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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

Commission file number 1-16253

COMPUTERIZED THERMAL IMAGING, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number including area code: (801) 776-4700

Securities registered under Section 12(b) of the Act:

None

Securities registered under Section 12(g) of the Act:

Common Stock
(Title of class)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not 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. o

The aggregate market value of Common Stock held by non-affiliates of the registrant at September 2, 2003 was approximately $36 million. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded from this computation in that such persons may be deemed to be affiliates.

As of September 2, 2003, there were 112,870,031 shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

COMPUTERIZED THERMAL IMAGING, INC.

FORM 10-K

ANNUAL REPORT

TABLE OF CONTENTS

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PART I

This document, and the documents incorporated by reference, including, but not limited to, certain statements contained in Item 1, “Business” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contain forward-looking statements within the meaning of the Securities Act of 1933 and Securities Exchange Act of 1934. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied. When used in this document the words “expects,” “anticipates,” “intends,” “plans,” “may,” “believes,” “seeks,” “estimates” and similar expressions generally identify forward-looking statements. All forward-looking statements included in this document are based on information available to the Company on the date hereof, and we assume no obligation to update any forward-looking statements, except as otherwise required under applicable laws and regulations.

This document should be read in conjunction with our audited financial statements included in Part II and “RISK FACTORS” noted below.

ITEM 1.     BUSINESS

Introduction

Computerized Thermal Imaging, Inc. (“we”, “us”, “our”, “CTI”, “the Company”) designs, manufactures and markets thermal imaging and infrared devices and services used for clinical diagnosis, pain management and non-destructive testing of industrial products and materials. We market our products with an internal sales force and independent distributors.

Our research emphasizes applications for thermal imaging technology and the development of equipment and methods for producing, interpreting, and cataloging thermal images. We believe our products provide our customers with valuable and unique data for the detection of abnormalities. Our pain management products are used in the diagnosis and treatment of certain diseases and disorders. If ultimately approved by the U.S. Food and Drug Administration (the “FDA”), we believe that our breast imaging system will be able to be used by radiologists to help distinguish between benign and malignant breast masses. Our industrial products are used for testing product quality and enabling more efficient designs.

We continue to develop enhancements for our existing products to improve their form, function and/or effectiveness. We are currently developing modifications and updates for our breast imaging system to reduce its size and weight and improve operator efficiency and clinical effectiveness. We developed an improved non-destructive turbine blade inspection system for Pratt and Whitney but, since April 2003, have suspended industrial product development to reduce expenses and conserve cash. We are developing various modest enhancements to our pain management products to improve manufacturability and quality.

We have applied for a pre-market approval (“PMA”) from the FDA for our breast imaging system: The BCS 2100™ (“BCS 2100”), a painless and non-invasive technique for acquiring physiological information from women recommended for breast biopsy. To receive PMA approval, we must establish the BCS 2100’s ability to consistently distinguish between malignant and benign tissue and thereby reduce the number of benign breast biopsies performed. On December 10, 2002, an Advisory panel convened by the FDA to review our application held a public hearing on our PMA application and decided to recommend to the FDA, by a vote of 4-3, that the FDA not approve our application. On January 23, 2003, the FDA concurred with the recommendation of the panel and recommended additional data analysis, clinical trials and other steps that we might take to obtain FDA approval. We have contacted the FDA’s ombudsman and are attempting to negotiate a reversal of the FDA’s decision. We may formally appeal the FDA’s non-approvable decision or avail ourselves of other remedies. As of the date of this document, we do not know whether our negotiations or any appeal we might file will be successful.

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We are not permitted to sell the BCS 2100 in the United States until after we receive an FDA approval, and lack of FDA approval hinders marketing of this product in international markets. Because FDA rules restrict marketing of unapproved products, CTI attends industry trade shows and professional conferences, where it can present product information in an educational format that is properly labeled to radiologists without risk of FDA censure.

Our pain management products have FDA clearance and are principally marketed in the United States to chiropractors and physical therapists who use them to locate soft tissue injuries or potential sources of pain, to verify the effect of treatment; or to treat the symptoms of soft tissue injuries and pain syndromes. Pain management products are shipped from inventory when ordered.

We market our pain management products with an internal sales force and independent distributors. We attend trade shows and conferences, make direct sales calls and sponsor clinics, where we introduce, demonstrate and educate customers about our BCS 2100, pain management and non-destructive testing products.  

We have developed a product that uses our technology in an industrial setting. Our Turbine Blade Inspection System is a quality assurance tool and, using techniques similar to our BCS 2100, meets industrial requirements for non-destructive testing and examination of turbine blades used in aircraft and power generation, and other industrial components, composite materials and metals.

Our industrial systems do not require FDA approval and are marketed directly to end-user customers in the United States and Europe. Industrial products are built-to-order, require tailoring to the customer’s specific requirements and require two to six months to complete. These products typically have long sales cycles and demand is directly impacted by economic conditions.

We manufacture our products (pain management, BCS 2100 and, as of April 2003, our industrial products) internally at our Ogden, Utah facility. The Ogden facilities certified to ISO 9000 quality standards.

