e10vq
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006
OR
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TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
FOR THE TRANSITION PERIOD FROM TO .
COMMISSION FILE NUMBER: 001-15063
Endocare, Inc.
(Exact name of Registrant as Specified in Its Charter)
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DELAWARE
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33-0618093 |
(State of Incorporation)
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(I.R.S. Employer I.D. No.) |
201 TECHNOLOGY DRIVE, IRVINE, CALIFORNIA 92618
(Address of Principal Executive Office, Including Zip Code)
(949) 450-5400
(Registrants Telephone Number, Including Area Code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the Registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. (1) Yes þ No o; (2) Yes
þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated
filer, or a non-accelerated filer. See definitions of accelerated filer and large accelerated
filer in Rule 12b-2 of the Exchange Act. (Check one):
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Large Accelerated Filer o
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Accelerated Filer þ
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Non-Accelerated Filer o |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of
the Exchange Act). Yes o No þ
The number of shares of the Registrants common stock, par value $.001 per share, outstanding
at June 30, 2006 was 30,174,977.
PART I FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
ENDOCARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
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Three Months Ended |
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Six Months Ended |
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June 30, |
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June 30, |
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2006 |
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2005 |
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2006 |
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2005 |
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(In thousands, except per share data) |
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Total revenues |
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$ |
6,908 |
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$ |
6,919 |
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$ |
14,170 |
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$ |
13,786 |
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Costs and expenses: |
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Costs of revenues |
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3,256 |
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3,924 |
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7,021 |
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8,110 |
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Research and development |
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475 |
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687 |
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1,486 |
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1,110 |
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Selling and marketing |
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3,904 |
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3,332 |
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7,673 |
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6,538 |
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General and administrative |
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2,072 |
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3,146 |
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6,067 |
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6,789 |
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Impairment charge |
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26 |
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Total costs and expenses |
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9,707 |
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11,089 |
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22,247 |
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22,573 |
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Loss from operations |
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(2,799 |
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(4,170 |
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(8,077 |
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(8,787 |
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Interest expense, net |
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2,091 |
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(352 |
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2,045 |
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(954 |
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Loss from continuing operations before taxes |
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(708 |
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(4,522 |
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(6,032 |
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(9,741 |
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Tax benefit on continuing operations |
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151 |
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Loss from continuing operations |
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(708 |
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(4,522 |
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(5,881 |
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(9,741 |
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Income from discontinued operations |
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326 |
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245 |
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1,038 |
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Net loss |
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$ |
(708 |
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$ |
(4,196 |
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$ |
(5,636 |
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$ |
(8,703 |
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Income (loss) per share basic and diluted: |
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Continuing operations |
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$ |
(0.02 |
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$ |
(0.15 |
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$ |
(0.20 |
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$ |
(0.35 |
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Discontinued operations |
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0.01 |
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0.01 |
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0.04 |
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Net loss |
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(0.02 |
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(0.14 |
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(0.19 |
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(0.31 |
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Weighted average shares of common stock outstanding |
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30,166 |
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30,044 |
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30,155 |
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27,835 |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
3
ENDOCARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
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June 30, |
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December 31, |
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2006 |
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2005 |
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(Unaudited) |
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(In thousands, |
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except per share data) |
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ASSETS
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Current assets: |
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Cash and cash equivalents |
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$ |
7,994 |
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$ |
8,108 |
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Accounts receivable, net |
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3,241 |
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3,549 |
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Inventories, net |
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2,199 |
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2,462 |
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Prepaid expenses and other current assets |
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1,015 |
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1,213 |
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Assets of discontinued operations |
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9,624 |
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Total current assets |
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14,449 |
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24,956 |
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Property and equipment, net |
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1,325 |
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1,794 |
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Intangibles, net |
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3,890 |
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4,167 |
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Investments and other assets |
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2,401 |
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1,320 |
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Total assets |
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$ |
22,065 |
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$ |
32,237 |
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LIABILITIES AND STOCKHOLDERS EQUITY
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Current liabilities: |
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Accounts payable |
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$ |
2,678 |
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$ |
2,680 |
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Accrued compensation |
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1,722 |
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3,614 |
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Other accrued liabilities |
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5,083 |
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6,629 |
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Liabilities of discontinued operations |
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1,461 |
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Total current liabilities |
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9,483 |
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14,384 |
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Common stock warrants |
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3,327 |
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5,023 |
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Total liabilities |
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12,810 |
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19,407 |
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Stockholders equity: |
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Preferred stock, $0.001 par value; 1,000
shares authorized; none issued and
outstanding |
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Common stock, $0.001 par value; 50,000
shares authorized; 30,175 and 30,089
issued and outstanding as of June 30,
2006 and December 31, 2005, respectively. |
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30 |
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30 |
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Additional paid-in capital |
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180,538 |
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178,477 |
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Accumulated deficit |
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(171,313 |
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(165,677 |
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Total stockholders equity |
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9,255 |
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12,830 |
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Total liabilities and stockholders equity |
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$ |
22,065 |
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$ |
32,237 |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
4
ENDOCARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
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Six Months Ended |
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June 30, |
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2006 |
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2005 |
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(Unaudited) |
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(In thousands) |
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Cash flows from operating activities: |
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Net loss |
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$ |
(5,636 |
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$ |
(8,703 |
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Adjustments to reconcile net loss to net cash used in operating activities: |
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Gain on divestiture |
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(418 |
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Depreciation and amortization |
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857 |
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1,804 |
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Loss on disposals of fixed assets |
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376 |
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12 |
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Stock compensation expense |
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1,858 |
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45 |
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Costs related to assets held for sale |
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(583 |
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Minority interests |
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(214 |
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Interest expense related to common stock warrants |
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(1,696 |
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1,105 |
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Changes in operating assets and liabilities: |
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Accounts receivable |
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540 |
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(21 |
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Inventories |
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(71 |
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(834 |
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Prepaid expenses and other current assets |
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531 |
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(234 |
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Accounts payable |
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(279 |
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(8 |
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Accrued compensation |
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(1,914 |
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(925 |
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Other accrued liabilities |
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(1,561 |
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(2,090 |
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Net cash used in operating activities |
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(7,413 |
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(10,646 |
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Cash flows from investing activities: |
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Purchases of property and equipment |
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(86 |
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(162 |
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Proceeds from divestitures |
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7,277 |
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850 |
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Net cash provided by investing activities |
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7,191 |
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688 |
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Cash flows from financing activities: |
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Borrowings under the credit facility |
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250 |
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Repayments under the credit facility |
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(250 |
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Stock options and warrants exercised |
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108 |
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108 |
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Proceeds from sale of common stock, net of issuance costs |
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14,585 |
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Net cash provided by financing activities |
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108 |
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14,693 |
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Net increase (decrease) in cash and cash equivalents |
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(114 |
) |
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4,735 |
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Cash and cash equivalents, beginning of period |
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8,108 |
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7,985 |
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Cash and cash equivalents, end of period |
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$ |
7,994 |
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$ |
12,720 |
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Non-cash activities: |
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Transfer of inventory to property and equipment |
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$ |
361 |
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$ |
254 |
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Note receivable received in divestiture |
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$ |
1,425 |
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$ |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
5
ENDOCARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Tabular numbers in thousands, except per share data)
(Unaudited)
1. Organization and Operations
We are a medical device company focused on developing, manufacturing and selling cryoablation
products which have the potential to assist physicians in improving and extending life by use in
the treatment of cancer and other tumors. We were formed in 1990 as a research and development
division of Medstone International, Inc. (Medstone), a manufacturer of shockwave lithotripsy
equipment for the treatment of kidney stones. Following our incorporation under the laws of the
state of Delaware in 1994, we became an independent, publicly-owned corporation upon Medstones
distribution of our stock to the existing stockholders on January 1, 1996.
Through February 10, 2006, we also offered vacuum therapy systems for non-pharmaceutical
treatment of erectile dysfunction through our wholly-owned subsidiary Timm Medical Techologies,
Inc. (Timm Medical), which was sold to a third party effective February 10, 2006 (see Note 4
Sale of Timm Medical). The operating results of Timm Medical through the date of sale are
included in discontinued operations.
2. Basis of Presentation
Following the rules and regulations of the Securities and Exchange Commission (the SEC), we
have omitted footnote disclosures in this report that would substantially duplicate the disclosures
contained in our annual audited financial statements. The accompanying condensed consolidated
financial statements should be read together with the consolidated financial statements and the
notes thereto included in our Annual Report on Form 10-K, filed with the SEC on March 16, 2006.
The accompanying condensed consolidated financial statements reflect all adjustments,
consisting solely of normal recurring accruals, needed to present fairly the financial results for
these interim periods. The condensed consolidated results of operations presented for the interim
periods are not necessarily indicative of the results for a full year. All intercompany
transactions and accounts have been eliminated in consolidation.
3. Recent Operating Results and Liquidity
Since inception, we have incurred losses from operations and have reported negative cash
flows. As of June 30, 2006, we had an accumulated deficit of $171.3 million and cash and cash
equivalents of $8.0 million. We expect to continue to generate losses from operations for the
foreseeable future though such losses are expected to decline.
As more fully discussed below in Note 9 Commitment and Contingencies, even though we
recently resolved the investigations of our historical accounting and financial reporting through
our settlements in July 2006 with the SEC and U.S. Department of Justice (DOJ), we still have
obligations to indemnify and advance the legal fees for our former officers and former directors in
connection with the ongoing investigations related to those individuals. The amount of those legal
fees may exceed the reimbursement due to us from our directors and officers liability insurance,
and the excess may have a material adverse effect on our results of operations and our liquidity.
For the year ended December 31, 2005 and the six months ended June 30, 2006, we incurred $1.1
million and $0.3 million (net of insurance reimbursement), respectively, in legal expenses, related
to these matters. We also face large cash expenditures in the future related to past due state and
local sales and use tax obligations, for which we estimated and accrued $2.9 million as of June 30,
2006. We currently are in negotiations with various states to resolve past due taxes. However,
there is no assurance that these obligations will be reduced as a result of the negotiations or
that we will be allowed to pay the amounts due over an extended period of time.
We have continued to experience year over year growth in cryosurgical disposable products and
procedure fee revenues. We have significantly reduced our operating expenses through streamlining
our corporate organization, elimination or deferral of some longer-term research and development
and clinical and marketing activities,
6
reconfiguration of our products to reduce manufacturing costs, transferring manufacturing to
lower cost suppliers and, in general, better controlling operating expenses.
For the remainder of the year we will use existing cash reserves, which includes the net
proceeds from our March 2005 private placement and the sale of Timm Medical described below, to
finance our projected operating and cash flow needs, along with continued expense management
efforts. In addition, we may borrow funds under our line of credit with our bank as long as we
remain in compliance with the representations, warranties, covenants and borrowing conditions set
forth in the agreements governing the line of credit. This line of credit permits us to borrow up
to the lesser of $4.0 million or amounts available under the Borrowing Base. The Borrowing Base
is (i) 80 percent of our eligible accounts receivable, plus (ii) the lesser of 30 percent of the
value of our eligible inventory or $500,000. We had no outstanding amounts under the line of credit
as of June 30, 2006.
