ITEM 1. BUSINESS
INTRODUCTION
Medstone International, Inc., (the "Company" or "Medstone"), a Delaware corporation formed in October 1984, manufactures, markets and maintains lithotripters. The Company, as a manufacturer of capital medical devices, has vertically integrated by offering its medical devices directly to providers on a fee-per-procedure basis. Medstone currently offers lithotripsy services both in the United States and internationally on a fee-per-procedure basis in both the fixed and mobile environment. Medstone intends to expand efforts to grow this medical service side of its business. The Company's consolidated revenues during fiscal 1997 came primarily from Medstone's lithotripsy business.
In early 1996, the Company completed efforts to separate its operating business units and revenue streams into independent operations by spinning off two subsidiaries, Endocare, Inc. ("Endocare") and Urogen Corp. ("Urogen"), to the Company's stockholders of record at December 29, 1995. Endocare manufactures equipment and devices to treat urologic soft tissue diseases. Urogen is a development stage company in the business of developing pharmaceuticals to treat prostate cancer.
In June 1996 the Company purchased, for $1.35 million cash, a 60% interest in Northern Nevada Lithotripsy Associates, LLC ("Northern Nevada"), an operator of lithotripsy services. In March 1997, the Company purchased, for $2.3 million cash, a 60% interest in Southern Idaho Lithotripsy Associates, LLC ("Southern Idaho"), another operator of lithotripsy services. The Company consolidates the revenues of Northern Nevada and Southern Idaho and reflects minority interest expense for the portion of profits earned by the minority partners. These companies' revenues are derived from invoicing patients or insurers.
United Physicians Resources, Inc. ("UPR") was incorporated as a majority-owned subsidiary of the Company in June 1996, to expand the Company's service orientation to the urologist practitioners. UPR provides billing, practice management, and consulting services as an additional service line once the initial physician relationship has been established. UPR purchased the operations of Integrated Healthcare Systems, Inc. in July 1996 for $30,000. The operating results of UPR are included in the consolidated financial statements of the Company since its incorporation.
MARKETS
The Company currently operates in the kidney stone treatment market. In the United States, it is estimated that over 1,500,000 persons per year suffer from kidney stones and an estimated 375,000 patients per year are hospitalized with a primary kidney stone. Historically, approximately 180,000 of these patients have been treated with extra corporeal shockwave lithotripsy each year. With an estimated installed base of 380 lithotripters in the United States, there is a sufficient number of lithotripters to respond to this market.
Outside the United States the incidence of kidney stones varies from country to country. The installed base of extra corporeal shockwave lithotripters is not as extensive as in the United States. Medstone has sold systems into Japan, Egypt, Russia, Israel, Saudi Arabia, U.A.E., Hong Kong and China.
In a joint effort, Medstone and Novartis ("Novartis") formerly known as Ceiba-Geigy have submitted an application to the U.S. Food and Drug Administration ("FDA") to non-invasively treat gallstones using the Company's lithotripter in conjunction with Actigall(R) (ursodiol USP). On March 5, 1998, the FDA informed Medstone in writing that its Pre-market Approval Application is considered filed. In the same letter, Medstone was informed that the FDA expects to take this submission before the Gastroenterology and Urology Device Advisory Panel on April 30, 1998. If the Medstone lithotripsy system were to receive such approval, it would be the only system approved to treat
kidney stones and gallstones on the same equipment in the United States although no assurance can be given that such approval will ever be given. See "Governmental Regulation" below.
In the United States, it is estimated that 20,000,000 persons have gallstones resulting in approximately 600,000 surgeries each year to remove these gallstones. At this time it is impossible to estimate the number of procedures that would be performed using the non-invasive lithotripsy/drug alternative.
Medstone is also investigating the application of shockwave therapy for various orthopedic applications.
The share of its markets that the Company will obtain will be dependent on successful development of new products, obtaining appropriate regulatory agency approvals, market acceptance of the products, the Company's ability to market, the alternative sources of equivalent products and future developments.
PRODUCTS
The Medstone STS ("System") is presently being used to treat kidney stones, without invasive surgery, in the U.S. and foreign locations. The Company received a pre-market approval ("PMA") from the FDA in 1988 authorizing commercial use of the device for treating patients with kidney stones.
A series of shockwaves are created outside the patient's body and focused to travel through water-based fluids until they enter the body and disintegrate the stone. Each successive shockwave serves to further break apart the kidney stone into smaller particles until they are small enough to be passed in the patient's urine. A treatment typically requires 1200-1600 shockwaves in a procedure which lasts 45 to 60 minutes.
In addition to the shockwave generator, the Medstone STS's components include a customized X-ray table on which the patient lies horizontally with his or her kidney positioned above the shockwave generator, a computer, an X-ray system, an ultrasound system, and an electrocardiogram ("ECG") monitor. The computer generates information regarding the treatment and monitors the patient's condition. The X-ray/ultrasound system produces images that are converted and analyzed by the computer and then used by the physician for proper positioning and to determine when the kidney stone has been sufficiently disintegrated to terminate the treatment. The ECG monitor supplies the data that allows the computer to synchronize the shockwaves with phases of the patient's heartbeat.
The Company has developed and copyrighted all the software that controls the Medstone STS. This software, an integral part of the system and therefore subject to review by regulatory agencies, is licensed for use on a per procedure basis.
The Company also has developed and manufactures its own disposable components for use with the Medstone STS. Electrodes manufactured by the Company are used to produce electrical sparks in the shockwave generator part of the device. A disposable coupling bag containing fluid for transmission of the shockwave is placed between the shockwave generator and the patient's back or stomach during the treatment. One complete set of the supplies is normally used in each patient procedure.
The Company, as a vertically integrated manufacturer, also offers fee-for-service lithotripsy in the continental United States. It has placed its lithotripters in mobile trailers and contracts with hospitals, clinics, and ambulatory surgery centers to provide the equipment necessary to treat kidney stones, usually on an outpatient basis. This allows small and mid-size facilities in wide ranging geographic locations to access equipment and technology that otherwise would only be economically viable in larger population centers. There are currently over 90 sites in the United States that are active sites on the Company's mobile routes. The Company plans to continue to expand its customer base for lithotripsy services in future years.
KIDNEY STONES AND TREATMENT
A kidney stone develops when the salt and mineral substances in urine form crystals that stick together and grow in size. In most cases, these crystals are removed from the body by the flow of urine, but they sometimes stick to the lining of the kidney or settle in places where the urine flow fails to carry them away. These crystals may gather and grow into a stone ranging in size from that of a grain of sand to a golf ball. Most stones start to form in the kidney. Some may travel to other parts of the urinary system, such as the ureter or bladder, and grow there.
Stones vary in size, composition, and the ease with which they can be dissolved. In some cases, certain medications may be used to lower the amount of acidity or alkalinity in the urine, thereby dissolving the stones. At present, stones that contain calcium cannot be dissolved. Most stones can be treated with conservative methods. This includes increased fluid intake, changes in diet, and medications. About 90 percent of stones that leave the kidney will pass through the ureter within three to six weeks. Stones that do not pass through the ureter may be removed with the aid of a grasping device (basket). The device is passed through a telescopic instrument (cystoscope) that the doctor inserts into the bladder or ureter (urethroscope). In some cases, the stones are removed whole, but sometimes they must be broken into smaller pieces with ultrasound before they can be removed with the basket.
The Medstone STS provides a non-invasive nonsurgical treatment for stones in the kidney and ureter called extra corporeal shockwave lithotripsy. In this method, X-rays are used to target the stone, and then high energy shockwaves are used to break down the stones into gravel which passes out with urine within a few weeks.
Although most stones can be treated with nonsurgical methods, certain stones still require conventional surgery, particularly when there is internal scarring and obstruction. With conventional surgery, an incision is made over the stone site. The hospital stay and recovery period are several weeks longer than when more conservative techniques are used. Therefore, stones are treated with non-invasive methods when possible.
PRODUCTION
Medstone manufactures, under FDA mandated Good Manufacturing Practice ("GMP") requirements, its devices at its plant in Aliso Viejo, California. The Company moved into its facility in March 1994. Subsequent to that move the Company was audited by the FDA and received notification from the FDA enabling it to manufacture and market devices in that facility. The Company has existing capacity to produce sufficient quantities of its shockwave lithotripters to support its commercial needs for the foreseeable future.
