascular revenues as reported as a
percentage of total revenue as reported 32% 32% 31% 30%
Cardiovascular adjusted revenues as a
percentage of total adjusted revenues(a) 32% 30% 31% 29%
Revenues as reported from cardiovascular preservation services decreased 31% and
33%, respectively, for the three and six months ended June 30, 2003 as compared
to the three and six months ended June 30, 2002. Cardiovascular revenues as
reported for the six months ended June 30, 2003 include $92,000 in favorable
adjustments to the estimated tissue recall returns due to lower actual tissue
returns under the FDA Order than were originally estimated. Cardiovascular
revenues as reported for the three and six months ended June 30, 2002 were
adversely affected by the estimated effect of the tissues returned subject to
the FDA Order on service revenues for non-valved cardiac tissues, which resulted
in an estimated decrease of $340,000 in service revenues during the three and
six months ended June 30, 2002.
Adjusted revenues from cardiovascular preservation services decreased 34% and
35%, respectively, for the three and six months ended June 30, 2003 as compared
to the three and six months ended June 30, 2002. The 34% decrease in adjusted
revenues for the three months ended June 30, 2003 was due to a decrease in
cardiovascular volume primarily due to a decline in demand related to the
adverse publicity surrounding the FDA Order, FDA Warning Letter, the FDA public
health web notification, and reported tissue infections, and the restrictions on
shipments of certain non-valved cardiac tissues subject to the FDA Order which
reduced revenues by 42%, partially offset by an increase in average service fees
which increased revenues by 8%. The 35% decrease in adjusted revenues for the
six months ended June 30, 2003 was due to a decrease in cardiovascular volume
primarily due to a decline in demand related to the adverse publicity
surrounding the FDA Order, FDA Warning Letter, the FDA public health web
notification, and reported tissue infections, and the restrictions on shipments
of certain non-valved cardiac tissues subject to the FDA Order which reduced
revenues by 42%, partially offset by an increase in average service fees which
increased revenues by 7%. The increase in average service fees for the three and
six months ended June 30, 2003 was due to a higher percentage of heart valve
shipments, which were not subject to the FDA Order, than non-valved cardiac
tissue shipments and due to a higher percentage of tissue shipments of valves
treated with the SynerGraft process than traditional processing when compared to
the corresponding prior year periods.
As a result of the adverse publicity surrounding the FDA Order, FDA Warning
Letter, and reported tissue infections, the Company's procurement of cardiac
tissues during the three and six months ended June 30, 2003, from which heart
valves and non-valved cardiac tissues are processed, decreased 20% and 24%,
respectively, as compared to the three and six months ended June 30, 2002. The
Company's second quarter 2003 procurement of cardiac tissues increased 12% from
the first quarter of 2003.
The Company believes that cardiovascular revenues in the third quarter of 2003
will approach third quarter 2002 levels, but will still show a decrease for the
full year 2003 compared to 2002, as a result of the adverse publicity
surrounding the FDA Order, FDA Warning Letter, the FDA public health web
notification, and certain reported tissue infections. On June 27, 2003 the FDA
modified its public health web notification on the Company by labeling it
"archived document - no longer current information - not for official use." This
action may assist the Company in rebuilding demand for its cardiovascular
tissues. If the Company is unable to rebuild demand for its preservation
services for these tissues, future cardiac preservation revenue could continue
to decrease. The Company currently has nominal amounts of SynerGraft processed
cardiovascular and vascular tissue, and as such, revenues and gross margins will
be adversely affected in the third and fourth quarters of 2003 until FDA
approval can be obtained to begin using the SynerGraft process again.
27
VASCULAR PRESERVATION SERVICES
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2003 2002 2003 2002
------------------------------- ------------------------------
Revenues as reported $ 3,299 $ 4,641 $ 7,554 $ 11,658
Estimated tissue recall returns -- 1,713 -- 1,713
Adjustment to estimated tissue recall
returns -- -- (711) --
------------------------------- ------------------------------
Adjusted revenues(a) $ 3,299 $ 6,354 $ 6,843 $ 13,371
=============================== ==============================
Vascular revenues as reported as a
percentage of total revenue as reported 21% 20% 24% 24%
Vascular adjusted revenues as a
percentage of total adjusted revenues(a) 21% 25% 22% 26%
Revenues as reported from vascular preservation services decreased 29% and 35%,
respectively, for the three and six months ended June 30, 2003 as compared to
the three and six months ended June 30, 2002. Vascular revenues as reported for
the six months ended June 30, 2003 include $711,000 in favorable adjustments to
the estimated tissue recall returns due to lower actual tissue returns under the
FDA Order than were originally estimated. Vascular revenues as reported for the
three and six months ended June 30, 2002 were adversely affected by the
estimated effect of the return of tissues subject to recall by the FDA Order,
which resulted in an estimated decrease of $1.7 million in service revenues.
Adjusted revenues from vascular preservation services decreased 48% and 49%,
respectively, for the three and six months ended June 30, 2003 as compared to
the three and six months ended June 30, 2002. The 48% decrease in adjusted
revenues for the three months ended June 30, 2003 was due to a decrease in
vascular volume primarily due to a decline in demand related to the adverse
publicity surrounding the FDA Order, FDA Warning Letter, and reported tissue
infections, and the restrictions on shipments of certain vascular tissues
subject to the FDA Order which reduced revenues by 49%, partially offset by an
increase in average service fees, which increased revenues by 1%. The 49%
decrease in adjusted revenues for the six months ended June 30, 2003 was due to
a decrease in vascular volume primarily due to a decline in demand related to
the adverse publicity surrounding the FDA Order, FDA Warning Letter, and
reported tissue infections, and the restrictions on shipments of certain
vascular tissues subject to the FDA Order which reduced revenues by 46% and by a
decrease in average service fees which reduced revenues by 3%.