On April 24, 2006, we entered into an amendment to the line of credit agreement, which
extended the term of the original agreement from October 2006 to February 2007. Additionally, a
financial covenant based on our tangible net worth was modified to reflect our sale of Timm
Medical, and the bank agreed to make available one or more term loans in an aggregate principal
amount of up to $500,000 (which counts toward the $4.0 million maximum referred to above) for up to
six months after the date of the amendment.
We expect that we will need to raise additional capital prior to March 31, 2007 to fund our
ongoing operations. Any additional capital may not be available on terms acceptable to us, or at
all. Additional equity financing may cause our existing stockholders to experience dilution and
negatively affect our stock price. Additional debt financing, if available, may involve
significant fees, interest expense, restrictive covenants and the granting of security interests in
our assets. Raising capital through a licensing or other transaction involving our intellectual
property could require us to relinquish valuable intellectual property rights and thereby sacrifice
long term value for short term liquidity.
If we fail to adequately address our liquidity concerns, then our independent auditors may
issue a qualified opinion, to the effect that there is substantial doubt about our ability to
continue as a going concern. A qualified opinion could itself have a material adverse effect on our
business, financial condition, results of operations and cash flows.
4. Sale of Timm Medical
We acquired Timm Medical in February 2002. During 2003, we divested certain non-core product
lines of Timm Medical. In July 2004, we began actively marketing Timm Medical to potential buyers
as part of an overall plan to raise additional capital. We reported Timm Medical as an asset held
for sale effective July 31, 2004 and recorded an impairment charge totaling $5.9 million to reduce
the carrying value of Timm Medical to fair value, less costs to sell. Following the completion of
our $15.6 million private placement in March 2005 (see Note 5 Private Placement of Common Stock
and Warrants), we reclassified Timm Medical as held and used in the first quarter of 2005 as we
were no longer seeking a buyer and had ceased all marketing efforts. As a result of this change in
plan, included in net income from discontinued operations for the six months ended June 30, 2005 is
$0.4 million in depreciation and amortization expense for fixed assets and intangibles for the
period from July 31, 2004 to March 31, 2005 and $0.6 million income as a result of the elimination
of the estimated costs to sell, which was previously recorded as a component of the impairment
charge in 2004.
In late 2005, we received substantive expression of interest from Plethora Solutions Holdings
plc (Plethora), a company listed on the London Stock Exchange, to acquire Timm Medical and the
parties entered into a Stock Purchase Agreement on January 13, 2006. The transaction closed on
February 10, 2006. We will not receive significant direct cash flows from Timm Medical or have
significant continuing involvement in its operations after the sale. In accordance with Statement
of Financial Accounting Standard (SFAS) No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, the assets and liabilities of Timm Medical were classified as discontinued
operations in the condensed consolidated financial statements for each period presented. The assets
and liabilities of Timm Medical as of December 31, 2005 have been classified as current. Sale
proceeds (net of $0.6 million in transaction costs) totaled $8.9 million and resulted in a gain on
sale of $418,000 in the first quarter of 2006. Gross proceeds of $9.5 million include cash of $8.1
million and a two-year, five percent promissory note secured by the assets of Timm Medical. The
note is convertible into Plethoras ordinary shares at any time at our option. If Plethoras shares
trade above a specified price for 20 consecutive days, Plethora has the option to require
conversion. Net cash proceeds from divestiture were $7.2 million (after $0.6 million in transaction
costs and $0.3 million in cash of Timm Medical as of the date of disposition).
7
We agreed to retain certain assets and liabilities of Timm Medical, including all tax
liabilities ($1.1 million), obligations and rights to a $2.7 million note receivable from the sale
of Timm Medicals urinary incontinence product line in 2003, certain litigation to which Timm
Medical is a party and ownership of Urohealth BV (Timm Medicals wholly-owned subsidiary with
insignificant operations). Assets and liabilities we retained and their related revenues and
expenses are excluded from discontinued operations. The stock purchase agreement requires an
indemnification escrow of $1.4 million (proceeds from the note receivable under certain
circumstances in conjunction with the notes payment terms) to indemnify Plethora against certain
claims and liabilities.
Assets and liabilities of discontinued operations as of December 31, 2005 include the
following:
|
|
|
|
|
Assets: |
|
|
|
|
Cash, inventories and other current assets |
|
$ |
1,216 |
|
Property and equipment, net |
|
|
75 |
|
Goodwill, net |
|
|
4,552 |
|
Intangibles, net |
|
|
3,716 |
|
Other assets |
|
|
65 |
|
|
|
|
|
Total assets |
|
$ |
9,624 |
|
|
|
|
|
|
|
|
|
|
Liabilities: |
|
|
|
|
Accounts payable and other current liabilities |
|
$ |
942 |
|
Other accrued liabilities |
|
|
519 |
|
|
|
|
|
Total liabilities |
|
|
1,461 |
|
|
|
|
|
|
|
|
|
|
Net assets |
|
$ |
8,163 |
|
|
|
|
|
Revenues for Timm Medical were $1.0 million (for the period from January 1, 2006 through date
of sale, February 10, 2006) and $2.2 million and $4.5 million for the three months and six months
ended June 30, 2005, respectively. Income from discontinued operations for the six months ended
June 30, 2006 includes a $0.4 million gain on disposal and is net of $0.2 million in taxes.
5. Private Placement of Common Stock and Warrants
On March 11, 2005, we completed a private placement of 5,635,378 shares of our common stock
and detachable warrants to purchase 3,944,748 common shares at an offering price of $2.77 per
share, for aggregate gross proceeds of $15.6 million. Transaction costs were $1.0 million,
resulting in net proceeds of $14.6 million. Of the total warrants, 1,972,374 have an initial
exercise price of $3.50 (Series A warrants) per share and 1,972,374 have an initial exercise price
of $4.00 (Series B warrants) per share. The warrants expire on March 11, 2010 unless exercised
before then. Two members of our management team made personal investments totaling $0.7 million in
the aggregate, and a member of our board of directors invested $0.3 million.
The warrants initially are exercisable at any time during their term for cash only. The
warrants may be exercised on a cashless exercise basis in limited circumstances after the first
anniversary of the closing date if there is not an effective registration statement covering the
resale of the shares underlying the warrants. Each warrant is callable by us at a price of $0.01
per share underlying such warrant if our stock trades above certain dollar thresholds ($6.50 for
the Series A warrants and $7.50 for Series B warrants) for 20 consecutive days commencing on any
date after the effectiveness of the registration statement, provided that (a) we provide 30-day
advanced written notice (Notice Period), (b) we simultaneously call all warrants on the same terms
and (c) all common shares issuable are registered. Holders may exercise their warrants during the
Notice Period and warrants which remain unexercised will be redeemed at $0.01 per share.
Upon exercise, we will pay transaction fees equal to six percent of the warrant proceeds under
an existing capital advisory agreement.
Pursuant to the terms of the registration rights agreement, we filed with the SEC a
registration statement on Form S-2 under the Securities Act of 1933, as amended, covering the
resale of all of the common stock purchased and the common stock underlying the issued warrants.
The S-2 registration statement was declared effective September 28, 2005. We subsequently filed a
post-effective amendment on Form S-3, which was declared effective March 28, 2006.
8
The registration rights agreement provides that if a registration statement is not filed
within 30 days of closing or does not become effective within 90 days thereafter, then in addition
to any other rights the holders may have, we will be required to pay each holder an amount in cash,
as liquidated damages, equal to one percent of the aggregate purchase price paid by such holder per
month. We incurred liquidated damages through September 28, 2005, when the S-2 registration
statement was declared effective. In the second and third quarters of 2005, we incurred an
aggregate of $0.6 million of total liquidated damages, which were included in general and
administrative expenses in the respective periods.
Under the registration rights agreement, we could incur similar liquidated damages in the
future (equal to one percent of the aggregate purchase price paid by each affected holder per
month) if holders are unable to make sales under the registration statement (for example, if we
fail to keep the registration statement current as required by SEC rules or if future amendments to
the registration statement are not declared effective in a timely manner).
Since the liquidated damages under the registration rights agreement could in some cases
exceed a reasonable discount for delivering unregistered shares, we have classified the warrants as
a liability until the earlier of the date the warrants are exercised or expire. In accordance with
EITF 00-19, Accounting for Derivative Financial Instruments Indexed To, and Potentially Settled In,
a Companys Own Stock, we have allocated a portion of the offering proceeds to the warrants based
on their fair value. EITF 00-19 also requires that we revalue the warrants as a derivative
instrument periodically to compute the value in connection with changes in the underlying stock
price and other assumptions, with the change in value recorded as interest expense. We determined
the fair value of the warrants as follows as of June 30, 2006:
|
|
|
First, we used the Black-Scholes option-pricing model with the following assumptions:
an expected life equal to the remaining contractual term of the warrants (3.75 years); no
dividends; a risk free rate of 5.13 percent, which equals the yield on Treasury bonds at
constant (or fixed) maturity equal to the remaining contractual term of the warrants; and
volatility of 60.97 percent. Under these assumptions, the Black-Scholes option-pricing
model yielded a value of $1.01 for each of the Series A warrants and $0.92 for each of the
Series B warrants, for an aggregate value of $3.8 million; |
|
|
|
|
Second, since the warrants are limited in the amount of realizable profit to the
holders as a result of the call provision described above, we reduced the value of the
warrants to account for the probability that the stock price will reach or exceed $6.50 and
$7.50, respectively (i.e., the prices above which we have the right to call the Series A
and Series B warrants, effectively compelling the holders to exercise their warrants). We
used a statistical formula to calculate the probability that our stock price will reach or
exceed $6.50 and $7.50, respectively. Based on this formula, we calculated that, for the
Series A warrants, the probability that the stock price of $6.50 will be reached or
exceeded is approximately 8.77 percent. Similarly, we calculated that, for the Series B
warrants, the probability that the stock price of $7.50 will be reached or exceeded is
approximately 4.51 percent. Based on these probabilities, we reduced the valuation of each
of the Series A warrants to $0.92 (which equals one minus 8.77 percent, multiplied by
$1.01) and we reduced the valuation of each of the Series B warrants to $0.88 (which equals
one minus 4.51 percent, multiplied by $0.92). This yields an aggregate value of the
warrants equal to $3.5 million; and |
|
|
|
|
Third, we further reduced the value of the warrants on the assumption that our stock
price on the day that the warrants are exercised will be affected by dilution as a result
of the additional stock introduced into the market. Given that we have approximately 30.2
million shares outstanding, we calculated that the exercise of the warrants will result in
dilution of approximately 6.2 percent. Using the dilution figure of 6.2 percent, we reduced
the value of each of the Series A warrants to $0.86 and the Series B warrants to $0.82.
