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SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Mark One

For The Quarterly Period Ended March 31, 2003

OR

     CHROMAVISION MEDICAL SYSTEMS, INC.

(949) 443-3355

NOT APPLICABLE

     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, and (2) has been subject to such filing requirements for the past 90 days.

     Yes x No o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

     Yes o No x

     As of May 1, 2003 there were 37,492,493 shares outstanding of the Issuer’s Common Stock, $.01 par value.

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CHROMAVISION MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

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PART I — Item 1

CHROMAVISION MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets
(in thousands, except share and per share amounts)
(Unaudited)

Assets

See accompanying notes to condensed consolidated financial statements.

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CHROMAVISION MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations
(in thousands, except share and per share amounts)
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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CHROMAVISION MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows
(in thousands, except share and per share amounts)
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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CHROMAVISION MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements
(in thousands, except share and per share amounts)
(Unaudited)

(1)  BASIS OF PRESENTATION

     These interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our 2002 annual report filed on Form 10-K with the Securities and Exchange Commission.

     The accompanying unaudited condensed consolidated financial statements reflect all adjustments which, in the opinion of management, are necessary for a fair presentation of the financial position and the results of operations for the interim periods presented. All such adjustments, except as indicated in Note 3 to the Notes to the Condensed Consolidated Financial Statements, are of a normal, recurring nature. Certain amounts have been reclassified to conform to the current period presentation. The results of our operations for any interim period are not necessarily indicative of the results to be obtained for a full fiscal year.

(2) NET LOSS PER SHARE

     Basic and diluted loss per common share is calculated by dividing net loss by the weighted average common shares outstanding during the year. Stock options and warrants to purchase 5,979,648, and 3,476,650 shares of Common Stock with a weighted average option price of $3.83 and $5.86 were outstanding at March 31, 2003 and 2002, respectively. These stock options and warrants outstanding were not included in the computation of diluted earnings per share because we incurred a loss in all periods presented and hence, the impact would be anti-dilutive.

(3)  RECLASSIFICATION

     The Company has reclassified customer service costs into cost of revenue. The effect of the reclassification has no impact upon net income and no impact upon earnings per share. Prior comparative amounts have been reclassified to conform to this presentation.

(4)  CURRENCY TRANSLATION

     The financial position and results of operations of our foreign subsidiaries are generally determined using the local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate in effect at each quarter-end. Income statement accounts are translated at the average rate of exchange prevailing during the period.

(5)  COMPREHENSIVE LOSS

     Our total comprehensive loss is summarized as follows:

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(6) BUSINESS SEGMENTS

     We operate primarily in one business segment engaged in the development, manufacture and marketing of an automated cellular imaging system which is designed to assist physicians in making critical medical decisions.

     The following table represents business segment information by geographic area:

     In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (“FIN 46”). FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. Since the Company has no interest in any variable interest entity, the Company believes that the adoption of this interpretation will not have a material impact on its consolidated financial position or results of operations.

     The Emerging Issues Task Force “EITF” recently reached a consensus on its tentative conclusions for EITF 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF 00-21 provides accounting guidance for customer solutions where delivery or performance of products, services and/or performance may occur at different points in time or over different periods of time. Companies are required to adopt this consensus for fiscal periods beginning after June 15, 2003. The Company believes the adoption of EITF 00-21 will not have a material impact on the Company’s financial position, results of operations, or liquidity.

(8)  STOCK TRANSACTIONS

     On July 10, 2001, we obtained $12.5 million in additional funding ($11.3 million net of transaction expenses) through a private placement of our Series D Redeemable Convertible Preferred Stock (“Series D Preferred Stock”) and warrants to seven institutional investors. The investors included Safeguard Scientifics, Inc. (“Safeguard”), currently the largest beneficial owner of our Common Stock.

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     On June 13, 2002 we signed a number of separate agreements pursuant to which Safeguard agreed to:

	•		purchase an aggregate of 4,416,404 shares of our Common Stock for $7 million, or $1.585 per share;
	•		acquire 10,730 of the 12,500 outstanding shares of our Series D 5% Cumulative Convertible Preferred Stock from six institutional investors; and
	•		guarantee up to $3 million in additional debt financing for our Company (see Note 9 of Notes to the Condensed Consolidated Financial Statements).

     Of the 4,416,404 shares to be purchased, 4,053,641 were purchased on June 13, 2002 and 100 were purchased on July 11, 2002 for an aggregate of $6.4 million. The remaining 1,270 shares of Series D Preferred Stock that were outstanding and held by others were converted in separate transactions into 819,290 shares of Common Stock on June 13, 2002.