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We are publicly traded on the American Stock Exchange under the symbol “CIO.” As of September 1, 2003, we had approximately 113 million shares of common stock outstanding; held by approximately 21 thousand shareholders. In addition to common stock, there are outstanding exercisable warrants and options to acquire approximately 10.4 million shares at exercise prices ranging from $0.63 to $5.00. Of the approximately 123 million fully-diluted common shares outstanding, 13.5 million are beneficially owned by insiders and affiliates. Other than our wholly-owned subsidiary, Bales Scientific, Inc., we have no interest in any other entity.

We use our capital to pay general corporate expenses, including salaries, manufacturing costs, professional fees, clinical study and technical support costs, and general and administrative expenses. We are a development stage company and, to date, we have funded our business activities with funds raised through the private placement of common stock, debt and warrants, and the exercise of warrants and options.

Industry Overview & Trends

The American Cancer Society estimates that 203,500 new cases of invasive breast cancer will be diagnosed among women and approximately 40 thousand women in the United States will die from the disease during 2002. Breast cancer is the most commonly diagnosed cancer among women, accounting for nearly one of every three new cancers diagnosed, and is the second leading cause of cancer death (after lung cancer). Each year, more than 20 million women in the United States have a mammogram to screen for breast cancer. Approximately two million of those mammograms require additional follow-up due to a suspicious finding, and approximately 1.3 million abnormal mammograms require a breast biopsy to characterize the suspicious tissue as benign or malignant. The American Cancer Society estimates that approximately 20%, or 203,500, of the suspicious tissues that are subjected to biopsies will turn out to be cancerous. In other words, more than 80% of these breast biopsies performed during 2002 are expected to yield benign results.

Of the 1.3 million breast biopsies performed in the United States each year, approximately 800 thousand are open surgical procedures where the patient is anesthetized or heavily sedated and a surgeon extracts the mass through an incision. The remaining approximately 500 thousand biopsies are less invasive “core” biopsies where a needle is guided to the region of interest and a sample is obtained without having to perform open surgery. The trend is toward less invasive biopsy methods to reduce scaring, cost and emotional trauma. The number of biopsies performed has doubled in the last 10 years and the trend toward less invasive biopsy techniques has accelerated.

If we receive FDA approval for our breast imaging system, we believe that, under prescribed circumstances, radiologists and surgeons will be able to use the physiological profile of the suspicious tissue produced by our BCS 2100 to determine whether breast masses are benign, without performing a biopsy. The target market for the BCS 2100 are the more than ten thousand certified mammography centers in the United States and more than ten thousand mammography centers throughout the rest of the world.

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Our target markets for the pain management products consists of over fifty thousand chiropractors, pain management practitioners, occupational therapists, physical therapists and major sports teams in the United States looking for ways to diagnose and treat injuries and pain conditions effectively and quickly. According to some reports, more than fifty million Americans suffer chronic pain and an additional twenty-five million suffer acute injury-related pain, costing the United States economy more than $70 billion annually in missed work days, emergency room visits, medications and other costs.

The target markets for our industrial products are primarily manufacturers of complex castings, particularly in the aerospace and power generation markets.

Our Products and Services

Our imaging systems integrate third-party hardware, our proprietary software and heat-sensing camera to produce, interpret, and catalogue thermal images. These systems provide medical professionals with physiological information to assist in the evaluation of breast abnormalities and the management of chronic pain. These systems also have industrial applications in non-destructive testing and inspection of complex industrial products; e.g., turbine blades.

We have developed six significant proprietary technologies, four of which relate to the breast imaging system: 1) a climate-controlled examination unit to provide patient comfort and facilitate reproducible tests for the BCS 2100; 2) an imaging protocol that produces consistent results for the BCS 2100; 3) a statistical model that detects physiological irregularities for the BCS 2100; 4) infrared imaging and analysis hardware, including our proprietary heat-sensing camera, which is used in the BCS2100 as well as our pain management and industrial systems (collectively, we refer to items 2-4 as the “Thermal Imaging Process”); 5) a system to treat pain and other symptoms of diseases that restrict blood flow (the “Photonic Stimulator”); and 6) a system for non-destructive testing and examination of turbine blades and other industrial components (the “Turbine Blade Inspection System”).

Medical Products - Breast Cancer System 2100

Our BCS 2100 provides a non-invasive, painless way to collect information that, if approved by the FDA, we believe could supplement the information provided by mammograms for the evaluation of suspicious breast lesions. To receive a breast scan on the BCS 2100, a patient will lie face down on our device and expose one breast at a time to the flow of cold air. The breast is then observed by our infrared imager as it cools. Because malignant tissue is more vascular and less likely to constrict upon contact with cool air than benign tissue, malignancies are measurably warmer than benign tissue. The BCS 2100 captures 103 dynamic images of each breast and analyzes over 8.3 million temperature values per breast to measure minute changes in physiological and metabolic activity. From these measurements, the system is able to compute a mathematical probability and indicate the likelihood that a suspicious breast lesion is benign or malignant. We believe that this data, when combined with diagnostic information from mammograms, will provide radiologists with additional information that can be useful in determining more precisely when a surgical biopsy is needed.