This yields an aggregate value of the warrants equal to $3.3 million. As a result of this
fair value calculation, we recorded a reduction to net interest expense of $1.9 million and
$1.7 million, respectively, for the three and six months ended June 30, 2006 (compared to
net expense $0.5 million and $1.1 million, respectively, for the three and six months ended
June 30, 2005), which represents the change in the fair value of the warrants from March
31, 2006 and December 31, 2005, respectively. |
|
|
|
|
The $1.9 million reduction in the fair value of the warrants during the second quarter of
2006 from $5.2 million at March 31, 2006 to $3.3 million at June 30, 2006 is primarily the
result of decrease in the our share price from $3.44 at March 31, 2006 to $2.50 at June 30,
2006 and decrease in the overall volatility of our common shares. The $1.7 million
reduction to net interest expense for the six months ended June 30, 2006 |
9
|
|
|
includes a $0.8 million ($0.03 per basic and diluted share) reduction in the fair value of
the warrants as calculated at December 31, 2005 due to changes in the methodology we used to
measure volatility in conjunction with the adoption of SFAS No. 123R, Share Based Payment as
further discussed in Note 7 Stock-Based Compensation below. This reduction is a change in
estimate and is recorded in 2006 first quarter operations. |
Upon the earlier of the warrant exercise or expiration date, the warrant liability will be
reclassified into stockholders equity. Until that time, the warrant liability will be recorded at
fair value based on the methodology described above. We do not expect that the warrants will be
exercised within the next 12 months based on the current trading prices of our common stock and
have classified the warrants as a non-current liability at June 30, 2006. Changes in fair value
during each period will be recorded as interest expense.
6. Capital Stock and Net Loss Per Share
Basic net loss per share is computed by dividing net loss by the weighted average number of
common shares outstanding for the respective periods. Diluted loss per share, calculated using the
treasury stock method, gives effect to the potential dilution that could occur upon the exercise of
certain stock options and warrants that were outstanding during the respective periods presented.
For periods when we reported a net loss, these potentially dilutive common shares were excluded
from the diluted loss per share calculation because they were anti-dilutive.
7. Stock-Based Compensation
As of June 30, 2006, we have five stock-based employee compensation plans and one non-employee
director stock-based compensation plan. Prior to January 1, 2006, we accounted for stock-based
compensation for those plans under the recognition and measurement provisions of Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) as permitted
by SFAS No. 123, Accounting for Stock Based Compensation. Compensation expense recorded under APB
25 has not been significant since we generally grant options with an exercise price equal to the
fair value of our common stock on the date of grant.
On May 18, 2006 we adopted the Employee Deferred Stock Unit Program and the Non-employee
Director Deferred Stock Unit Program. Under the terms of the employee program, certain eligible
employees have the option to elect to receive all or a portion of their annual bonus (at a minimum
of 25%) in deferred stock units in lieu of cash. In addition each participating employee will also
receive an additional premium in stock at a percentage determined by the Compensation Committee.
That percentage premium for 2006 is 20 percent. Irrevocable deferral elections are made during a
designated period no later than June 30 of each year. The units vest upon the determination of the
bonus achieved and the number of stock units earned in the first quarter of the following fiscal
year. The stock price to determine the number of shares to be issued is the fair market value of
the stock on the date of grant. In 2006, the date of grant was June 23, 2006, on which date the
closing stock price was $2.70. Compensation expense related to the bonus program is recorded
prorata during the performance year based on the estimated incentives achieved, whether payable in
cash or in stock units. The portion of bonus payable in stock units is recorded as additional
paid-in-capital. Incentives estimates are periodically adjusted based on current expectations
regarding the levels of achievement.
Under the directors plan, members of the board of directors can choose to have all or a
portion of their directors fees paid in fully vested deferred stock units (at a minimum of 25%)
commencing July 1, 2006. Additionally, directors may choose to have up to 50 percent of their
deferred stock units paid in cash at the date of issuance. Annual deferral elections are made in
December for the following year. Deferred stock units are granted each quarter based on the
director fees earned in the prior quarter and the fair market value of the stock on the date of
grant. Directors fees, whether payable in cash or in stock units, are expensed when incurred.
Common shares underlying the vested stock units in the employee and director plans are issued
at the earlier of the payout date specified by the participant (which is at least 2 years from the
date of grant), a change in control event as defined, or the month following the participants
death.
Effective January 1, 2006, we adopted SFAS No. 123 (revised 2004), Share Based Payment (SFAS
No. 123R) using the modified transition prospective method. Among other items, SFAS No. 123R
eliminates the use of the
10
intrinsic value method of accounting under APB 25 and requires companies to recognize in the
financial statements the cost of employee services received in exchange for awards of equity
instruments based on the grant date fair value of those awards. Under the modified prospective
method, we recognize compensation cost in the financial statements beginning with the effective
date based on the requirements of SFAS No. 123R for all share-based payments granted, modified or
settled after January 1, 2006, and based on the requirements of SFAS No. 123 for all unvested
awards granted prior to the effective date.
We will continue to use the Black-Scholes standard option pricing model and the single option
award approach to measure the fair value of the stock options granted to employees. In conjunction
with the adoption of SFAS No. 123R, we modified certain assumptions and estimation methodologies
for inputs to the Black-Scholes valuation calculations in accordance with the requirements of SFAS
No. 123R and Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment. These changes primarily
include the following:
|
a. |
|
We increased the expected term from five years to 6.25 years using the shortcut
method under SAB 107 (an expected term based on the mid point between the vesting date
and the end of the contractual term). The use of the short cut method is permitted
through December 31, 2007. We will convert to company-specific experience on or before
January 1, 2008. The options have a maximum contractual term of 10 years and vest
pro-rata over four years, which is the requisite service period. |
|
|
b. |
|
While we continue to use historical volatility (based on daily trading prices) to
estimate the fair value of options granted, we have increased the period over which
volatility is measured from three years to 6.25 years. We have excluded the period from
October 24, 2002 to January 16, 2003 (inclusive) during which our common stock
experienced unusually high volatility as a result of announcement of our failure to file
the September 30, 2002 Form 10-Q, temporary suspension of trading, delisting of our
shares from NASDAQ, and an investigation commenced by the SEC. |
|
|
c. |
|
These changes resulted in a net decrease in volatility from previous estimates.
Average volatility for options granted in 2005 and during the six months ended June 30,
2006 was approximately 89.6 percent and 70.6 percent, respectively. We did not
incorporate implied volatility since there are no actively traded option contracts on our
common stock and sufficient data for an accurate measure of implied volatility was not
available. |
|
|
d. |
|
Prior to January 1, 2006, we accounted for forfeitures as they occurred.
Compensation expense related to unvested forfeited options was reversed in the period the
employee was terminated. Upon adoption of SFAS No. 123R, we have estimated an average
forfeiture rate of approximately 25.0 percent based on historical experience during 2001
through June 30, 2006. Stock-based compensation expense recorded in the 2006 periods is
net of expected forfeitures. We will periodically assess the forfeiture rate. Changes in
estimates will be recorded in the period of adjustment. |
We have no unamortized deferred compensation relating to outstanding option grants since we
generally award stock options to our employees with exercise prices equal to the fair value of the
underlying common stock on the date of grant. Due to our continuing losses, we do not recognize
deferred tax assets related to our stock-based compensation and we have not recorded benefits for
tax deductions in excess of recognized compensation costs (required to be recorded as financing
cash flows) due to the uncertainty of when we will generate taxable income to realize such
benefits.
As a result of adopting SFAS No. 123R, our loss from continuing operations and net loss for
the three and six months ended June 30, 2006 was $0.8 million ($0.03 per basic and diluted share)
and $1.7 million ($0.06 per basic and diluted share) greater, respectively, than if we had
continued to account for stock-based compensation under APB 25 and its related interpretations. Of
the $0.8 million recorded during the three months ended June 30, 2006, $40,000 was expensed as cost
of goods sold, $40,000 was included in research and development expenses, $0.2 million in selling
and marketing expenses and $0.5 million in general and administration expenses. Of the $1.7 million
recorded during the six months ended June 30, 2006, $40,000 was expensed as cost of goods sold,
$80,000 was included in research and development expenses, $0.4 million in selling and marketing
expenses and $1.2 million in general and administrative expenses. As of June 30, 2006, there was
$5.6 million of total unrecognized compensation costs related to unvested stock-based compensation
arrangements granted under the stock option
11
plans. That cost is expected to be amortized on a straight-line basis over a weighted average
period of 1.3 years less any stock options forfeited prior to vesting. During the three months and
six months ended June 30, 2006 and 2005 stock compensation cost capitalized as inventory was
insignificant.
Prior to January 1, 2006, we accounted for stock-based employee compensation plans in
accordance with APB 25 and followed the pro forma disclosure requirements set forth in SFAS No.
123. The following table illustrates the effect on net loss and loss per share for the three and
six months ended June 30, 2005 as if we had applied the fair value recognition provisions of SFAS
No. 123 to stock-based employee compensation. The amounts in the table below include stock-based
compensation expense related to Timm Medical which was not significant (dollars in thousands,
except per share amounts):
|
|
|
|
|
|
|
|
|
|
|
Three Months |
|
|
Six Months |
|
|
|
Ended |
|
|
Ended |
|
|
|
June 30,2005 |
|
|
June 30,2005 |
|
Net loss, as reported |
|
$ |
(4,196 |
) |
|
$ |
(8,703 |
) |
Add: Stock-based employee
compensation expense included in
reported net loss for all awards |
|
|
|
|
|
|
|
|
Less: Total stock-based employee
compensation expense determined
under fair value based method for
all awards |
|
|
(919 |
) |
|
|
(1,820 |
) |
|
|
|
|
|
|
|
Net loss, as adjusted |
|
$ |
(5,115 |
) |
|
$ |
(10,523 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic and diluted loss per share: |
|
|
|
|
|
|
|
|
As reported |
|
$ |
(0.14 |
) |
|
$ |
(0.31 |
) |
As adjusted |
|
$ |
(0.17 |
) |
|
$ |
(0.38 |
) |
Weighted average expected volatility for stock options granted prior to December 31, 2005 was
based on daily trading prices from April 2003 and expected term of five years. The average
volatility for options granted during the six months ended June 30, 2006 and 2005 was 70.6 percent
and 89.6 percent, respectively. The risk free interest rate reflected the yield on zero coupon U.S.
treasuries at the date of grant, based on the median time the options granted are expected to be
outstanding. The risk free interest rate during the six months ended June 30, 2006 and 2005 was an
average of 4.46 percent and 3.71 percent, respectively. No expected dividend yield is used because
we have not historically paid dividends and do not intend to pay dividends in the foreseeable
future.
The weighted average fair value for stock options granted during the six months ended June 30,
2006 and June 30, 2005 was $2.19 and $2.27 respectively.