During the first quarter of 2003 the Company limited its vascular procurement
until it addressed the observations detailed in the April 2002 483, most of
which were addressed in the first quarter of 2003, and due to resource
constraints as a result of the September 2002 employee force reduction. The
Company continued to limit its vascular procurement in the second quarter of
2003 and will continue to limit its vascular procurement until it can fully
evaluate the demand for its vascular tissues. The Company's procurement of
vascular tissue for the three and six months ended June 30, 2003 decreased 50%
and 57%, respectively, as compared to the three and six months ended June 30,
2002. The Company's second quarter 2003 procurement of vascular tissues
increased 53% from first quarter of 2003. The Company expects that vascular
procurement will continue to increase during 2003.
The Company believes that vascular revenues in the third quarter of 2003 will
exceed third quarter 2002 levels, but will still show a decrease for the full
year 2003 compared to 2002, as a result of the adverse publicity surrounding the
FDA Order, FDA Warning Letter, and certain reported tissue infections. If the
Company is unable to rebuild demand for its preservation services for these
tissues, future vascular preservation revenue could continue to decrease.
28
ORTHOPAEDIC PRESERVATION SERVICES
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2003 2002 2003 2002
------------------------------- ------------------------------
Revenues as reported $ 280 $ 5,559 $ 430 $ 11,472
Estimated tissue recall returns -- 380 -- 380
Adjustment to estimated tissue recall
returns -- -- (45) --
------------------------------- ------------------------------
Adjusted revenues(a) $ 280 $ 5,939 $ 385 $ 11,852
=============================== ==============================
Orthopaedic revenues as reported as a
percentage of total revenue as reported 2% 24% 1% 24%
Orthopaedic adjusted revenues as a percentage
of total adjusted revenues(a) 2% 23% 1% 23%
Revenues as reported from orthopaedic preservation services decreased 95% and
96%, respectively, for the three and six months ended June 30, 2003 as compared
to the three and six months ended June 30, 2002. Orthopaedic revenues as
reported for the six months ended June 30, 2003 include $45,000 in favorable
adjustments to the estimated tissue recall returns due to lower actual tissue
returns under the FDA Order than were originally estimated. Orthopaedic revenues
as reported for the three and six months ended June 30, 2002 were adversely
affected by the estimated effect of the return of tissues subject to recall by
the FDA Order, which resulted in an estimated decrease of $380,000 in service
revenues.
Adjusted revenues from orthopaedic preservation services decreased 95% and 97%,
respectively, for the three and six months ended June 30, 2003 as compared to
the three and six months ended June 30, 2002. The 95% decrease in adjusted
revenues for the three months ended June 30, 2003 was due to a decrease in
orthopaedic volume primarily resulting from the restrictions on shipments of
certain orthopaedic tissues subject to the FDA Order, cessation of processing of
orthopaedic tissue until late February 2003, and a decline in demand related to
the adverse publicity surrounding the FDA Order, FDA Warning Letter, and
reported tissue infections, which reduced revenues by 94% and a decrease in
orthopaedic average service fees which reduced revenues by 1%. The 97% decrease
in adjusted revenues for the six months ended June 30, 2003 was due to a
decrease in orthopaedic volume primarily due to the restrictions on shipments of
certain orthopaedic tissues subject to the FDA Order, cessation of processing of
orthopaedic tissue until late February 2003, and a decline in demand related to
the adverse publicity surrounding the FDA Order, FDA Warning Letter, and
reported tissue infections, which reduced revenues by 96% and a decrease in
orthopaedic average service fees which reduced revenues by 1%.
The Company resumed limited processing of orthopaedic tissues in late February
2003 following the FDA inspection of the Company's operations as discussed in
Note 2 to the Summary Consolidated Financial Statements, and during the quarter
ended June 30, 2003 the Company began shipments of the non-boned orthopaedic
tissues processed. The Company resumed shipment of boned orthopaedic tissues
processed since February 2003 in early August 2003. The majority of orthopaedic
revenues for the three months ended June 30, 2003 have been from shipments of
orthopaedic tissues that were processed since February 2003. The Company's
procurement of whole and partial knees during the three and six months ended
June 30, 2003 was approximately 43% and 26%, respectively, of whole and partial
knee procurement levels for the three and six months ended June 30, 2002. The
Company's procurement of orthopaedic tendons during the three and six months
ended June 30, 2003 was approximately 14% and 8%, respectively, of orthopaedic
tendon procurement levels for the three and six months ended June 30, 2002. The
Company resumed limited distribution of recently processed orthopaedic tissues
in the first quarter of 2003.
The Company believes that orthopaedic revenues will continue to increase slowly
during the third and fourth quarters of 2003, but will still show a significant
decrease for the third quarter of 2003 as compared to the third quarter of 2002
as well as for the full year 2003 compared to 2002, due to the Company's
inability to ship orthopaedic grafts processed between October 3, 2001 and
September 5, 2002 pursuant to the FDA Order, the adverse publicity resulting
29
from the FDA Order, FDA Warning Letter, and the reported infections in some
orthopaedic allograft recipients. If the Company is unable to rebuild demand for
its preservation services for orthopaedic tissues, future orthopaedic
preservation revenue may be minimal.
IMPLANTABLE MEDICAL DEVICES
Revenues from implantable medical devices decreased 58% to $93,000 for the three
months ended June 30, 2003 from $222,000 for the three months ended June 30,
2002, representing 1% of total revenues as reported during such periods.
Revenues from implantable medical devices decreased 52% to $198,000 for the six
months ended June 30, 2003 from $414,000 for the six months ended June 30, 2002,
representing 1% of total revenues as reported during such periods.
DISTRIBUTION AND GRANT REVENUES
Grant revenues increased to $166,000 and $357,000, respectively, for the three
and six months ended June 30, 2003 from $104,000 and $131,000 for the three and
six months ended June 30, 2002. Grant revenues in 2003 and 2002 were
attributable to the Activation Control Technology ("ACT") research and
development programs through AuraZyme Pharmaceuticals, Inc. ("AuraZyme") and the
SynerGraft research and development programs. In February 2001 the Company
formed the wholly owned subsidiary AuraZyme to foster the commercial development
of ACT, a reversible linker technology that has potential uses in the areas of
cancer therapy, fibrinolysis (blood clot dissolving), and other drug delivery
applications.