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Mammography and related imaging methods capture a snapshot of anatomical structure at a moment in time, but do not provide information about the behavior of the structures exposed. While mammography may detect the presence of an abnormality in the breast, a biopsy is required to determine whether the abnormality is benign or malignant. We believe our technology produces images that expose the physiology and function of breast tissue. If we receive FDA approval, we believe that this physiological information can provide health professionals with a tool for more accurately discriminating between those cases that require invasive biopsy and those that do not; furthermore, we believe our BCS 2100 will be able to provide physiological data that can lead to fewer biopsies, 80% of which have benign findings.

We believe the BCS 2100 provides a tool that could detect cancer in almost all types of abnormal breast lesions: masses, micro-calcifications and architectural distortions. In our clinical trials, where BCS 2100 findings were confirmed by biopsy, we detected malignancy 96.4% of the time cancer was present, and we believe we can improve this overall sensitivity with additional clinical research studies and statistical software development.

Our best sensitivity is with lesions classified as masses. According to our clinical trials, where BCS results were confirmed by biopsies our BCS 2100 detected cancer in lesions described as masses 99.3% of the time when cancer was present. This means that we have a false negative rate of less than 1%. Our PMA application addresses efficacy for all breast lesions, but later amendments and the panel presentation focused on lesions described as "masses," which represent about half of all anomalies noted on mammograms referred for biopsy, and where we had the best clinical sensitivity. If utilized as a decision tool, excluding all other factors, procedures and tests, we believe our system would have resulted in the deferral or avoidance of 19.2% of biopsies in women who had masses detected on their mammograms.   The efficacy data presented shows a false positive rate, that is cases where results from the BCS 2100 indicated the possible presence of cancer when none existed, approximately 80% of the time when cancer was not present. We believe that ongoing clinical research and future developments in the software algorithms (statistical models), as part of the product maturation process and under FDA approved procedures, will enable the system to safely achieve significantly lower false positive rates, thereby leading to higher biopsy avoidance rates.

We view biopsy as the direct competition for the BCS 2100. According to the American College of Radiology, the average breast biopsy costs between one thousand and three thousand dollars per patient. We believe that a breast scan on the BCS 2100 should cost a fraction of the cost of a biopsy and avoid the pain, risk of infection and other complications arising from an invasive surgical procedure.

Medical device marketing and distribution efforts rely upon building relationships with other manufacturers (strategic alliances), equipment dealers, physicians and clinical investigators. Local distributors tend to have the essential relationships with hospitals that are difficult to duplicate with a captive sales force. While we cannot guarantee whether or when the FDA will approve our product, in anticipation of possible FDA approval we have initiated relationships with distributors who have established relationships in the radiology and medical imaging communities. Because FDA rules restrict marketing of unapproved products, we attend industry trade shows and professional conferences where we can present product information in an educational format to radiologists without risk of FDA censure.

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Medical Products - Pain Management

We market two FDA-cleared pain management devices used for diagnostic imaging and therapeutic treatment. The Thermal Image Processor (“TIP”), which uses the same infrared camera as the BCS 2100, measures body heat naturally radiated by the patient as he/she stands (or sits) before the camera, and develops a physiological profile to assist in the diagnosis and treatment of a wide range of physiological and circulatory abnormalities, principally soft-tissue related injuries and pain.

A complementary infrared light therapy device (“Photonic Stimulator”) is a hand-held device that emits infrared energy which penetrates the skin to stimulate blood flow, promote circulation, reduce pain and speed healing. The Photonic Stimulator is FDA-cleared to treat general aches and pains. However, anecdotal feedback from practitioners who use the Photonic Stimulator and published research reports indicate that infrared light therapy can reduce pain, promote circulation and speed healing.

The TIP system competes indirectly with x-ray, computed tomography, ultrasound and magnetic resonance imaging (MRI). Medical practitioners typically view imaging technologies as elements of a toolkit, each uniquely suited for the diagnosis of a specific problem or problems. The TIP also competes against infrared cameras available in the aftermarket and marketed by several small direct competitors. The Photonic Stimulator, also a non-invasive and painless modality, competes with therapeutic ultrasound, electrical stimulation and newly approved laser light therapy devices.

The recent outbreak of Sudden Acute Respiratory Syndrome (SARS) has provided a new opportunity for employing our Thermal Image Processor as a health screening device at international ports of entry and other public facilities; e.g., train stations and airports. Since the identification of SARS, we have sold cameras for screening use into the People’s Republic of China, we are participating in a Canadian program to evaluate the use of infrared imaging for airport passenger screening and we are exploring other, similar, projects. While these activities appear exciting, we cannot guarantee the adoption of the methods we propose or the selection of our products by customers adopting infrared passenger screening.

The current suggested retail price for the TIP is $55,000. Our average selling price for new equipment during Fiscal 2003 was $43,800 and during 2002 was $41,300. Our average selling price for reconditioned TIP system is $28,000. Although we believe our TIP system competes favorably with aftermarket and other direct offerings in terms of capability and price, we expect TIP system prices to decline over time as a result of increased competition. The current suggested retail price of our Photonic Stimulator is $4,500. Our average selling price during 2003 was $2,130 and $4,366 during 2002. We expect Photonic Stimulator resale prices to remain at its current price level as we continue our efforts to expand unit volume and compete with other light therapy devices as light therapy becomes more accepted.

