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FORM 10-K
U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For fiscal year ended December 31, 1998
Commission file number: 0-22340
[OBJECT OMITTED]
PALOMAR MEDICAL TECHNOLOGIES, INC.
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(Exact name of registrant as specified in its charter)
Delaware 04-3128178
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(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)
45 Hartwell Avenue, Lexington, Massachusetts 02173
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(Address of principal executive offices)
(781) 676-7300
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(Issuer's telephone number, including area code)
Securities registered pursuant to Section 12 (b) of the Act:
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Name of each exchange on
Title of each class which registered
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Not Applicable Not Applicable
Securities registered pursuant to Section 12 (g) of the Act:
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Common Stock, $.01 par value
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 report(s)), and (2) has been subject to
such filing requirements for the past 90 days. Yes X No
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Check if there is no disclosure of delinquent filers in response to Item
405 of Regulation S-K contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. [ ]
As of March 2, 1999, 72,145,509 shares of Common Stock were outstanding.
The aggregate market value of the voting shares (based upon the closing price
reported by Nasdaq on March 20, 1998) of Palomar Medical Technologies, Inc.,
held by nonaffiliates was $$43,549,606. For purposes of this disclosure, shares
of Common Stock held by entities who own 5% or more of the outstanding Common
Stock, as reported in Amendment No. 4 to a Schedule 13G filed on January 22,
1999 and Amendment No. 3 to a Schedule 13D filed on February 16, 1999, and
shares of common stock held by each officer and director have been excluded in
that such persons may be deemed to be "affiliates" as that term is defined under
the Rules and Regulations of the Securities Exchange Act of 1934. This
determination of affiliate status is not necessarily conclusive.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive proxy statement to be filed prior to April 30,
1998, pursuant to Regulation 14A of the Securities Exchange Act of 1934 are
incorporated by reference into Part III of this Form 10-K
Transitional Small Business Disclosure Format: Yes X No
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INDEX
Item Page No.
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PART I.........................................................................................................1
Item 1. Business.........................................................................................1
(a) Introduction.....................................................................................1
(b) Financial Information About Industry Segments....................................................1
(c) Description of Business..........................................................................1
(d) Financial Information About Exports by Domestic Operations......................................10
Item 2. Properties......................................................................................10
Item 3. Legal Proceedings...............................................................................10
Item 4. Submission of Matters to a Vote of Security Holders.............................................11
PART II.......................................................................................................12
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters...........................12
Item 6. Selected Financial Data.........................................................................14
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations...........15
(a) Overview........................................................................................15
(b) Results.........................................................................................15
(c) Liquidity and Capital Resources......................................................................19
(d) Year 2000 Issues.....................................................................................21
(e) Nasdaq Stock Market Listing..........................................................................21
(f) Recently Issued Accounting Standard..................................................................22
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.....................................22
Statement Under the Private Securities Litigation Reform Act.............................................22
Risk Factors.............................................................................................23
Item 8. Financial Statements............................................................................27
Reports of Independent Public Accountants............................................................28
Consolidated Balance Sheets as of December 31, 1997 and 1998.........................................30
Consolidated Statements of Operations for the years ended December 31, 1996, 1997 and 1998...........31
Consolidated Statements of Stockholders' Equity (Deficit) for the years ended
December 31, 1996, 1997 and 1998................................................................32
Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1997 and 1998...........35
Notes to Consolidated Financial Statements...........................................................37
Item 9. Changes and Disagreements with Accountants on Accounting and Financial Disclosures..............63
PART III .....................................................................................................64
Item 10. Directors and Executive Officers of the Registrant.............................................64
Item 11. Executive Compensation.........................................................................64
Item 12. Security Ownership of Certain Beneficial Owners and Management.................................64
Item 13. Certain Relationships and Related Transactions.................................................64
PART IV.......................................................................................................65
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K................................65
(a) Index to Consolidated Financial Statements and Schedules........................................65
(b) Reports on Form 8-K.............................................................................65
(c) Exhibits........................................................................................66
SIGNATURES....................................................................................................73
ii
PART I
Item 1. Business.
(a) Introduction
Palomar Medical Technologies, Inc. (the "Company," "Palomar," or "we")
was organized in 1987 to design, manufacture and market lasers, delivery systems
and related disposable products for use in medical procedures. In December 1992
the Company went public. Subsequently, the Company pursued an aggressive
acquisition program, acquiring companies in its core laser business as well as
others, principally in the electronics industry, in order to spread risk and
bolster operating assets, among other reasons. By the beginning of 1997, the
Company had more than a dozen subsidiaries. At the same time, having obtained
FDA clearance to market its EpiLaser(R) hair removal laser system in March 1997,
the Company was well positioned to focus on what it believed was at that time
the most promising product in its core laser business. Hence, under the
direction of a new Board and management, the Company undertook an ambitious
program in 1997, completed in May of 1998, of exiting all non-core businesses
and investments and focusing only on those businesses which it believes hold the
greatest promise for maximizing stockholder value. The Company's exclusive focus
is now the use of lasers in dermatology and cosmetic procedures, with an
emphasis on laser hair removal and research and development relating to that and
other cosmetic laser products. Currently, the Company has three operating
subsidiaries, Palomar Medical Products, Inc. ("PMP"), Esthetica Partners, Inc.
("Esthetica") (formerly Cosmetic Technology International, Inc.) and Star
Medical Technologies, Inc. ("Star"). PMP, located at the Company's headquarters
in Lexington, Massachusetts, oversees the manufacture and sale of the Company's
two ruby hair removal laser system currently on the market. Esthetica, also
based in Lexington, Massachusetts, places the Company's lasers in clinical and
cosmetic settings and shares in a portion of the revenue generated thereby.
Star, based in Pleasanton, California, manufactures the LightSheer(TM) diode
hair removal laser. Palomar has entered into an agreement with Coherent, Inc.
("Coherent') to sell Star to Coherent. The agreement is subject to stockholder
approval and standard closing conditions. (On March 12, 1999, Palomar filed a
proxy statement with the Securities and Exchange Commission that details the
Star Sale.) A Special Meeting of Palomar's stockholders has been scheduled for
April 21, 1999. If the Star sale is approved at that meeting by the holders of a
majority of the shares of Palomar's outstanding common stock, then the sale will
be completed shortly after the meeting date. (See Item 7., "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Overview.")
(b) Financial Information About Industry Segments
The Company conducts business in one industry segment, medical products
and services. In 1998 the Company completed the program, begun in 1997, of
divesting all of its non-core electronics subsidiaries. (See Item 7.
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Overview" and Note 2 to Financial Statements.)
(c) Description of Business
(i) Principal Products and Services
Lasers for Hair Removal
The Technology
The word "laser" is the acronym for "light amplification by stimulated
emission of radiation." The emitted radiation oscillates within an optical
resonator and is amplified by an active medium, resulting in a monochromatic
beam of light, which is narrow, highly coherent and thus can be focused to a
small spot with a high degree of precision. In recent years, scientists and
clinicians have developed a concept called tissue optics to describe how the
unique properties of the laser can be used to treat human tissue selectively and
more precisely. By careful selection of laser parameters, such as wavelength
(color), energy and pulse width (exposure time), and with a detailed
understanding of the physical and optical properties of the target tissue, the
clinician can selectively treat the target tissue while minimizing or
eliminating damage to surrounding tissue. The concept of color selectivity has
been useful in developing a number of successful dermatological applications.
The patented hair removal technology licensed exclusively to Palomar targets the
pigment in a hair follicle and was developed at Massachusetts General Hospital
("MGH"), Palomar's research partner. Pigment, called melanin, is found in the
upper layer of the skin and in the hair shaft and hair follicle deeper below the
surface of the skin. With the appropriate
1
selection of wavelength (color), energy and pulse width to allow for the
preferential absorption of laser energy by the melanin present in the hair,
there is negligible absorption by the surrounding tissue. Energy from ruby
lasers is particularly well absorbed by melanin and absorption by other cells
and tissue is particularly low. Palomar uses a patented and proprietary contact
cooling technology to protect the upper layer of the skin while the laser light
is targeting and destroying the follicle deeper within the skin tissue. In
addition, Palomar's patented contact-cooling handpiece enables the laser light
to penetrate to the correct depth while at the same time limiting the amount of
discomfort associated with the procedure. This method of hair removal using the
cooling handpiece allows for selective destruction of the target follicle
without harming the surrounding skin or surface of the skin. The laser light is
pulsed at a rapid rate covering approximately one square inch at each pulse.
This treatment method allows for a large area of treatment over a relatively
short period of time.
In an effort to find a way to allow the laser light to pass through top
skin layers and be deeply absorbed in the hair follicle below, a contact cooling
handpiece was developed by MGH and the underlying patents licensed to Palomar on
an exclusive world-wide perpetual basis. This unique cooling handpiece is key to
the success and safety of Palomar's laser hair removal systems, as it permits
laser applications of higher power with better targeting and greater safety. The
cold sapphire tip protects the epidermis while allowing the laser light to
efficiently destroy the target follicles.
The Products
Using its core ruby laser technology, originally developed for tattoo
removal and pigmented lesions, Palomar developed a long pulse ruby laser, the
EpiLaser(R) laser system, that is specifically configured to allow the
appropriate wavelength, energy level and pulse duration to be absorbed
effectively by the hair follicle without being absorbed by the surrounding
tissue. That, combined with the patented cooling handpiece, allows for safe and
effective hair removal. In March 1997, Palomar was the first company to receive
FDA clearance to sell and market a ruby laser (the EpiLaser(R) system) in the
U.S. for hair removal.
In December 1997 and January 1998 respectively, Palomar was also the
first company to receive FDA clearance for a diode laser for hair removal and
for leg vein treatment, the LightSheer(TM) diode laser system manufactured by
Star. The LightSheer(TM) diode laser also incorporates the patented
contact-cooling system licensed exclusively to Palomar. Star's high-powered
diode system is a compact, solid-state laser that is significantly smaller than
most current systems, and relatively easy to install and service. The
LightSheer(TM) is the only high-power pulsed diode laser hair removal system
available on the market today.
Palomar recently introduced its second generation ruby laser, the
Palomar E2000(TM), a product which the Company anticipates will be superior to
hair removal lasers currently available in a number of respects, including speed
and efficacy. The Palomar E2000(TM) has already received FDA clearance for hair
removal.
Studies using Palomar's laser hair removal process demonstrated
significant permanent reduction of hair following treatment with the EpiLaser(R)
ruby laser. The first treatment causes a portion of the hair (typically the hair
in the growth mode) to be reduced in size, color and/or quantity (based on
studies followed for up to three years) and causes significant growth delay
(three to six months) of most of the rest of the hair. Since the partial
re-growth tends to occur in synchrony, the follow-up treatment is often more
effective than the first treatment. The EpiLaser(R) and the Palomar E2000(TM)
are the only hair removal lasers on the market that have been cleared by the FDA
for "permanent hair reduction" labeling.