Distribution revenues decreased to zero for the three and six months ended June
30, 2003 from $151,000 and $292,000, respectively, for the three and six months
ended June 30, 2002. Distribution revenues consisted of commissions received for
the distribution of orthopaedic tissues for another processor. The Company does
not currently anticipate receiving distribution revenues from any third party
processors in 2003.
COST OF HUMAN TISSUE PRESERVATION SERVICES
Cost of human tissue preservation services decreased to $5.2 million and $7.6
million, respectively, for the three and six months ended June 30, 2003 as
compared to $17.2 million and $25.3 million, respectively, for the three and six
months ended June 30, 2002. Cost of human tissue preservation services as a
percentage of revenues as reported is 60% and 43%, respectively, for the three
and six months ended June 30, 2003 as compared to 98% and 67%, respectively, for
the three and six months ended June 30, 2002. Cost of human tissue preservation
services for the three and six months ended June 30, 2003 includes an increase
to cost of preservation services to adjust the value of certain deferred tissue
preservation costs that exceeded market value of $1.1 million and $1.4 million,
respectively, and the favorable effect of shipments of tissue with a zero cost
basis due to write-downs of deferred preservation costs in the second and third
quarter of 2002 of $1.0 million and $3.4 million, respectively. Cost of human
tissue preservation services for the three and six months ended June 30, 2002
includes a $10.0 million write-down of deferred preservation costs for tissues
subject to the FDA Order, offset by a $1.1 million decrease in cost of
preservation services due to the estimated tissue returns resulting from the FDA
Order (the costs of such recalled tissue are included in the $10.0 million
write-down). Factors that negatively impacted cost of human tissue preservation
services were higher overhead cost allocations associated with the decreased
volume of tissues processed and changes in processing methods resulting from the
FDA Order.
The Company anticipates cost of human tissue preservation services will increase
quarter over quarter during the third and fourth quarters of 2003 as compared to
2002, but will still show a significant decrease for the full year 2003 compared
to 2002, due to the deferred preservation cost write-downs in the second and
third quarters of 2002 as discussed in Note 2 to the Summary Consolidated
Financial Statements. The cost of human tissue preservation services as a
percent of revenue will continue to be high compared to pre-FDA Order levels as
a result of lower tissue processing volumes and changes in processing methods,
which have increased the cost of processing human tissue. The cost of human
tissue preservation services may be minimally favorably affected, depending on
the future level of tissue shipments related to previously written-down deferred
preservation costs, because the write-down creates a new cost basis, which
cannot be written back up if these tissues are shipped or become available for
shipment. The shipment levels of these written-down tissues will be affected by
the amount and timing of the release of tissues processed after September 5,
2002, pursuant to the Agreement with the FDA, since written-down tissues may
30
only be shipped if tissues processed after the Agreement are not available for
shipment. Additionally, the Company believes that once the issues with the FDA
are resolved, cost of human tissue preservation as a percentage of revenues will
decrease as compared to current levels.
COST OF PRODUCTS
Cost of products aggregated $2.0 million for the three months ended June 30,
2003 compared to $1.8 million for the three months ended June 30, 2002,
representing 29% and 34%, respectively, of total product revenues as reported
during such periods. The increase in cost of products for the three months ended
June 30, 2003 is primarily due to an increase in shipments of BioGlue, partially
offset by a decrease in the costs related to bioprosthetic products. Cost of
products aggregated $3.6 million for the six months ended June 30, 2003 compared
to $4.1 million for the six months ended June 30, 2002, representing 27% and
39%, respectively, of total product revenues as reported during such periods.
The decrease in cost of products for the six months ended June 30, 2003 is
primarily due to a large decrease in the costs related to bioprosthetic products
in the first quarter of 2003 as compared to 2002 due to lower sales and
production levels for these products, partially offset by an increase in BioGlue
shipments. The decrease in cost of products as a percentage of total product
revenues as reported for the three and six months ended June 30, 2003 is
primarily due to a favorable product mix that was affected by the increase in
revenues from BioGlue Surgical Adhesive, which carries higher gross margins than
bioprosthetic devices.
GENERAL, ADMINISTRATIVE, AND MARKETING EXPENSES
General, administrative, and marketing expenses increased 106% to $23.5 million
for the three months ended June 30, 2003, compared to $11.4 million for the
three months ended June 30, 2002, representing 150% and 49%, respectively, of
total revenues during such periods. General, administrative, and marketing
expenses increased 68% to $35.1 million for the six months ended June 30, 2003,
compared to $20.9 million for the six months ended June 30, 2002, representing
111% and 43%, respectively, of total revenues during such periods. The increase
in expenditures for the three and six months ended June 30, 2003 was primarily
due to an accrual of $9.0 million for the estimated expense to resolve ongoing
product liability claims in excess of insurance coverage, $3.9 million for
estimated unreported product liability claims related to services performed and
products sold prior to June 30, 2003, and $150,000 for required insurance
retention payments for the Company's product liability insurance policies
related to prior policy years, partially offset by a $575,000 reversal of
previous retention accruals for which the Company has already fulfilled its
payment obligations. (See Legal Proceedings at Part II Item 1 for further
discussion of these items.) Additional increases in costs for the three and six
month periods ending June 30, 2003 were due to an increase of approximately $1.3
million and $3.3 million, respectively, in professional fees (legal, consulting,
and accounting) due to increased litigation, litigation settlement costs, and
issues surrounding the FDA Order, and an increase of approximately $179,000 and
$488,000, respectively, in insurance premiums.
The Company expects to continue to incur significant legal costs and
professional fees to defend and resolve the lawsuits filed against the Company
and to address FDA compliance requirements.
RESEARCH AND DEVELOPMENT EXPENSES
Research and development expenses decreased 9% to $1.1 million for the three
months ended June 30, 2003, compared to $1.2 million for the six months ended
June 30, 2002, representing 7% and 5%, respectively, of total revenues during
such periods. Research and development expenses decreased 15% to $2.0 million
for the six months ended June 30, 2003, compared to $2.3 million for the six
months ended June 30, 2002, representing 6% and 5%, respectively, of total
revenues as reported during such periods. Research and development spending in
2003 was primarily focused on the Company's core tissue cryopreservation,
SynerGraft, and Protein Hydrogel Technologies. Research and development spending
in 2002 was primarily focused on the Company's SynerGraft and Protein Hydrogel
Technologies.