The following is a summary of the stock option activity for the six months ended June 30,
2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Remaining |
|
|
Aggregate |
|
|
|
Number of |
|
|
Weighted |
|
|
Contractual |
|
|
Intrinsic |
|
|
|
Options |
|
|
Average |
|
|
Term |
|
|
Value |
|
|
|
(in thousands) |
|
|
Exercise Price |
|
|
(in years) |
|
|
(in thousands) |
|
Options
outstanding at
December 31, 2005 |
|
|
6,006 |
|
|
|
4.27 |
|
|
|
|
|
|
|
|
|
Granted |
|
|
612 |
|
|
|
3.25 |
|
|
|
|
|
|
|
|
|
Exercised |
|
|
(66 |
) |
|
|
0.79 |
|
|
|
|
|
|
|
|
|
Canceled |
|
|
(121 |
) |
|
|
4.09 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options outstanding
at March 31, 2006 |
|
|
6,431 |
|
|
$ |
4.21 |
|
|
|
|
|
|
|
|
|
Granted |
|
|
66 |
|
|
|
3.31 |
|
|
|
|
|
|
|
|
|
Exercised |
|
|
(20 |
) |
|
|
2.81 |
|
|
|
|
|
|
|
|
|
Canceled |
|
|
(176 |
) |
|
|
4.38 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options outstanding
at June 30, 2006 |
|
|
6,301 |
|
|
$ |
4.20 |
|
|
|
7.50 |
|
|
$ |
360 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options
exercisable at June
30, 2006 |
|
|
3,544 |
|
|
$ |
4.95 |
|
|
|
6.65 |
|
|
$ |
264 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
12
The following table summarizes information regarding options outstanding and options
exercisable at June 30, 2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Number |
|
Remaining |
|
Weighted |
|
Number |
|
Weighted |
|
|
|
|
|
|
|
|
|
|
Outstanding As |
|
Contractual |
|
Average |
|
Exercisable As of |
|
Average |
Range of Exercise Prices |
|
|
of June 30, 2006 |
|
Life (Years) |
|
Exercise Price |
|
June 30, 2006 |
|
Exercise Price |
$2.03 |
|
|
|
|
|
$ |
2.15 |
|
|
|
347,865 |
|
|
|
6.95 |
|
|
$ |
2.13 |
|
|
|
198,908 |
|
|
$ |
2.11 |
|
$2.25 |
|
|
|
|
|
$ |
2.25 |
|
|
|
875,000 |
|
|
|
6.67 |
|
|
$ |
2.25 |
|
|
|
695,313 |
|
|
$ |
2.25 |
|
$2.36 |
|
|
|
|
|
$ |
2.80 |
|
|
|
959,583 |
|
|
|
8.39 |
|
|
$ |
2.72 |
|
|
|
346,960 |
|
|
$ |
2.64 |
|
$2.83 |
|
|
|
|
|
$ |
3.26 |
|
|
|
644,503 |
|
|
|
8.57 |
|
|
$ |
3.04 |
|
|
|
175,871 |
|
|
$ |
3.06 |
|
$3.27 |
|
|
|
|
|
$ |
3.45 |
|
|
|
774,500 |
|
|
|
9.31 |
|
|
$ |
3.35 |
|
|
|
82,760 |
|
|
$ |
3.43 |
|
$3.69 |
|
|
|
|
|
$ |
4.20 |
|
|
|
455,250 |
|
|
|
7.59 |
|
|
$ |
4.07 |
|
|
|
277,417 |
|
|
$ |
4.08 |
|
$4.27 |
|
|
|
|
|
$ |
4.27 |
|
|
|
1,000,000 |
|
|
|
7.46 |
|
|
$ |
4.27 |
|
|
|
562,500 |
|
|
$ |
4.27 |
|
$4.50 |
|
|
|
|
|
$ |
5.13 |
|
|
|
688,459 |
|
|
|
6.43 |
|
|
$ |
4.75 |
|
|
|
648,459 |
|
|
$ |
4.75 |
|
$6.19 |
|
|
|
|
|
$ |
18.84 |
|
|
|
555,300 |
|
|
|
5.21 |
|
|
$ |
12.97 |
|
|
|
554,728 |
|
|
$ |
12.97 |
|
$21.23 |
|
|
|
|
|
$ |
21.23 |
|
|
|
1,000 |
|
|
|
5.35 |
|
|
$ |
21.23 |
|
|
|
1,000 |
|
|
$ |
21.23 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$2.03 |
|
|
|
|
|
$ |
21.23 |
|
|
|
6,301,460 |
|
|
|
7.50 |
|
|
$ |
4.20 |
|
|
|
3,543,916 |
|
|
$ |
4.95 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The aggregate intrinsic value is calculated as the difference between the exercise price of
the underlying awards and the quoted price of our common stock for those awards that have an
exercise price currently below the quoted price. During the three months ended June 30, 2006 and
June 30, 2005, the aggregate intrinsic value of options exercised under the stock option plans was
$4,000 and $20,000 respectively. The aggregate intrinsic value of options exercised under the
stock option plans for the six months ended June 30, 2006 and 2005 was $0.1 million and $0.2
million, respectively.
Cash received from option exercises under all stock-based payment arrangements for the
quarters ended June 30, 2006 and 2005 was $50,000 and $90,000 respectively. Cash received from
option exercises for the six months ended June 30, 2006 and 2005 was $0.1 million for each
respective period.
8. Inventories
Inventories, consisting of raw materials, work-in-process and finished goods, are stated at
the lower of cost or market, with cost determined by the first-in, first-out method. Reserves for
slow-moving and obsolete inventories are provided based on historical experience and product
demand. We evaluate the adequacy of these reserves periodically.
The following is a summary of inventories (excluding assets of discontinued operations):
|
|
|
|
|
|
|
|
|
|
|
June 30 |
|
|
December 31, |
|
|
|
2006 |
|
|
2005 |
|
Raw materials |
|
$ |
1,601 |
|
|
$ |
1,646 |
|
Work in process |
|
|
231 |
|
|
|
275 |
|
Finished goods |
|
|
853 |
|
|
|
911 |
|
|
|
|
|
|
|
|
Total inventories |
|
|
2,685 |
|
|
|
2,832 |
|
Less inventory reserve |
|
|
(486 |
) |
|
|
(370 |
) |
|
|
|
|
|
|
|
Inventories, net |
|
$ |
2,199 |
|
|
$ |
2,462 |
|
|
|
|
|
|
|
|
9. Commitments and Contingencies
Litigation and Regulatory Investigations
As discussed in Note 3, we have been in settlement discussions with the staff of the SEC and
the DOJ regarding the terms of a settlement of the previously announced investigations commenced in
January 2003 related to
13
allegations that we and certain of our former officers and directors and
one current employee issued, or caused to be issued, false and misleading financial statements in
prior periods. We reached a settlement concerning Endocare with the SEC and DOJ in July 2006.
Under the terms of the settlement with the SEC (i) we paid a total of $750,000 in civil penalties
and disgorgement; and (ii) we agreed to a stipulated judgment enjoining future violations of
securities laws.
On April 7, 2006, we entered into an escrow agreement with Morrison & Foerster LLP, our
outside counsel, pursuant to which we agreed to place the $750,000 in escrow with Morrison &
Foerster LLP at the request of the SEC staff. As a matter of practice, the SEC generally requires
that, when an offer of settlement includes payment of disgorgement or civil penalties, the funds be
placed in escrow prior to the determination by the SEC to accept or reject the offer of settlement.
The funds were released from escrow to the SEC in August, 2006. A liability for the monetary
penalty was accrued in prior years.
The investigations conducted by the SEC and the DOJ relative to certain former officers and
directors of the Company are ongoing, and are not affected by the Companys settlements with the
SEC and the DOJ. We have obligations to indemnify and advance the legal fees for the former
officers and directors who remain under investigation. Our directors and officers liability and
other insurance may fund certain losses, including defense costs, related to these matters.
Recoveries will be recorded when the amounts are determined to be recoverable from the insurance
carriers.
On May 15, 2006, we entered into a Mediation and Tolling Agreement with our former independent
auditors, KPMG LLP (the Mediation Agreement). Pursuant to the Mediation Agreement, we agreed to
engage in mediation with KPMG with respect to our claims against KPMG relating to KPMGs audits of
our financial statements for the fiscal years ending December 31, 2000 and December 31, 2001 and
KPMGs quarterly reviews of our unaudited financial statements for the first three quarters of 2000
and 2001 and for the first two quarters of 2002. The Mediation Agreement provides that the
mediation will be conducted before a third-party neutral mediator no later than October 15, 2006.
The Mediation Agreement continues in effect for 30 days after the close of the mediation. The
Mediation Agreement provides that, during the time that the Mediation Agreement is in effect, we
will refrain from commencing any action or suit against KPMG relating to or arising out of its
prior audits and reviews.
In January 2006, we entered into a settlement and release agreement with certain parties
against whom we had a claim from a judgment awarded to us in prior years. We received $162,500 in
the settlement of this claim, which was recorded as a reduction of general and administrative
expenses in the first quarter of 2006.
In addition, in the normal course of business, we are subject to various other legal matters,
which we believe will not individually or collectively have a material adverse effect on our
consolidated financial condition, results of operations or cash flows. However, the results of
litigation and claims cannot be predicted with certainty, and we cannot provide assurance that the
outcome of various legal matters will not have a material adverse effect on our consolidated
financial condition, results of operations or cash flows. As of June 30, 2006, we have not
established a liability for contingencies in the consolidated balance sheets since the likelihood
of loss and potential liability cannot be reliably estimated at this time. However, our evaluation
of the likelihood of an unfavorable outcome with respect to these actions could change in the
future.
From time to time, we have received correspondence alleging infringement of proprietary rights
of third parties. No assurance can be given that any relevant claims of third parties would not be
upheld as valid and enforceable, and therefore we could be prevented from practicing the subject
matter claimed or would be required to obtain licenses from the owners of any such proprietary
rights to avoid infringement. We do not expect any material adverse effect on our consolidated
financial condition, results of operations or cash flows because of such claims.
Other
We have tax obligations pertaining to employee loans forgiven and stock option exercises that
occurred in 2002 and prior. During the three months ended June 30, 2006, we reduced the tax
liabilities by $0.9 million (or $0.03 per basic or diluted share) to reflect tax liabilities which
were no longer statutorily due.
14
10. Income Taxes
We reported no net income tax expense from continuing and discontinued operations for each of
the three months ended June 30, 2006 and 2005 due to our operating losses. The 2006 tax benefit on
continuing operations of $151,000 is the result of the 2006 first quarter pre-tax book losses being
utilized against pre-tax book income from discontinued operations. There is an offsetting tax
provision within discontinued operations. The operating losses resulted in an increase in the
valuation allowance of $2.1 million and $3.0 million during the six months ended June 30, 2006 and
2005, respectively. Due to our history of operating losses, management has determined that it is
more likely than not that our deferred tax assets will not be realized through future earnings.
Accordingly, valuation allowances were recorded to fully reserve the deferred tax assets as of June
30, 2006 and December 31, 2005.
11. Results of Operations
Revenues and cost of revenues from continuing operations related to the following products and
services for the periods ended June 30, 2006 and 2005 are as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Six Months Ended |
|
|
|
June 30, |
|
|
June 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cryocare Surgical Systems |
|
$ |
225 |
|
|
$ |
120 |
|
|
$ |
445 |
|
|
$ |
263 |
|
Cryoablation disposable products and procedure fees |
|
|
6,532 |
|
|
|
6,557 |
|
|
|
13,406 |
|
|
|
13,046 |
|
Cardiac royalties (CryoCath) and other revenues |
|
|
151 |
|
|
|
242 |
|
|
|
319 |
|
|
|
477 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
6,908 |
|
|
$ |
6,919 |
|
|
$ |
14,170 |
|
|
$ |
13,786 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost of Revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cryocare Surgical Systems |
|
$ |
228 |
|
|
$ |
158 |
|
|
$ |
597 |
|
|
$ |
315 |
|
Cryoablation disposable products and procedure fees |
|
|
3,028 |
|
|
|
3,766 |
|
|
|
6,424 |
|
|
|
7,795 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
3,256 |
|
|
$ |
3,924 |
|
|
$ |
7,021 |
|
|
$ |
8,110 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues from the sales of cryoablation disposable products and cryoablation procedure fees
are comprised of the following for the periods ended June 30, 2006 and 2005:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Six Months Ended |
|
|
|
June 30, |
|
|
June 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Disposable products |
|
$ |
3,397 |
|
|
$ |
1,689 |
|
|
$ |
5,808 |
|
|
$ |
2,809 |
|
Procedure fees |
|
|
3,135 |
|
|
|
4,868 |
|
|
|
7,598 |
|
|
|
10,237 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
6,532 |
|
|
$ |
6,557 |
|
|
$ |
13,406 |
|
|
$ |
13,046 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost of revenues for cryoablation disposable product sales and procedure fees are combined for
reporting purposes. Sales of cryoablation disposable products and procedure fees both incorporate
similar inventory when sold and we do not separately track the cost of disposals sold directly to
customers and those consumed in cryoablation procedures. Cryoablation procedure services are
provided to medical facilities upon request to facilitate the overall delivery of our technology
into the marketplace.