The Hair Removal Market
The market for laser-based hair removal is in its early stages. Palomar
believes that this market remains a growing one. Benefits of Palomar's laser
hair removal process, as compared to other hair removal methods currently
available, include significant long term cosmetic improvement, treatment of
larger areas in each treatment session, relatively painless procedure, reduced
risk of scarring, non-invasive procedure, no risk of cross-contamination, and
higher success rates than with previous methods.
Market surveys report that the great majority of women in the United
States employ one or more techniques for temporary hair removal from various
parts of the body. Pulling hair from the follicle produces temporary results,
but is painful and may cause skin irritation. A number of techniques are used to
pull hair from the follicle including waxing, depilatories and tweezing. In the
waxing process, a lotion, generally beeswax-based, is spread on the area to be
treated and
2
allowed to harden, thereby trapping the hairs. The hardened film is then rapidly
peeled off, pulling out the entrapped hairs. Depilatories employ rotating spring
coils or slotted rubber rolls to trap and pull out the hairs. Tweezing involves
removing individual hairs with a pair of tweezers. Depilatory creams, which
contain chemicals to dissolve hair, frequently leave a temporary, unpleasant
odor and may also cause skin irritation. Shaving is the most widely used method
of hair removal, especially for legs and underarms, but produces the
shortest-term results. Hair bleaches do not remove hair, but instead lighten the
color of hair so that it is less visible. A principle drawback of all of these
methods is that they require frequent treatment.
Before the advent of laser hair removal, electrolysis was the only
method available for the long-term removal of body hair. Electrolysis is a
process in which an electrologist inserts a needle directly into a hair follicle
and activates an electric current in the needle, which disables the hair
follicle. The tiny blood vessels in each hair follicle are heated and
coagulated, presumably cutting off the blood supply to the hair matrix, or are
destroyed by chemical action depending upon modality used. The success rate for
electrolysis is variable depending upon the skill of the electrologist and
always requires a series of treatments. Electrolysis is time-consuming,
expensive and sometimes painful. There is also some risk of skin blemishes and a
rising concern relating to needle infection. Since electrolysis only treats one
hair follicle at a time and can only treat visible hair follicles, the treatment
of an area as small as an upper lip may require numerous visits at an aggregate
cost of up to $1,000. Although 70% of all electrolysis treatments are for facial
hair, the neck, breasts and bikini line are also treated. Because hair follicles
are disabled one at a time, electrolysis is rarely used to remove hair from
large areas such as the back, chest, abdomen and legs. The Company believes its
unique delivery system enables the user to address a potentially larger market
than electrolysis currently does by offering to treat large areas of the body
such as back, chest, abdomen, legs, arms and other areas.
Marketing, Distribution and Service
Pursuant to an agreement executed in November 1997, Coherent acts as
the exclusive distributor for Palomar's hair removal lasers. Under its agreement
with Palomar, Coherent is responsible for sales, marketing, service, training
and education. However, Coherent and Palomar agreed that, beginning January 1,
1999, Palomar would take over all service for Palomar's ruby hair removal
lasers. Coherent has over 200 sales persons worldwide, and 50 service
representatives in the US and over 100 worldwide. If Star is sold to Coherent,
Coherent will continue to act as a distributor of Palomar's products, but on a
non-exclusive basis. If the Star sale is not completed, Coherent will remain as
the Company's exclusive distributor through November 2001, pursuant to the terms
of the Sales Agency Agreement between the parties. In December, 1998, Palomar
signed a letter of intent with Continuum Biomedical, Inc., a medical division of
the scientific laser-based company Continuum Electro-Optics (which is in turn a
wholly-owned subsidiary of Hoya Corp. of Japan), to distribute Palomar's
products (other than Star's LightSheer(TM) laser) on a non-exclusive basis. The
Company intends to tailor distribution methods to different geographic regions
and may include a combination of exclusive and non-exclusive distributors,
independent representatives or direct salespeople. In exchange for a payment of
$2,740 per day from January 20, 1999 until the closing of the Star sale,
Coherent has agreed to waive its exclusive distribution rights under the
Company's Sales Agency Agreement with Coherent, so that Palomar may begin to
sell the Palomar E2000(TM) immediately through other channels, including
Continuum Biomedical, without the necessity of paying commissions to Coherent or
waiting for the Sales Agency Agreement to terminate upon the closing of the Star
sale.
Laser for Tattoo and Pigmented Lesion Removal
The Company also sells a Q-switched ruby laser for tattoo removal and
treating pigmented lesions, the RD-1200(TM). The RD-1200(TM) has been on the
market for ten years. In 1998, RD-1200(TM) sales constituted less than 5% of the
Company's sales, and were primarily overseas, in Japan, Korea and other parts of
the world. Intense competition in the medical device industry and market
saturation for this type of laser have reduced RD-1200(TM) sales over the last
five years. In addition, there are less expensive products now available for
this purpose. Palomar expects sales of this product to continue in 1999 at a low
volume to foreign countries where the advantages of ruby laser for treatment of
pigmented lesions is especially important. Palomar sells and services the
RD-1200(TM) through distributors internationally. In the United States, Palomar
provides service through its own service organization.
3
Cosmetic Laser Services
An additional avenue that the Company has explored for its laser
technology is the service business conducted through its Esthetica subsidiary,
which was incorporated in 1996 (under the name Cosmetic Technology
International, Inc.) for that purpose. During 1997 and 1998, Esthetica
established a number of test sites to explore business models. Esthetica
provides each of its sites with a turnkey package of laser and medical device
technology, equipment, training and service, strategic advertising and marketing
programs, and management assistance. To date, ten Esthetica revenue-sharing
sites are open and under development.
(ii) Products Under Development
Other Cosmetic Applications
Palomar aims to address dermatology and cosmetic procedure markets
other than hair removal, and its research and development is not limited to hair
removal. (See "Research and Development.")
Palomar will consider a number of alternatives with respect to its
future products, including manufacturing them itself and selling them directly
and/or through distributors or (as in the case of Star) selling the product line
and/or technology to others. Palomar will choose in each case the alternative
which it believes best maximizes long-term stockholder value.
Non-Cosmetic Applications Developed at Star
The only non-cosmetic products under development are all being
developed out of Palomar's Star subsidiary, and these projects would transfer to
Coherent upon the sale of Star. One of the products under development at Star is
a diode laser for burn diagnosis. The system is designed to illuminate the wound
site with near infrared light from a diode laser and to image the blood flow
using a fluorescence dye as an aid to the doctor in determining the extent of
blood flow within the dermis to more accurately diagnose the degree of a burn
and to enable physicians to improve treatment of burn patients. In 1994, Star
obtained an exclusive, worldwide license to a patent relating to the measurement
of burn depth in skin from the Office of Technology Affairs at MGH. In 1996,
Star began initial clinical testing of the burn diagnosis system at the Shriner
Burn Center in Boston, Massachusetts and at the Augusta Medical Center in
Augusta, Georgia. To date the system has been tested on a small number of burn
patients and has demonstrated the ability to detect the absence or presence of
blood flow deep in the dermis. The system has also been used clinically to
determine blood flow surrounding skin ulcers and in surgical flaps, again, on a
very limited number of patients. Clinical testing continues at the Augusta
Medical Center.
Non-Cosmetic Applications Developed at Palomar
Another area of non-cosmetic laser product development being conducted
by Palomar is laser tonsillectomy. In June 1994, Palomar signed an agreement
with the Otolaryngology Research Center for Advanced Endoscopic Applications at
New England Medical Center, Boston, Massachusetts (the "NEMC Agreement"), to
provide a research grant and to sponsor investigations and development of laser
applications, advanced delivery systems and disposable products in the area of
dye and diode laser applications in otolaryngology and related specialties.
Under the NEMC Agreement, the Company provided a total of $150,000 in funding
and $50,000 in the form of laser hardware. Palomar will obtain ownership rights
or the right of first refusal to exclusive worldwide licenses to sell and market
any inventions developed with the grant funding. In August 1994, the NEMC
Agreement was amended to support animal testing with one of Star's diode lasers
in connection with performing tonsillectomies. The animal studies were completed
successfully in 1997.
Palomar expects that it may take several years before commercial
products are available as a result of any of the above-described non-cosmetic
product development efforts.
4
Dye Laser
During 1995, the Company entered into a two-year cost plus fixed fee
contract with the U.S. Army for the investigation of compact, wavelength
diverse, high efficiency solid-state dye lasers. In 1997, the Company, which
does not anticipate this research will result in a commercial product within the
next few years, concluded with the U.S. Army a Novation Agreement which novates
this contract to Physical Sciences, Inc. ("PSI"). Upon completion of the
contract, PSI has agreed to offer the Company a right of first refusal for a
commercial license to sell, manufacture or otherwise dispose of solid-state dye
laser technology as developed by PSI under the contract for use in medical
products.
Laser Thrombolysis
In 1993, the Company entered into an agreement with the Edwards LIS
Division of Baxter regarding an integrated system utilizing lasers and catheters
for the removal of blood clots. Under this agreement, Baxter licensed its
proprietary technology to the Company, and the Company cross-licensed its laser
thrombolysis technology to Baxter. The Company also granted to Baxter a license
to sell and market products incorporating such technology. Baxter agreed to
transfer its interest in the agreement to Advanced Cardiovascular Systems, Inc.
("ACS"), a division of Eli Lilly, as part of a purchase by Eli Lilly of the
Baxter LIS division. Eli Lilly subsequently sold ACS to Guidant Corp. In January
1997, Palomar became an equity partner in the formation of a new company, LaTIS,
Inc., created to use Palomar's laser thrombolysis technology to develop a
pulsed-dye laser system for treating strokes. All licenses relating to this
technology have been transferred to LaTIS. Palomar owns approximately 10% of
LaTIS. With the formation of this new venture, laser thrombolysis is no longer
part of Palomar's strategic agenda, although the Company can still derive some
benefits from its research due to its equity participation. The results of
LaTIS' operations and financial position have been immaterial to Palomar to
date.
(iii) Production and Sources and Availability of Materials
Palomar's manufacturing operations are currently located in both
Lexington, Massachusetts and Pleasanton, California. The ruby laser systems are
manufactured in Massachusetts and the diode laser system is manufactured in
California. If Star is sold to Coherent, Palomar will no longer have facilities
in California. Manufacturing consists of the assembly and testing of components
purchased from outside suppliers and contract manufacturers. Palomar maintains
control of and manufactures key components in-house. The entire fully assembled
system is subjected to a rigorous set of tests prior to shipment to the customer
or distributors.