The principal factors in growing the pain management segment will be increased market adoption of both technologies based on customer referral and testimonials, and published third-party research to build credibility of products and earn expanded indications for use of the devices from the FDA. The adoption of new products may be adversely affected by general economic conditions, changes in insurance coverage offered by private insurers in response to the general economy and new competitive offerings. We cannot guarantee that customers will accept our products, or that we will be able to profitably manufacture and sell these products.

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Pain management product marketing has relied upon trade advertising, word-of-mouth, public relations and media outreach, trade show attendance, direct and channel sales, and educational seminars, where products are demonstrated to groups of potential customers. We hold user group meetings and work with the current customer base to place articles and provide testimonials about how our pain management devices have impacted their practices and improved the condition of challenging patients.

CTI has a direct field and a small inside sales team. To build credibility and to obtain additional market exposure, we have developed relationships with pain management dealers in California, Texas, Florida, New England and Asia who have established relationships and reputations in these markets.

Industrial - Non-Destructive Testing Products

The Turbine Blade Inspection System (“TBIS”) provides customers with an effective, cost-efficient quality assurance tool. Using techniques similar to those employed by our BCS 2100 and the infrared camera used in the BCS 2100 and TIP products, our automated infrared inspection system creates thermal stress by rapidly heating a component, collecting a series of images as the component returns to ambient temperature, and then analyzing these images to determine the presence or absence of characteristics determined to correlate with certain manufacturing and usage-induced defects. The analysis identifies defects, abnormalities and flaws in the test material. This system can identify blockages in cooling holes as small as the diameter of a human hair.

The Company performs services for customers in connection with developing additional hardware, software to expand the type and number of components a customer can test, repairing previously installed equipment, and helping customers solve quality assurance or product design problems.

TBIS base systems are sold in a range between $350,000 and $450,000 and compete with industrial x-ray, ultrasound and other technological approaches. This system provides a safe, effective and hygienic approach to locating product defects, and requires no disposable supplies; i.e., x-ray film. We also market smaller, less expensive systems utilizing our TIP and an alternative thermal stimulus device costing approximately $130,000. We market these products directly to engine and power system manufacturers and other industrial type customers. These products typically have long sales cycles and demand is directly impacted by the economic conditions.

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Patents

As of June 30, 2003, we had the following patents or patent applications pending before the United States Patent and Trademark Office:

We expect to apply for additional patents in the future to cover other technologies or components of our products. We believe these patents and patent applications are valid and enforceable and provide some competitive protection for our products by requiring our competitors to either license intellectual property from the Company, invest in developing an alternative solution that would not infringe upon our patents or contest the validity of our patent in a legal proceeding.

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Source of Supply

Manufacture and assembly of our pain management and thermal imaging devices require standard electronic components, formed or machined metal and plastic parts, wiring harnesses, printed circuit boards and metal cases which are available from any number of suppliers with relatively short lead times. We single-source certain proprietary optical components and cooling equipment; these typically require 12 to 16 week lead times. To date, we have experienced no supply disruptions with these vendors. While there are alternative sources for these products, the loss of one of our current suppliers would require that we invest time developing and certifying a new supplier. Until the new vendor is certified we could experience a disruption in ability to supply TIP systems, which are a component of the BCS 2100 and our industrial products.

Business Strategy and Markets

We believe our products and technologies provide a unique collection of new and cost-effective diagnostic, pain management and product testing solutions for medical and industrial customers. Our target customers are hospital radiology departments, cancer research facilities and imaging centers, chiropractors and physical therapists, and manufacturers of products with complex cast components or processes.

To exploit the BCS 2100 and expand the market for our pain management products, the Company is pursuing FDA approvals and clearances. Our BCS 2100 qualifies as a medical device under federal law because of its intended use in the diagnosis of disease. We are pursuing FDA approval for our BCS 2100 and we believe that this approval will enhance our ability to market our products by: 1) allowing us to reference medical efficacy claims in connection with marketing our BCS 2100; 2) improving physician acceptance of our systems; and 3) facilitating the designation of insurance payment codes. We are in the process of conducting future clinical studies to expand the approved labeling and indications for use for our pain management products. We believe that expanding indications for use will improve physician acceptance of our products and increase pain management product revenues.

Our marketing efforts rely upon building relationships with manufacturers, local medical equipment dealers, physicians and clinical investigators. We established a medical advisory board to assist us in preparing for the FDA panel meeting and to help us devise programs and projects to facilitate acceptance in the market place. We also attend trade shows and conferences and make direct sales calls on industrial customers and sponsor clinics, where we introduce and demonstrate our breast imaging, pain management and non-destructive testing products. We believe marketing our medical products directly and through a dealer channel, augmented with trade shows, conference presentations, direct mail and inside sales, provides a cost-effective approach to diagnostic imaging and pain management practitioners. As of the date of this report, the medical advisory board is dormant, we have discontinued trade show participation and limited our marketing activities to user group meetings with current and potential customers and direct selling; however, if we are successful in securing additional capital, we plan to continue investing resources in these programs.