12. Recent Accounting Pronouncements
In May 2005, the Financial Accounting Standards Board (FASB) issued Statement No. 154 (SFAS
No. 154), Accounting Changes and Error Corrections, which replaced APB Opinion No. 20, Accounting
Changes, and SFAS No. 3, Reporting Changes in Interim Financial Statements. SFAS No. 154 requires
retrospective application to prior periods financial statements of voluntary changes in accounting
principles and changes required by a new accounting standard when the standard does not include
specific transition provisions. Previous guidance required most voluntary changes in accounting
principle to be recognized by including the cumulative effect of changing to the new accounting
principle in net income of the period in which the change was made. SFAS No. 154 carries forward
existing guidance regarding the reporting of the correction of an error and a change in accounting
estimate. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal
years beginning after December 15, 2005. We adopted SFAS No. 154 as of January 1, 2006. The
adoption did not have a material effect on our consolidated financial position or results of
operations.
15
Other recent accounting pronouncements issued by the FASB (including its Emerging Issues
Task Force), the American Institute of Certified Public Accountants, and the SEC did not, or are
not believed by management to, have a material impact on our present or future consolidated
financial statements.
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the unaudited
condensed consolidated financial statements and notes thereto included in Part I Item 1 of this
report, and the audited consolidated financial statements and notes thereto, and Managements
Discussion and Analysis of Financial Condition and Results of Operations contained in the Annual
Report on Form 10-K for the fiscal year ended December 31, 2005.
This discussion contains forward-looking statements based on our current expectations. There
are various factors many beyond our control that could cause our actual results or the
occurrence or timing of expected events to differ materially from those anticipated in these
forward-looking statements. Some of these factors are described below and other factors are
described elsewhere in this Quarterly Report on Form 10-Q or under Risk Factors in our Annual
Report on Form 10-K referred to above. In addition, there are factors not described in this
Quarterly Report on Form 10-Q or in our Annual Report on Form 10-K that could cause our actual
results or the occurrence or timing of expected events to differ materially from those anticipated
in these forward-looking statements. All forward-looking statements included in this Quarterly
Report on Form 10-Q are based on information available to us as of the date hereof, and we assume
no obligation to update any such forward-looking statements.
Overview
We are an innovative medical device company focused on the development of minimally invasive
technologies for tissue and tumor ablation through cryoablation, which is the use of lethal ice to
destroy tissue, such as tumors, for therapeutic purposes. We develop and manufacture devices for
the treatment of prostate and renal cancers and we believe that our proprietary technologies have
broad applications across a number of markets, including the ablation of tumors in the lung and
liver and pain resulting from bone metastases.
Today, our FDA-cleared Cryocare Surgical System occupies a growing position in the urological
market for treatment of prostate and renal cancers. Because of our initial concentration on
prostate and renal cancers, the majority of our sales and marketing resources are directed toward
the promotion of our technology to urologists. In addition to selling our cryosurgical disposable
products to hospitals and mobile service companies, we contract directly with hospitals for the use
of our Cryocare Surgical System and disposable products on a fee-for-service basis. Since 2003, we
maintain a dedicated sales team focused on selling percutaneous cryoablation procedures related to
liver, kidney and lung cancer and pain resulting from bone metastases to interventional radiology
physicians throughout the United States. We intend to continue to identify and develop new markets
for our cryosurgical products and technologies, particularly in the area of tumor ablation.
We previously owned Timm Medical Technologies, Inc. (Timm Medical), a company focused on
erectile dysfunction products. We sold Timm Medical to United Kingdom-based Plethora Solutions
Holdings plc effective on February 10, 2006.
Strategy, Key Metrics and Developments
Our primary objective is to grow market share, currently measured in terms of the number of
procedures performed with our Cryocare Surgical System, which we calculate using two primary
components. The first component is that we include the actual number of cryoablation cases for
which we are responsible for performing the service element on behalf of the healthcare facility.
In the second, we compute a procedure case equivalent based on sales of our cryoablation disposable
products by using the expected disposable product usage for those sales. Procedure growth has been
an important metric to which we have referred during the past several years in order to measure the
success of our strategy.
In addition to being a key business metric, procedure growth has been an important driver of
revenue growth, because a significant percentage of our revenues consists of sales of the
disposable products used in procedures performed with the Cryocare Surgical System, as shown below
under Results of Operations. In 2003 we
16
redirected our strategy for our cryoablation business away from emphasizing sales of Cryocare
Surgical Systems and instead toward seeking to increase sales of cryoablation disposable products.
We have focused on measuring our success by referring to procedure growth because of the
disparity in per-procedure revenue between cases for which we are responsible for providing the
service element and cases for which we merely sell disposable products. This disparity results
from the fact that the revenue from a case for which we merely sell disposable products is less
than the revenue from a case for which we are responsible for providing the service element
(referred to as procedure fees below). As the percentage of cases for which we merely sell
disposable products increases relative to cases for which we are responsible for providing the
service element, our incremental revenues grow at a slower rate than our overall procedure growth.
However, the gross profit realized is generally equivalent since we do not incur fees to third
party service providers for cases for which we merely sell disposable products. In contrast, in
cases for which we are responsible for providing the service element, we typically subcontract with
a third party service provider to provide the service element on our behalf and thereby incur
service fees. As a result, our gross margin (gross profit as a percent of revenues) increases as we
shift from procedure fees to sale of disposable products.
In the past several years, we have been successful in increasing the number of procedures on a
year-over-year basis. Most recently, in 2005 total procedures increased 35.9 percent to 6,407 from
4,713 in 2004. During the three months ended June 30, 2006, total procedures increased 19.6
percent to 1,938 from 1,620 in the quarter ended June 30, 2005. Year to date in 2006 our procedures
have increased 18.9 percent to 3,699 from 3,112 in the same period last year.
The factors driving interest in and utilization of cryoablation by urologists include
increased awareness and acceptance of cryoablation by physicians and industry thought leaders,
continued publication of clinical follow up data on the effectiveness of cryoablation, including
10-year data presented in 2005, increased awareness among patients of cryoablation and its
preferred outcomes as compared to other modalities, the efforts of our dedicated cryoablation sales
force and our continued expenditure of funds on patient education and advocacy.
Historically, we were responsible for performing the service element of the procedure on
behalf of the healthcare facility for the majority of our reported procedures. In 2004, we decided
to change our business model to emphasize our strength as a medical device manufacturer and
strategically reduce the amount of revenue attributable to a service model, with the goal of
eventually having the substantial majority of our procedures comprised of the sale of cryoablation
disposable products instead of performing the service element of the procedure. In 2005, we
succeeded in causing the percentage of procedures for which we perform the service element to
decline from 72.4 percent of total reported procedures for the three months ended March 31, 2005,
to 59.3 percent of total reported procedures for the three months ended December 31, 2005.
During the six months ended June 30, 2006, we experienced a faster than anticipated shift from
procedure fees to sales of cryoablation disposable products. For the three months ended June 30,
2006, the percent of total procedures for which we are responsible for the service element of the
procedure decreased to 33.5 percent.
Results of Operations
Revenues and costs of revenues from continuing operations related to the following products
and services for the three and six months ended June 30, 2006 and 2005 are as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Six Months Ended |
|
|
|
June 30, |
|
|
June 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cryocare Surgical Systems |
|
$ |
225 |
|
|
$ |
120 |
|
|
$ |
445 |
|
|
$ |
263 |
|
Cryoablation disposable products and procedure fees |
|
|
6,532 |
|
|
|
6,557 |
|
|
|
13,406 |
|
|
|
13,046 |
|
Cardiac royalties (CryoCath) and other revenues |
|
|
151 |
|
|
|
242 |
|
|
|
319 |
|
|
|
477 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
6,908 |
|
|
$ |
6,919 |
|
|
$ |
14,170 |
|
|
$ |
13,786 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Costs of Revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cryocare Surgical Systems |
|
$ |
228 |
|
|
$ |
158 |
|
|
$ |
597 |
|
|
$ |
315 |
|
Cryoablation disposable products and procedure fees |
|
|
3,028 |
|
|
|
3,766 |
|
|
|
6,424 |
|
|
|
7,795 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
3,256 |
|
|
$ |
3,924 |
|
|
$ |
7,021 |
|
|
$ |
8,110 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
17
Revenues from the sales of cryoablation disposable products and cryoablation procedure fees
are comprised of the following for the periods ended June 30, 2006 and 2005:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Six Months Ended |
|
|
|
June 30, |
|
|
June 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Disposable products |
|
$ |
3,397 |
|
|
$ |
1,689 |
|
|
$ |
5,808 |
|
|
$ |
2,809 |
|
Procedure fees |
|
|
3,135 |
|
|
|
4,868 |
|
|
|
7,598 |
|
|
|
10,237 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
6,532 |
|
|
$ |
6,557 |
|
|
$ |
13,406 |
|
|
$ |
13,046 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Costs of revenues for cryoablation disposable products and procedure fees are combined for
reporting purposes. Sales of cryoablation disposable products and procedure fees incorporate
similar inventory when sold and we do not separately track the cost of disposable products sold
directly to customers and those consumed in cryoablation procedures. Procedure fees relate to
services which are provided to medical facilities upon request to facilitate the overall delivery
of our technology into the marketplace.
We recognize revenues from sales of Cryocare Surgical Systems and disposable cryoprobes when
persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed and
determinable, and collectibility is reasonably assured. We also contract with medical facilities
for the use of the Cryocare Surgical Systems in cryoablation treatments for which we charge a
per-procedure fee. Cryoablation services generally consist of rental and transport of a Cryocare
Surgical System as well as the services of a technician to assist the physician with the setup and
monitoring of the equipment.
Costs of revenues consist of fixed and variable costs incurred in the manufacture of our
products in addition to depreciation of Cryocare Surgical Systems placed in the field with
customers under our placement program or with our sales and service personnel. We incur an
additional cost of revenues in the form of a fee for equipment usage and other services when a
procedure is performed on a system owned by an unrelated service provider. The fee paid to the
third-party service provider is charged to costs of revenues when the procedure is performed and
billed.
Research and development expenses include expenses associated with the design and development
of new products as well as enhancements to existing products. We expense research and development
costs when incurred. Our research and development efforts are occasionally subject to significant
non-recurring expenses and fees that can cause some variability in our quarterly research and
development expenses.
Selling and marketing expenses primarily consist of salaries, commissions and related benefits
and overhead costs for employees and activities in the areas of selling, marketing and customer
service. Expenses associated with advertising, trade shows, promotional and training costs related
to marketing our products are also classified as selling and marketing expenses.