PRODUCT DEVELOPMENT
The Company has focused its research in 1997 on developments intended to improve performance and convenience, and also to reduce the size and costs, of its lithotripter systems. In 1997, the Company devoted a significant portion of its research and development expenditures on the Medstone STS-T, a smaller, movable lithotripsy system. This new product, which has been previewed at focus groups, is scheduled for introduction in 1998, pending FDA approvals and the Company will continue to invest significantly in product enhancements and proprietary products. During the years ended December 31, 1995, 1996, and 1997, the Company's expenditures for research and development totaled $926,665, $521,793, and $1,021,349, respectively.
PRODUCT LIABILITY AND INSURANCE
The Company currently has in force commercial liability insurance, with coverage limits of $1 million per incident, and $2 million on an annual aggregate basis. It also has general umbrella liability insurance with coverage limits of $4 million per incident for a total aggregate amount of $5,000,000 per incident. The Company's D & O insurance policies provide coverage on a claims-made basis and are subject to annual renewal.
GOVERNMENT REGULATION
Governmental regulations in the United States and other countries are a significant factor affecting the research and development, manufacture and marketing of the Company's products. In the United States, the FDA has broad authority under the Federal Food, Drug and Cosmetic Act and the Public Health Service Act to regulate the distribution, manufacture and sale of drugs, including biologics, and medical devices. Foreign sales of drugs and medical devices are subject to foreign governmental regulation and restrictions which vary from country to country.
DEVICES - Medical devices intended for human use in the United States are classified into three categories, depending upon the degree of regulatory control to which they will be subject. Such devices are classified by regulation into either class I (general controls), class II (performance standards) or class III (pre-market approval) depending upon the level of regulatory control required to provide reasonable assurance of the safety and effectiveness of the device. A class III product, such as the Medstone STS, and class I and II devices for which a PMA is necessary generally require initial Investigational Device Exemption ("IDE") approval by the FDA. An IDE permits limited clinical evaluation of the product under controlled conditions. Extensive reporting and monitoring of patient treatments made pursuant to the IDE are required. After the PMA is obtained, the product may be marketed to an unrestricted number of users in the United States, but general medical device regulations regarding FDA inspection of facilities, Good Manufacturing Practices, labeling, maintenance of records and filings with the FDA continue to be applicable.
A subset of medical devices categorized as class I or II and classified as "old" devices, that is, commercially distributed before March 28, 1976 or substantially equivalent to a device that was in commercial distribution before that date, may be marketed after the acceptance of the premarket notification under a 510(k) exemption. The 510(k) section of the Federal Food, Drug and Cosmetic Act allows an exemption from the requirement of premarket notification.
Medstone has obtained from the California Department of Health Services a license to manufacture medical devices and is subject to periodic inspections and other regulation by that agency.
Certificate of Need ("CON") laws and regulations are in effect in many states. Under such laws, a CON issued by a governmental agency is generally required before the introduction of certain new health care services or before a hospital or other provider can acquire certain new medical equipment or facilities having values exceeding specified amounts. Failure to obtain a required CON may prohibit the purchase of desired equipment or cause the denial of Medicare or other governmental reimbursements or payments for patient treatments. In recent years several states have repealed their CON laws and many other states have made or are considering possible amendments to the laws. Most of the revisions involve raising the thresholds for review, eliminating certain types of facilities or services from review or streamlining the review process.
On January 9, 1998, the Health Care Finance Administration (HCFA) published proposed Stark II regulations with the intent of seeking public comments regarding the proposal and its effects. Stark II proposes that lithotripsy would be defined as an "inpatient and outpatient hospital procedure" and this definition would put physician ownership of lithotripsy units in violation of HCFA regulations. This would apply to patients covered under Medicare, Medicaid and Champus health care.
With the completion of the comment period in the beginning of March 1998, no further information is currently available to the Company regarding the public comments. The regulations, if enacted as first published, could force physician partnerships to either divest ownership or find a "safe harbor" under which to operate lithotripsy partnerships.
PATENTS, COPYRIGHTS, TRADE SECRETS AND LICENSES
The Company's policy is to secure and protect intellectual property rights relating to its technology. While Medstone believes that the protection of patents or licenses is important to its business, it also relies on trade secrets, know-how and continuing technological innovation to maintain its competitive position. The Company has received or filed for certain patents or copyrights for its lithotripter operating systems.
The Company seeks to preserve the confidentiality of its technology by entering into confidentiality agreements with its employees, consultants, customers, and key vendors and by other means. No assurance can be given, however, that these measures will prevent the unauthorized disclosure or use of such technology.
COMPETITION
The Company's products currently marketed and under development will be competing with many existing products and therapies for market share. The Company competes with fully integrated device companies, many of which have substantially more experience, financial and other resources and superior expertise in research and development, manufacturing, testing, obtaining regulatory approvals, marketing and distribution.
Future products of the Company are expected to address the urological market. The Company's competition will be determined in part by the particular urological disease to which the Company's potential products relate. An important factor in competition may be the timing of market introduction of its or competitive products. Accordingly, the relative speed with which Medstone can develop products, complete the clinical trials and approval processes and supply commercial quantities of the products to the market are expected to be important competitive factors. The Company expects that competition among products approved for sale will be based on, among other things, product efficacy, safety, reliability, availability, price, patent position and sales, marketing and distribution capabilities.
The Company's competitive position also depends upon its ability to attract and retain qualified personnel, obtain patent protection or otherwise develop proprietary products or processes and secure sufficient capital resources for the often substantial period between technological conception and commercial sales.
SHOCKWAVE LITHOTRIPTERS
The Company's two principal competitors in shockwave lithotripsy are Dornier, a subsidiary of a Singapore-based conglomerate, and Siemens GmbH, a German electronic company. In addition, a number of other companies, both in the U.S. and foreign countries, have PMAs to sell their lithotripters for the treatment of kidney stones in the U.S. or are conducting clinical studies on the use of lithotripters for the treatment of kidney stones.
The Company believes that, in addition to the obtaining of FDA and other governmental approvals, important competitive factors in the markets for shockwave lithotripters include the reliability, effectiveness in treating patients and pricing of particular systems. The Company believes the Medstone System compares favorably with other lithotripters presently being offered by competitors with respect to the precision of its imaging systems, its ease of patient handling, its simplicity of operation design, its safety features and its success rate in treating patients.
MOBILE LITHOTRIPSY SERVICES
In the fee-for-service business segment, the Company competes with a number of service oriented medical businesses, in a fragmented and highly competitive industry, both nationally and locally. Moreover, certain of the Company's current and potential competitors have substantially greater financial resources than the Company and may compete with the Company for acquisitions and development of operations in markets targeted by the Company. The Company has experienced competition in the acquisition of existing lithotripsy facilities and the development of relationships with treating physicians. The Company has experienced competition from hospitals or treating physicians
who have opened their own lithotripsy facilities. Such competition could intensify in the event of a decrease in the purchase price of lithotripters or if the supply of new or used lithotripters increases over time.
The Company's main competitors in the fee-for-service business are Prime Medical Services, Inc., a Texas-based mobile lithotripsy provider, the lithotripsy business of Integrated Health Services, Inc., a Maryland based healthcare concern, of which one operating entity owns lithotripsy provider partnerships, and other smaller regional and local providers.
SALES AND MARKETING
The Company's current products and planned future of products are targeted at the lithotripsy market. Medstone has a direct sales force, covering the continental United States. Outside the United States, the Company uses a network of distributors.
The Company generates revenue from the sale of equipment, and also from the sale of software licenses, disposable supplies, procedure fees and service contracts to hospitals, physicians, and other health care providers.
The Company offers to hospitals, surgery centers and physician groups lithotripsy services on a fee basis. In the current cost conscious healthcare environment, many facilities do not have the patient flow to justify owning, or the available capital to purchase, a lithotripsy machine. These facilities are candidates for fee-for-service. In a fee-for-service arrangement the customer will sign a contract for a period of time, typically one to three years, and will pay a fixed fee for each patient treated on the lithotripter. Most often this service is provided by a lithotripter that is in a mobile van so a single machine can provide service over a wide geographic area. For facilities with adequate patient flow, fee-for-service can be provided with a fixed unit installed in that facility.