Palomar depends and will depend upon a number of outside suppliers for
components used in its manufacturing process. Most of Palomar's components and
raw materials are available from a number of qualified suppliers. Two critical
components that are available through only one qualified supplier each are ruby
rods for the ruby lasers and diode bars for the diode lasers. To date, the
Company has not experienced, nor does it expect to experience, any significant
delays in obtaining component parts or raw materials. Palomar has expanded its
manufacturing capabilities to satisfy projected demand. Palomar has the approval
for the CE Mark for the EpiLaser(R) laser system, and is working towards
completion of ISO 9001 registrations for both facilities.
(iv) Patents and Licenses
Certain products of the Company and methods for the use of such
products are largely proprietary. The Company believes that patent protection of
its technology and products that result from the Company's research and
development efforts is important to the possible commercialization of the
Company's technology. The Company continually attempts to protect its
proprietary technology by obtaining patent protection and relying on trade
secret laws and non-disclosure and confidentiality agreements with its employees
and persons that have access to its proprietary technology.
To date, the Company and its subsidiaries have filed thirteen patent
applications related to its laser products with the United States Patent and
Trademark Office in order to protect its current technology. This includes two
applications that are continuations of previous applications. To date, four of
these patents have been issued. Additionally, the Company extends many of its
domestic filings into foreign applications. To date, ten foreign applications
have been filed, and no foreign patents have been issued. The Company intends to
aggressively pursue any person or company that offers products that the Company
believes infringe on one or more of its patents or on patents licensed
exclusively to the Company.
5
The Company believes it owns, or has the right to use, the basic
patents covering its products. However, each year there are many patents granted
worldwide related to lasers and their applications. In the past, the Company has
been able to obtain patent licenses for patents related to its products on
commercially reasonable terms. The failure to obtain a key patent license from a
third party could cause the Company to incur liabilities for patent infringement
and, in the extreme case, to discontinue manufacturing products that infringe
upon the patent. Management believes that none of the Company's current products
infringe upon a valid claim of any patents owned by third parties, where the
failure to license the patent would have a material and adverse effect on the
Company's financial position or results of operations.
In March 1997, one of Palomar's competitors, Selvac Acquisitions Corp.
("Selvac"), filed a complaint alleging, among other things, that the EpiLaser(R)
laser system infringes a patent held by Selvac. Palomar successfully argued that
the Selvac patent was invalid, and now Selvac has appealed that ruling. See Item
3. "Legal Proceedings.")
Other than the matter described above, the Company has not been
notified that it is currently infringing on any patents nor has it been the
subject of any patent infringement action. Defense of a claim of infringement is
costly and could have a material adverse effect on the Company's business, even
if the Company were to prevail. (See Item 3. "Legal Proceedings" and Item 7.
"Risk Factors - Patents/Possible Patent Infringements.")
In August 1995, the Company entered into an agreement with MGH whereby
MGH agreed to conduct clinical trials on a laser treatment for hair
removal/reduction developed at MGH's Wellman Laboratories of Photomedicine. As
part of the agreement, MGH provided the Company with prior data already
generated at MGH with respect to the ruby laser device. This information was the
basis for the Company's application filed with the FDA for approval of the
Company's EpiLaser(R) laser system for treating unwanted hair. Effective
February 14, 1997, the Company amended the 1995 agreement with MGH. Under the
terms of this amendment, the Company agreed to provide MGH with a grant of
approximately $204,000 to perform research and evaluation in the field of hair
removal. During 1998, the Company incurred approximately $517,000 under its
clinical research agreement with MGH and other clinical studies. The Company
expects to incur approximately $350,000 of clinical research with MGH during
1999. The Company is also in the process of negotiating another amendment to
both extend the term and expand the scope of the clinical trial agreement with
MGH.
MGH has filed a number of patents surrounding technology involving
laser hair removal. The first patent was issued on January 21, 1997, and a
continuation-in-part of this patent was issued on April 7, 1998. MGH licenses
these patents exclusively to Palomar. Palomar, in turn, has the right to
sublicense these patents to others. Palomar also has the right to exclusively
license any other patents arising out of MGH's Palomar-funded clinical trials.
As consideration for this license, the Company is obligated to pay MGH royalties
of 5% of net revenues on laser hair removal products covered by valid patents
licensed to the Company exclusively; 2.5% of net revenues on products covered by
valid patents licensed to the Company non-exclusively; no less than 2.5% of net
revenues for products sold for hair removal as well as other uses, and a royalty
to be negotiated on services or commercial dispositions (other than sales)
involving products covered by valid patents licensed to the Company.
Star owns four patents, two relating to the use of a high-powered diode
laser for the treatment of psoriasis and subsurface blood vessels, one related
to the design and use of high-powered diode lasers, and one related to laser
diode array packaging. Under a patent license agreement which will take effect
only if and when Star is sold to Coherent (the "Patent License Agreement"),
Palomar will sublicense to Coherent the two MGH hair removal patents discussed
above for a royalty of 7.5% of the net sales price of all licensed products.
Licensed products means products manufactured by Coherent or Star which infringe
one or more claims of either of the two MGH hair removal patents. Assuming it
purchases Star, then, Coherent will have to pay Palomar a 7.5% royalty on all
LightSheer(TM) diode lasers that are sold by Coherent. Palomar, in turn, will
pay a portion of this royalty income back to MGH.
The Patent License Agreement further provides that, if it is sold to
Coherent, Star will grant to Palomar a royalty-free license on its two patents
relating to treatment of subsurface blood vessels, in the following limited
respect: Palomar may sublicense these patents only to other companies in
connection with their manufacture and sale of so-called "dual use devices," that
is, lasers that perform both hair removal and the treatment of subsurface blood
vessels (for example, leg veins). If Palomar does enter into such sublicensing
agreements, it will not have to pay any royalty amounts back to Coherent.
However, for a period of two years from the closing of the Star sale, Palomar
may not offer to sublicense the two subsurface blood vessel patents for
semiconductor lasers that operate in a continuous wave mode or in a
quasi-continuous wave mode
6
that deliver more than 5 joules in any 50 millisecond period ("Competitive
Products"). After the two year period, Palomar may sublicense dual use devices
that constitute Competitive Products, but then it must pay a royalty back to
Coherent.
The Patent License Agreement also provides that Star will grant to
Palomar a royalty-free license to Star's high-fluence diode laser patent for
uses other than Competitive Products. Once again, Palomar may license this
patent in connection with Competitive Products at the end of the two year
period, but only if it pays a royalty back to Coherent.
All licenses granted under the Patent License Agreement are granted for
the life of the respective patents. The Patent License Agreement also includes a
so-called "most favored licensee" provision, which means that, should either
party grant to a third party a license to any of these patents on more favorable
royalty terms than those established in the Patent License Agreement, then the
other party can immediately obtain that same lower royalty going forward
(assuming that all of the other material terms of the license agreement with the
third party are essentially like those in the Patent License Agreement).
(v) Seasonal Influences
There is no significant seasonal influence on the Company's sales.
(vi) Financing of Operations and Increase in Outstanding Shares
If Star is sold to Coherent, Palomar will receive net proceeds of
approximately $49 million in cash. In addition, as part of the sale of Star,
Coherent has agreed to pay the Company an ongoing 7.5% sublicensing royalty on
future sales of its hair removal lasers. (See "Patents and Licenses.") There can
be no assurance that the sale of Star to Coherent will be completed and that
events in the future will not require the Company to seek additional financing.
The sale must be approved by a majority of the Company's shares outstanding, and
is also subject to standard closing conditions. Financing of the Company's
future operating plan is now to a great extent dependant on completing the sale.
If the sale of Star is not completed the Company will require additional
financing during 1999 and there can be no assurance that any such financing will
be available on terms satisfactory to the Company. Based on its historical
ability to raise funds as necessary and ongoing discussions with potential
financing sources, the Company believes that it will be successful in obtaining
additional financing, if required, in order to fund future operations.
To enhance stockholder value and increase revenues, Palomar will also
consider licensing its intellectual property (in particular, the patents
licensed exclusively to Palomar by MGH under which the Company practices its
proprietary method of skin cooling and hair removal), selling intellectual
property rights that the Company does not intend to exploit, and mergers,
acquisitions or other transactions.
The Company has financed current operations and past expansion of its
core business with short-term financial borrowings and investments through the
private sale of debt and equity securities of the Company. Net cash provided by
financing activities totaled approximately $7,050,000 and $31,198,000 for the
years ended December 31, 1998, and December 31, 1997, respectively. If Star is
not sold, the Company may from time to time be required to raise additional
funds through additional private sales of the Company's debt or equity
securities. Sales of securities to private investors have been sold at a
discount to the current or future public market for similar securities. It has
been the Company's experience that private investors require that the Company
make its best effort to register their securities for resale to the public at
some future time. There can be no assurance that the Company would be successful
in raising additional capital on favorable terms. (See Notes 1, 6, and 7 to
Financial Statements, Item 5. "Market for Common Equity and Related Stockholder
Matters," and Item 7. "Risk Factors")
The Company has a $10,000,000 revolving line of credit from a bank.
This revolving line of credit matures on March 31, 2000 and bears interest at
the bank's prime rate (7.75% at December 31, 1998). Borrowings are limited to
80% of domestic accounts receivable under 90 days from invoice. A director of
the Company has personally guaranteed borrowings under the line of credit. As of
March 20, 1999, $725,000 was available under that line of credit. Substantially
all of Star's account receivables provide the borrowing base under this line of
credit.
As a result of financing activities, business developments, mergers and
acquisitions, issuance of incentive stock options and warrants to purchase
common stock to attract and retain key employees, the Company's issued and
outstanding
7
shares of common stock have increased to 70,179,027 at December 31, 1998. The
Company also had additional reserved but unissued shares of common stock of
33,807,020 shares at December 31, 1998. As of March 18, 1999, the Company's
issued and outstanding shares of common stock increased to 72,145,509 shares,
and reserved but unissued shares of common stock stood at 31,268,118 shares. A
substantial number of the Company's reserved shares are registered and could be
resold into the public market. (See Item 7. "Risk Factors.")
There are no special inventory requirements or credit terms extended to
customers that would have a material adverse effect on the Company's working
capital.
(vii) Dependency on a Single Customer
Sales pursuant to the Company's Sales Agency, Development and License
Agreement with Coherent accounted for approximately 89% of the Company's total
revenues in fiscal 1998. (See - "Marketing, Distribution and Service," Item 7.
"Risk Factors" and Notes 3(i) and 12(d) to Financial Statements.) If Star is not
sold to Coherent, then this Sales Agency Agreement will remain in effect until
November 17, 2001. Otherwise, the Sales Agency Agreement will terminate upon the
closing of the sale of Star.