General and administrative expenses primarily consist of salaries and related benefits and
overhead costs for employees and activities in the areas of legal affairs, finance, information
technology, human resources and administration. Fees for attorneys, independent auditors and
certain other outside consultants are also included where their services are related to general and
administrative activities. This category also includes reserves for bad debt, and litigation losses
less amounts recoverable under our insurance policies. Litigation reserves and insurance recoveries
are recorded when such amounts are probable and can be reasonably estimated.
Effective January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123
(revised 2004), Share Based Payment (SFAS No. 123R) using the modified-prospective transition
method. Under that transition method, compensation cost recognized in the six months ended June 30,
2006 includes (a) compensation cost for all share-based payments granted prior to, but not yet
vested as of January 1, 2006 based on the grant-date fair value estimated in accordance with the
original provisions of SFAS 123 and (b) compensation cost for all share-based payments granted
subsequent to January 1, 2006, based on the grant-date fair value estimate in accordance with the
provisions of SFAS 123R. Results for prior periods have not been restated. As a result of
adopting SFAS No. 123R, our net loss for the three and six months ended June 30, 2006 was $0.8
million and $1.7 million,
18
respectively, greater than if we had continued to account for stock-based compensation under Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and its related
interpretations. As of June 30, 2006, there was $5.6 million of total unrecognized compensation
costs related to unvested stock-based compensation arrangements granted under the stock option
plans. That cost is expected to be amortized on a straight-line basis over a weighted average
period of 1.3 years less any stock options forfeited prior to vesting.
Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005
Revenues. Revenues for the each of the three months ended June 30, 2006 and June 30, 2005
were $6.9 million. Although our total procedures increased 19.6 percent over the same period last
year, our rapid shift in revenue mix has caused a decrease in our average selling price per case
and case equivalents. Generally, we earn less revenue per case for sales of cryoablation disposable
products than for procedure fees; however the related gross margin as a percent of revenues for
sales of cryoablation disposable products is greater.
The total number of cryoablation procedures performed increased 19.6 percent to 1,938 in the
second quarter of 2006 from 1,620 in the comparable period of 2005, while the related revenues
decreased 0.4 percent to $6.5 million in the second quarter of 2006 from $6.6 million for the
comparable period in 2005. Of the total procedures performed during the three months ended June 30,
2006, 33.5 percent were those in which we provided cryoablation services and 66.5 percent were from
the sale of cryoablation disposable products. This compares to 60.4 percent of cryoablation
procedures and 39.6 percent for sales of disposable cryoablation products during the three months
ended June 30, 2005. Contributing to growth in sales of cryoablation products was an increase in
sales to a market served by interventional radiologists, treating tumors in the kidney, lung and
liver and pain resulting from metastases of cancer in the bone. Direct sales of disposable products
and interventional radiology procedures generally have a lower average selling price than
procedures performed by urologists on prostate and renal cancer, although costs of revenues are
also lower. Therefore, as the percentage of cases derived from sale of cryosurgical disposable
products increases relative to cases derived from cryoablation procedure fees (where we are
responsible for providing the service element of the procedure), our incremental revenues grow at a
slower rate than our overall procedure growth and our gross margin as a percent of revenues
increases. However, gross profit realized is generally equivalent since we do not incur fees to
third party service providers for sale of cryoablation disposable products.
Cardiac royalty revenues decreased 39.8 percent or $92,000 in the second quarter of 2006 over
the same period in 2005. The contractual rate of royalties CryoCath is obligated to pay us as a
percentage of related revenues decreased from 9% in 2005 to 5% in 2006. Revenues from Cryocare
Surgical Systems increased 87.5 percent or $0.1 million during the three months ended June 30, 2006
compared to the same period in 2005.
Cost of Revenues. Costs of revenues for the three months ended June 30, 2006 decreased 17.0
percent to $3.3 million compared to $3.9 million for the same period in 2005. The decrease in cost
of revenues resulted from decreases in materials, labor, and overhead per cryoablation case, as
well as decreases in the average service fee paid to third party service providers per procedure.
Costs of revenues related to our cryoablation disposable products and procedure fees decreased 19.6
percent to $3.0 million for the second quarter of 2006 from $3.8 million for the same period in
2005. During the three months ended June 30, 2006 and 2005, substantially all of our cryoablation
procedures for which we were responsible for the service element were performed by third party
service providers at an additional cost to us.
Gross Margins. Gross margins on revenues increased to 52.9 percent for the three months ended
June 30, 2006 compared to 43.3 percent for the same period in 2005. The positive trend in gross
margins was primarily related to our shift from procedures where we bear responsibility for the
service element of the procedure to those where we solely sell our cryoablation disposable
products. Sale of cryoablation disposable products yields a higher gross margin as a percent of
revenues than procedures performed by third parties subcontractors. Additional factors include
continued reductions in manufacturing costs for our cryoablation disposable products as well as a
decline in the average fee we paid to third parties to provide cryoablation procedures on our
behalf. The decrease in gross margins for the three months ended June 30, 2006 was partially offset
by several transactions for which we allowed certain customers to upgrade our Cryocare CS system
from a previous generation of our Cryocare Surgical System without additional payment, resulting in
negative gross profit. In total during the three months ended June 30, 2006, we recorded $0.2
million of revenues from sales of Cryocare Surgical Systems and $0.2 million of related cost of
goods sold.
19
Research and Development Expenses. Research and development expenses for the three months
ended June 30, 2006 decreased to $0.5 million compared to $0.7 million during the three months
ended June 30, 2005. As a percentage of revenues, research and development expenses decreased to
6.9 percent for the three months ended June 30, 2006 from 9.9 percent during the comparable period
in 2005. During the period, clinical development studies decreased by $0.2 million as a result of
more milestone payments being incurred in the 2005 period Included in research and development
expenses for the second quarter of 2006 is $40,000 in non-cash stock-based compensation expense.
Selling and Marketing Expenses. Selling and marketing expenses for the three months ended June
30, 2006 increased 17.2 percent to $3.9 million as compared to $3.3 million for the same period in
2005. The increase partly resulted from non-cash stock-based compensation expenses relating to the
implementation of SFAS No. 123R in the amount of $0.2 million, as well as a personnel-related
increase in compensation and related expenses in our sales organization. Physician training expense
also increased by $0.2 million, which is consistent with our objective of increasing the
utilization of cryoablation systems and our cryoablation disposable products by urologists for
prostate and renal cancers.
General and Administrative Expenses. General and administrative expenses for the three months
ended June 30, 2006 decreased 34.1 percent to $2.1 million as compared to $3.1 million for the same
period in 2005. This decrease is primarily due to a $1.0 million reduction in legal fees related to
the SEC and DOJ investigations, accounting and consulting costs related to Sarbanes-Oxley
compliance and other audit and tax compliance. The decrease was also due to a $0.7 million
reduction in accrued payroll taxes pertaining to employee loans forgiven and stock option exercises
that occurred in 2002 and prior, which was no longer statutorily due. Partially offsetting these
reductions was $0.5 million in non-cash stock-based compensation expense.
Interest Expense, Net. Interest expense, net, for the three months ended June 30, 2006 was a
negative expense of ($2.1) million compared to $0.4 million of expense for the same period in 2005.
Interest expense, net for the three months ended June 30, 2006 and 2005 includes a reduction of
interest expense of ($1.9) million and expense of $0.5 million, respectively, which represents the
change in the fair value of common stock warrants issued in connection with our private placement
in March 2005. This represents the (decrease) increase in the fair value of the warrants during the
respective quarters. Interest expense, net in the 2006 and 2005 periods also includes interest
income on a note receivable for the 2003 sale of our urinary incontinence product line and interest
income earned from the investment of our cash balances.
Loss from Continuing Operations. Loss from continuing operations for the three months ended
June 30, 2006 was $0.7 million or $0.02 per basic and diluted share on 30.2 million weighted
average shares outstanding compared to a net loss of $4.5 million or $0.15 per basic and diluted
share on 30.0 million weighted shares outstanding for the same period in 2005. Included in the
second quarter 2006 loss is an aggregate of $0.8 million of non-cash stock-based compensation
expense in accordance with SFAS No. 123R, $0.9 million reduction in payroll tax liabilities which
were no longer statutorily due and the reduction in interest expense of $1.9 million from the
change in the fair value of common stock warrants.
Income from Discontinued Operations. There was no income from discontinued operations for the
three months ended June 30, 2006 due to the fact that our disposition of Timm Medical was completed
during the three months ended March 31, 2006. Income from discontinued operations for the three
months ended June 30, 2005 was $0.3 million or $0.01 per basic and diluted share on 30.0 million
weighted average shares outstanding.
Net Loss. Net loss for the three months ended June 30, 2006 was $0.7 million or $0.02 per
basic and diluted share on 30.2 million weighted average shares outstanding, compared to a net loss
of $4.2 million, or $0.14 per basic and diluted share on 30.0 million weighted average shares
outstanding during the same period in 2005.
Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005
Revenues. Revenues for the six months ended June 30, 2006 increased 2.8 percent to $14.2
million compared to $13.8 million in 2005. The primary reasons for the revenue increase includes
the number of cryoablation procedures performed during the six months ended June 30, 2006 compared
to the same period in 2005, offset by the rapid shift in mix from procedures for which we are
responsible for providing the service element to those for which we solely
20
sell our cryoablation disposable products. Total procedures increased 18.9 percent to 3,699
for the six months ended June 30, 2006 from 3,112 in the comparable period of 2005, while the
related revenues increased at 2.8 percent to $13.4 million from $13.0 million for the comparable
period in 2005. Of the total procedures performed during the six months ended June 30, 2006, 41.4
percent were those for which we provided cryoablation services and 58.6 percent were from the sale
of cryoablation disposable products. This compares to 66.2 percent for cryoablation procedures and
33.8 percent for sales of cryoablation disposable products during the six months ended June 30,
2005. Cardiac royalty revenue decreased 32.7 percent due to the reduction in the contractual
royalty percentage due from CryoCath from 9% in 2005 to 5% in 2006. Revenue from the sale of
Cryocare Surgical Systems increased 69.2 percent to $0.4 million.
Costs of Revenues. Costs of revenues for the six months ended June 30, 2006 decreased 13.4
percent to $7.0 million compared to $8.1 million for the same period in 2005. Costs of revenues
related to cryoablation revenues decreased 17.6 percent to $6.4 million for 2006 from $7.8 million,
for the same period in the 2005. The decrease was driven mainly by the rapid shift in revenue mix
resulting in a decrease in the number of cryoablation procedures for which we bear responsibility
for providing the service element as opposed to solely selling our cryoablation disposable
products, as well as a continued decrease in the average amount per procedure we pay to the third
party service providers and decreased costs for materials, labor and overhead per cryoablation
case. During the six months ended June 30, 2006 and 2005, substantially all of our cryoablation
procedures for which we were responsible for the service element were performed by third party
service providers at an additional cost to us.