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As with all medical devices, it is important that our BCS 2100 customers receive adequate reimbursements from third-party payers: insurance companies, Medicare and Medicaid reimbursement agencies. We applied for a reimbursement code from the American Medical Association during December 2001 for our BCS 2100. Our application will not be acted upon unless and until we receive FDA approval for the BCS 2100.

Our pain management products qualify for insurance reimbursement in most states at rates that vary on a state-by-state basis. Generally insurance providers offer coverage if the state’s workers compensation scheme recommends coverage. Currently only New York, Montana and Minnesota do not recommend coverage for treatments that include infrared imaging or infrared therapy. Average reimbursement for an infrared imaging procedure with our TIP camera, in states offering reimbursement, is $198, with a high of $375 and a low of $96. Average reimbursement for an infrared treatment with the Photonic Stimulator is $12, with a high of $38 and a low of $4 per treatment.

We plan to continue conducting clinical studies utilizing the BCS 2100 with institutions and practitioners to obtain user feedback, test product enhancements, secure technical papers, and for training and educational marketing purposes.Clinical studies are not the same as clinical trials, which we conducted for FDA PMA approval purposes, in that in clinical studies we are able to view the study results during the study and, therefore, cannot use study results as direct evidence in support of our PMA application. During 2002, we entered into a research relationship with McKay-Dee Hospital for a study of up to 70 patients referred for biopsy of a single mass after undergoing conventional diagnostic procedures. We conducted this study to acquire information about the effectiveness of the BCS 2100 for women age 60 and over presenting with a lesion described as a mass. We ended this study during the third quarter of fiscal 2003, without conclusion when it became apparent that the institution did not treat sufficient patients to complete the study in a timely fashion. A separate study at McKay-Dee Hospital involved 125 women to obtain baseline information regarding the characteristic thermal profile associated with normal breast tissue in women 21 and older. We concluded this study during March 2002 and are holding the data for further analysis if we receive FDA approval. We also initiated a study at Massachusetts General Hospital, Harvard Medical School’s largest teaching hospital, for a clinical study involving up to 250 patients referred for biopsy of a single mass after undergoing conventional diagnostic procedures. This study is intended to acquire information to study the effectiveness of the BCS 2100 in women age 60 and under who present with a lesion described as a mass. This study is ongoing. In addition, these studies provide us with an opportunity to evaluate the form and function of the BCS 2100 and develop product enhancements for next generation products. We are currently conducting a study with the Photonic Stimulator, evaluating its effect on neck and shoulder pain. This study is not yet complete. We are not currently conducting clinical studies or trials for our Thermal Image Processor.

The legacy Bales Scientific subsidiary provided industrial test services and has designed and sold industrial test systems to customers who desire to perform their own testing for many years. Our industrial non-destructive testing product focus has been the analysis of turbine blade defects. Turbine blades are very complex cast parts used in aircraft, power generation, pumps and compressors. The TBIS analyzes turbine blades under conditions that mimic the extreme operating environment of a turbine by applying heat and measuring temperature changes as the part cools. We believe that this technology is uniquely capable of testing blades automatically, quickly, inexpensively and without destroying or compromising the blade part. During the third quarter of fiscal 2003, to reduce cash outlays, we relocated this activity to our Ogden, Utah facility and closed the Walnut Creek, California operation.

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The turbine blades tested using CTI’s TBIS include aircraft turbines employed in military aircraft, and electrical power turbines. TBIS sales have long lead times and require significant integration into the customer’s production systems. We address this market with a direct sales person, by attending trade shows and advertising in channel appropriate publications. TBIS sales have been infrequent, are dependent upon the health of the aerospace industry and general economic conditions and there may be relatively few customers for this device.

Although we have scaled back operations and staffing levels to conserve cash as we seek FDA approval, we continue to expend financial and technical resources improving and developing new applications for our medical products. We are continuing to develop enhancements for our existing products to improve their form, function and effectiveness. We are developing improvements for our BCS 2100 to reduce its size and weight and improve operator efficiency and clinical effectiveness. We developed an improved non-destructive TBIS for Pratt and Whitney, but have suspended additional industrial research until we secure additional funding. We have also delayed various small enhancements to our pain management products until future funding is obtained. While we cannot assure the success of any new product or regulatory approval of any proposed indication for use, we believe that improving product features and functions will expand the market for our products and increase revenues.

Segment Sales

We have two business segments medical and industrial. Medical products include the BCS 2100 and our pain management products, the TIP and Photonic Stimulator. Medical products share common infrastructure, sales and regulatory functions. Industrial Products includes our non-destructive testing products and services. The sales for our business units during the last three fiscal years ending June 30 were:

In 2003, NanDa Thermal Medical Technology, Inc. (“Nanda”) was our largest medical customer and represents 33% of total sales and 50% of medical sales for the year. Prior to 2003, medical sales were made to numerous customers, none of which was more than 10% of the business unit’s sales. We fulfill our pain management sales as we receive orders and have no backlog.