Marketing for the Company's products is accomplished through advertisement in medical journals, direct mail, direct physician contact, company participation in various associations, product exhibition and telephonic marketing.
BACKLOG - SHOCKWAVE LITHOTRIPSY
The Company's lithotripsy equipment sale backlog was $250,000 as of March 1, 1998 and $480,000 as of March 24, 1997. Due to the high per unit price of the Medstone Systems, equipment backlog can vary significantly from period to period based upon the number of systems on order. Backlog consists only of orders evidenced by signed contracts for equipment scheduled for delivery and installation within 12 months and does not include revenues for maintenance and per procedure charges, or management services contracts.
With the maturity of Medstone's lithotripsy business, recurring revenues from fee for service and procedure fees and maintenance services have become a major source of Medstone's revenue stream. Maintenance services are generally provided under annual service contracts, and procedure and fee for service fees are earned based upon usage of the System.
HUMAN RESOURCES
As of February 28, 1998, Medstone had 77 employees. Of the 77 employees, 9 are engaged directly in research and development activities, 12 are engaged in manufacturing, 18 are engaged in mobile operations, 16 are engaged in field service, 11 are engaged in sales and marketing and 11 are employed in general and administrative positions.
Although Medstone conducts most of its research and development using its own employees, the Company has funded, and plans to continue to fund, research using consultants. Consultants provide services under written agreements and are paid based on the amount of time spent on Company matters. Under their consulting agreements, Medstone's consultants are required to disclose and assign to the Company any ideas, discoveries and inventions developed by them in the course of providing consulting services.
ITEM 2.
ITEM 2. PROPERTIES
In March 1994, the Company took occupancy of office, manufacturing, engineering, and warehouse space, and research and development laboratories, located in Aliso Viejo, California, under an operating lease with an initial term of two years. Under extensions of the lease, the monthly lease rate was $12,862 through February 1997 and $13,360 through February 1998. The Company exercised its option to extend the lease, extending the lease until March 1999 at a monthly lease rate of $13,874. The Company negotiated an extension for a sixteen month period running from March 1999 to June 2000, at a monthly rate of $14,410.
United Physicians Resources leases a 1,417 square foot office in Phoenix, Arizona with a monthly rental expense of $1,990 under an operating lease which expires in October 1999.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company carries director and officer liability insurance, and has indemnification agreements with its officers and directors.
The Company was a defendant in two related class action lawsuits filed by two shareholders of the Company alleging that adverse material information was not disclosed at the time of the initial public offering and in subsequent periods. On June 20, 1996 the defendants and plaintiffs reached an agreement whereby a $6 million, non-recapturable settlement fund was established in return for dismissal of all claims against the Company, its underwriter and current and former officers and directors. The Company recorded a one-time, $5.5 million expense in the second quarter of 1996 to cover its portion of the settlement fund, with the first half paid on July 9, 1996 and the second half paid on August 15, 1996. All funds for the settlement were remitted by the Company, with the co-defendants having paid their portions to the Company.
From time to time, the Company is subject to legal actions and claims for personal injuries or property damage related to patients who use its products. The Company has obtained a liability insurance policy providing coverage for product liability and other claims. Management does not believe that the resolution of any current proceedings will have a material financial impact on the Company or the consolidated financial statements.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company's annual meeting of shareholders was held on May 1, 1997. At the meeting Frank R. Pope, David V. Radlinski, Donald Regan and Michael C. Tibbitts were elected directors and the 1997 Stock Incentive Plan was approved.
EXECUTIVE OFFICERS OF THE REGISTRANT
Information regarding the Company's executive officers is included in Item 10 of Part III.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Prior to January 24, 1991, the Company's common stock was traded on the NASDAQ Stock Market under the symbol MSHK. On January 24, 1991, the Company changed its name to Cytocare, Inc. and began trading on the NASDAQ Stock Market under the symbol CYTI. On September 25, 1995, the Company changed its name to Medstone International, Inc. and began trading on the NASDAQ Stock Market under the symbol MEDS. The following table sets forth the high and low sales prices of the Company's common stock for the two years ended December 31, 1996 and December 31, 1997 as reported in the NASDAQ National Market System for the quarter indicated.
The stock markets have experienced extreme price and volume fluctuations during certain periods. These broad market fluctuations and other factors may adversely affect the market price of the Company's Common Stock. Any shortfall in revenue or earnings from levels expected by securities analysts could have an immediate and significant adverse effect on the trading price of the Company's common stock in any given period. Additionally, the Company may not learn of such shortfalls until late in the fiscal quarter, which could result in an even more immediate and adverse effect on the trading price of the Company's stock. Finally, the Company participates in a highly dynamic industry, which often results in significant volatility of the Company's common stock price.
At March 17, 1998, there were 304 stockholders of record and approximately 3,200 beneficial owners of the Company's Common Stock.
On February 9, 1996, the Company distributed two stock dividends, one common share of both Endocare and of Urogen for each common share of Medstone to holders of record at the close of business on December 29, 1995. The shares represent a distribution of all the assets of these two subsidiaries of the Company which became separate public companies upon distribution. Those companies operate as separate entities as of January 1, 1996. (See Footnote 10 to the Company's Consolidated Financial Statements.)
The Company has not paid any cash dividends during its two most recent fiscal years. The Company's board of directors does not presently anticipate that any cash dividends will be paid in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
CONSOLIDATED STATEMENTS OF OPERATIONS DATA: (in thousands, except per share amounts)
CONSOLIDATED BALANCE SHEET DATA: (in thousands)
- ---------- (1) Restated in accordance of SFAS Statement No. 128 "Earnings Per Share".
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
Medstone manufactures, markets and maintains lithotripters, and continues to expand its Fee-for-Service Program to supply lithotripsy equipment to providers on a per procedure basis. To date, the Company's consolidated revenues have come primarily from Medstone's lithotripsy business.
The Company as a manufacturer of capital medical devices has been vertically integrating by offering its medical devices directly to providers. It currently offers lithotripsy procedures using 13 mobile systems and two fixed sites in the United States on a per procedure basis. With the ability to offer quality equipment at reasonable prices, Medstone intends to continue the growth of this manufacturer direct business.
In June 1996, the Company completed the acquisition of a 60% interest in Northern Nevada, a lithotripsy partnership which deals directly with patient and insurers, and also founded UPR as a majority-owned subsidiary of the Company, to expand the Company's service orientation to the urologist practitioner. Both entities signify the Company's emphasis on growth through expansion of relationships and acquisition. In March 1997, the Company completed the acquisition of a 60% interest in Southern Idaho Lithotripsy Associates LLC, another operator of "retail" lithotripsy operations in Southern Idaho, and operating results have been consolidated effective March 1, 1997.
The Company began the year with approximately $11 million in cash and marketable securities, no debt, inventories of $2.5 million, and total assets of $25.4 million. After an acquisition, purchase of $1.3 million of treasury stock and payment of costs relating to the attempted acquisition of the lithotripsy division of Coram Healthcare, the Company ended the year with approximately $11 million in cash and marketable securities, no debt, inventories of $2.7 million and total assets of $27.4 million.
Through its continuing research and development, management of the Company is putting in place the scientific and engineering base it believes is necessary to carry it through the next phases of its growth plans.
The Company was a defendant in two related class action lawsuits filed by two shareholders of the Company alleging that adverse material information was not disclosed at the time of the initial public offering and in subsequent periods. On June 20, 1996 the defendants and plaintiffs reached an agreement whereby a $6 million, non-recapturable settlement fund was established in return for dismissal of all claims against the Company, its underwriter and current and former officers and directors. The Company recorded and paid a one-time, $5.5 million expense in 1996 to cover its portion of the settlement fund. All funds for the settlement were remitted by the Company, with the co-defendants paying their portions to the Company. (See Item 3. Legal Proceedings).