Gross Margins. Gross margins on revenues increased to 50.4 percent for the six months ended
June 30, 2006 compared to 41.2 percent for the same period in 2005. The positive trend in our gross
margins relates primarily to the shift in our business model to a much larger percentage of total
procedures for which we solely sell our cryoablation disposable products as opposed to bearing
responsibility for providing the service element of the procedure, which generate a lower gross
margin as a percent of revenues. Also contributing to the increase in gross margin were continued
reductions in manufacturing costs for our cryoablation disposable products and a reduction in the
average fees we paid to third parties to provide cryoablation procedures on our behalf. This
increase was negatively affected during the six months ended June 30, 2006 by transactions where we
allowed certain customers to upgrade to our Cryocare CS System from a previous generation of our
Cryocare Surgical System with nominal additional payment, resulting in a negative gross profit. In
total during the six months ended June 30, 2006, we recorded $0.4 million of revenues from sales of
Cryocare Surgical Systems with a negative gross margin.
Research and Development Expenses. Research and development expenses for the six months ended
June 30, 2006 increased 33.9 percent to $1.5 million compared to $1.1 million for the comparable
period in 2005. The increase was primarily attributable to increased costs associated with several
new development projects we have undertaken in our efforts to reduce manufacturing costs of the
disposable components used in cryoablation surgical procedures as well as efforts to broaden the
application of cryoablation outside of our current markets in urology and interventional radiology.
Included in research and development expenses for the first half of 2006 is $80,000 in non-cash
stock-based compensation expense. As a percentage of revenues, research and development expenses
increased to 10.5 percent during the six months ended June 30, 2006, from 8.1 percent during the
six months ended June 30, 2005.
Selling and Marketing Expenses. Selling and marketing expenses for the six months ended June
30, 2006 increased 17.4 percent or $1.1 million to $7.7 million as compared to $6.5 million for the
same period in 2005. Driving the increases were proctor fees and related cost increases of $0.4
million, non-cash stock-based compensation expenses relating to the implementation of SFAS No. 123R
in the amount of $0.4 million, and a personnel-related increase in compensation and related
expenses in our sales organization of $0.2 million.
General and Administrative Expenses. General and administrative expenses for the six months
ended June 30, 2006 declined 10.6 percent or $0.7 million to $6.1 million as compared to $6.8
million for the same period in 2005. The decline resulted from decreases in legal and accounting
costs of $1.4 million payroll taxes of $0.7 million and receipt of a legal settlement of $0.2
million, which were partially offset by $1.2 million non-cash stock-based compensation expenses
relating to the implementation of SFAS No. 123R. There also was a reduction in overall legal fees
and reimbursement of costs associated with the SEC and DOJ investigations from our directors and
officers liability insurance policy, which reimbursement did not occur in the 2005 period. These
decreases were partially offset by an aggregate of $0.4 million in increases relating primarily to
compensation and related personnel
21
costs resulting from establishing an in-house legal department to reduce overall legal fees as
well as from changing the classifications of certain regulatory and compliance employees from
selling and marketing expenses.
Interest Expense, Net. Interest expense, net, for the six months ended June 30, 2006 was a
negative expense of ($2.0) million compared to $1.0 million in expense for the same period in 2005.
Interest expense, net for the six months ended June 30, 2006 and 2005 includes a reduction of
interest expense of ($1.7) million and interest expense of $1.1 million, respectively, which
represents the change in the fair value of common stock warrants issued in connection with our
private placement in March 2005. This represents the (decrease) increase in the fair value of the
warrants during the respective periods. Interest expense, net, in the 2006 and 2005 periods also
includes interest income on a note receivable for the 2003 sale of our urinary incontinence product
line and interest income earned from the investment of our cash balances.
Loss from Continuing Operations. Loss from continuing operations for the six months ended June
30, 2006 was $5.9 million or $0.20 per basic and diluted share on 30.2 million weighted average
shares outstanding compared to a net loss of $9.7 million or $0.35 per basic and diluted share on
27.8 million weighted average shares outstanding for the same period in 2005. Included in the loss
from continuing operations during the six months ended June 30, 2006 is an aggregate of $1.7
million of non-cash stock-based compensation expense in accordance with SFAS No. 123R, $0.9 million
reduction in accrued payroll taxes which were no longer statutorily due and the reduction in
interest expense of $1.7 million from the change in the fair value of common stock warrants.
Income from Discontinued Operations. Income from discontinued operations for the six months
ended June 30, 2006 represents the operating results of Timm Medical through the date of sale on
February 10, 2006. Income for the 2006 period was $0.2 million or $0.01 per basic and diluted share
on 30.2 million weighted average shares outstanding. The 2006 income included $0.4 million gain on
sale of Timm Medical and a tax provision of $0.2 million. Income from discontinued operations for
the six months ended June 30, 2005 was $1.0 million or $0.04 per basic and diluted share on 27.8
million weighted average shares outstanding. The 2005 period includes income of $0.6 million as a
result of the elimination of the estimated costs to sell, which was previously reported as a
component of a 2004 impairment charge when Timm Medical was initially marketed for sale.
Net Loss. Net loss for the six months ended June 30, 2006 was $5.6 million or $0.19 per basic
and diluted share on 30.2 million weighted average shares outstanding, compared to a net loss of
$8.7 million, or $0.31 per basic and diluted share on 27.8 million weighted average shares
outstanding for the same period in 2005.
Liquidity and Capital Resources
Since inception, we have incurred losses from operations and have reported negative cash
flows. As of June 30, 2006, we had an accumulated deficit of $171.3 million and cash and cash
equivalents of $8.0 million.
We do not expect to reach break-even or cash flow positive operations in 2006, and we expect
to continue to generate losses from operations for the foreseeable future. These losses, which are
expected to decline, have resulted in part from our continued investment to gain acceptance of our
technology and investment in cost reduction initiatives. In addition to these continued
investments, although we recently resolved the investigations by the SEC and DOJ of our historical
accounting and financial reporting (see below under Part II, Item 1 Legal Proceedings), we
still have obligations to indemnify and advance the legal fees for our former officers and former
directors in connection with the ongoing investigations related to those individuals. The amount
of those legal fees may exceed the reimbursement due to us from our directors and officers
liability insurance, and the excess may have a material adverse effect on our results of operations
and our liquidity. We also face large cash expenditures in the future related to past due sales and
use tax obligations, which we estimate to be approximately $2.9 million and which was accrued as of
June 30, 2006. We are in the process of negotiating resolutions of the past due state and local tax
obligations with the applicable tax authorities.
On March 11, 2005, we issued 5,635,378 shares of our common stock, warrants to purchase an
additional 1,972,374 shares of common stock at $3.50 per share and warrants to purchase an
additional 1,972,374 shares of common stock at $4.00 per share for an aggregate cash purchase price
of $15.6 million ($2.77 per share), in a private placement to a syndicate of institutional
investors as well as our chairman and chief executive officer, our president and chief operating
officer and a non-employee director.
22
On February 10, 2006, we closed the sale to Plethora Solutions Holdings plc of all of the
stock of our wholly-owned subsidiary, Timm Medical, in exchange for:
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$8.1 million in cash paid to us on February 10, 2006; and |
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$1.4 million in the form of a secured convertible promissory note due and payable in
full, together with all accrued interest, on the date 24 months or, under certain
circumstances, 15 months following the closing date of the transaction, bearing
interest at five percent per annum. |
The proceeds from our sale of Timm Medical provide an important cash infusion in the short
term. However, Timm Medicals operations were profitable and generated cash. Accordingly, we expect
that, as a result of the sale, we will incur greater losses and experience greater cash use until
our ongoing operations are able to offset the effects of the sale.
We intend to continue investing in our sales and marketing efforts to physicians in order to
raise awareness and gain further acceptance of our technology. This investment is required in order
to increase physicians usage of our technology in the treatment of prostate and renal cancers,
lung and liver cancers and in the management of pain from bone metastases. Such costs will be
reported as current period charges under generally accepted accounting principles.
We will use existing cash reserves, which includes the net proceeds from our March 2005
private placement and the sale of Timm Medical, to finance our projected operating and cash flow
needs, along with continued expense management efforts for the remainder of the year. In addition,
we may borrow funds under our line of credit with our bank as long as we remain in compliance with
the representations, warranties, covenants and borrowing conditions set forth in the agreements
governing the line of credit. This line of credit permits us to borrow up to the lesser of $4.0
million or amounts available under the Borrowing Base. The Borrowing Base is (i) 80 percent of
our eligible accounts receivable, plus (ii) the lesser of 30 percent of the value of our eligible
inventory or $500,000. We have no amounts outstanding under this line of credit at June 30, 2006.
We expect that we will need to raise additional capital prior to March 31, 2007 to fund our
ongoing operations. Any additional capital may not be available on terms acceptable to us, or at
all. Additional equity financing may cause our existing stockholders to experience dilution and
negatively affect our stock price. Additional debt financing, if available, may involve
significant fees, interest expense, restrictive covenants and the granting of security interests in
our assets. Raising capital through a licensing or other transaction involving our intellectual
property could require us to relinquish valuable intellectual property rights and thereby sacrifice
long term value for short term liquidity.
If we fail to adequately address our liquidity concerns, then our independent auditors may
issue a qualified opinion, to the effect that there is substantial doubt about our ability to
continue as a going concern. A qualified opinion could itself have a material adverse effect on our
business, financial condition, results of operations and cash flows.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The primary objective of our investment activities is to preserve principal while at the same
time maximizing the income we receive from our invested cash without significantly increasing risk
of loss. Our financial instruments include cash, cash equivalents, accounts receivable, accounts
payable and accrued liabilities. As of June 30, 2006, the carrying values of our financial
instruments approximated their fair values. Our policy is not to enter into derivative financial
instruments. In addition, we do not enter into any futures or forward contracts and therefore we do
not have significant market risk exposure with respect to commodity prices.
Although we transact our business in U.S. dollars, future fluctuations in the value of the
U.S. dollar may affect the price competitiveness of our products. However, we do not believe that
we currently have any significant direct foreign currency exchange rate risk and have not hedged
exposures denominated in foreign currencies or any other derivative financial instruments.
23
Item 4. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures. We maintain disclosure controls and
procedures that are designed to ensure that information required to be disclosed in our reports
pursuant to the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and
reported within the time periods specified in the Securities and Exchange Commissions rules and
forms and that such information is accumulated and communicated to our management, including our
chief executive officer and chief financial officer, as appropriate, to allow for timely decisions
regarding required disclosure. In designing and evaluating the disclosure controls and procedures,
management recognizes that any controls and procedures, no matter how well designed and operated,
can provide only reasonable assurance of achieving the desired control objectives, and management
is required to apply its judgment in evaluating the cost-benefit relationship of possible controls
and procedures.
As required by Rule 13a-15(b) of the Securities Exchange Act of 1934, as amended, we carried
out an evaluation, under the supervision and with the participation of our management, including
our chief executive officer and chief financial officer, of the effectiveness of the design and
operation of our disclosure controls and procedures as of the end of the quarter covered by this
report. Based on the foregoing, our chief executive officer and chief financial officer concluded
that our disclosure controls and procedures were effective at the reasonable assurance level.
(b) Changes in Internal Controls. There was no change in our internal control over financial
reporting during our second fiscal quarter for 2006 that has materially affected, or is reasonably
likely to materially affect, our internal control over financial reporting.
24
PART II OTHER INFORMATION
Item 1. Legal Proceedings
We are a party to lawsuits in the normal course of our business. Litigation and governmental
investigation can be expensive and disruptive to normal business operations. Moreover, the results
of complex legal proceedings are difficult to predict. Significant judgments or settlements in
connection with the legal proceedings described below may have a material adverse effect on our
business, financial condition, results of operations and cash flows. Other than as described below,
we are not a party to any legal proceedings that we believe to be material.