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Medical sales by geographical location for the last three years ending June 30 were:

Alstom Power UK, Ltd (“Alstom”) was our largest and primary industrial customer during fiscal 2001, 2002 and 2003, and provided 94%, 74% and 69% of all industrial sales respectively. During 2003, we recognized revenue of approximately $318,000 from a TBIS we shipped and installed at Alstom’s plant in the United Kingdom during 2002, which we deferred because of customer acceptance test requirements (which we have successfully completed) and multiple elements included in the sale including software and a warranty provision, which requires us to repair and correct all defects in material and workmanship started after the customer acceptance provisions. During fiscal 2003, we shipped a TBIS system to Pratt and Whitney and are in the process of obtaining final customer acceptance. We will recognize this sale as gain on the sale of fixed assets once the customer acceptance provisions have been completed.We also shipped a non-destructive test system to Dresser-Rand Company during the second quarter of fiscal 2003.

Industrial sales for the last three years ending June 30 were:

Industrial sales by geographical location for the last three years ending June 30 were:

We fulfill industrial sales by building equipment to a customer’s order and providing industrial thermal inspection services. We tailor our systems to meet our customers’ needs and requirements because each customer has its own requirements for production equipment and their products are unique.

TBIS sales have a long sales cycle and are dependant upon, among other things, general economic conditions, and specifically the economic condition of the aerospace industry and demand for new or replacement power stations. We cannot guarantee that demand will be sufficient to ensure profitable operation of this business segment.

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Backlog

Unfulfilled orders as of June 30, 2003, 2002 and 2001 are $0, $425,000 and $600,000 respectively. As of June 30, 2003, although we have not recognized the sale of the Pratt and Whitney TBIS, we are not including it in backlog. This order was shipped during Fiscal 2003 and will be recognized as a gain on sale of fixed assets when all of our sales commitments and obligations have been fulfilled. The 2002 backlog represents the Pratt and Whitney TBIS. The June 2001 backlog represents two TBIS ordered by Alstom. We shipped one system during the second quarter of Fiscal 2002, but have not recognized any revenue from that shipment because the terms of the sale did not meet our revenue recognition policy. Rather than purchase a second system, Alstom purchased fixtures and programming services to expand the application of the unit we delivered and cancelled its order for the second system, resulting in a net reduction in backlog of $153,000.

We conduct research and development on medical and industrial products in our own facilities, conduct clinical studies and clinical trials at hospitals; however, we have no company sponsored or customer sponsored third-party or purchased research and development activities.

Our Competition

Medical Imaging. The principal methods used to visualize internal human anatomy are x-ray, computed tomography, ultrasound and magnetic resonance imaging. Physicians view these technologies as elements of a toolkit, each uniquely suited to the diagnosis of a specific problem or problems.

Our BCS 2100 provides physiological information that supplements the anatomical information obtained from mammography and does not compete directly with x-ray, computed tomography, ultrasound or magnetic resonance imaging. Our system is painless, requires no radioactive materials and involves no invasive technology.

Our pain management products compete with ultra-sound, electrical stimulation, newly approved laser light therapy devices and infrared cameras purchased from competitors or in the aftermarket for infrared cameras.

Our industrial applications compete with industrial x-ray, and high pressure water and air techniques; which require skilled labor, are time consuming and may utilize dangerous radiation that requires special facilities. Our system provides additional defect analysis more quickly by using less skilled labor and no special environment; and may replace high pressure water and air or x-ray for certain applications.

The companies that supply diagnostic and industrial imaging equipment range from large manufacturers to smaller specialized companies. Large diversified manufacturers, for which imaging systems define only a portion of their total business, include General Electric, Siemens, Toshiba, Hitachi and Philips.

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New Technologies. Digital x-ray captures images electronically and may provide several important benefits relative to existing technologies: 1) reduced radiation dosage; 2) faster access to images, which is critical for emergency room use; 3) digital technology, which can be distributed and accessed through a computer, enables remote consultation; and 4) reductions in labor and radiographic film costs. Our BCS 2100 does not compete with digital x-ray equipment. In fact, as mammography technology improves more women are referred for biopsies. We believe this will create a greater demand for technologies, like our BCS 2100 that may be able to determine whether a patient’s mass is benign without the use of an invasive surgical procedure.

Positron Emission Tomography (“PET”), an invasive, nuclear medicine-based diagnostic imaging technique for measuring the metabolic activity of human cells, may benefit patients suffering from certain types of cancer or certain conditions affecting the brain and heart. Many insurance carriers approve PET, but the technology is expensive and difficult to administer.

Optical imaging of the breast is based on laser transillumination. This technology is under investigation as a possible approach for medical imaging and at least one potential competitor is attempting to secure FDA approval for their version of this technology. Laser transillumination has been investigated for over 20 years and recent implementations of this technology use computed tomography to improve the results. We believe our BCS 2100 competes favorably with this technology.