OTHER COSTS AND EXPENSES
Interest expense, net of interest income, was $31,000 and $32,000 for the three
and six months ended June 30, 2003, as compared to $43,000 and $149,000,
respectively, of interest income, net of interest expense, for the three and six
months ended June 30, 2002. The decrease in net interest income for the three
and six months ended June 30, 2003 was due to reduced investments earning
31
interest in 2003 as compared to 2002, lower investment interest rates in 2003,
and additional interest payments due to the financing of 2003 insurance
premiums, partially offset by a reduction in the principal debt amount
outstanding due to scheduled principal payments. Interest expense for the six
months ended June 30, 2002 was unfavorably affected by interest from the
convertible debenture early in 2002 before its conversion into common stock in
March of 2002.
Other expense was $166,000 and $140,000 for the three and six months ended June
30, 2003 as compared to other income of $16,000 and $72,000 for the three and
six months ended June 30, 2002. The increase in other expense was primarily due
to an expense of $222,000 to reclass the unamortized portion of the other
comprehensive loss on the Company's interest rate swap to other expense/income
(discussed in the Interest Rate Swap Agreements section below).
The Company's income tax expense of $3.6 million for the three months ended June
30, 2003 was primarily due to the establishment of an additional valuation
allowance against the Company's deferred tax assets of $9.0 million, partially
offset by the current quarter income tax benefit of $5.4 million, recorded at an
effective income tax rate of 33%. The Company's income tax expense of $3.4
million for the six months ended June 30, 2003 was primarily due to the expense
related to the establishment of a valuation allowance against the Company's
deferred tax assets of $9.0 million, partially offset by an income tax benefit
of $5.6 million, recorded at an effective income tax rate of 33%. The effective
income tax rate was 34% for the three and six months ended June 30, 2002.
SEASONALITY
The demand for the Company's cardiovascular tissue preservation services is
seasonal, with peak demand generally occurring in the second and third quarters.
Management believes this trend for cardiovascular tissue preservation services
is primarily due to the high number of surgeries scheduled during the summer
months. However, the demand for the Company's human vascular and orthopaedic
tissue preservation services, BioGlue Surgical Adhesive, and bioprosthetic
cardiovascular and vascular devices does not appear to experience seasonal
trends.
LIQUIDITY AND CAPITAL RESOURCES
OVERALL TREND IN LIQUIDITY AND CAPITAL RESOURCES
The Company expects its liquidity to continue to decrease significantly over the
next twelve months due to 1) the anticipated decrease in preservation revenues
as compared to preservation revenues prior to the FDA Order as a result of
reported tissue infections, the FDA Order, and associated adverse publicity, 2)
the increase in cost of human tissue preservation services as a percent of
revenue as a result of lower tissue processing volumes and changes in processing
methods, which have increased the cost of processing human tissue and 3) an
expected use of cash due to the increased costs relating to the defense and
resolution of lawsuits (discussed in Note 13 to the Summary Consolidated
Financial Statements) and legal and professional costs relating to the ongoing
FDA compliance and the anticipated required Term Loan pay off during 2003
(discussed in Note 6 to the Summary Consolidated Financial Statements). The
Company believes that anticipated revenue generation, expense management, tax
refunds of approximately $2.4 million resulting from tax loss carrybacks,
savings resulting from the reduction in the number of employees in September
2002 necessitated by the reduction in revenues, and the Company's existing cash
and marketable securities will enable the Company to meet its liquidity needs
through at least June 30, 2004. In addition, as discussed in Note 13, the
Company has recorded $9.0 million related to the potential expense of resolving
current product liability claims in excess of insurance coverage. The $9.0
million accrual is reflective of settlement costs related to outstanding
lawsuits, and does not reflect actual settlement arrangements or judgments,
including punitive damages, which may be assessed by the courts. The $9.0
million accrual is not a cash reserve. Should expenses related to the accrual be
incurred, the expenses would have to be paid from insurance proceeds and liquid
assets, if available. The Company has called a meeting with the plaintiffs'
attorneys to determine the feasibility of obtaining a global settlement on
outstanding claims in order to substantially reduce the potential cash payout
related to these accruals and is currently evaluating all of its alternatives in
connection with resolving the dispute with its upper layer excess carrier
concerning the restrictions on the matters it has excluded from coverage. If the
Company is unsuccessful in arranging settlements of product liability claims for
an amount substantially below the amount accrued, there may not be sufficient
insurance coverage and liquid assets to meet these obligations, even if the
32
Company satisfactorily resolves the restrictions on the upper layer excess
insurance coverage. However, if the Company is unable to settle the outstanding
claims for amounts within its ability to pay and one or more of the product
liability lawsuits in which the Company is a defendant should be tried during
this period with a substantial verdict rendered in favor of the plaintiff(s),
there can be no assurance that such verdict(s) would not exceed the Company's
available insurance coverage and liquid assets. The Company's product liability
insurance policies do not include coverage for any punitive damages that may be
assessed at trial. There is a possibility that significant punitive damages
could be assessed in one or more lawsuits which would have to be paid out of the
liquid assets of the Company, if available.
In addition, as discussed in Note 13, the Company has recorded $7.5 million for
estimated costs of unreported product liability claims related to services
performed and products sold prior to June 30, 2003. The $7.5 million accrual is
not a cash reserve. The timing of the actual payment of the expense related to
the accrual is dependent on when and if claims are asserted. Should expenses
related to the accrual be incurred, the expenses would have to be paid from
insurance proceeds and liquid assets, if available. Since amounts expensed are
estimates, the actual amounts required could vary significantly.
The Company's long term liquidity and capital requirements will depend upon
numerous factors, including the Company's ability to return to the level of
demand for its tissue services that existed prior to the FDA Order, the outcome
of litigation against the Company (discussed in Note 13), the timing of and
amount required to resolve the product liability claims (discussed in Note 13),
the resolution of the dispute with its upper excess product liability insurance
carrier (discussed in Note 13), the ability to arrange and fund a global
settlement of outstanding claims for an amount substantially below the amount of
the accrual (discussed in Note 13), and the Company's ability to find suitable
funding sources to replace the Term Loan (discussed in Note 6). The Company may
require additional financing or seek to raise additional funds through bank
facilities, debt or equity offerings, or other sources of capital to meet
liquidity and capital requirements beyond June 30, 2004. Additional funds may
not be available when needed or on terms acceptable to the Company, which could
have a material adverse effect on the Company's business, financial condition,
results of operations, and cash flows. These are factors that indicate that the
Company may be unable to continue operations.