(viii) Backlog
The Company's backlog of firm orders for its continuing operations at
December 31, 1998, and December 31, 1997, was approximately $3.4 million and
$2.5 million, respectively. This backlog consists almost entirely of orders for
Star's LightSheer(TM) diode laser. The Company has filled $2.1 million of this
year-end backlog in 1999. As of March 20, 1999, the Company's backlog of firm
orders related to Star's LightSheer(TM) was approximately $4.4 million, and, to
the Palomar E2000(TM), approximately $750,000.
(ix) Government Contracts
Not applicable.
(x) Competition
The markets in which the Company is engaged are subject to keen
competition and rapid technological change. Nine other companies, ThermoLase
Corporation; Candela, Inc.; Medical Laser Technologies Ltd. (Aesculap-Medtec);
Light Age, Inc.; Dornier Surgical Products, Inc.; Continuum Biomedical, Inc.;
Polytec PI, Inc. (Lambda Photometics); Leisegang Medical, Inc. and Cynosure,
Inc. have received market clearance from the FDA for laser hair removal and
another company, ESC Medical Systems Limited, has received FDA clearance to
market a laser-like system using filtered intense light to remove hair. The
Company expects that other hair removal devices will be developed and/or
introduced in 1999, making laser hair removal a competitive application within
the cosmetic laser marketplace. The Company also expects that there may be
further consolidation of companies within the laser hair removal industry via
acquisitions, partnering arrangements or joint ventures. The Company's products
will also compete with other hair removal products and methods. The Company
competes primarily on the basis of technology, product performance, price,
quality, reliability, distribution and customer service and support. To remain
competitive, the Company will be required to continue to develop new products,
periodically enhance its existing products and compete effectively in the areas
described above.
In the cosmetic laser services industry, the Company's Esthetica
subsidiary competes not only with other laser companies which also either
revenue-share with physicians and/or operate their own centers, but also with
healthcare providers. Esthetica's services will also compete for business with
other aesthetic service providers such as electrologists, beauty salons, spas,
and aestheticians, among others. Product efficacy, location, marketing, a wide
offering of laser procedures, price and customer service are all important
competitive factors. (See Item 7. "Risk Factors.")
(xi) Research and Development
Among Palomar's research and development goals in the field of laser
hair removal are to design systems that (1) permit more rapid treatment of large
areas, (2) have high gross margins, and (3) are lower cost, thus addressing
broader markets. Further, Palomar aims to address dermatology and cosmetic
procedure markets other than hair.
8
During fiscal 1998, fiscal 1997, and fiscal 1996, the Company incurred
approximately $7,029,000 $11,990,000 and $6,297,000, respectively, of internally
sponsored research and development programs. Due to the intense competition and
rapid technological changes in the laser industry, the Company believes that it
must continue to improve and refine its existing products and services, and
develop new applications for its technology.
Wellman Laboratories, the world's largest biomedical laser research
facility and part of the MGH Laser Center located in Boston, Massachusetts, was
created to oversee and speed the flow of biomedical laser research from the
laboratory to patient care. Funded in part by a grant from the Department of
Energy, the MGH Laser Center brings together two strengths of MGH: its clinical
departments and the Wellman Labs. The MGH Laser Center works together with
industry, academia and the Department of Energy Laboratories to access
information and technology across a broad spectrum of laser and medical
capabilities. The principals at Wellman Labs study the fundamental photophysical
and photochemical properties and processes of biomolecules excited by
ultraviolet, visible and near infrared radiation. Engineers, laser physicists
and physicians familiar with all aspects of biomolecules, cells and tissue in
vitro staff the labs. The scientists work side by side with the clinicians to
understand the basic principles involved in the complex interactions of light
and tissue. In 1994, the Company began a number of studies for the treatment of
certain dermatological conditions using its diode laser at Wellman Labs. In
1995, those studies were expanded to include the Company's ruby lasers for
cosmetic procedures. In 1997, those studies were again expanded to include the
Company's diode lasers for cosmetic purposes. Wellman Labs and the Company are
currently evaluating the data associated with these treatments. The Company
works closely with Dr. R. Rox Anderson, the Research Director of the MGH Laser
Center and Associate Professor of Dermatology at Harvard Medical School, who is
a recognized expert in laser tissue interaction and the inventor of a number of
laser procedures in use today. Dr. Anderson has authored over 60 papers in
peer-reviewed publications relating to the use of lasers in dermatology, is the
recipient of numerous awards in the field of laser medicine and serves as a
member of the Blue Ribbon Government Liaison Committee of the American Society
for Laser Medicine and Surgery. Dr. Anderson holds 23 U.S. patents and has
pending applications for an additional eleven. The Company feels that these
types of relationships are critical in developing effective products for
widespread use in the market on a timely basis, and that this method of
conducting research and development provides a higher level of technical and
clinical expertise than it could provide on its own and in a more cost-efficient
manner.
PMP's Vice President of Research and Development, Gregory Altshuler, is
the former Director of the Laser Center of the St. Petersburg (Russia) Institute
of Fine Mechanics and Optics (the "St. Petersburg Laser Center)" and the Company
continues to work closely with the St. Petersburg Laser Center, contracting its
research and development tasks to them on a project basis. In 1998, the Company
spent approximately $178,000 on research and development conducted at the St.
Petersburg Laser Institute. Dr. Altshuler holds approximately 50 patents in
Russia in the field of lasers and the application of lasers in medicine, and has
authored approximately 130 papers relating to laser physics, engineering and
medicine.
While MGH focuses on the biological aspects of laser hair removal, Dr.
Altshuler's in-house research and development team focuses on the physical
aspects. Approximately 43 employees of the Company and its subsidiaries were
engaged full time in research and development activities at December 31, 1998.
Twenty-three of these employees work at Star and will no longer work for Palomar
if Star is sold.
Under the Sales Agency, Development and License Agreement that the
Company entered into with Coherent in November 1997, the Company committed to
spend the following amounts on research and development over the next three
years: at least $5,000,000 in 1998, at least 10% of its 1998 gross revenues
(minus commissions to Coherent) from cosmetic laser products ("Product
Revenues") in 1999, and at least 10% of its 1999 Product Revenues in 2000.
Although the Company expects to continue to devote substantial resources to
research and development regardless of whether the sale of Star to Coherent is
consummated, this specific commitment will terminate upon the sale.
(See Item 7. "Risk Factors" and Note 8 to Financial Statements.)
9
(xii) Environmental Protection Regulations
The Company believes that compliance with federal, state and local
environmental regulations will not have a material adverse effect on its capital
expenditures, earnings or competitive position.
(xiii) Impact of Medical Device Regulations
The Company's products are subject to regulation and control by the
Center for Devices and Radiological Health, a branch of the Food and Drug
Administration (FDA) within the Department of Health and Human Services. The FDA
medical device regulations require either an Investigational Device Exemption,
Pre-Market Approval or 510(K) clearance before new products can be marketed to,
or utilized by, the physician. The Company's products are subject to similar
regulations in its major international markets. Complying with these regulations
is necessary for the Company's strategy of expanding the markets for and sales
of its products into these countries. These approvals may necessitate clinical
testing, limitations on the number of sales and controls of end user purchase
price, among other things. In certain instances, these constraints can delay
planned shipment schedules as design and engineering modifications are made in
response to regulatory concerns and requests. The Company's competitors are
subject to the same regulations. (See Item 7. "Risk Factors.")
(xiv) Number of Employees
As of December 31, 1998, the Company and its PMP, Esthetica and Star
subsidiaries employed 164 people, 3 independent contractors and 14 temporary
employees. Of these employees, 71 are with Star and would not remain with the
Company following the sale of Star.
The Company's ability to develop, manufacture and market its products
and to establish and maintain a competitive position in the industry will
depend, in large part, upon its ability to attract and retain qualified
technical, marketing and managerial personnel. The Company believes that its
relations with its employees are good. None of the Company's employees are
represented by a union. (See Item 7. "Risk Factors.")
(d) Financial Information About Exports by Domestic Operations
Aggregate export sales for the Company's continuing operations were
approximately $3,870,000 for 1996, $5,030,000 for 1997 and $17,360,000 for 1998.
The 1996 export sales consisted primarily of the RD-1200(TM) tattoo removal
laser and the EpiLaser(R) laser system, the 1997 export sales consisted
primarily of the EpiLaser(R) laser system, and the 1998 export sales consisted
primarily of the LightSheer(TM). (See Notes 3(i) and 13 to Financial
Statements.)
Item 2. Properties.
The Company occupies approximately 25,000 square feet of office,
manufacturing and research space in Lexington, Massachusetts under a lease
expiring in May 2000. The Company's Star subsidiary occupies approximately
25,000 square feet of office, manufacturing and research space in Pleasanton,
California under two leases expiring in April 1999 and March 2001. Upon the sale
of Star to Coherent, Coherent will assume these leases for Star's operations.
The Company believes that these facilities are in good condition and are
suitable and adequate for its current operations, assuming it does not sell
Star. However, if the Star sale is completed, the Company expects that it will
require additional office, manufacturing and research space for its existing
operations.
Item 3. Legal Proceedings.
On March 7, 1997, Selvac Acquisition Corp. ("Selvac"), a subsidiary of
Mehl Biophile International, Inc. ("Mehl"), filed a complaint for injunctive
relief and damages for patent infringement and for unfair competition in the
United States District Court for the District of New Jersey against the Company,
two of its subsidiaries and a New Jersey dermatologist. Selvac's complaint
alleged that the Company's EpiLaser(R) ruby laser hair removal system infringed
a patent licensed to Selvac (the "Selvac Patent") and that the Company unfairly
competed by promoting the EpiLaser(R) ruby laser hair removal system for hair
removal before it had received FDA approval for that specific application. On
May 18, 1998 the court granted the Company's motion for partial summary judgment
on the ground that the Selvac patent is invalid because prior art anticipated
it. The court has since denied Selvac's motion for reconsideration of the
summary judgment ruling.
10
On September 25, 1998, the court denied Selvac's motion for reconsideration of
its prior order dismissing so much of Selvac's unfair competition claim as
relied on interpreting the Food, Drug and Cosmetics Act or FDA regulations, and
dismissed without prejudice the state law remainder of Selvac's unfair
competition claim. On October 26, 1998, Selvac filed its notice of appeal to the
Court of Appeals for the Federal Circuit. Selvac subsequently filed its opening
brief on appeal; the Company filed its opposition. Selvac will likely file a
reply brief in April 1999. The Company is unable to express an opinion as to the
likely outcome of Selvac's appeal.