From time to time, the Company is subject to legal actions and claims for personal injuries or property damage related to patients who use its products. The Company has obtained a liability insurance policy providing coverage for product liability and other claims. Management does not believe that the resolution of any current proceedings will have a material financial impact on the Company or the consolidated financial statements.
In 1996, the Company negotiated with Coram Healthcare ("Coram") for the right to purchase the lithotripsy related operations of Coram. In October 1996, negotiations ceased and, upon Coram's subsequent acquisition by Integrated Health Services, Inc., a breakup fee clause was enacted and the Company received reimbursement of $1.25 million of certain documented out-of-pocket expenses relating to the attempted acquisition and related financing. The Company received the $1.25 million in 10 installments during 1997.
ASSETS
Accounts receivable increased by $434,000 from December 31, 1996 to December 31, 1997 due to the addition of the Southern Idaho receivables and a higher number of customers utilizing the fee-for-service program. $3,000 was written off against the accounts receivable reserves in 1997.
Income taxes receivable increased by $547,000 due to the overpayment of tax estimates and utilization of net operating loss carryforwards.
Note receivable decreased by $1,250,000 in the current year due to the Company's reimbursement from Coram Healthcare for certain expenses related to the Company's 1996 bid to acquire the lithotripsy operations of Coram.
Prepaid expenses and other current assets increased by $299,000 due to the Company's prepayment of directors and officers liability insurance and recognition of the value of a van due to the Company.
Goodwill, net, increased by $2,148,000 in the current year due to $2,223,000 in goodwill recorded in connection with the purchase of Southern Idaho, offset by amortization expense (see Footnote 2).
LIABILITIES
Customer deposits increased by $133,000 at December 31, 1997 compared to December 31, 1996 due to receipt of deposits for three equipment orders with future shipment dates.
Accounts payable at December 31, 1997 decreased by $873,000 compared to December 31, 1996 due to payment of expenses in connection with the Company's attempted acquisition of the lithotripsy related operations of Coram.
Accrued income taxes decreased $376,000 in the current year due to over payment of estimated taxes.
Deferred tax liabilities increased by $258,000 from December 31, 1996 to December 31, 1997 due to a difference between tax and book depreciation and goodwill amortization expenses.
Minority interest increased by $255,000 due to the acquisition in 1997 of Southern Idaho, of which the Company is a 60% owner.
STOCKHOLDERS' EQUITY
Additional paid-in-capital increased $283,000 in the current year due to the exercise of common stock options held by employees.
Treasury Stock increased by $1,292,000 due to the Company's repurchase of 156,000 shares of its common stock under the repurchase program initiated in 1996.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
Total revenues increased to $21.7 million, or 21% for the year ended December 31, 1997 when compared to revenues of $18.0 million in the year ended December 31, 1996. The revenues from equipment sales increased by 12% as the number of units sold increased but the average unit selling price decreased due to competition. Decreasing was the revenue from equipment upgrades when compared to 1996 as fewer field upgrades are being performed.
Revenue from procedure and maintenance fees, or recurring revenue, increased by $3.4 million, or 23%, from 1996 levels due to the Company's continued revenue growth in its fee-for-service business, and the additional revenue from the Southern Idaho acquisition. Volume on company owned mobile lithotripsy units increased by 51% in 1997 when compared to 1996 with fees remaining constant. Procedure revenue on third-party owned equipment was flat in 1997 when compared to 1996 as patient volume increased slightly and per procedure fees decreased slightly. Revenues acquired with Southern Idaho, when combined with the previously acquired Northern Nevada, increases per procedure averages due to the higher fees for direct billings.
Interest income decreased by 21% in 1997 when compared to 1996 due to lower average invested cash balances which resulted from the payment of Coram expenses, acquisition costs and treasury stock repurchases.
Cost of equipment sales in 1997 increased by 57% in 1997 from 1996 levels due to the higher number of unit shipments in the year. Gross margins on equipment and equipment upgrades decreased due to the decrease in average unit selling prices.
Cost of recurring revenues increased by $752,000, or 11%, in 1997 when compared to 1996 due to increased activity in staffing costs and van movement costs for mobile services in correlation with higher patient volume. Gross margin, as percentage of recurring revenue, increased to 60% in 1997 from 55% due to higher utilization of existing equipment as fixed costs remain stable.
Research and development costs increased in 1997 by 96% when compared to 1996 levels due to increased spending on materials, staffing and consultants as the Company accelerated its development of a portable lithotripter.
Selling expenses increased by $111,000, or 5%, in 1997 when compared to 1996 due to higher commission expense in connection with revenue growth, the cost of a national ad campaign, and bad debt expenses.
General and administrative expenses increased by 34% or $565,000 from 1996 to 1997, due to higher staffing costs associated with a full year's operations of United Physicians Resources, increased legal expenses and increased billing service expense for the direct billings done on acquired entities.
Other income/expense, net decreased by $442,000 in 1997 when compared to 1996 due to the class action litigation preparation expenses incurred in 1996, partially offset by the gain on the sale of securities held for investment in 1996.
Lawsuit settlement costs decreased by $5.5 million due to the settlement of the class action lawsuit in 1996.
Minority interest expense of $468,000 represents the minority shareholder's interest in the results of operations of Northern Nevada and Southern Idaho.
Provision for (benefit from) income taxes recognizes the tax expense of the current year's income compared to the operating loss incurred in 1996.
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995
Total revenues increased slightly to $18.0 million, or 2% for the year ended December 31, 1996 when compared to revenues of $18.4 million in the year ended December 31, 1995. The revenues from equipment sales decreased by 47% as both the number of units and the average unit selling price decreased. Also decreasing was the revenue from equipment upgrades when compared to 1995.
Revenue from procedure and maintenance fees, or recurring revenue, increased by $2.1 million, or 16%, from 1995 levels due to the Company's continued success in its fee-for-service business, continued growth in revenue from procedure fees on third-party owned equipment, and the addition of the Northern Nevada "direct" revenues. Volume on company owned mobile lithotripsy units increased by 43% in 1996 when compared to 1995. Procedure revenue increased by 9% in 1996 when compared to 1995 as the volume on third party owned equipment continued to grow. Revenues acquired with Northern Nevada increase the per patient revenue due to the revenue recognized when billing patients or insurers when compared to the revenue from billing providers. Partially offsetting these gains was the loss of the Endocare revenues, which totaled $951,000 in 1995, which were spun out effective January 1, 1996.
Interest income decreased by 33% in 1996 when compared to 1995 due to dramatically lower average invested cash balances which resulted from the large capital expenditures for mobile lithotripsy trailers and the settlement of the class action lawsuit.
Cost of equipment sales in 1996 decreased by 38% in 1996 from 1995 levels due to the lower number of unit shipments in the year. Gross margins on equipment and equipment upgrades decreased due to the decrease in average unit selling prices.
Cost of recurring revenues increased by $1,158,000, or 21%, in 1996 when compared to 1995 due to the additional costs associated with the eight additional fee-for-service vans placed in service in 1996, which include depreciation, van movement costs, and staffing costs. Gross margins decreased due to lower than optimal utilization on the newer vans placed in service.
Research and development costs decreased in 1996 by 44% when compared to 1995 levels due to 1995's level of expenses associated with numerous Endocare new product development projects, most of which became salable new product lines before completion of the spin out of Endocare. In 1996 the Company concentrated its research efforts on lithotripsy products.
Selling expenses increased by $96,000, or 5%, in 1996 when compared to 1995 due to the additional sales staff and associated expenses for travel, along with the costs of product brochures as the Company expanded its mobile fee-for-service program from a Western United States concentration to include the Southwest, Southeast and Northeastern areas of the country. The Company also increased its efforts in connection with international sales in 1996.
General and administrative expenses remained constant, with an increase of less than 1% in 1996 compared to 1995 expenses. Administrative staff expenses of Endocare, spun out at the end of 1995, were offset by staff expenses for UPR and Northern Nevada.
Other income/expense, net increased by $239,000 in 1996 when compared to 1995 due to the litigation preparation expenses for the class action litigation incurred before settlement of the action, partially offset by the gain on the sale of securities held for investment.