On August 4, 2003 the Company approved a buyback of employee stock options with
an exercise price of $23 or greater. The option buyback was approved for an
aggregate of up to $350,000 using a Black Scholes valuation model. The Company
anticipates making the offer to employees in third quarter of 2003.
NEITHER THE ABOVE STATEMENT NOR THIS QUARTERLY REPORT ON FORM 10-Q IS AN OFFER
TO PURCHASE, OR A SOLICITATION OF AN OFFER TO SELL, OPTIONS TO PURCHASE SHARES
OF COMMON STOCK OF CRYOLIFE, INC. SUCH AN OFFER WILL BE MADE ONLY BY AN "OFFER
TO PURCHASE OPTIONS" AND RELATED "LETTER OF TRANSMITTAL" TO BE DISSEMINATED TO
OPTIONHOLDERS AT A LATER DATE. OPTIONHOLDERS INVITED TO PARTICIPATE IN THE
BUYBACK DESCRIBED IN THE ABOVE STATEMENT SHOULD READ THESE DOCUMENTS, AS WELL AS
CRYOLIFE'S TENDER OFFER STATEMENT ON SCHEDULE TO, WHEN THEY ARE AVAILABLE
BECAUSE THEY CONTAIN IMPORTANT INFORMATION. THESE AND OTHER FILED DOCUMENTS WILL
BE AVAILABLE FOR FREE FROM THE SEC'S WEBSITE AT WWW.SEC.GOV AND CRYOLIFE. THE
OFFER WILL NOT BE MADE TO, NOR WILL TENDERS BE ACCEPTED FROM OR ON BEHALF OF,
OPTIONHOLDERS IN ANY JURISDICTION IN WHICH MAKING OR ACCEPTING THE OFFER WOULD
VIOLATE THAT JURISDICTION'S LAWS.
NET WORKING CAPITAL
At June 30, 2003 net working capital (current assets of $55.1 million less
current liabilities of $31.8 million) was $23.3 million, with a current ratio
(current assets divided by current liabilities) of 2 to 1, compared to net
working capital of $37.6 million, with a current ratio of 3 to 1 at December 31,
2002. The Company's primary capital requirements historically arose from general
working capital needs, capital expenditures for facilities and equipment, and
funding of research and development projects. The Company has historically
funded these requirements through bank credit facilities, cash generated by
operations, and equity offerings. Based on the decrease in revenues resulting
from the adverse publicity surrounding the FDA Order, FDA Warning Letter, and
reported tissue infections, and the anticipated costs to be paid by the Company
in resolving pending litigation, the Company expects that its cash used in
operating activities will continue to be high and will increase to the extent
33
funds are needed to defend and resolve litigation, and that net working capital
will significantly decrease.
NET CASH FROM OPERATING ACTIVITIES
Net cash provided by operating activities was $3.0 million and $750,000 for the
six months ended June 30, 2003 and 2002, respectively. Current year net cash
provided of $3.0 million is primarily due to the receipt of $11.4 million in
federal income tax returns through a carry back of operating losses and
write-downs of deferred preservation costs and estimated tax payments for 2002,
partially offset by the year to date net loss excluding the effect of non-cash
items. The non-cash items which favorably affect the net loss for the six months
ended June 30, 2003 include an increase in accounts payable, accrued expenses,
and current liabilities of $10.9 million, largely due to accruals of legal fees
and settlement costs expected to be paid out in future periods as discussed in
the Results of Operations section above, valuation on deferred tax assets net of
current year deferred tax benefit of $4.4 million, depreciation and amortization
of $2.8 million, write-down of deferred preservation costs of $1.4 million and
provision for doubtful accounts of $48,000. These favorable non-cash items are
partially offset by a $6.6 million increase in deferred preservation costs.
NET CASH FROM INVESTING ACTIVITIES
Net cash provided by investing activities was $4.5 million and $4.1 million in
the six months ended June 30, 2003, and June 30, 2002, respectively. The $4.5
million in current year net cash provided was primarily due to $4.7 million in
cash from sales and maturities of marketable debt securities, partially offset
by $333,000 in capital expenditures.
NET CASH FROM FINANCING ACTIVITIES
Net cash used in financing activities was $1.6 million and $1,000 in the six
months ended June 30, 2003 and 2002, respectively. The $1.6 million in current
year net cash used was primarily due to $827,000 in principal payments on short
term notes payable for the financing of insurance premiums, $800,000 in
principal payments on the Term Loan and $320,000 in payments on capital leases,
partially offset by a $325,000 increase in cash due to proceeds from the
issuance of stock in connection with the exercise of stock options and the
Company's employee stock purchase plan.
SCHEDULED CONTRACTUAL OBLIGATIONS AND FUTURE PAYMENTS
Scheduled contractual obligations and the related future payments subsequent to
June 30, 2003 are as follows (in thousands):
Remainder of
Total 2003 2004 2005 Thereafter
----------- ----------- ----------- ----------- -----------
Debt $ 4,800 $ 4,800 $ -- $ -- $ --
Note Payable 1,634 1,362 272 -- --
Capital Lease Obligations 3,215 421 843 843 1,108
Operating Leases 26,096 1,111 2,115 2,091 20,779
Purchase Commitments 635 235 400 -- --
----------- ----------- ----------- ----------- -----------
Total Contractual Obligations $ 36,380 $ 7,929 $ 3,630 $ 2,934 $ 21,887
=========== =========== =========== =========== ===========
The Company's Term Loan, of which the principal balance was $4.5 million as of
August 4, 2003, contains certain restrictive covenants including, but not
limited to, maintenance of certain financial ratios and a minimum tangible net
worth requirement, and the requirement that no materially adverse event has
occurred. The lender has notified the Company that the FDA Order, as described
in Note 2 to the Summary Consolidated Financial Statements, and the SEC's
investigation of the Company, as described in Note 13, have had a material
adverse effect on the Company that constitutes an event of default.