Procedures. We view biopsies, either needle aspiration or open surgery, as direct competition for the BCS 2100. We believe that the BCS 2100, if approved by the FDA with the indications for use (“Labeling”) we have requested, will be adjunctive to mammography, and that every patient with an abnormal mammogram indicating a mass, who might be referred to biopsy under current protocols, will be a potential candidate for a BCS 2100 procedure. We believe that, through the product maturation process involving additional product development, we will be able to obtain expanded Labeling and effectively screen all patients referred for biopsy. To successfully market our product, which can occur only if we receive FDA approval, we will have to educate physicians about the BCS 2100 so that they will be able to recommend a BCS 2100 procedure to their patients, persuade hospitals and imaging centers to purchase the equipment and convince insurance carriers to provide reimbursement for the BCS 2100 procedure.

Our Sales and Marketing Strategy

Overview. We plan to market our products with a multi-channel strategy incorporating independent distributors, direct marketing, telemarketing, the internet and corporate marketing. We plan to address the industrial market with a direct sales force augmented by distributors and dealer representatives as appropriate.

Distributors. The Company has retained and will continue to seek the services of distributors. Our distributors usually focus their efforts on a specific channel in a specific region; e.g. chiropractors and physical therapists in Northern California. We believe that distributors provide intimate local market knowledge and contacts critical to accessing hospital imaging facilities, radiologists, chiropractors and physical therapists, and local service capability. Our agreements with these distributors allow the distributor to purchase products at a discount from list price, usually 30%, and provide extended terms for an initial order of demonstration equipment, which we do not recognize as a gain on sale of fixed assets until the distributor actually pays for the equipment. We retain the right to develop and service national accounts in the distributor’s territory, but provide a period of limited exclusivity with regard to the distributors own customers, which can be extended only if the distributor meets certain sales goals. To date, no distributor has met these goals. We also require the distributor to participate with us in certain marketing programs; e.g., user group meetings.

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Telemarketing / Telesales. We believe telemarketing/telesales provides important direct marketing, lead follow-up and customer service capability, particularly in the pain management segment. Telemarketing creates revenue through direct sales and generates leads for distributors.

Internet. We use the internet to provide information to current and potential customers.

User Groups and Seminars. We believe meeting with our customers and potential customers at informal user conferences and training sessions provides valuable market intelligence, product use information, and assists us in selling our products. We conduct user group meetings at various sites across the United States and by conference call.

Trade Shows and Associations. We attend medical and industrial trade shows and present papers at professional conferences. We believe attendance at trade shows and conferences allows us to build product awareness, demonstrate our products, educate customers and generate leads for future sales.

Corporate Marketing. We intend to develop product and company collateral materials, advertise in select trade journals, demonstrate our products and present papers, and research results at conferences and trade shows. We believe that these activities will build corporate and product awareness and support our sales efforts in selected vertical markets.

Industrial Products. The Company has a small internal team pursuing industrial opportunities. This team manages relationships with existing and potential customers in the turbine power market and is exploring potential relationships with industrial customers requiring non-destructive testing capabilities.

Service Providers and Contractor Relationships

Overview. As a development company, our business model relies upon contractors and suppliers to reduce our development risk and to provide necessary clinical resources. We continue to utilize some of these contractors to support our PMA application and clinical studies.

Battelle Memorial Institute assists us in the preparation of regulatory submissions and provides technical consulting services, on a time and materials basis, in connection with algorithm development and statistical consultation for interaction with the FDA.

Quintiles, Inc. is an independent consulting firm, authorized by the FDA to verify clinical examination results, provide clinical trial monitoring and FDA preparation support. Quintiles provides the Company services on a time and materials basis and continues to provide consulting support in connection with securing FDA approval.

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Clinical Trials. We contracted with six hospitals to conduct the clinical trials necessary for FDA approval of the BCS 2100. The Company continues to maintain relationships with these institutions in connection with completion of the PMA:

–            USC/Norris Comprehensive Cancer Center, Los Angeles;
–            Los Angeles County Hospital, Los Angeles;
–            Mt. Sinai Hospital, Miami;
–            St. Agnes Hospital, Baltimore;
–            Lahey Clinic, Boston; and
–            Providence Hospital, Washington, D.C.

Clinical Studies. Clinical studies are clinical research conducted for purposes of developing expanded indications for use, testing product enhancements, identifying potential product issues and obtaining product trial by practitioners and patients. Clinical trials are experiments where patient results are withheld from the Company pursuant to experimental controls designed to ensure scientific accuracy and are conducted in connection with obtaining FDA PMA approval. We have relationships and agreements with two hospitals and plan to secure relationships with additional hospitals, clinics and practitioners, perhaps including the six hospitals previously mentioned in connection with our prior clinical trials, to conduct clinical studies on our BCS 2100 and other products. Clinical study agreements specify the number of patients studied, cost reimbursement, the study investigator, protocol, objectives and estimated time to complete the study. They also require the hospital to maintain professional and general liability insurance and comply with the protocol and all relevant FDA regulations. In some circumstances we may provide for the purchase of the equipment upon study completion. As of June 30, 2003, we had active clinical study relationships with McKay-Dee Hospital located in Ogden, Utah, and Massachusetts General Hospital in Boston, Massachusetts, for clinical studies with our BCS 2100. We are conducting these studies to acquire information about the effectiveness of the BCS 2100 for women presenting with a lesion described as a mass. During fiscal 2003, we terminated the McKay-Dee study because the hospital could not obtain sufficient patients to complete the study in a timely fashion. The Massachusetts General study is ongoing. In addition, we are using a third-party clinical research organization to conduct a study with our Photonic Stimulator to evaluate its effect on neck and shoulder pain after a limited course of treatment. We cannot guarantee customer acceptance, published results, expanded indications for use or the effectiveness of any product enhancement or protocol tested in connection with these efforts. However, we believe these efforts are important and plan to continue this activity. We have no clinical trials pending at this time. Depending on whether we receive FDA approval of our BCS 2100, and perhaps to obtain additional approvals for new indications for use, we may have to conduct additional clinical trials in the future.