As reported in the Form 8-K that we filed on July 20, 2006, we executed a consent to entry of
judgment in favor of the Securities and Exchange Commission (theSEC) on July 14, 2006 and
entered into a non-prosecution agreement with the Department of Justice (the DOJ) on July 18,
2006. These two agreements effectively resolve with respect to the Company the investigations
begun by the SEC and by the DOJ in January 2003. The investigations related to certain former
officers and directors remain ongoing.
Under the terms of the consent judgment with the SEC, the Company, without admitting or
denying any wrongdoing, agreed to pay a total of $750,000 in civil penalties and is enjoined from
future violations of securities laws. In April 2006, we had placed this amount in escrow at the
request of the SEC staff.
Under the terms of the non-prosecution agreement with the DOJ, the United States Attorneys
Office for the Central District of California has agreed not to prosecute the Company for any
crimes committed by the Companys employees relating to the DOJs investigation. The agreement
becomes final and irrevocable on January 1, 2007.
Given the recent announcements by numerous companies and the SECs current focus on stock
option plan administration, our Audit Committee requested that management conduct an internal
review of our historical stock option practices, the timing of stock option grants and related
accounting and documentation. Based on this review, management identified several stock option
grants made between 1997 and 2002 for which the actual measurement dates appeared to differ from
the recorded grant dates. Management analyzed the potential accounting impact, assuming that the
measurement dates for these option grants differ from the recorded grant dates, and concluded that
the financial impact did not necessitate adjustment to or restatement of our previously-issued
financial reports. Management reported the results of its review to our Audit Committee and Board
of Directors at their regularly scheduled meetings on July 26, 2006. Following these meetings, we
contacted the SEC and the DOJ and reported our findings. On August 1, 2006, we met with the SEC
staff to discuss our findings and later received a subpoena from the SEC requesting additional
option-related information. We are in the process of responding to
this subpoena and will continue to fully cooperate with the SEC and DOJ and with their ongoing investigations
related to certain of our former officers and directors.
Item 1A. Risk Factors
Please see our 2005 Annual Report on Form 10-K filed with the SEC on March 16, 2006, which
includes a detailed discussion of our risk factors. We do not believe that there have been any
material changes in our risk factors from those disclosed in the Form 10-K, except for the addition
of the following risk factors.
We face risks relating to our liquidity.
As described above in Part I, Item 2 under Liquidity and Capital Resources, we expect that
we will need to raise additional capital prior to March 31, 2007 to fund our
ongoing operations. Any additional capital may not be available on terms acceptable to us, or at
all. Additional equity financing may cause our existing stockholders to experience dilution and
negatively affect our stock price. Additional debt financing, if available, may involve
significant fees, interest expense, restrictive covenants and the granting of security interests in
our assets. Raising capital through a licensing or other transaction involving our intellectual
property could require us to relinquish valuable intellectual property rights and thereby sacrifice
long term value for short term liquidity.
If we fail to adequately address our liquidity concerns, then our independent auditors may
issue a qualified opinion, to the effect that there is substantial doubt about our ability to
continue as a going concern. A qualified
25
opinion could itself have a material adverse effect on our business, financial condition,
results of operations and cash flows.
Furthermore, our failure to raise adequate capital would have a material adverse effect on our
business, financial condition, results of operations and cash flows, and could cause us to
discontinue operations or declare bankruptcy.
Our business may be materially and adversely impacted by the loss of our largest customer or
the reduction, delay or cancellation of orders from this customer; in addition, our business may be
materially and adversely impacted if this customer delays payment or fails to pay for products sold
to this customer.
For the quarter ended June 30, 2006 our largest customer accounted for 18.9% of our net
revenues, and as of June 30, 2006 this customer accounted for 21.6% of our accounts receivable.
Our sales to this customer may be materially and adversely impacted by various factors relating to
this customers business, financial condition, results of operations and cash flows. Our
business, financial condition, results of operations and cash flows may be materially and adversely
impacted by the loss of this customer, or the reduction, delay or cancellation of orders. In
addition, our business, financial condition, results of operations and cash flows may be materially
and adversely impacted if this customer delays payment or fails to pay for products sold. This
customer is not obligated to purchase a specific quantity of our products or provide binding
forecasts of purchases for any period.
We may be subject to civil or criminal liability if we violate the terms of our settlements
with the SEC and the DOJ.
As described above under Part II, Item 1, we recently entered into settlements with the SEC
and the DOJ. If we violate the terms of these settlements, then we may be subject to civil or
criminal liability, which would have a material adverse effect on our business, financial
condition, results of operations and cash flows. Our non-prosecution agreement with the DOJ does
not become final and irrevocable until January 1, 2007. Until that date, the DOJ may bring
criminal charges against us if it determines that we have violated the terms of the non-prosecution
agreement.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Not applicable.
Item 3. Defaults Upon Senior Securities
Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders
We held our Annual Meeting of Stockholders on Thursday, May 18, 2006. Our stockholders
approved the following matters at the Annual Meeting by the votes indicated:
1. The stockholders elected the following six directors to our Board of Directors to serve
until the 2007 Annual Meeting of Stockholders or until their respective successors are duly elected
and qualified:
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Number of Shares |
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For |
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Abstain |
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John R. Daniels, M.D. |
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23,308,983 |
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474,165 |
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Craig T. Davenport |
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23,308,799 |
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474,349 |
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David L. Goldsmith |
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23,658,551 |
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124,597 |
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Eric S. Kentor |
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23,669,551 |
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113,597 |
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Terrence A. Noonan |
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23,669,551 |
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113,597 |
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Thomas R. Testman |
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23,658,551 |
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124,597 |
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26
2. The stockholders voted to reauthorize our Board of Directors, in its discretion, to amend
our Restated Certificate of Incorporation to effectuate a reverse stock split of our common stock,
at an exchange ratio ranging from one-to-two to one-to-five:
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Number of Shares |
For |
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21,665,105 |
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Against |
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1,991,124 |
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Abstain |
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126,919 |
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3. The stockholders ratified the selection of Ernst & Young LLP as our independent auditor for
the fiscal year ending December 31, 2006:
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Number of Shares |
For |
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23,718,355 |
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Against |
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62,293 |
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Abstain |
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2,500 |
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Item 5. Other Information
None.
Item 6. Exhibits
A list of exhibits filed with this Form 10-Q or incorporated by reference herein is found in
the Exhibit Index immediately following the Signature Page of this Form 10-Q, which is hereby
incorporated by reference herein.
27
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized.
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ENDOCARE, INC. |
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By:
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/s/ CRAIG T. DAVENPORT |
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Craig T. Davenport |
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Chief Executive Officer and |
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Chairman of the Board |
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(Duly Authorized Officer) |
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By:
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/s/ MICHAEL R. RODRIGUEZ |
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Michael R. Rodriguez |
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Senior Vice President, Finance and |
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Chief Financial Officer |
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(Principal Financial and |
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Accounting Officer) |
Date: August 8, 2006 |
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28
EXHIBIT INDEX
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Exhibit |
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No. |
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Description |
2.1(1)
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Partnership Interest Purchase Agreement, dated as of December 30, 2004, by and between the
Company and Advanced Medical Partners, Inc. |
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2.2(2)
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Stock Purchase Agreement, dated as of January 13, 2006, by and among the Company, Plethora
Solutions Holdings plc and Timm Medical Technologies, Inc. The schedules and other
attachments to this exhibit were omitted. The Company agrees to furnish a copy of any
omitted schedules or attachments to the Securities and Exchange Commission upon request. |
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2.3(3)
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$1,425,000 Secured Convertible Promissory Note, dated as of February 10, 2006, from
Plethora Solutions Holdings plc to the Company. |
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3.1(4)
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Certificate of Amendment of Restated Certificate of Incorporation of the Company. |
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3.2(4)
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Certificate of Designation of Series A Junior Participating Preferred Stock of the Company. |
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3.3(4)
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Restated Certificate of Incorporation. |
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3.4(5)
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Amended and Restated Bylaws of the Company. |
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4.1(6)
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Form of Stock Certificate. |
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4.2(7)
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Form of Series A Warrant. |
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4.3(7)
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Form of Series B Warrant. |
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4.4(8)
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Rights Agreement, dated as of June 30, 1999, between the Company and U.S. Stock Transfer
Corporation, which includes the form of Certificate of Designation for the Series A Junior
Participating Preferred Stock as Exhibit A, the form of Rights Certificate as Exhibit B
and the Summary of Rights to Purchase Series A Preferred Shares as Exhibit C. |
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4.5(9)
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Amendment No. 1 to Rights Agreement, dated as of June 24, 2005, between the Company and
U.S. Stock Transfer Corporation. |
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10.1(10)
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Amendment to Loan Documents, dated as of April 24, 2006, by and between Endocare, Inc. and
Silicon Valley Bank. |
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10.2
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First Amendment to Lease, dated as of May 19, 2006, between Endocare, Inc. and The Irvine
Company LLC. |
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10.3(11)
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Employee Deferred Stock Unit Program. |
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10.4(11)
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Non-Employee Director Deferred Stock Unit Program. |
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10.5*
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Customer Quote, dated as of
January 9, 2006, to Advanced Medical Partners, Inc. |
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10.6*
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Amended and Restated Endocare Service Agreement, dated as of January 9, 2006, between
Endocare, Inc. and Advanced Medical Partners, Inc. |
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31.1
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Certification under Section 302 of the Sarbanes-Oxley Act of 2002 for Craig T. Davenport. |
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31.2
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Certification under Section 302 of the Sarbanes-Oxley Act of 2002 for Michael R. Rodriguez. |
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32.1
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Certification under Section 906 of the Sarbanes-Oxley Act of 2002 for Craig T. Davenport. |
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32.2
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Certification under Section 906 of the Sarbanes-Oxley Act of 2002 for Michael R. Rodriguez. |
29
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Management contract or compensatory plan or arrangement |
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* |
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Certain confidential portions of this exhibit were omitted and provided separately to the SEC
pursuant to a request for confidential treatment. |
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(1) |
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Previously filed as an exhibit to our Form 8-K filed on January 6, 2005. |
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(2) |
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Previously filed as an exhibit to our Form 8-K filed on January 18, 2006. |
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(3) |
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Previously filed as an exhibit to our Form 10-K filed on March 16, 2006. |
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(4) |
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Previously filed as an exhibit to our Registration Statement on Form S-3 filed on September 20, 2001. |
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(5) |
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Previously filed as an exhibit to our Form 10-K filed on March 15, 2004. |
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(6) |
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Previously filed as an exhibit to our Form 10-K for the year ended December 31, 1995. |
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(7) |
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Previously filed as an exhibit to our Form 8-K filed on March 16, 2005. |
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(8) |
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Previously filed as an exhibit to our Form 8-K filed on June 3, 1999. |
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(9) |
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Previously filed as an exhibit to our Form 8-K filed on June 28, 2005. |
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(10) |
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Previously filed as an exhibit to our Form 8-K filed on April 25, 2006. |
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(11) |
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Previously filed as an exhibit to our Form 8-K filed on May 22, 2006. |
30