On October 16, 1997, the Company brought a declaratory judgment action
in U.S. District Court for the District of Massachusetts against the holders and
the indenture trustee of the Company's 4.5% Subordinated Convertible Debentures
due 2003, denominated in Swiss francs (the "Swiss Franc Debentures"). The
defendants in this action are Banque SCS Alliance SA, Arbuthnot Fund Managers,
Ltd., Banca Commerciale Lugano, Privatinvest Bank AG (these four defendants
being referred to collectively as the "Asserting Holders"), CUF Finance S.A.,
Fibi Bank (Schweiz) AG, Teawood Nominees, Ltd., JS Gadd & CIE SA, Swedbank
(Luxembourg) SA, Christiana Bank Luxembourg SA (now know as Credit Agricole
Indosuez), Landatina Financiera SA and American Stock Transfer & Trust Co., as
trustee ("Trustee"). Just prior to this suit, the Asserting Holders had alleged
that the Company was in breach of certain protective covenants under the
indenture, and on October 22, 1997 they sued the Company and all of its
principal subsidiaries in the same court; the October 16 and October 22 cases
have been assigned to the same judge, and the dispute between the Asserting
Holders and the Company is proceeding under the October 22 case. The Asserting
Holders claim that the Company has breached certain protective indenture
covenants and that the Asserting Holders are entitled to immediate payment of
their indebtedness under the Swiss Franc Debentures (which amounts to
approximately US$5,600,000 at December 31, 1998 exchange rates). As of November
13, 1997, acting under applicable provisions of the indenture, the Company
notified the holders of the Swiss Franc Debentures that it is causing the
conversion of all of the Swiss Franc Debentures into an aggregate of 914,028
shares of the Company's common stock. Palomar filed a motion for summary
judgment, asserting that its conversion of the debentures into Palomar common
stock deprives the plaintiffs of standing to bring a claim. That motion has been
denied without prejudice, and the court also denied the plaintiffs' motion for
summary judgment. By mutual agreement, the Asserting Holders and the Company
requested that the case be removed from the Court's October 1998 trial calendar.
The parties have discussed ways to resolve their dispute, including the
restructuring of the debentures (so that Palomar would withdraw its forced
conversion and repay on a modified schedule the original debt, with a
substantial prepayment of principal). But there can be no absolute assurance
that all of the debentureholders, including the Asserting Holders, and the
Company will complete the proposed settlement. If the case is returned to the
trial calendar, the Company expects to vigorously contest the claims of the
Asserting Holders, as the Company believes its position in the lawsuit is
correct, and that the debt cannot properly be accelerated. The court has given
the parties until April 30, 1999 to complete their agreement.
On March 11, 1999, the United States District Court for the Southern
District of New York granted plaintiffs leave to amend their complaint in the
action styled VARLJEN V. H.J. MEYERS, INC., ET. AL. to join the Company, Steven
Georgiev and Joseph Caruso as defendants. On March 17, 1999, the Second Amended
Class Action Complaint ("Complaint") in Varljen was served upon the Company and
Caruso. The Complaint alleges that the Company, Georgiev and Caruso violated the
federal securities laws in various public disclosures that the Company made
directly and indirectly during the period from February 1, 1996 to March 26,
1997. In particular, the Complaint alleges that Palomar, Georgiev and Caruso
misrepresented the Company's financial results and future prospects through
their direct disclosure and through disclosures made by securities analysts and
other third parties. The case is in its earliest stages, and the Company cannot
predict its outcome.
The Company is also aware of a claim alleging that the Company had
previously committed to make an additional capital contribution to Nexar. The
Company believes that this claim is without merit.
The Company is involved in other legal and administrative proceedings
and claims of various types. While any litigation contains an element of
uncertainty, management, in consultation with the Company's general counsel, at
present believes that the outcome of each such other proceeding or claim which
is pending or known to be threatened, or all of them combined, will not have a
material adverse effect on the Company.
(See "Risk Factor.")
Item 4. Submission of Matters to a Vote of Security Holders.
Not applicable.
11
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
The Company's common stock is currently traded on the National
Association of Securities Dealers Automated Quotation System (Nasdaq) under the
symbol PMTI. The following table sets forth the high and low bid prices quoted
on Nasdaq for the Common Stock for the periods indicated. Such quotations
reflect inter-dealer prices, without retail markup, markdown or commission and
do not necessarily represent actual transactions.
Fiscal Year Ended
December 31, 1997
-----------------
High Low
---- ---
Quarter Ended March 31, 1997 9 1/4 5 7/16
Quarter Ended June 30, 1997 5 3/4 2 3/8
Quarter Ended September 30, 1997 4 7/16 1 15/16
Quarter Ended December 31, 1997 2 31/32 25/32
Fiscal Year Ended
December 31, 1998
-----------------
High Low
---- ---
Quarter Ended March 31, 1998 2 11/32 5/8
Quarter Ended June 30, 1998 1 9/16 31/32
Quarter Ended September 30, 1998 1 7/32 3/4
Quarter Ended December 31, 1998 1 1/8 19/32
As of March 2, 1999, the Company had 939 holders of record of common
stock. This does not include holdings in street or nominee names.
The Company has not paid dividends to its common stockholders since its
inception and does not plan to pay dividends to its common stockholders in the
foreseeable future. The Company intends to retain any earnings to finance the
operations of the Company.
Private Placements of Common Stock
Pursuant to Section 4(2) of the Act, on February 20, 1998 the Company
sold 2,000,000 shares, 1,500,000 shares, 1,100,000 shares, 1,000,000 shares,
250,000 shares and 1,350,000 shares of the Company's common stock to the
Travelers Insurance Company, AIM Overseas Ltd., TJJ Corporation, PAR Investment
Partners L.P., Pequot Scout Fund L.P., and other third party unaffiliated
individual investors, respectively, for an aggregate of $7,200,000. In addition,
for every share purchased the investor received a warrant to purchase one share
of the Company's common stock for $3 per share. These warrants expire five years
from the closing date and are exercisable beginning six months after the closing
date.
Pursuant to Section 4(2) of the Act, on July 24, 1998 the Company sold
1,800,000 shares and 1,200,000 shares of the Company's common stock to the
Rockside Foundation and Mark T. Smith, respectively, for an aggregate of
$3,000,000. In addition, for every share purchased the investors received a
warrant to purchase one share of the Company's common stock for $3 per share.
These warrants expire five years from the closing date and are exercisable
beginning six months after the closing date.
Each of these sales was made without general solicitation or
advertising. Each purchaser was a sophisticated investor with access to all
relevant information necessary to evaluate the investment in the Company, and
each purchaser represented to the Company that the securities were being
acquired for investment.
12
Convertible Debentures
Pursuant to Section 4(2) of the Act, the Company sold a $2,000,000
convertible debenture on March 27, 1998 to Hechtor Wiltshire, an individual
unaffiliated third party investor. The debenture was due the earlier of May 26,
1998 or one day following the sale of Dynaco or any other Palomar assets outside
the normal course of business or any other financing where the use of proceeds
to pay back debt was not prohibited. If the debenture was not repaid by the
maturity date, the debenture would become convertible at market value at the
option of the debentureholder, as defined. Interest on this debenture was in the
form of a warrant to purchase 125,000 shares of common stock for $.01 per share
exercisable over five years. The Company repaid $1,250,000 and $750,000 of this
$2,000,000 convertible debenture on April 8, 1998 and May 27, 1998,
respectively. The warrant to purchase 125,000 shares of common stock for $.01
per share was exercised by the individual on May 18, 1998.
This sales was made without general solicitation or advertising. The
purchaser was a sophisticated investor with access to all relevant information
necessary to evaluate the investment in the Company, and represented to the
Company that the securities were being acquired for investment.
Conversions of Preferred Stock and Debentures
During the year ended December 31, 1998, the following securities were
converted by the accredited investor unaffiliated third-party holders for the
number of shares of common stock indicated:
Number of Shares
Type of Security Number of Shares Common Stock Issued
---------------- ---------------- -------------------
Preferred Stock Series G 1,941 2,703,032
Preferred Stock Series H 3,947 4,188,650
Debenture 5% Due December 31, 2001 N/A 1,160,999
Debenture 5% Due January 13, 2002 N/A 924,029
Debenture 5% Due March 10, 2002 N/A 1,561,064
Debenture 4.5% Due October 21, 1999, 2000, 2001 N/A 60,809
Debenture 6%,7%,8% Due September 30, 2002 N/A 3,328,761
The Company received no proceeds in connection with any of these
conversions.
13
Item 6. Selected Financial Data.
The following table sets forth selected consolidated financial and other
information (in thousands except per share data) on a consolidated historical
basis for the Company and its subsidiaries as of and for each of the fiscal
years in the five year period ended December 31, 1998. Pursuant to Accounting
Principles Board Opinion ("APB") No. 30, Reporting the Results of Operations -
Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,
Unusual and Infrequently Occurring Events and Transactions, the consolidated
financial statements of the Company have been reclassified to reflect the
dispositions of its subsidiaries that comprise the electronics segment. (See
Note 2 to Consolidated Financial Statements.) (Note that in 1994 the Company
changed its fiscal year end from March 31 to December 31.) This table should be
read in conjunction with the Consolidated Financial Statements of the Company
and the Notes thereto included elsewhere in this Annual Report on Form 10-K.
Selected Financial Data
(in thousands, except per share data)
Nine months
ended Year ended
December 31, December 31,
-----------------------------------------------------------------------------
Statement of Operations Data 1994 1995 1996 1997 1998
-------------- ------------ ------------ ------------ ------------
Revenues $ 40 $ 5,610 $ 17,607 $ 20,995 $ 44,514
Gross Profit (Loss) 22 2,146 3,437 939 21,463
Operating Expenses 5,740 10,985 26,548 42,867 30,897
Loss from Operations (5,718) (8,839) (23,110) (41,929) (9,434)
Net Loss from Continuing Operations (5,689) (8,390) (20,798) (58,369) (9,967)
Net Loss from Discontinued Operations (3) (4,231) (17,066) (27,435) (2,624)
Net Loss (5,692) (12,621) (37,864) (85,804) (12,591)
Basic and Diluted Net Loss Per Common Share:
Continuing Operations $ (0.84) $ (0.60) $ (0.84) $ (1.79) $ (0.18)
Discontinued Operations - (0.30) (0.65) (0.78) (0.04)
-------------- ------------ ------------ ------------ ------------
Total Loss Per Common Share $ (0.84) $ (0.90) $ (1.49) $ (2.57) $ (0.22)
Weighted Average Number of
Common Shares Outstanding
6,759 14,165 26,167 35,105 62,869
============== ============ ============ ============ ============
Balance Sheet Data:
Working Capital $ 2,491 $ 12,998 $ 15,203 $ (7,269) $ (6,004)
Total Assets 6,551 33,656 67,533 28,968 23,526
Long-term debt 2,322 1,765 14,665 12,446 3,150
Stockholders' Equity (Deficit) 2,794 25,289 38,077 (6,184) (6,463)
14
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
(a) Overview
On December 7, 1998, the Company entered into an Agreement and Plan of
Reorganization (the "Agreement") with Coherent, Inc. ("Coherent") to sell all of
the issued and outstanding common stock of Star Medical Technologies, Inc.