Additionally, as of June 30, 2003, the Company is in violation of the debt
coverage ratio and net worth financial covenants. Therefore, all amounts due
under the Term Loan as of June 30, 2003 are reflected as a current liability on
the Summary Consolidated Balance Sheets. The Company and the lender are
currently in the process of negotiating specific terms of a forbearance
agreement, which, if entered into, would increase the interest rate charged on
the Term Loan effective August 1, 2003 to LIBOR plus 4% (5.32% at June 30,
34
2003), accelerate the principal payments on the Term Loan by requiring a balloon
payment to pay off the outstanding balance by October 31, 2003, and cause the
Company to pay a $12,000 modification fee and the lender's attorneys costs,
which have yet to be determined. As of August 4, 2003 the Company has sufficient
cash and cash equivalents to pay the remaining outstanding balance of the Term
Loan. Since the lender is in the process of accelerating the payment of the
debt, the above chart shows payment of the outstanding balance of the Term Loan
during 2003.
In the quarter ended June 30, 2003 the Company entered into two agreements to
finance $2.9 million in insurance premiums associated with the yearly renewal of
certain of the Company's insurance policies. The amount financed accrues
interest at a 3.75% rate and is payable in equal monthly payments through
January 2004. As of August 4, 2003 the outstanding balance of the agreements was
$1.3 million.
Due to cross default provisions included in the Company's debt agreements, as of
June 30, 2003 the Company was in default of certain capital lease agreements
maintained with the lender of the Term Loan. Therefore, all amounts due under
these capital leases are reflected as a current liability on the Summary
Consolidated Balance Sheets as of June 30, 2003.
INTEREST RATE SWAP AGREEMENT
The Company's Term Loan, which currently accrues interest computed at Adjusted
LIBOR plus 1.5%, exposes the Company to changes in interest rates going forward.
On March 16, 2000, the Company entered into a $4 million notional amount
forward-starting interest swap agreement, which took effect on June 1, 2001 and
expires in 2006. This swap agreement was designated as a cash flow hedge to
effectively convert a portion of the Term Loan balance to a fixed rate basis,
thus reducing the impact of interest rate changes on future income. This
agreement involves the receipt of floating rate amounts in exchange for fixed
rate interest payments over the life of the agreement, without an exchange of
the underlying principal amounts. The differential to be paid or received is
recognized in the period in which it accrues as an adjustment to interest
expense on the Term Loan.
On January 1, 2001 the Company adopted SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133") as amended. SFAS 133 requires
the Company to recognize all derivative instruments on the balance sheet at fair
value, and changes in the derivative's fair value must be recognized currently
in earnings or other comprehensive income, as applicable. The adoption of SFAS
133 impacts the accounting for the Company's forward-starting interest rate swap
agreement. Upon adoption of SFAS 133, the Company recorded an unrealized loss of
approximately $175,000 related to the interest rate swap, which was recorded as
part of long-term liabilities and accumulated other comprehensive income as the
cumulative effect of adopting SFAS 133 within the Statement of Shareholders'
Equity.
In August 2002 the Company determined that changes in the derivative's fair
value could no longer be recorded in other comprehensive income, as a result of
the uncertainty of future cash payments on the Term Loan caused by the lender's
ability to declare an event of default as discussed in Note 6 to the Summary
Consolidated Financial Statements. Beginning in August 2002 the Company started
recording all changes in the fair value of the derivative currently in other
expense/income on the Summary Consolidated Statements of Operations, and
amortizing the amounts previously recorded in other comprehensive income into
other expense/income over the remaining life of the agreement.
During the quarter ended June 30, 2003 the Company became aware of the lender's
intention to accelerate the payment of the Term Loan, as discussed in Note 6.
Therefore, the Company recorded an expense of $222,000, to reclass the
unamortized portion of the other comprehensive loss to other expense/income on
the Summary Consolidated Statements of Operations. The Company and the lender
are currently in the process of negotiating the specific terms of a forbearance
agreement, which, if entered into, is expected to require the Company to pay the
lender by October 31, 2003 an amount equal to the fair value of the swap
agreement. For the three and six months ended June 30, 2003 the Company recorded
a total expense of $216,000 and $207,000, respectively, on the interest rate
swap.
As of June 30, 2003 the notional amount of this swap agreement was $2.4 million,
and the fair value of the interest rate swap agreement, as estimated by the bank
based on its internal valuation models, was a liability of $227,000. The fair
35
value of the swap agreement is recorded as part of short-term liabilities. The
unamortized value of the swap agreement, recorded in the accumulated other
comprehensive income account of shareholders' equity, was zero at June 30, 2003.
STOCK REPURCHASE
On July 23, 2002 the Company's Board of Directors authorized the purchase of up
to $10 million of its common stock. As of August 13, 2002 the Company had
repurchased 68,000 shares of its common stock for $663,000. No further purchases
are anticipated in the near term.
CAPITAL EXPENDITURES
The Company expects that its full year capital expenditures in 2003, which were
$333,000 through June 30, 2003, will be less than its expenditures in 2002,
which were approximately $4.1 million. The Company expects to have the
flexibility to increase or decrease the majority of its planned capital
expenditures depending on its ability to resume normal operating levels once it
has fully evaluated the demand for its tissues and resumed distribution of
orthopaedic tissues. The Company does not currently anticipate any major
purchase of equipment as a result of the April 2002 and February 2003 FDA
inspections.
36
FORWARD-LOOKING STATEMENTS
This Form 10-Q/A contains forward-looking statements and information made or
provided by the Company that are based on the beliefs of its management as well
as estimates and assumptions made by and information currently available to
management. The words "could," "may," "might," "will," "would," "shall,"
"should," "pro forma," "potential," "pending," "intend," "believe," "expect,"
"anticipate," "estimate," "plan," "future" and other similar expressions
generally identify forward-looking statements, including, in particular,
statements regarding anticipated revenues, cost savings, insurance coverage,
regulatory activity, available funds and capital resources, and pending
litigation. These forward-looking statements are made pursuant to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995.