Lawsuit settlement costs increased by $5.5 million due to the expense recorded for the out-of-court settlement reached by the plaintiffs and defendants, of which the Company was a co-defendant, on the class action lawsuit that had been in existence since 1989. This settlement charge represents closure of all open charges against the Company.
Minority interest expense of $143,000 represents the minority shareholder's interest in the results of operations of Northern Nevada.
Provision for (benefit from) income taxes recognizes the tax benefit in 1996 of the net operating loss carryforwards generated in 1996 with that carryforward expected to be utilized in future periods.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1997, the Company had cash and short-term investments of approximately $11.0 million. These funds were generated from operating activities and from the Company's initial public offering in June 1988.
The Company's long-term capital expenditure requirements and treasury shares repurchase will depend upon numerous factors, including the progress of the Company's research and development programs, the time required to obtain regulatory approvals, the resources that the Company devotes to the development of self-funded products, proprietary manufacturing methods and advanced technologies, the cost of acquisition and/or new revenue opportunities, the ability of the Company to obtain additional licensing arrangements and to manufacture products under those arrangements, and the demand for its products if and when approved and possible acquisitions of products, technologies and companies.
The Company believes that its existing working capital and funds anticipated to be generated from operations will be sufficient to meet the cash needs for continuation of its present operations during 1998. See "Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995."
YEAR 2000
The Company is aware of the issues associated with the programming code in existing computer systems as the millenium (year 2000) approaches. The "year 2000" problem is pervasive and complex as virtually every computer operation will be affected in some way by the rollover of the two digit year value to 00. This issue is whether computer systems will properly recognize date sensitive information when the year changes to 2000. Systems that do not properly recognize such information could generate erroneous data or could fail.
During 1997, the Company has conducted a comprehensive review of its computer systems and lithotripsy equipment to identify areas that could be affected by the "Year 2000" issue. The Company presently believes that, with conversion to a newer version of operating software developed in 1996, the year 2000 problem will not materially affect the Company's operations, financial position or cash flows.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the FASB issued Statement No. 130 (SFAS 130), REPORTING COMPREHENSIVE INCOME, effective for fiscal years beginning after December 15, 1997, which establishes standards for the reporting and display of comprehensive income and its components in financial statements. Comprehensive income generally represents all changes in shareholders' equity except those resulting from investments by owners and distributions to owners. The Company will adopt the new standards in 1998 and does not expect the impact on the financial statement presentation to be significant.
In June 1997, the FASB issued Statement No. 131 (SFAS 131), DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION, effective for fiscal years beginning after December 15, 1997, which
establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report information about operating segments in interim financial reports. SFAS 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. The Company will adopt the new standards retroactively in 1998. Management has not completed its review of SFAS 131.
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Forward-looking statements in this report, including without limitation, statements relating to the Company's plans, strategies, objectives, expectations, intentions and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that such forward-looking statements involve risks and uncertainties including without limitation the following: (i) the Company's plans, strategies, objectives, expectations and intentions are subject to change at any time at the discretion of the Company, (ii) the Company's plans and results of operations will be affected by the Company's ability to manage its growth; (iii) the Company's businesses are highly competitive and the entrance of new competitors into or the expansion of the operations by existing competitors in the Company's markets and other changes could adversely affect the Company's plans and results of operations; and (iv) other risks and uncertainties indicated from time to time in the Company's filings with the Securities and Exchange Commission.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Item 14. "Exhibits, Financial Statement Schedules, and Reports on Form 8-K."
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS The following are the directors of the Company:
Mr. Radlinski has been the Chairman of the Board and Chief Executive Officer of the Company since September 1995. He had been the President of the Company's subsidiary, Medstone International, Inc., and Chief Financial Officer and Secretary of the Company from January 1991 to September 1995. From July 1987 to January 1991, he was the Company's Executive Vice President of Finance, Chief Financial Officer and Secretary. From 1984 to 1987, he was Vice President of Finance and Chief Financial Officer of Printronix, Inc., a publicly-owned company which manufactured computer printers.
Mr. Pope is Managing Director of Verdigris Capital, a private merchant banking firm. From April 1981 to October 1996, Mr. Pope was a General Partner with Technology Funding, a venture capital investment firm. He was also the Executive Vice President, Chief Financial Officer and a director of Technology Funding Inc. Mr. Pope is also a director of Thermatrix, Inc. and a director and officer of Advanced BioCatalytics Corp. Mr. Pope is a C.P.A. and a member of the California Bar. He has been a director of the Company since January 1991.
Mr. Regan is currently the Vice President and General Counsel of Kinsell, O'Neal, Newcomb & De Dios, Inc., a municipal securities investment banking firm. Mr. Regan has practiced securities, municipal finance, nonprofit corporation, real estate, and business transactions law for over thirty years. He is a member of the National Association of Bond Lawyers, has published several articles on securities law and served as a lecturer for the Practicing Law Institute. He specializes in revenue and project finance bonds. He has been a director of the Company since September 1995.
Mr. Tibbitts, who was elected to the Board of Directors on May 13, 1996, has been with Gulf South Medical Supply, Inc. since 1991 as an officer and Vice President. Prior to joining that corporation, he was employed for 19 years by Johnson & Johnson in two divisions: Sterile Design (which manufactured and marketed kit packages) and Surgikos (which manufactured and marketed surgical supplies). He has been a Director of the Company since May 1996.
EXECUTIVE OFFICERS
The names, ages and positions of all the executive officers of the Company as of March 1998 are listed below, followed by a brief account of their business experience during the past five years. Officers are normally appointed annually by the Board of Directors at a meeting of the directors immediately following the Annual Meeting of Shareholders. There are no family relationships among these officers nor any arrangements or understandings between any officer and any other person pursuant to which an officer was selected. None of these officers has been involved in any court or administrative proceeding within the past five years adversely reflecting on his or her ability or integrity.
Mr. Radlinski has been the Chairman and Chief Executive Officer of the Company since September 1995. He had been the President of the Company's subsidiary, Medstone International, Inc., and Chief Financial Officer and Secretary of the Company from January 1991 to September 1995. From July 1987 to January 1991, he was the Company's Executive Vice President of Finance, Chief Financial Officer and Secretary. From 1984 to 1987, he was Vice President of Finance and Chief Financial Officer of Printronix, Inc., a publicly-owned company which manufactured computer printers.
Mr. Selawski has been the Chief Financial Officer, Vice President of Finance and Secretary of the Company since September 1995. He had previously served as the Company's Manager of Planning and Analysis since joining the Company in 1988. Prior to joining the Company he held various finance management positions with several high-tech manufacturing companies.
Ms. Novotny has been Executive Vice President of Sales and Marketing of the Company since October 1997. Prior to joining the Company, she was Director of Marketing for Imagyn Medical, formerly UroHealth, from June 1995 to October 1997. From 1985 to 1995, Mentor Corporation employed her as Marketing Manager and later as Director of Marketing for Mentor Urology.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
The Company is not aware of any director, officer or 10% shareholder who during 1997 failed to file on a timely basis any report regarding the Company's securities required by Section 16(a) of the Securities Exchange Act of 1934, except as follows; Mr. Radlinski, Mr. Selawski and Ms. Novotny did not timely file Form 5's regarding changes in stock option holdings.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
EXECUTIVE COMPENSATION
The following table sets forth certain information regarding compensation paid by the Company during each of the Company's last three fiscal years to the Company's Chief Executive Officer and to each of the Company's other executive officers during fiscal 1997.
SUMMARY OF COMPENSATION TABLE
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(1) In addition to the cash compensation shown in the table, executive officers of the Company may receive indirect compensation in the form of perquisites and other personal benefits. For each of the named executive officers, the amount of this indirect compensation in 1997, 1996 and 1995 did not exceed the lesser of $50,000 or 10% of the executive officer's total salary and bonus for that year.
(2) Options to acquire shares of Common Stock.
(3) Mr. Radlinski served as the Chief Financial Officer and Secretary of the Company until his election as Chairman of the Board and Chief Executive Officer on September 21, 1995.
(4) Mr. Selawski was appointed Chief Financial Officer, Vice President of Finance and Secretary on September 21, 1995.
(5) Mr. Gardner resigned his position with the Company as of October 9, 1997.