("Star"), its 99.96% majority-owned subsidiary, to Coherent for $65 million in
cash. The Company currently owns substantially all of the issued and outstanding
common shares of Star. However, options that have been granted to Palomar and
employees of Star to purchase shares of Star's common stock remain outstanding.
When all of the outstanding options under Star's Stock Option Plan have been
exercised, the Company will own 82.46% of Star's common stock and the employees
will collectively own 17.54% at the time of the sale of Star. Therefore, the
Company anticipates that it will receive net proceeds from this sale of
approximately $46 million after taxes (see Note 7 to the Consolidated Financial
Statements). Under the terms of the Agreement, the Company will also receive an
ongoing royalty of 7.5% from Coherent on the sale of any products by Coherent
that employ certain patented technology related to laser hair removal currently
licensed by the Company on an exclusive basis from Massachusetts General
Hospital ("MGH") (see Note 12(b) to the Consolidated Financial Statements). The
sale is subject to stockholder approval, as well as customary closing
conditions.
If this transaction is consummated, revenues would decline
significantly in the near term and the successful introduction and marketing of
new products will become more critical to the Company's long-term success. A
significant portion of the Company's current revenue base will need to be
replaced with future revenues from the Company's other laser products, including
the Palomar E2000TM hair removal laser introduced in February of 1999 and other
products currently in development. For the year ended December 31, 1998, gross
revenues associated with Star's LightSheer(TM) diode laser comprised 80% of the
Company's total revenues. There can be no assurance that the Palomar E2000TM or
the Company's future products will achieve market acceptance or generate
sufficient margins. Broad market acceptance of laser hair removal is critical to
the Company's success. The Company recognizes the need and intends to broaden
its product line by developing cosmetic laser products other than hair removal
lasers.
In the third and fourth quarters of 1997, the Board of Directors
authorized management to focus the Company on its core laser products and
services business, principally related to laser hair removal, and to proceed
with a restructuring plan to reorganize the Company and divest its electronic
subsidiaries, Dynaco Corp. ("Dynaco"), Dynamem, Inc. ("Dynamem"), Comtel
Electronics, Inc. ("Comtel") and Nexar Technologies, Inc. ("Nexar")
(collectively, the "Electronic Subsidiaries"), and other non-core businesses.
Pursuant to Accounting Principles Board Opinion No. 30, "Reporting the
Results of Operations Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions," the consolidated financial statements of the Company have been
reclassified to reflect the dispositions of the Electronic Subsidiaries.
Accordingly, the revenues, cost and expenses, assets and liabilities and cash
flows of the Electronics Subsidiaries have been reported as discontinued
operations in these consolidated financial statements (see Note 2 to
Consolidated Financial Statements).
The Company has simplified its organization and now conducts business
in only two locations, Lexington, Massachusetts and Pleasanton, California.
Prior to this restructuring, the Company conducted business in over a dozen
different locations.
(b) Results
(i) REVENUES AND GROSS MARGIN: Year Ended December 31, 1998,
Compared to Year Ended December 31, 1997
For the year ended December 31, 1998, the Company's revenues increased
to $44.5 million as compared to $21.0 million for the year ended December 31,
1997. The increase in the Company's revenue of $23.5 million or 112% from the
year ended December 31, 1997 was mainly due to additional sales volume of $35.6
million associated with the introduction of the LightSheer(TM) diode laser,
partially offset by a decrease in revenue of approximately $12.1 million in
other cosmetic laser product revenue. The Company obtained FDA clearance to
market and sell its LightSheer(TM) laser for hair removal and leg vein treatment
in the United States at the end of 1997. The decrease in sales volume associated
with other cosmetic laser
15
product revenue was principally due to declining sales of the Company's
EpiLaser(R) ruby laser. The Company focused on bringing the LightSheer(TM) laser
to market while further developing a new generation of ruby hair removal lasers
during 1998. Using its core ruby laser technology, originally developed for
tattoo and pigmented lesion removal, Palomar developed its long pulse
EpiLaser(R) ruby laser that is specifically configured to allow the appropriate
wavelength, energy level and pulse duration to be absorbed effectively by the
hair follicle without being absorbed by the surrounding tissue. That, combined
with Company's patented cooling handpiece, allows safe and effective hair
removal. Palomar expects its new generation long pulse ruby laser, the Palomar
E2000TM, to permit more rapid treatment of large areas of the body. In July
1998, the Company obtained FDA clearance to market and sell its EpiLaser(R)
laser system in the United States for "permanent hair reduction." In March of
1999, the Company also obtained FDA clearance to market and sell its Palomar
E2000TM laser system in the United States for "permanent hair reduction."
Gross margin for the year ended December 31, 1998 was approximately
$21.5 million (48% of revenues) compared to $939,000 (4% of revenues) for the
year ended December 31, 1997. The increase in gross margin and gross margin
percentage was due to sales of the LightSheer(TM) diode laser system. This new
laser system has a significantly higher gross margin than the Company's
EpiLaser(R) laser and other cosmetic products. The Company anticipates that if
the sale of Star is consummated, its gross margin percentage from the sale of
Palomar E2000TM will decrease compared to the current gross margin from the sale
of its LightSheer(TM) product unless and until the Palomar E2000TM achieves
volume production and manufacturing efficiencies.
(ii) OPERATING AND OTHER EXPENSES: Year Ended December 31, 1998,
Compared to Year Ended December 31, 1997
Research and development costs decreased to $7.0 million for the year
ended December 31, 1998 from $12.0 million for the year ended December 31, 1997.
Research and development expenses as a percentage of revenue totaled 16% for the
year ended December 31, 1998 and 57% for the year ended December 31, 1997. The
decline in spending is primarily the result of the Company's receipt of FDA
approval for the LightSheer(TM) laser at the end of 1997. The continued spending
on research and development reflects the Company's commitment to research and
development for medical devices and delivery systems for cosmetic laser
applications and other medical applications using a variety of lasers, while
continuing dermatology research utilizing the Company's ruby and diode lasers.
Among the Company's research and development goals in hair removal is to design
systems permitting more rapid treatment of large areas, and to produce systems
with high gross margins. Management believes that research and development
expenditures will remain constant over the next year as the Company continues
product development and clinical trials for additional applications for its
lasers and delivery systems in the cosmetic and dermatological markets.
Selling and marketing expenses increased to $15.1 million (34% of
revenues) for the year ended December 31, 1998, from approximately $7.0 million
(33% of revenues) for the year ended December 31, 1997. The increase in selling
and marketing expenses is attributable to the costs associated with the
Company's distribution agreement with Coherent, which increase in direct
proportion to sales volume (see Note 12(d) to the Consolidated Financial
Statements) because Coherent receives a commission for each of the Company's
products that it sells to compensate it for its selling and marketing efforts.
The amounts received by Coherent (as a percentage of the Company's net revenues)
are greater than the Company's selling and marketing expenses when it performed
these functions internally during 1997. The Company anticipates that its selling
and marketing expenses will decrease as a percentage of revenue after the
completion of the sale of Star to Coherent as the Company begins to sell the
Palomar E2000TM through other sales channels, including distribution through
Continuum Biomedical, a distributor of medical products. The Company also will
consider establishing its own direct sales force to compliment these sales
channels. The Company anticipates that its selling and marketing costs incurred
through other sales channels and its own direct sales force will be less than
the commissions currently earned by Coherent as a percentage of the Company's
net revenues.
General and administrative expenses decreased to $8.9 million (20% of
revenues) for the year ended December 31, 1998, as compared to $15.3 million
(73% of revenues) for the year end ended December 31, 1997. This decrease is
attributable to the Company's restructuring and consolidation of administrative
functions in the third and fourth quarters of 1997, including a reduction in
costs attributable to Palomar Technologies, Ltd., Esthetica, Inc. (formerly
Cosmetic Technology International, Inc.), Palomar Medical Products, Inc. and
corporate costs totaling $1.0 million, $2.4 million, $1.9 million and $2.0
million, respectively. This reduction was offset by an increase of $900,000 for
general and administrative expenses incurred at the Company's Star subsidiary to
support its successful introduction of its LightSheer(TM) laser. In previous
16
years, the Company used management's time and allocated resources to developing
businesses outside of the medical and cosmetic laser industry and financing the
non-core businesses. Beginning in the fourth quarter of 1997, the Company
focused its efforts on its core business. The Company anticipates general and
administrative expense will continue to stabilize in the future and after the
sale of Star as the Company focuses on its core operations in the cosmetic laser
business.
The Company incurred no business development and financing costs during
the year ended December 31, 1998 as compared to $2.1 million (10% of revenues)
for the year ended December 31, 1997. This decrease is attributable to the
Company's restructuring efforts to focus on its core medical business.
Restructuring and asset write-off costs were approximately $13.0
million for the year ended December 31, 1997. These charges reflect
restructuring and asset write-off costs for certain operating and non-operating
assets that the Company believes were not fully realizable for both the
Company's medical business and other non-medical investments. Included in this
charge is a $2.7 million reserve for severance costs associated with
consolidating selling, general and administrative functions, including the
closing of certain facilities. Through December 31, 1998, the Company paid out
$2.3 million of severance costs and has a remaining liability of $279,000
related to two individuals that will be paid out in 1999, resulting in actual
restructuring costs incurred of $2.6 million. Accordingly, the Company reversed
the balance of this restructuring accrual of approximately $131,000 in its
consolidated statement of operations during the fourth quarter of fiscal 1998
(see Note 4 to Consolidated Financial Statements).
For the year ended December 31, 1998, the Company did not incur
settlement expenses. Settlement costs of $3.2 million were incurred in the year
ended December 31, 1997. These charges consisted mainly of a legal accrual
related to a legal settlement with an investment bank.
Interest expense decreased to $1.3 million for the year ended December
31, 1998, from $7.0 million for the year ended December 31, 1997. The amount for
1997 includes $5.5 million of non-cash interest expense related to the value
ascribed to the discount features of the convertible debentures issued by the
Company during 1996 and 1997. This 82% decrease is primarily the result of a
decrease in convertible debenture financings and the Company's increased use of
conventional financing. Also, operations did not require as much financing in
1998 as compared to 1997.
Interest income decreased to $33,000 for the year ended December 31,
1998, from approximately $457,000 for the year ended December 31, 1997. This
decrease is primarily the result of a reduction in interest received due to a
decrease in other loans and investments and a decrease in the Company's average
cash position during 1998.
Net gain on trading securities represents a realized gain of
approximately $703,000 for the year ended December 31, 1998 related to the
Company's investment in a publicly traded company that was sold during 1998. The
Company does not have any marketable trading securities as of December 31, 1998.