Readers are cautioned not to place undue reliance on these forward-looking
statements, which are as of their respective dates.
Some of the forward-looking statements contained in this Form 10-Q/A include
those regarding:
o Expected increases in tissue processing revenues;
o The impact of recent accounting pronouncements;
o The adequacy of insurance coverage;
o The outcome of lawsuits filed against the Company;
o The impact of the FDA Order, related Agreements, reported tissue
infections, and the related adverse publicity on future revenues,
profits and business operations, future tissue procurement levels, and
the estimates underlying the related charges recorded in the second
and third quarter;
o Future costs of human tissue preservation services;
o The impact of the February 2003 FDA 483 and of the FDA letter
regarding SynerGraft processed cardiovascular and vascular tissues;
o The estimates of the amounts accrued for the retention levels under
the Company's product liability and directors' and officers' insurance
policies;
o The estimates of the amounts accrued for product liability claims;
o The amount and timing of tax refunds the Company expects to receive;
o The adequacy of current financing arrangements through June 30, 2004,
product demand, and market growth; and
o Expectations regarding an offer to repurchase certain options from
employees.
These statements are based on certain assumptions and analyses made by the
Company in light of its experience and its perception of historical trends,
current conditions, and expected future developments as well as other factors it
believes are appropriate in the circumstances. However, whether actual results
and developments will conform with the Company's expectations and predictions is
subject to a number of risks and uncertainties which could cause actual results
to differ materially from the Company's expectations, including without
limitation, in addition to those specified in the text surrounding such
statements, the risk factors set forth below, the risks set forth under "Risk
Factors" in Part I, Item 1 of the Company's Form 10-K for the year ended
December 31, 2002 and other factors, many of which are beyond the control of the
Company. Consequently, all of the forward-looking statements made in this Form
10-Q/A are qualified by these cautionary statements and there can be no
assurance that the actual results or developments anticipated by the Company
will be realized or, even if substantially realized, that they will have the
expected consequences to or effects on the Company or its business or
operations. The Company assumes no obligation to update publicly any such
forward-looking statements, whether as a result of new information, future
events, or otherwise.
37
RISKS AND UNCERTAINTIES
The risks and uncertainties which might impact the forward-looking statements
and the Company include concerns that:
o The impact of the FDA Order, the FDA Warning Letter, reported tissue
infections, and the resulting adverse publicity on CryoLife's
business, liquidity, and capital resources has been and may continue
to be material;
o The Company may not have sufficient borrowing or other capital
available to fund its business over the long-term;
o Present and future litigation is expected to be resolved only by
substantial payments by the Company in excess of available insurance
coverage;
o The outcomes of product liability, securities class action, and
derivative cases are inherently uncertain, which makes predicting
liability difficult;
o Pending litigation may not be settled on terms acceptable to the
Company;
o The Company may not have sufficient resources to pay damage awards in
lawsuits against it to the extent that they exceed or are not covered
by insurance;
o Damage awards may include punitive damages, which are not covered by
insurance;
o Due to the possibility of severe decreases in the Company's revenues
and working capital, and to the extent the Company does not have
sufficient resources to pay the existing and future claims against it,
it may be forced to cease operations or to obtain protection under
applicable bankruptcy or insolvency laws;
o The Company may not be able to obtain sufficient cardiovascular,
vascular, and orthopaedic tissue to operate profitably;
o Shipments of orthopaedic tissues are now minimal and demand may not
return;
o Physicians may be reluctant to implant the Company's preserved
tissues;
o Heart valves processed by the Company may also be recalled;
o Products not included in the FDA Order may come under increased
scrutiny;
o Demand for heart valves processed by the Company has decreased and may
decrease further in the future;
o Adverse publicity may reduce demand for products not affected by the
FDA Order;
o The Company may be unable to address the concerns raised by the FDA in
its February 2003 Form 483 Notice of Observations, or the February
2003 letter regarding the use of SynerGraft technology to process
human tissue;
o Regulatory action outside of the U.S. may also affect the Company's
business;
o The Company may not receive all or a portion of the expected income
tax refunds when expected;
o The Company is the subject of a formal SEC investigation;
o As a result of the FDA Order and resulting financial impact,
CryoLife's lender has notified it that it is in default of certain
provisions of the Company's credit facility, resulting in cross
defaults under CryoLife's leases on various equipment;
o The Company's insurance coverage is expected to be insufficient to
cover judgments under existing or future claims;
o Insurance coverage may be difficult or impossible to obtain in the
future and if obtained, the cost of insurance coverage is likely to be
much more expensive than in the past;
o Intense competition may affect the Company's ability to recover from
the FDA Order and develop its surgical adhesive business;
o Extensive government regulation may delay the Company's ability to
develop and sell products and services;
o Uncertainties regarding future health care reimbursement may affect
the amount and timing of the Company's revenues; and
o Depending upon market and other conditions, the Company may not make
an offer to repurchase employee options during the third quarter as
currently anticipated, or ever.
38
Item 4. Controls and Procedures.
The Company's management, including the Company's President and Chief Executive
Officer ("CEO") along with the Company's Vice President of Finance, Treasurer,
and Chief Financial Officer ("CFO"), does not expect that its Disclosure
Controls will prevent all error and all fraud. A control system, no matter how
well conceived and operated, can provide only reasonable, not absolute,
assurance that the objectives of the control system are met. The design of any
system of controls is based in part upon certain assumptions about the
likelihood of future events, and there can be no assurance that any design will
succeed in achieving its stated goals under all potential future conditions.
Further, the design of a control system must reflect the fact that there are
resource constraints, and the benefits of controls must be considered relative
to their costs. Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, within the Company have been detected. These
inherent limitations include the realities that judgments in decision-making can
be faulty, and that breakdown can occur because of simple error or mistake.
In October of 2003 the Company in consultation with its audit firm determined
that there were tax loss carrybacks available to the Company that had not
previously been identified that should have been accounted for in the quarter
ended June 30, 2003. This amendment to the Company's Form 10-Q corrects that
error. The Company's audit firm also provides tax return preparation, tax advice
and tax planning services.