(6) Ms. Novotny joined the Company as of October 15, 1997.
STOCK OPTION GRANTS DURING 1997
The following table provides information related to the stock options granted in 1997.
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(1) Mr. Gardner resigned in October 1997 and forfeited these options.
STOCK OPTIONS HELD AT END OF FISCAL YEAR
The following table provides information related to options exercised during 1997 and options held by the named executive officers at December 31, 1997.
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(1) The value is calculated based on the difference between the option exercise price and the market price for the Company's Common Stock on the exercise date, multiplied by the number of shares purchased. For this purpose, the surrender or withholding of shares to pay the exercise price is not taken into account.
(2) The closing price for the Company's Common Stock as reported by the National Association of Securities Dealers (NASD) on December 31, 1997 was $10.38. Value is calculated on the basis of the difference between the option exercise price and $10.38, multiplied by the number of shares of Common Stock underlying the option.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
During 1997 Donald J. Regan and Frank R. Pope served as the members of the Company's Compensation Committee. Neither such individual is a current or former officer or employee of the Company or any of its subsidiaries. During 1997 there were no compensation committee interlocks between the Company and other entities involving Medstone executive officers serving as directors or members of compensation or similar committees of such other entities.
COMPENSATION OF DIRECTORS
The Company currently compensates Messrs. Regan, Tibbitts and Pope $1,000 per meeting for their services, in addition to reimbursement to all directors for expenses incurred by them in connection with the Company's business.
Under the Nonemployee Director Stock Option Plan, each new nonemployee director is automatically granted an option to purchase up to 5,000 shares as of the effective date of his or her first appointment to the Board or first election to the Board by the shareholders, whichever is earlier. Subject to acceleration of the option exercises in the event of certain events specified in the plan, each such option becomes exercisable with respect to 1/60 of the shares issuable for each elapsed full month during the five-year period after its grant date, but will not be initially exercisable until six months after the grant date. The exercise price of each option will equal the fair market value of the underlying Common Stock on the date the option is granted. Each option will expire six years after its grant, except that the expiration will be extended until one year after the optionee's death if it occurs less than one year before the option's expiration date. An option granted under the plan is not transferrable during the grantee's lifetime and must be exercised within one year following his or her death, or within 90 days after the grantee ceases to be a member of the Board for any other reason, and will only be exercisable to the extent it is exercisable on the date the grantee leaves the Board. Under this plan, Mr. Pope was granted 5,000 shares at $2.38 per share in January 1992, which were exercised during 1997, Mr. Regan was granted 5,000 shares in September 1995 at $11.88 and Mr. Tibbitts was granted 5,000 shares at $8.63 per share in May 1996.
As additional compensation, each current nonemployee director of the Company has received an option to purchase up to 15,000 shares of the Company's Common Stock. The options issued to Mssrs. Pope, Tibbitts and Regan were issued in November 1996 and have exercise prices of $7.13 per share. The options are exercisable, after six months following their grant dates, in incremental amounts equal to 1/48 of the underlying shares for each elapsed calendar month during which the director remains on the Company's board. The terms of the options are five years, subject to earlier termination related to the director no longer serving on the board.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth the number of shares of the Company's Common Stock known to the Company to be beneficially owned as of March 1, 1998 by each person who owns beneficially more than 5 percent of the outstanding shares of Common Stock, by each of the present directors and nominees for director, by each of the executive officers named in the Executive Compensation in Item 11 and by all executive officers and directors of the Company as a group, and the percentage of the total outstanding shares of Common Stock such shares represented as of March 1, 1998.
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(1) All such shares were held of record with sole voting and investment power, subject to applicable community property laws, by the named individual and/or by his wife, except as indicated in the following footnotes.
(2) Director of the Company.
(3) Executive officer of the Company.
(4) Includes 117,500 shares issuable upon exercise of presently outstanding stock options.
(5) Includes 5,000 shares issuable upon exercise of presently outstanding stock options.
(6) Includes 20,667 shares issuable upon exercise of presently outstanding stock options.
(7) Includes 6,646 shares issuable upon exercise of presently outstanding stock options.
(8) Includes 4,063 shares issuable upon exercise of presently outstanding stock options.
(9) Includes 5,979 shares issuable upon exercise of presently outstanding stock options.
(10) Percentage information is omitted because the beneficially owned shares represent less than 1% of the outstanding shares of the Company's Common Stock
(11) Includes 159,855 shares issuable upon exercise of presently outstanding stock options.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
During 1991, the Company was a party to the formation of Cardiac Science, Inc., for which the Company purchased 5,353,031 (pre-split) shares of common stock, for a cash payment of $.0016 per share. This purchase represented 77.3% of the outstanding stock. As of July 8, 1991, the Company distributed, as a dividend to its shareholders of record on that date, one share of Cardiac Science, Inc. stock for each share of Medstone stock held. The Company retained 629,768 (pre-split) shares of common stock of Cardiac Science, Inc.
From 1991 through 1996, the Company performed various financings for Cardiac Science and received warrants to purchase Cardiac Science common stock. Due to exercise of warrants, common stock issued in lieu of interest and unsecured advances the Company received 5,619,054 (pre-split) shares of Cardiac Science.
In April 1997, Cardiac Science effectuated a 1 for 11.42857143 reverse stock split, reducing the Company's holdings to 546,772 shares, which is the number of shares held at December 31, 1997. This investment is recorded at a cost of $750,054 and the Company currently is restricted from trading this investment, therefore a corresponding valuation reserve has been established, making the net investment value $0.
The Company also holds warrants to purchase 87,500 (post-split) shares at $.011 each, with an expiration date of September 2004.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
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(1) Previously filed with the same exhibit number with the Company's Registration Statement on Form S-1 under the Securities Act of 1933, Reg. No 33-16340 and with the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988, and incorporated herein by reference.
(2) Previously filed with the same exhibit number with the Company's Registration Statement on Form 10-Q for the quarter ended September 30, 1997, and incorporated herein by reference.
(3) Previously filed with the same exhibit number with the Company's Registration Statement on Form S-1 under the Securities Act of 1933, Reg. No. 33-16340 and incorporated herein by reference.
(4) Previously filed with the same exhibit number with the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989, and incorporated herein by reference.
(5) Compensatory plan or arrangement.
(6) Previously filed with the same exhibit number with the Company's annual report on Form 10-K for the year ended December 31, 1993.
(7) Previously filed with the same exhibit number with the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997.
(8) Previously filed with the same exhibit number with the Company's current report on Form 8-K dated June 26, 1991, and incorporated herein by reference.
(9) Previously filed with the Company's current report on Form 8-K dated February 9, 1996, and incorporated herein by reference.
Report of Independent Auditors
Stockholders and Board of Directors Medstone International, Inc.
We have audited the accompanying consolidated balance sheets of Medstone International, Inc. as of December 31, 1997 and 1996 and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Medstone International, Inc. at December 31, 1997 and 1996, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
ERNST & YOUNG LLP
Orange County, California February 14, 1998
MEDSTONE INTERNATIONAL, INC.
CONSOLIDATED BALANCE SHEETS
See accompanying notes
MEDSTONE INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes
MEDSTONE INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
See accompanying notes
MEDSTONE INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes
MEDSTONE INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1997
1. ORGANIZATION AND OPERATIONS OF THE COMPANY
Medstone International, Inc. ("Medstone" or "the Company"), was incorporated in Delaware in October 1984. The Company designs, manufactures and markets the Medstone STSTM Shockwave Therapy System (the "System") for the noninvasive disintegration of kidney stones in human patients. In addition to sales of the System, Medstone generates recurring revenue from procedure fees and fee for service arrangements for use of the System and from repairs and maintenance of the System.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of consolidation
The consolidated financial statements include the accounts of the Company, United Physicians Resources, an 80% owned physicians practice management operation, incorporated in June 1996, Northern Nevada Lithotripsy Associates, LLC, a 60% owned Nevada Limited Liability Company, Southern Idaho Lithotripsy Associates, LLC, a California Limited Liability Company, also 60% owned, (See Note 3), and Medstone Sales Corporation, a 100% owned foreign sales corporation. All material intercompany transactions and accounts have been eliminated.