The loss from discontinued operations for the year ended December 31,
1998 was $2.6 million compared to a loss of $27.4 million for the year ended
December 31, 1997. The loss from discontinued operations in 1998 was due to a
delay in the disposition of Dynaco resulting in operating expenses of
approximately $1.1 million above the estimated operating expenses accrued at
December 31, 1997. A loss on disposition of discontinued entities for the year
ended December 31, 1998 of $1.5 million was incurred. The majority of this
charge relates the write-off of the Company's carrying value of its investment
in Nexar during the second quarter of 1998.
(iii) REVENUES AND GROSS MARGIN Year Ended December 31, 1997,
Compared to Year Ended December 31, 1996
Revenues from continuing operations for the year ended December 31,
1997 were $21.0 million as compared to $17.6 million for the year ended December
31, 1996. The 19.2% increase mainly was due to additional sales volume of
approximately $11.3 million associated with the EpiLaser(R) hair removal laser
system and service revenue and with the RD-1200(TM) tattoo removal and pigmented
lesion treatment laser manufactured by the Company. The Company obtained FDA
clearance to market and sell the EpiLaser(R) laser system for hair removal in
the United States in March 1997. This increase in revenues was offset by a
decline of approximately $7.9 million in sales volume for the Company's
Tru-Pulse(R) CO2 laser product.
17
Gross margin for the year ended December 31, 1997 was $939,000 (4% of
revenues) compared to $3.4 million (20% of revenues) for the year ended December
31, 1996. The decline in gross margin percentage was caused mainly by lower
margins attained on the Company's EpiLaser(R) laser system due to manufacturing
and production inefficiencies in the initial manufacturing stage of this product
as well as under-absorbed overhead costs incurred during the fourth quarter of
1997 as the Company transitioned to its exclusive distribution arrangement with
Coherent. The decline in gross margin dollars was due principally to a reduction
in revenues related to the Company's Tru-Pulse(R) CO2 laser product. The
Company's overall strategy was to first demonstrate and prove the overall
efficacy of its proprietary cosmetic hair removal technology licensed from MGH
and gain early entrance to the market. This resulted in higher than anticipated
costs of materials and manufacturing techniques. As a result of this strategy,
the Company believes that during 1997 it demonstrated to the medical community
the efficacy of its technology and its long-term benefits and advantages which
led to the successful introduction and sales of its LightSheer(TM) laser in
1998.
(iv) OPERATING AND OTHER EXPENSES: Year Ended December 31, 1997,
Compared to Year Ended December 31, 1996
Research and development costs increased to $12.0 million (57% of
revenues) for the year ended December 31, 1997, from $6.3 million (36% of
revenues) for the year ended December 31, 1996. This 90% increase in research
and development reflects the Company's strategic decision to accelerate its
research and development efforts during 1997 to develop and obtain FDA clearance
for its successor hair removal and other cosmetic products using the Company's
proprietary cooling technology licensed from MGH. The Company also continued to
concentrate on the development of additional products for other medical laser
applications.
Selling and marketing expenses increased to $7.0 million (33% of
revenues) for the year ended December 31, 1997, from $5.1 million (29% of
revenues) for the year ended December 31, 1996. This 37% increase reflected the
Company's effort to expand its marketing and distribution for the Company's
EpiLaser(R) laser system.
General and administrative expenses increased to $15.3 million (73% of
revenues) for the year ended December 31, 1997, from $9.8 million (55% of
revenues) for the year ended December 31, 1996. This 57% increase was the result
of additional administrative resources required at the Company's now closed
separate corporate offices and subsidiaries to oversee the growth of the
Company's medical products and service businesses, the initial public offering
of common stock of Nexar, and divestiture efforts substantially completed during
1997, totaling approximately $500,000. Additional general and administrative
costs were also incurred at Palomar Medical Products, Inc., Esthetica and
Palomar Technologies, Ltd. totaling approximately $1.7 million, $2.3 million and
$1.0 million, respectively. The majority of these general and administrative
expenditures incurred by the subsidiaries were for employee and infrastructure
expenses to manage the transition from a development stage company to the
commercialization stage.
Business development and financing costs decreased to $2.1 million (10%
of revenues) for the year ended December 31, 1997, from $2.9 million (16% of
revenues) for the year ended December 31, 1996. This 28% decrease is
attributable to the Company's restructuring efforts to focus on its core medical
product and service businesses.
Restructuring and asset write-off costs totaling $13.0 million were
incurred for the year ended December 31, 1997 as compared to $1.7 million for
the year ended December 31, 1996. These charges reflect restructuring and asset
write-off costs for certain operating and non-operating assets that the Company
believes were not fully realizable for both the Company's medical business and
other non-medical investments. Included in this charge for 1997 is a $2.7
million charge for severance costs associated with consolidating the selling,
general and administrative functions, including the closing of certain
facilities. Through December 31, 1998, the Company paid out $2.3 million of
severance costs and has a remaining liability of $279,000 to two individuals
that will be paid out in 1999 resulting in total restructuring costs incurred of
$2.6 million. Accordingly, the Company reversed the balance of this
restructuring accrual of approximately $131,000 in its consolidated statement of
operations during the fourth quarter of fiscal 1998 (see Note 4 to Consolidated
Financial Statements).
Settlement and litigation costs increased to $3.2 million for the year
ended December 31, 1997 from $880,000 for the year ended December 31, 1996.
These costs are primarily attributable to a lawsuit brought by an investment
bank. In
18
this suit, the investment bank alleged that the Company breached a contract in
which the bank was to provide certain investment banking services in return for
certain compensation. This case was settled on August 18, 1997 for $1.9 million.
Interest expense from continuing operations increased to $7.0 million
for the year ended December 31, 1997, from $272,000 for the year ended December
31, 1996. This amount for 1997 includes $5.5 million of non-cash interest
expense related to the value ascribed to the discount features of the
convertible debentures issued by the Company.
Interest income decreased to $457,000 for the year ended December 31,
1997, from $1.4 million for the year ended December 31, 1996. This decrease is
primarily the result of a reduction in interest received due to a decrease in
other loans and investments and a decrease in the Company's average cash
position during 1997.
Loss from discontinued operations was $27.4 million for the year ended
December 31, 1997 as compared with a loss of $17.1 million for the year ended
December 31, 1996. The Company also reported a gain of $2.1 million on the
disposition of its discontinued operations. This amount includes a gain of $6.2
million related to the disposition of 1,960,736 shares of Nexar common stock
which was offset by losses incurred and accrued of $4.1 million on the
disposition of Dynaco and its wholly owned subsidiaries. The Company completed
the disposition of Comtel and Dynamem on December 9, 1997. The disposition of
Dynaco was completed in May of 1998 (see Note 2 to the Consolidated Financial
Statements).
(c) Liquidity and Capital Resources
The Company is a holding company with no significant operations or
assets other than its investments in operating subsidiaries and strategic
investments. The Company depends upon dividends, cash advances and/or other cash
payments from its subsidiaries to meet its cash flow requirements. To date, the
Company's operating subsidiaries have required cash advances from the Company to
fund their operations.
On December 7, 1998, the Company entered into a Agreement and Plan of
Reorganization (the "Agreement") with Coherent to sell all of the issued and
outstanding common stock of Star, its 99.96% majority-owned subsidiary, to
Coherent. The Company currently owns substantially all of the issued and
outstanding common shares of Star. However, options outstanding granted to
Palomar and employees of Star to purchase shares of Star's common stock remain
outstanding. When all of the outstanding options under Star's Stock Option Plan
have been exercised, the Company will own 82.46% of Star's common stock and the
employees will collectively own 17.54%. See Note 7 to the Financial Statements.
Under the terms of the Agreement, the selling price of Star is $65 million. In
addition, the Company will receive an ongoing royalty of 7.5% from Coherent on
the sale of any products by Coherent that use certain patents currently licensed
by the Company on an exclusive basis from Massachusetts General Hospital. See
Note 12(b) to the Financial Statements. This sale is subject to the approval of
the stockholders of Palomar. The Company anticipates that it will receive net
proceeds of approximately $49 million for the sale. The Company intends to use
these funds to support its ongoing operations and research and development
activities.
As of December 31, 1998, the Company had $1.9 million in cash and cash
equivalents. In order to meet its cash flow requirements and fund operating
losses at its subsidiaries, the Company generated $9.8 million and $3.0 million
in net proceeds from the issuance of common stock and short-term notes payable,
respectively, during the year ended December 31, 1998. The Company's net cash
used in operating activities for the year end ended December 31, 1998 was
approximately $11.1 million which includes approximately $2.1 million of net
cash generated from Star's operating activities. The Company's net loss for the
year ended December 31, 1998 included approximately $2.7 million of non-cash
depreciation and amortization expense.
As of December 31, 1998, the Company's accounts receivable totaled $9.9
million as compared to $2.2 million as of December 31, 1997. The amount at
December 31, 1998 is principally related to accounts receivable from the sale of
Star's LightSheer(TM) diode laser. The Company began shipping this product in
the first quarter of 1998. The increase in this balance from 1997 is related to
the sale of Star's LightSheer(TM) diode laser product. The Company's allowance
for doubtful accounts totaled approximately $364,000 as of December 31, 1998,
compared to $746,000 as of December 31, 1997. This reduction was principally due
to a decrease in the allowance for doubtful accounts for write-offs during 1998
of certain accounts receivable related to the sales of the Company's EpiLaser(R)
laser systems sold in 1997 totaling approximately $565,000, and an increase in
the allowance for doubtful accounts for the Company sale of its LightSheer(TM)
diode laser products during 1998.
19
As of December 31, 1998 accounts payable totaled approximately $6.6
million as compared to $4.2 million as of December 31, 1997. This increase of
$2.4 million is principally due to the additional purchases of inventory and
additional plant cost for the manufacturing of the Company's LightSheer(TM)
product during the fourth quarter of 1998 and the buildup of inventory for the
anticipated sales of Palomar E2000(TM) laser system.
The Company anticipates that capital expenditures for 1999 will total
approximately $1.0 million, consisting primarily of machinery, equipment and
computers and peripherals. The Company expects to finance these expenditures
with cash on hand, its line of credit and equipment leasing lines. However,
there can be no assurance that the Company will be able to obtain the necessary
financing.
The Company has a $10,000,000 revolving line of credit from a bank.
This revolving line of credit matures on March 31, 2000 and bears interest at
the bank's prime rate (7.75% at December 31, 1998). Borrowings are limited to
80% of domestic accounts receivable under 90 days from invoice. A director of
the Company has personally guaranteed borrowings under the line of credit. As of
March 20, 1999, approximately $725,000 was available under this line of credit.
The Company entered into a Loan Agreement with Coherent, pursuant to
which Coherent agreed to loan the Company money to help finance the Company's
working capital requirements. These loans are collateralized by Star's
inventory. As of December 31, 1998, the total amount outstanding under this loan
agreement was $4.0 million (see Note 6 to the Consolidated Financial
Statements).