Based upon the Company's most recent Disclosure Controls evaluation, including
an analysis of the reasons underlying the error regarding the tax refund
available to the Company in the second quarter, the CEO and CFO have concluded
that, as of June 30, 2003, the Company's Disclosure Controls were effective at
the reasonable assurance level to satisfy their objectives and to ensure the
information required to be disclosed by the Company in its periodic reports is
accumulated and communicated to management, including the CEO and CFO, as
appropriate to allow timely decisions regarding disclosure and is recorded,
processed, summarized and reported within the time periods specified in the
United States Securities and Exchange Commission's rules and forms. The CEO and
CFO have determined that no changes in the Company's Disclosure Controls or
internal control over financial reporting were required as a result of the error
regarding the tax refund available to the Company in the second quarter.
During the quarter ended June 30, 2003, there were no changes in the Company's
internal control over financial reporting that materially affected or that are
reasonably likely to materially affect the Company's internal control over
financial reporting.
Part II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K.
(a) The exhibit index can be found below.
Exhibit
Number Description
- ------ -----------
3.1 Restated Certificate of Incorporation of the Company, as amended.
(Incorporated by reference to Exhibit 3.1 to Form 10-Q for the quarter
ended March 31, 2003.)
3.2 ByLaws of the Company, as amended. (Incorporated by reference to
Exhibit 3.2 to Form 10-Q for the quarter ended March 31, 2003.)
3.3 Articles of Amendment to the Certificate of Incorporation of the
Company. (Incorporated by reference to Exhibit 3.3 to the Registrant's
Annual Report on Form 10-K for the fiscal year ended December 31,
2000.)
4.1 Form of Certificate for the Company's Common Stock. (Incorporated by
reference to Exhibit 4.1 to the Registrant's Registration Statement on
Form S-1 (No. 33-56388).
39
12.1* Letter Agreement between the Company and FDA, dated June 13, 2003.
31.1** Certification by Steven G. Anderson pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.
31.2** Certification by D. Ashley Lee pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.
32** Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
(b) Current Reports on Form 8-K.
The Registrant filed a Current Report on Form 8-K with the
Commission on May 1, 2003 with respect to the Press Release dated
May 1, 2003 announcing the registrant's results of operations for
the first quarter 2003.
The Registrant filed a Current Report on Form 8-K with the
Commission on April 3, 2003 with respect to the Press Release
regarding the settlement of the Lykins lawsuit.
- -----------------
* Previously filed.
** Filed herewith.
40
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CRYOLIFE, INC.
(Registrant)
/s/ STEVEN G. ANDERSON /s/ DAVID ASHLEY LEE
- ------------------------------------ -----------------------------------
STEVEN G. ANDERSON DAVID ASHLEY LEE
Chairman, President, and Vice President, Treasurer, and
Chief Executive Officer Chief Financial Officer
(Principal Executive Officer) (Principal Financial and
Accounting Officer)
November 13, 2003
- ------------------------
DATE
41
EXHIBIT 31.1
CERTIFICATIONS
I, Steven G. Anderson, Chairman, President, and Chief Executive Officer, certify
that:
1. I have reviewed this quarterly report on Form 10-Q/A of CryoLife, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as
of, and for, the periods presented in this report.
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:
a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our supervision, to
ensure that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this report is being
prepared;
c) Evaluated the effectiveness of the registrant's disclosure controls and
procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the end of
the period covered by this report based on such evaluation; and
d) Disclosed in this report any change in the registrant's internal control
over financial reporting that occurred during the registrant's most recent
fiscal quarter (the registrant's fourth fiscal quarter in the case of an
annual report) that has materially affected, or is reasonably likely to
materially affect, the registrant's internal control over financial
reporting; and
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation of internal control over financial reporting, to the
registrant's auditors and the audit committee of registrant's board of directors
(or persons performing the equivalent function):
a) All significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are reasonably
likely to adversely affect the registrant's ability to record, process,
summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls
over financial reporting.
Date: November 13, 2003
/s/STEVEN G. ANDERSON
----------------------------------
Chairman, President, and Chief
Executive Officer
EXHIBIT 31.2
CERTIFICATIONS
I, David Ashley Lee, Vice President, Treasurer, and Chief Financial Officer,
certify that:
1. I have reviewed this quarterly report on Form 10-Q/A of CryoLife, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as
of, and for, the periods presented in this report.
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:
a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our supervision, to
ensure that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this report is being
prepared;
c) Evaluated the effectiveness of the registrant's disclosure controls and
procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the end of
the period covered by this report based on such evaluation; and
d) Disclosed in this report any change in the registrant's internal control
over financial reporting that occurred during the registrant's most recent
fiscal quarter (the registrant's fourth fiscal quarter in the case of an
annual report) that has materially affected, or is reasonably likely to
materially affect, the registrant's internal control over financial
reporting; and
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation of internal control over financial reporting, to the
registrant's auditors and the audit committee of registrant's board of directors
(or persons performing the equivalent function):
a) All significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are reasonably
likely to adversely affect the registrant's ability to record, process,
summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls
over financial reporting.
Date: November 13, 2003
/s/DAVID ASHLEY LEE
------------------------------------
Vice President, Treasurer, and Chief
Financial Officer
EXHIBIT 32
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of CryoLife Inc. (the "Company") on Form
10-Q/A for the quarter ending June 30, 2003, as filed with the Securities and
Exchange Commission on the date hereof (the "Report"), each of Steven G.
Anderson, the Chairman, President, and Chief Executive Officer of the Company,
and David Ashley Lee, the Vice President, Treasurer, and Chief Financial Officer
of the Company, hereby certifies, pursuant to and for purposes of 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, that, to his knowledge:
(1) The Report fully complies with the requirements of Section 13(a) or
15(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations of the
Company.
/s/ STEVEN G. ANDERSON /s/ DAVID ASHLEY LEE
- ---------------------------------- ----------------------------------
STEVEN G. ANDERSON DAVID ASHLEY LEE
Chairman, President, and Vice President, Treasurer, and
Chief Executive Officer Chief Financial Officer
November 13, 2003 November 13, 2003