We believe our relationships with these organizations and hospitals are good. Battelle continues to provide consultation and statistical analysis on an as needed basis. Quintiles and the hospitals that conducted our clinical trials have completed their work examining patients on the BCS 2100, but may be called upon in connection with FDA audits of clinical cases. While we believe that termination of any of these relationships, and the resultant loss of familiarity and know-how could result in delays in compiling information or preparing data in response to FDA inquiries, we believe that any such loss would not be material.

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Government Regulation

Overview. Our BCS 2100 and pain management devices qualify as medical devices under federal law because they are intended for use in the diagnosis, cure, mitigation, treatment or prevention of disease but do not interact chemically with the body. Typically, low risk devices that are classified as Class I or Class II devices and are substantially similar to approved products already on the market obtain FDA clearance by the agency’s pre-market notification known as a 510(k) filing. Our pain management products, the TIP and Photonic Stimulator, have these 510(k) clearances, have been listed with FDA and, accordingly, may be used by practitioners in accordance with the proposed indications and conditions for use without exception, monitoring, further approval, conditions or control, and without reporting obligations to any government entity. Each year more than four thousand new devices are cleared using this approach.

Sophisticated instruments that entail significant risk, or utilize unique or new technology and are classified as Class III devices, require manufacturers to submit a PMA to the FDA. More complex and time consuming to prepare than a 510(k) filing, a PMA typically contains significant clinical testing, manufacturing and other data, all of which are scrutinized by the FDA to demonstrate the product’s safety, reliability and effectiveness, and that proposed indications and conditions for use are appropriate. Typically, less then 40 devices a year are granted PMA approval. Only companies that are registered with the FDA can submit a 510(k) or PMA for clearance or approval from the FDA for either a 510(k) or a PMA. As a registered company, we obtained the necessary clearance from the FDA prior to submitting the PMA.

For the past five years, we have pursued PMA approval for our BCS 2100 as an adjunct diagnostic tool to mammography in patients with suspicious breast lesions that include mass being considered for biopsy. We believe an approved PMA provides valuable benefits that enhance our ability to market the product, including: 1) an ability to reference medical efficacy claims in our marketing; 2) improved physician acceptance of our system; and 3) assistance in obtaining insurance reimbursement codes, which we believe will enhance the successful marketing of the BCS 2100. To date, as described below, we have not obtained FDA approval of our PMA application for the BCS 2100.

The FDA, in addition to clearing and approving medical devices, also regulates clinical trials and studies. Our clinical activities are subject to rules requiring that we adhere to specified clinical and investigational practices and procedures, obtain specified approvals from each study site, monitor clinical sites and data to assure adherence to protocol and report any adverse patient reactions that might occur in connection with our studies. The FDA may conduct an audit of clinical trials in connection with approving a PMA. During September 2002, the FDA conducted such an audit of our clinical trials at our Ogden, Utah, facility and concluded that our clinical trials were conducted in compliance with FDA regulations.

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The FDA also regulates products after they have received approval or clearance. Regulations require that we maintain manufacturing processes in accordance with the FDA’s regulations and prescribed procedures regarding manufacturing processes, including a quality assurance system, document control, Medical Device Reporting relating to adverse events, maintenance of a corrective and preventative action program and appropriate design controls and process validation. The FDA also regulates export and import of any approved or non-approved device. In the event the Company is found out-of-compliance with any of these regulations, the FDA may require that we cease production and marketing until corrective measures have been implemented. The FDA also could require a product recall and could enforce civil and criminal penalties against the Company, its officers and others. Based on FDA actions to date, we believe we are in compliance with all applicable FDA regulations related to the design and manufacture of our products.

We submitted our PMA in five modules. Module 1 provided:

Module 2 provided:

Module 3 provided:

Module 4 reiterated certain information and provided additional information regarding:

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Finally, Module 5 was an evaluation of our clinical trials, including the accumulation and analysis of all the clinical trials, efficacy data and an update to our indicated use as follows: “The CTI BCS 2100 is a dynamic computerized infrared-based image acquisition device intended for use as an adjunct mammography in patients with suspicious breast lesions that include mass being considered for biopsy. The CTI BCS 2100 provides additional information to guide a breast biopsy recommendation”.

On December 10, 2002, the FDA’s Radiological Devices Panel, which is composed of independent experts, was convened by the FDA and held a public hearing to evaluate our application in order to make a recommendation to the FDA whether to approve or disapprove the BCS 2100 for its intended uses. The panel, by a vote of 4-3, reco