Reclassifications
Certain prior year balances have been reclassified to conform with the December 31, 1997 presentation.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that effect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates made in preparing these financial statements include the allowance for doubtful accounts.
Statement of cash flows
The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.
The Company had net non-cash transfers of inventory into fixed assets of $250,000, $1,376,000 and $804,000 for the years ended December 31, 1997, 1996 and 1995, respectively.
The Company had net non-cash transfers of accounts receivable, inventory, prepaid expenses, fixed assets, accounts payable accrued expenses and deferred revenue totaling $966,000 in 1996 in the form of a dividend as a result of the spinout of the Endocare, Inc. and Urogen, Inc. subsidiaries.
Short-term Investments
The Company applies the provisions of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Under this statement, management determines the appropriate
classification of such securities at the time of purchase and reevaluates such classification as of each balance sheet date. Based on its intent, the Company's investments are classified as available-for-sale and are carried at fair value, with unrealized gains and losses, net of tax, reported as a separate component of stockholders' equity. The investments are adjusted for amortization of premiums and discounts to maturity and such amortization is included in interest income. Realized gains and losses and declines in value judged to be other than temporary are determined based on the specific identification method and are reported in the consolidated statements of operations.
The Company invests primarily in U.S. government securities and corporate obligations. As of December 31, 1997 and December 31, 1996, investments are summarized as follows:
No gains or losses were realized in 1997 and 1996.
The amortized cost and estimated fair value of investments at December 31, 1997 by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because the issuer of the securities may have the right to repurchase such securities.
Concentrations of credit risk
Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash equivalents, marketable securities and accounts receivable. The Company's marketable securities consist principally of U.S. Treasury Bills.
The Company sells its products primarily to hospitals worldwide. Credit is extended based on an evaluation of the customer's financial condition and collateral generally is not required. The Company's ten largest customers accounted for approximately 15% of accounts receivable at December 31, 1997.
Inventories
Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following:
Property and equipment
Property and equipment are carried at cost. Depreciation and amortization are computed on the straight-line method over the following estimated useful lives:
Depreciation expense for the years ended December 31, 1997, 1996 and 1995 was $1,538,000, $1,223,000 and $945,000, respectively.
Goodwill
The Company recorded goodwill resulting from the excess of the purchase prices of Northern Nevada and Southern Idaho over the fair market value of the net assets. Goodwill is being amortized over a period not to exceed forty years using the straight-line basis. Accumulated amortization at December 31, 1997 and 1996 is $96,503 and $21,374, respectively.
Long-Lived Assets
Long-lived assets and certain identifiable intangibles held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Based upon the Company's analysis, the Company believes no material impairment of the carrying value of its long-lived assets, inclusive of intangible assets, existed at December 31, 1997. The Company's analysis was based on a comparison of the carrying amount of such assets to the Company's historical actual cash flows and to an estimate of future undiscounted cash flows.
Earnings (Loss) Per Share
The Company has adopted SFAS 128 "Earnings Per Share," and applied this pronouncement to all periods presented. This statement requires the presentation of both basic and diluted net income (loss) per share for financial statement purposes. Basic net income (loss) per share is computed by dividing income (loss) available to common stockholders by the weighted average number of common shares outstanding. Diluted net income (loss) per share includes the effect of the potential shares outstanding, including dilutive stock options and warrants using the treasury stock method. Because the impact of options and warrants are antidilutive, there is no difference between the loss per share amount computed for basic and diluted purposes for 1996. All earnings (loss) per share amounts for all periods have been restated to conform with the Statement No. 128 requirements and the accounting rules set forth in Staff Accounting Bulletin 98 issued by the Securities and Exchange Commission on February 3, 1998.
The following table sets forth the computation of earnings (loss) per share:
Stock Compensation
The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related Interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under FASB Statement No. 123, Accounting for Stock-Based Compensation, requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.
To calculate the pro forma information required by Statement 123, the Company uses the Black-Scholes option pricing model. The Black-Scholes model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
Revenue recognition
Revenues are recognized in accordance with the underlying contractual terms of each sale. Typically, revenue recognition requires the transfer of title upon shipment, customer acceptance, receipt of specified down payments and performance of all significant contractual obligations. All foreign sales contracts are negotiated with payment terms in U.S. dollars so the Company has no exposure to foreign currency price fluctuations.
Service and maintenance contract revenues are deferred and amortized over the terms of the related contracts.
Advertising
The Company expenses advertising costs including promotional literature, brochures and trade shows as incurred. Advertising expense was $126,000, $107,000 and $124,000 for the years ended December 31, 1997, 1996 and 1995, respectively.
Recent Accounting Pronouncements
In June 1997, the FASB issued Statement No. 130 (SFAS 130), REPORTING COMPREHENSIVE INCOME, effective for fiscal years beginning after December 15, 1997, which establishes standards for the reporting and display of comprehensive income and its components in financial statements. Comprehensive income generally represents all changes in shareholders' equity except those resulting from investments by owners and distributions to owners. The Company will adopt the new standards in 1998 and does not expect the impact on the financial statement presentation to be significant.
In June 1997, the FASB issued Statement No. 131 (SFAS 131), DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION, effective for fiscal years beginning after December 15, 1997, which establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report information about operating segments in interim financial reports. SFAS 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. The Company will adopt the new standards retroactively in 1998. Management has not completed its review of SFAS 131.
3. ACQUISITIONS
Purchase of Northern Nevada
The Company acquired, in the second quarter of 1996, a 60% interest in Northern Nevada, an operator of a "retail" lithotripsy operation which bills patients or insurers for their services. The assets acquired, accounted for on the purchase method, consisted of the accounts receivable and contracts to provide service to insurers. The Company acquired this 60% interest for $1.35 million cash. The operating results of Northern Nevada are included in the consolidated financial statements of the Company since April 1, 1996.
Purchase of Southern Idaho
On March 18, 1997, the Company completed the acquisition of a 60% interest in Southern Idaho Lithotripsy Associates, LLC, an operator of a "retail" lithotripsy operation in southern Idaho, for a purchase price of $2.3 million in cash. The assets acquired, accounted for on the purchase method, consisted of the accounts receivable and contracts to provide services to insurers. The operating results of Southern Idaho are included in the consolidated financial statements of the Company since March 1, 1997.
4. INCOME TAXES
The Company provides for income taxes under the liability method. Accordingly, deferred income tax assets and liabilities are computed for differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to amounts which are more likely than not to be realized.
The provision (benefit) for income taxes consists of the following:
The following is a reconciliation of the provision (benefit) for income taxes at the federal statutory rate compared to the Company's effective tax rate:
The tax effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows:
At December 31, 1997 and 1996 there was no valuation allowance recognized to offset to Company's deferred tax assets since it is more likely than not that the assets will be fully utilized.
5. STOCK OPTIONS
In 1987, the Company adopted the 1987 Stock Option Plan (1987 Plan) under which options could be granted to key employees or directors of the Company by a committee appointed by the Company's Board of Directors (the Committee) to purchase up to 476,323 shares of the Company's common stock. The exercise price for options granted under the 1987 Plan were equal to the fair market value of the common stock on the date of grant. During 1988 and 1989, the Committee granted options which generally become exercisable with respect to 1/60th of the issuable shares for each elapsed month during the five-year period commencing with dates determined by the Committee. All options granted in 1988 and 1989 terminated one year after the end of the five-year period. In June 1989, the Company terminated the 1987 Plan as to the granting of additional options. In April 1996, the remaining options outstanding under this Plan were exercised and the Plan is now terminated.
In June 1989, the Company's stockholders approved the 1989 Stock Incentive Plan which provides for the granting of a variety of stock-related securities, including shares of common stock, stock options and stock appreciation rights to employees and other selected individuals. In May 1991, the Company's stockholders amended the Plan to increase the number of shares issuable to 1,593,783 and eliminated the provision for an automatic increase in the number of shares issuable on January 1 of each year by one percent of the then outstanding shares. In May 1997 the Company terminated the 1989 Plan as to the granting of additional options. As of December 31, 1997, 673,803 options for shares of common stock had been granted and are outstanding under this plan.