     On August 28, 2002, after receiving stockholder approval at a special meeting, we completed the sale of the balance of the $7 million of Common Stock ($6.1 million net of transaction expenses) and the conversion and retirement of all of the outstanding shares of the Series D Preferred Stock. Safeguard purchased the remaining 362,663 shares of Common Stock and converted the 10,730 shares of Series D Preferred Stock, acquired by it as well as the additional 500 shares it already owned, into 7,142,280 shares of Common Stock. Pursuant to the June 13, 2002 agreements, we reduced the exercise price of the warrants to purchase 524,750 shares of our Common Stock held by six institutional holders of the Series D Preferred Stock (excluding Safeguard) from $6.86 to $2 per share. The exercise price of a similar warrant held by Safeguard to purchase 21,865 shares was reduced to $4.0019 per share in accordance with the terms of the warrant.

     We have also issued to Safeguard a warrant to purchase up to 975,000 additional shares of our Common Stock in the event any presently outstanding options or warrants to purchase our Common Stock are exercised. The exercise price payable by Safeguard under the warrant would equal the exercise price of the existing options or warrants being exercised. We have also entered into a right of first refusal and entered into certain other agreements intended to protect Safeguard against dilution from future issuances of our Common Stock.

     Prior to our entering into these transactions with Safeguard, Safeguard and its affiliates owned beneficially 6,556,672 shares of our Common Stock, or approximately 32% of the number of shares beneficially owned (calculated in accordance with a rule of the Securities and Exchange Commission). As a result of the transaction and an unrelated acquisition of additional shares by Safeguard, it owned beneficially 18,529,556 shares of our Common Stock or approximately 56% of the number of shares outstanding. As a result, Safeguard has the power to elect all of the directors of our Company. We have also given Safeguard contractual rights enabling it to exercise significant control over our Company.

     In 2001, the Company allocated a portion of the proceeds received for the Series D Preferred Stock to the value of the warrants issued and to the value of the conversion feature. These amounts, plus the issuance costs of the transaction resulted in a discount on the Series D Preferred Stock. The discount was being accreted (amortized) as a charge to net income available to Common Stockholders over the three-year period prior to the scheduled mandatory redemption of the Preferred Stock on July 10, 2004.

     As a result of the conversion of the Series D Preferred Stock, the unamortized balance of the discount on the Series D Preferred Stock of approximately $2.7 million, was written off as a charge to net income available to Common Stockholders. For the three months ended March 31, 2002, the total charge to net income available to Common Stockholders was $.5 million No such charge was incurred for the comparable period in 2003 due to the conversion of all of the outstanding shares of Series D Preferred Stock in August 2002.

     On February 26, 2003 we issued 4,646,408 shares of our Common Stock for an aggregate cash purchase price of $5 million ($1.0761 per share) in a private placement to Safeguard. As a result of the transaction, Safeguard’s percentage of beneficial ownership increased from 56% to 62%. ChromaVision and Safeguard also entered into an agreement giving Safeguard certain rights to have the purchased shares registered under the Securities Act of 1933.

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(9)  LINE OF CREDIT

     On February 24, 2003 we entered into a $3 million revolving credit agreement with the Technology and Life Sciences Division of Comerica Bank-California (NYSE:CMA). The borrowings under the line of credit will be used for working capital purposes and will bear interest at Comerica’s prime rate plus one-half percent. The agreement expires February 2004. The borrowings will be guaranteed by Safeguard. We will pay to Safeguard a one-time fee for the guarantee of fifteen thousand dollars plus an amount equal to 4.5% of the daily-weighted average principal balance outstanding under the line of credit. We also paid to Comerica a one-time facility fee of fifteen thousand dollars for the line of credit. The agreement also provides for an unused line fee of .25%, various restrictive covenants and the maintenance of certain financial ratios. No amounts were drawn on the revolving credit agreement during the first quarter of 2003.