In connection with the disposition of Comtel, a former wholly-owned
subsidiary in the electronics segment, the Company guaranteed $2.5 million of a
$3.3 million line of credit extended by a loan association to Biometric
Technologies Corp. ("BTC"), the buyer of Comtel. The stockholders of BTC have
personally guaranteed to the Company payment for any amounts borrowed under this
line of credit in excess of approximately $1.5 million in the event the Company
is obligated to honor this guaranty. The amount BTC has outstanding under the
line of credit at December 31, 1998 was approximately $2.1 million.
Regardless of whether the sale of Star to Coherent is consummated, the
Company's strategic plan is to continue to fund research and development for its
medical and cosmetic laser products. The Company expects to expand the scope and
extend the term of its current Clinical Trial Agreement with MGH following the
sale of Star. This research and development effort entails extensive clinical
trials. These activities are an important part of the Company's business plan.
Due to the nature of clinical trials and research and development activities, it
is not possible to predict with any certainty the timetable for completion of
these research activities or the total amount of funding required to
commercialize products developed as a result of such research and development.
The rate of research and the number of research projects underway are dependent
to some extent upon external funding. While the Company is regularly reviewing
potential funding sources in relation to these ongoing and proposed research
projects, there can be no assurance that the current levels of funding or
additional funding will be available, or, if available, on terms satisfactory to
the Company.
The Company will consider a number of alternatives with respect to its
future products, including manufacturing them itself and selling them directly
and/or through distributors or selling the product line and/or technology to
others. The Company will in each case choose the alternative which it believes
best maximizes profitability and long-term shareholder value.
The Company has historically incurred significant losses. While the
Company achieved profitable operations for the three and six months ended
December 31, 1998, primarily related to the operations of Star, there can be no
assurance that this will continue. Therefore, the Company may need to continue
to secure additional financing to complete its research and development
activities, commercialize its current and proposed medical products and
services, and fund ongoing operations.
There can be no assurance that the sale of Star to Coherent will be
completed (resulting in cash proceeds to the Company of $49 million) and that
events in the future will not require the Company to seek additional financing.
The sale must be approved by the Company's stockholders, and is also subject to
regulatory approval and other standard closing conditions. Financing of the
Company's future operating plan is now to a great extent dependant on completing
the sale. If the sale of Star is not completed the Company will require
additional financing during 1999 and there can be no assurance that any such
financing will be available on terms satisfactory to the Company. Based on its
historical ability to raise funds as
20
necessary and ongoing discussions with potential financing sources, the Company
believes that it will be successful in obtaining additional financing, if
required, in order to fund future operations.
The report of the Company's independent public accountants in
connection with the Company's Consolidated Balance Sheets at December 31, 1998
and 1997, and the related Consolidated Statements of Operations, Stockholders'
Equity (Deficit) and Cash Flows for the three years ended December 31, 1998
includes an explanatory paragraph stating that the Company's recurring losses,
working capital deficiency and stockholders' deficit raises substantial doubt
about the Company's ability to continue as a going concern.
(d) Year 2000 Issues
During 1998, the Company has been actively engaged in addressing Year 2000
(Y2K) issues, which result from the use of two-digit, rather than four-digit,
year dates in software, a practice which could cause date-sensitive systems to
malfunction or fail because they may not recognize or process date information
correctly.
State of Readiness:
To manage its Y2K program, the Company has divided its efforts into
four program areas:
o Information Technology (computer hardware and software)
o Physical Plant (manufacturing equipment and facilities)
o Products (including product development)
o Extended Enterprise (suppliers and customers)
For each of these program areas, the Company is using a four-step
approach:
o Ownership (creating awareness, assigning tasks)
o Inventory (listing items to be assessed for Y2K readiness)
o Assessment (prioritizing the inventoried items, assessing
their Y2K readiness, planning corrective actions, developing
initial contingency plans)
o Corrective Action Deployment (implementing corrective actions,
verifying implementation, finalizing and executing contingency
plans)
At December 31, 1998, the Ownership, Inventory and Assessment steps
were essentially complete for all program areas. The Company expects to complete
Corrective Action Deployment by June 1999.
Costs to Address Y2K Issues:
The Company's estimated aggregate costs for its Y2K activities from
1998 through 2000 are expected to be less than $100,000. Through December 31,
1998 the Company has spent approximately $20,000.
Risks of Y2K Issues and Contingency Plans:
The Company continues to assess the Year 2000 issues relating to its
physical plant, products and suppliers. The Company intends to develop a
contingency planning process to mitigate worst-case business disruptions such as
delays in product delivery, which could potentially result from events such as
supply chain disruptions. The Company expects its contingency plans to be
complete by June 1999.
(e) Nasdaq Stock Market Listing
The Company has been notified by the Nasdaq Stock Market ("Nasdaq") that
for continued listing on the Nasdaq SmallCap Market the Company must meet
Nasdaq's minimum bid price requirement of $1.00 per share. Because the
21
Company's stock price fell below $1.00 for a 30 day trading period between
August 28 and October 9, 1998, it is now subject to delisting. The Company met
with representatives of Nasdaq on March 18, 1999 and presented arguments
supporting continued listing. At the hearing, the Company volunteered to delist
from the Nasdaq SmallCap Market on May 18, 1999 if it is not in compliance with
the minimum bid price requirement by that date. The Company expects that it will
be in compliance by that date, as a result of the reverse split and the Star
sale. Nasdaq's decision is still pending. To regain compliance with the minimum
bid price requirement, the Company has asked its stockholders to approve a
reverse split of the Company's common stock. However, the reverse split may not
enable the Company to regain compliance with the minimum bid price requirement
in time to prevent delisting. The Company's management anticipates that the
absence of the Nasdaq listing for the Company's common stock would have an
adverse effect on the market for, and potentially the market price of, the
Company's common stock. The delisting of the common stock would likely reduce
stockholders' ability to buy and sell Company common stock, and the Company's
ability to raise capital. If the Company's common stock is delisted from Nasdaq,
the Company expects that brokers would continue to make a market in the
Company's common stock on the OTC Bulletin Board.
(f) Recently Issued Accounting Standard
In February 1997, Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No.133 Accounting for
Derivative Instruments and Hedging Activities. SFAS No. 133 establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts (collectively referred to as
derivatives) and for hedging activities. SFAS No. 133 is effective for fiscal
years beginning after June 15, 1999. The Company believes that the adoption of
this new accounting standard will not have a material impact on the Company's
financial statements.
Item 7A Quantitative And Qualitative Disclosures About Market Risk
(i) Derivative Financial Instruments, Other Financial Instruments,
and Derivative Commodity Instruments.
As of December 31, 1998, the Company did not participate in any
derivative financial instruments or other financial and commodity instruments
for which fair value disclosure would be required under SFAS No. 107. All of the
Company's investments are considered cash equivalents money market accounts that
are carried on the Company's books at amortized cost, which approximates fair
market value. Accordingly, the Company has no quantitative information
concerning the market risk of participating in such investments.
(ii) Primary Market Risk Exposures.
The Company's primary market risk exposures are in the areas of
interest rate risk and foreign currency exchange rate risk. The Company's
investment portfolio of cash equivalents is subject to interest rate
fluctuations, but the Company believes this risk is immaterial due to the
short-term nature of these investments.
The Company's exposure to currency exchange rate fluctuations has been
and is expected to continue to be modest due to the fact it currently sells its
products in United States dollars. The Company does not engage in foreign
currency hedging activities.
Statement Under the Private Securities Litigation Reform Act
In addition to the other information in this Annual Report on Form 10-K
the following cautionary statements should be considered carefully in evaluating
the Company and its business. Statements contained in this Form 10-K that are
not historical facts (including, without limitation, statements concerning the
sale of Star, financing of future operations, and the Company's research
partnership with MGH) and other information provided by the Company and its
employees from time to time may contain certain forward-looking information, as
defined by (i) the Private Securities Litigation Reform Act of 1995 (the "Reform
Act") and (ii) releases by the SEC. The risk factors identified below, among
other factors, could cause actual results to differ materially from those
suggested in such forward-looking statements. Readers are cautioned not to place
undue reliance on these forward-looking statements, which speak only as of the
date hereof. The Company undertakes no obligation to release publicly the
results of any revisions to these forward-looking statements that may be made to
reflect
22
events or circumstances after the date hereof or to reflect the occurrence of
unanticipated events. The cautionary statements below are being made pursuant to
the provisions of the Reform Act and with the intention of obtaining the
benefits of safe harbor provisions of the Reform Act.
RISK FACTORS
IF WE DO NOT CLOSE THE SALE OF OUR STAR SUBSIDIARY, WE MAY NOT HAVE ENOUGH MONEY
TO FINANCE FUTURE OPERATIONS.
We have recently signed an agreement with Coherent in which Coherent
has agreed to buy our Star subsidiary for $65 million in cash. The sale must be
approved by stockholders holding a majority of the shares of our outstanding
common stock. The sale is also subject to other standard closing conditions. We
may not receive a sufficient number of stockholder votes to approve the
transaction, or the transaction may fail to close for other reasons. Our future
operating plan is now to a great extent dependant on completing the sale, in
that it will provide us with the money necessary to finance our future
operations, including research and product development.
WE MAY BE DELISTED FROM NASDAQ. DELISTING MAY REDUCE YOUR ABILITY TO BUY AND
SELL OUR COMMON STOCK AND OUR ABILITY TO RAISE MONEY.
We have been notified by the Nasdaq Stock Market that for continued
listing on the Nasdaq SmallCap Market we must meet Nasdaq's minimum bid price of
$1.00 per share. Because our stock price fell below $1.00 for a 30 day trading
period between August 28 and October 9, 1998, it is now subject to delisting.
Nasdaq held a hearing on our delisting on March 18, 1999. Nasdaq's decision is
pending. To regain compliance with the minimum bid price requirement, we have
asked our stockholders to approve a one-for-seven reverse split of our common
stock. At the March 18, 1999 hearing, the Company volunteered to delist from the
Nasdaq SmallCap Market on May 18, 1999 if it is not in compliance with the
minimum bid price requirement by that date. We expect that we will be in
compliance by that date as a result of the reverse split and the Star sale.
Nevertheless, the reverse split may not enable us to regain compliance with the
minimum bid price requirement in time to prevent delisting. The delisting of our
common stock would likely reduce stockholders' ability to buy and sell our
common stock and our ability to raise capital. If our common stock is delisted
from the Nasdaq SmallCap Market, it will likely be quoted on the "pink sheets"
maintained by the National Quotation Bureau, Inc. or Nasdaq's OTC Bulletin
Board. These listings can make trading more difficult for stockholders. In
addition, a reverse s