In June 1989, the Company's stockholders also approved the Nonemployee Director Stock Option Plan. This plan provides for the issuance of up to 50,000 shares of the Company's common stock upon exercise of options granted under the plan. As of December 31, 1997, 15,000 options for shares of common stock had been granted under this plan and 5,000 shares have been exercised. In addition, three outside directors have each been granted separate options to purchase 15,000 shares.
In May 1997, the Company's stockholders approved the 1997 Stock Incentive Plan which provides for the granting of a variety of stock-related securities, including shares of common stock, stock options and stock appreciation rights to employees and other selected individuals. The Plan allows for the issuance of up to 800,000 shares, with increases each January 1 that the Plan is in effect by a number of shares equal to one percent of the total number of outstanding shares of Common Stock on that date. As of December 31, 1997, 242,000 options for shares of common stock had been granted and are outstanding under this plan.
Stock option activity under the Company's plans is summarized as follows:
A summary of the Company's stock option plans as of the end of 1997 and 1996 and changes during the years is presented below:
The following table summarizes information about stock options outstanding at December 31, 1997:
In calculating pro forma information regarding net income and net income per share, as required by Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation, the fair value was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for the options on the Company's common stock for the years ended December 31, 1997 and 1996, respectively: risk free interest rates of 6% and 6.5%; dividend yields of 0% and 0%; volatility of the expected market prices of the Company's common stock of 2.303 and .543; and expected life of the options of 5.5 years for both periods.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's proforma information for the years ended December 31, 1997 and 1996 follows (in thousands, except per share information):
These pro forma amounts reflect only the cumulative effect of the expense of options granted during the years ended December 31, 1997, 1996 and 1995, and does not give effect to options granted prior to January 1, 1995.
6. DISTRIBUTION TO SHAREHOLDERS
On February 9, 1996, the Company distributed two stock dividends, payable to stockholders of record on the close of trading on December 29, 1995. The two dividends represent distribution of all the assets and operations of the Endocare and Urogen divisions of the Company. Effective with the start of business on January 1, 1996 these two companies were no longer a part of the Medstone operations, as Medstone distributed to its shareholders all outstanding common stock of each company, retaining only 100,000 shares of each company. These two companies are separate, publicly-held companies.
Medstone, as part of the distribution of Endocare, forgave intercompany debt of $2,831,364 and contributed $500,000 in cash and net other assets of $803,133 to Endocare. As part of the distribution of Urogen, Medstone forgave intercompany debt of $3,888,875 and contributed $500,000 in cash and net other assets of $163,082 to Urogen.
In October 1996, the Company liquidated its position in Endocare. The average sales price was $5.53 per share, net of commissions, for the 100,000 shares that were owned by the Company. A $553,372 gain was recognized in the fourth quarter of 1996.
7. STOCK REPURCHASE PLAN
On March 29, 1996, the Company announced a Stock Repurchase Program of up to 500,000 shares of its Common Stock. For the year ended December 31, 1997, the Company has repurchased a total of 156,000 shares at a cost of $1,292,366, For the year ended December 31, 1996, the Company repurchased a total of 112,800 shares at a cost of $908,370. The Company has repurchased 268,800 shares at a total cost of $2,200,736 since the inception of the repurchase program with all amounts recorded as treasury stock.
As of March 17, 1998, the Company has repurchased an additional 110,400 shares at a total cost of $1,052,825.
8. COMMITMENTS
In March 1994, the Company took occupancy of new office, manufacturing, engineering, warehouse space, and research and development laboratories under an operating lease with an initial term of two years. Under lease extensions, the monthly lease rate was $12,862 through February 1997 and $13,360 through February 1998. The Company has exercised its option to lease through February 1999 at a monthly lease rate of $13,874. The Company has negotiated an extension for a sixteen month period from March 1999 to June 2000, at a monthly rate of $14,410. The future minimum lease payments under the lease are as follows:
Total net rent expense under all operating leases for the years ended December 31, 1997, 1996 and 1995 was $182,000, $156,000 and $152,000, respectively.
9. CONTINGENCIES
In June 1996, the Company negotiated a settlement of the two related class action lawsuits filed by two shareholders of the Company. The settlement in the third quarter of 1996 totaled $6.0 million, with $500,000 paid by the Company's underwriter and $5.5 million paid by the Company. The $5.5 million was charged against earnings in the second quarter of 1996.
From time to time, the Company is subject to legal actions and claims for personal injuries or property damage related to patients who use its products. The Company has obtained a liability insurance policy providing coverage for product liability and other claims. Management does not believe that the resolution of any current proceedings will have a material financial impact on the Company or the consolidated financial statements.
10. RELATED PARTY TRANSACTIONS
During 1991, the Company was a party to the formation of Cardiac Science, Inc., for which the Company purchased 5,353,031 (pre-split) shares of common stock, for a cash payment of $.0016 per share. This purchase represented 77.3% of the outstanding stock. As of July 8, 1991, the Company distributed, as a dividend to its shareholders of record on that date, one share of Cardiac Science, Inc. stock for each share of Medstone stock held. The Company retained 629,768 (pre-split) shares of common stock of Cardiac Science, Inc.
From 1991 through 1996, the Company performed various financings for Cardiac Science and received warrants to purchase Cardiac Science common stock. Due to exercise of warrants, common stock issued in lieu of interest and unsecured advances the Company received 5,619,054 (pre-split) shares of Cardiac Science.
In April 1997, Cardiac Science effectuated a 1 for 11.42857143 reverse stock split, reducing the Company's holdings to 546,772 shares, which is the number of shares held at December 31, 1997. This investment has been recorded at a net investment value $0 due to Cardiac Science's historical financial performance and significant fluctuations in its stock price. The Company's investment in Cardiac Science is currently restricted from trading.
The Company also holds warrants to purchase 87,500 (post-split) shares of Cardiac Science at $.011 each, with an expiration date of September 2004.
11. EMPLOYEE BENEFIT PLAN
In January 1990, the Company established a defined contribution profit sharing 401(k) plan for all eligible employees. The plan provides for the deferral of up to 15% of an employee's qualifying compensation under Section 401(k) of the Internal Revenue Code. Contributions by the Company may be made to the plan at the discretion of the Board of Directors. During 1997, the Company's Board of Directors elected to match employee contributions $.25 on a dollar, up to a maximum company contribution of $2,000. In 1997, the Company's contribution totaled $37,991. No such contributions were made to the plan during the years ended December 31, 1996 and 1995.
12. MAJOR CUSTOMERS AND FOREIGN SALES
During the 12 months ended December 31, 1997 no single customer accounted for 10% or more of total revenues and the Company derived 2% of its total revenues from sales to foreign customers. During the year ended December 31, 1996 no single customer accounted for 10% or more of total revenues and the Company derived 11% of its total revenues from sales to foreign customers. During the year ended December 31, 1995, no single customer accounted for 10% of total revenues of the Company and the Company derived 9% of its total revenues from sales to foreign customers.
13. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The tables below set forth selected quarterly financial information for 1997 and 1996 (in thousands, except per share amounts).
In 1997 and 1996, the Company's effective income tax rate approximated statutory rates. (See Note 4).
MEDSTONE INTERNATIONAL, INC.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
(a) Reserve transferred to Endocare with the spinout.
(b) Write-off of inventory
(c) Write-off of bad debt
(d) Reserve transferred from loan provision to investment provision due to restructuring.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
MEDSTONE INTERNATIONAL, INC.
By: DAVID V. RADLINSKI ------------------------------- David V. Radlinski Chief Executive Officer
Dated: March 24, 1998
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 24, 1997.
SIGNATURE TITLE --------- -----
DAVID V. RADLINSKI Chairman of the Board, ------------------ Chief Executive Officer David V. Radlinski and Director (Principal Executive Officer)
MARK SELAWSKI Chief Financial Officer ------------- (Principal Financial and Accounting Officer) Mark Selawski
DONALD J. REGAN Director --------------- Donald J. Regan
FRANK R. POPE Director ------------- Frank R. Pope
MICHAEL C. TIBBITTS Director ------------------- Michael C. Tibbitts