(10) STOCK OPTIONS

     We apply APB 25 and related interpretations in accounting for stock option plans. Had compensation cost been recognized consistent with SFAS No. 123, our consolidated net loss and loss per share would have been increased to the pro forma amounts indicated below:

     The following assumptions were used by us to determine the fair value of stock options granted using the Black-Scholes option-pricing model:

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PART I – Item 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
(000’s included)

     Statements in this report describing our plans, goals, strategies, intentions, expectations and anticipated events are forward-looking statements. Important factors which could cause actual results to differ materially from those described in such forward-looking statements include the following: commercialization of our products is dependent on acceptance by the medical community and continued receipt of satisfactory reimbursement from third-party payers; any future success depends upon our ability to expand and maintain a successful sales and marketing organization and to successfully manufacture products in commercial quantities; we may require additional financing for our business, and it is uncertain whether the financing will be available on favorable terms or at all; we may encounter unanticipated expenses, liabilities or other adverse events affecting cash flow; our ability to develop new applications depends on successful collaboration with third parties that we do not control; proper utilization of our system is dependent upon the quality of third party stains and reagents; we must successfully compete with other technologies and with emerging competitors in cell imaging; an inadequate supply of biological samples could delay completion of clinical trials for new applications for our Automated Cellular Imaging System (“ACIS”); the clinical trials could fail to demonstrate the efficacy of the ACIS for new applications; new applications may not be successfully developed; the ability to commercialize new applications may be dependent on obtaining appropriate U.S. Food and Drug Administration (the “FDA”) and foreign regulatory approvals and clearances, which may not be obtained when anticipated or at all; our competitive position is dependent upon our ability to protect our patents and proprietary rights; manufacture of the ACIS is subject to FDA regulation and our ability to implement our strategy of providing decentralized ACIS analysis capabilities over the internet is dependent upon successful development of the related imaging technology and obtaining any required regulatory approvals. Recent experience with respect to ACIS placements, new contracts for placements, revenues and results of operations may not be indicative of future results for the reasons set forth above.

Results of Operations

Overview

     Our mission is to improve the quality and reduce the cost of patient care, and speed drug discovery. We develop, manufacture and market a versatile automated digital microscope system with the ability to detect, count and classify cells based on color, size and shape to assist pathologists in making critical medical decisions that can affect patient treatment.

     The ACIS® (Automated Cellular Imaging System) combines an automated microscope with computer-based color imaging technology originally developed for the U.S. government’s “Star Wars” program. The FDA-cleared ACIS device is currently being used by pathologists and researchers to analyze specimens placed on slides and stained with color-producing, commercially available reagents. The system’s ability to overcome the limitations of the human eye (even when aided by a microscope) dramatically improves the observer’s ability to analyze cells and tissue. Peer-reviewed clinical data and publications have demonstrated that the ACIS digital microscope and proprietary software can considerably improve accuracy and consistency over other methods of laboratory testing. ChromaVision brings standardization, accuracy and reproducibility to anatomic pathology, an area of the laboratory focused on esoteric tests, which have traditionally been analyzed manually. In a multi-pathologist clinical study, observers improved their rates of correlation with an independent standard from a range of 42 to 92% scoring manually to 91 to 95% using ACIS. Even the most accurate pathologist scoring manually was able to achieve improved accuracy using ACIS.

     Safeguard Scientifics, Inc., a Pennsylvania corporation whose shares are listed on the New York Stock Exchange, owns beneficially approximately 62% of the outstanding shares of our Common Stock. We refer to Safeguard Scientifics, Inc. and its wholly-owned subsidiaries as “Safeguard”. As a result of this stock ownership, Safeguard has the ability to elect all of our directors and it also has significant contractual rights to control our business. See Note 8 of Notes to Condensed Consolidated Financial Statements.

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Critical Accounting Policies and Estimates

     Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods presented. Therefore, on an ongoing basis, we evaluate our estimates, including those provisions for bad debts and reserves for ACIS in progress.

     For estimated bad debts, we review on an individual account basis the age of the receivable, all circumstances surrounding the transaction that gave rise to the receivable and whether the customer continues to have the financial resources to pay the receivable as of the balance sheet date and prior to the issuance of the financial statements for the respective period. For ACIS in progress, the respective reserve is based upon the expected future use of the ACIS components based upon proposed design changes, high value components that may be discontinued in the near future and whether there are any lower of cost or market considerations. For other obligations, where judgment is required, we review the circumstances surrounding the obligation and evaluate the facts and circumstances to determine an appropriate level of accrual for each obligation.

     We place most of our instruments with users on a “fee-per-use” basis. We obtain the billing information via modem, which accesses the ACIS database. Revenue is recognized based on the greater of actual usage fees or the minimum monthly rental fee. Under this pricing model, we will own most of the ACIS instruments that are engaged in service and, accordingly, all related depreciation and maintenance and service costs are expensed as incurred. For those instruments that are sold, we recognize and defer revenue using the residual method pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Modification of SOP 97-2, Software Revenue