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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2004

For the transition period from                          to                         

Commission file number: 000-33001

NATUS MEDICAL INCORPORATED

(Exact name of registrant as specified in its charter)

1501 Industrial Road, San Carlos, CA 94070

(Address of principal executive offices) (Zip Code)

(650) 802-0400

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for 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  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The number of issued and outstanding shares of the registrant’s Common Stock, $0.001 par value, as of August 9, 2004, was 17,059,561.

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NATUS MEDICAL INCORPORATED

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PART I.    FINANCIAL INFORMATION

Item 1.    Financial Statements

NATUS MEDICAL INCORPORATED

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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NATUS MEDICAL INCORPORATED

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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NATUS MEDICAL INCORPORATED

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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NATUS MEDICAL INCORPORATED

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1—Basis of Presentation

The accompanying interim condensed consolidated financial statements of Natus Medical Incorporated (“Natus,” “we,” “us,” or “the Company”) have been prepared in accordance with accounting principles generally accepted in the United Sates of America (“GAAP”). The accounting policies followed in the preparation of the interim condensed consolidated financial statements are consistent in all material respects with those presented in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

Interim financial reports are prepared in accordance with the rules and regulations of the Securities and Exchange Commission, accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. The interim financial information is unaudited, but reflects all normal adjustments that are, in the opinion of management, necessary for fair presentation of our financial position, results of operations, and cash flows for the periods presented. Operating results for the three and six months ended June 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries; significant intercompany transactions have been eliminated.

Comprehensive Loss

Following are the components of comprehensive loss (in thousands):

2—Inventories

Inventories consisted of (in thousands):

3—Reserve For Product Warranties

The Company provides a one-year warranty on its medical device products. The Company also sells extended service agreements on its medical device products. Service for domestic customers is provided by a company-owned service center that performs all service, repair, and calibration services. Service for international customers is provided by a combination of company-owned facilities and third-party vendors on a contract basis.

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NATUS MEDICAL INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

3—Reserve For Product Warranties (Continued)

The Company has accrued a warranty reserve, included in accrued liabilities on the accompanying balance sheets, for the expected future costs of servicing products during the initial one-year warranty period. Amounts are added to the reserve on a per-unit basis by reference to historical experience in honoring warranty obligations. On new products, where the Company does not have historical experience of the cost to honor warranties, additions to the reserve are based on a combination of factors including the standard cost of the product and other judgments, such as the degree to which the product incorporates new technology. As warranty costs are incurred, they are relieved from the reserve.

Activity in the warranty reserve during the three and six months ended June 30, 2004 and 2003 (in thousands):

4—Basic and Diluted Net Loss Per Common Share

Basic net loss per common share excludes dilution and is computed by dividing net loss by the weighted average number of common shares outstanding during the respective period. Diluted loss per share reflects the potential dilution that could occur if stock options were exercised. As a result of net losses for all periods presented, there is no difference between basic and diluted net loss per share. Options to purchase 3,245,772 and 2,121,911 shares of common stock for the six month periods ending June 30, 2004 and 2003, respectively were not included in the computation of diluted net loss per share because the loss position would have rendered the additional shares antidilutive.

5—Stock-Based Compensation

The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (“APB”) No. 25, Accounting for Stock Issued to Employees, as interpreted by Financial Accounting Standards Board (“FASB”) Interpretation No. 44, Accounting for Transactions Involving Stock Compensation —an Interpretation of APB Opinion No. 25. The Company accounts for stock-based awards to non-employees in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation and Emerging Issues Task Force (“EITF”) Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

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NATUS MEDICAL INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

5—Stock-Based Compensation (continued)

The Company typically grants stock option awards at market value; consequently, no compensation expense is recorded. In 2001, options were granted at an exercise price deemed to be less than their fair market value which resulted in the recording of deferred stock compensation of $2,659,000, based on the difference between the exercise price and the deemed fair value of the options. The difference was recorded as deferred stock-based compensation in stockholders’ equity and is being amortized on a straight-line basis over the vesting period of the related options, with prior period charges being reversed in the current period to the extent that vested options expire unexercised.

During the three months ended June 30, 2004, we recorded stock compensation expense totaling $352,000 related to modification of the terms of certain stock options granted to the Company’s former chief executive officer.

Stock-based compensation during the three and six months ended June 30, 2004 and 2003 (in thousands) consisted of the following:

Had compensation expense for the Company’s stock option awards been determined based on the Black-Scholes fair value method at the grant dates, consistent with the fair value method of SFAS No. 123, Accounting for Stock-Based Compensation, the Company would have recorded additional compensation expense and its net income and earnings per share (“EPS”) would have been reduced to the pro forma amounts presented in the following table:

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NATUS MEDICAL INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

6—Segment, Customer, and Geographic Information

The Company currently operates in one reportable segment, developing, manufacturing, and marketing products used by clinicians for the detection, monitoring, treatment, and tracking of common medical disorders that may occur during the time from conception to a baby’s first birthday. With the exception of the Neometrics data management system, the nature of the Company’s products and production processes as well as the type of customers and distribution methods are consistent among all of the Company’s product lines. While the Neometrics data management system is not a medical device or related supply, we believe over time it will become highly integrated with our other products in tracking information generated through detection, monitoring, and treatment. We acquired our Neometrics data management system product line on July 1, 2003.

Revenue from customers by geographic area is as follows (in thousands):

For both the three and six months ended June 30, 2004 and 2003, no sales to a single end-user customer or distributor accounted for greater than 10% of total revenue.

7—Indemnifications

Under its bylaws, the Company has agreed to indemnify its directors and officers for certain events or occurrences arising as a result of their serving in such capacities. The Company has a directors and officers’ liability insurance policy that limits the Company’s exposure and enables it to recover a portion of any amounts paid resulting from the indemnification of its directors and officers. In addition, the Company enters into indemnification agreements with other parties in the ordinary course of business. In some cases the Company has obtained liability insurance providing coverage that limits its exposure for these other indemnified matters. The Company has not incurred material costs to defend lawsuits or settle claims related to these indemnification agreements. The Company believes the estimated fair value of these indemnification agreements is minimal and has not recorded a liability for these agreements as of June 30, 2004.

8—Restructuring Charges

For the three months ended June 30, 2004, the Company recorded a restructuring charge of approximately $776,000 relating to an operating cost reduction plan that was initiated during the three months ended June 30, 2004. The initiative resulted in an immediate reduction of 24 employees and the accrual of associated employee termination-related benefits of $629,000. The remainder of the charge was associated with the liquidation of the Company’s subsidiary in Japan, which was initiated in June 2004, including write-downs of capital assets, inventory, and prepaid expenses of $80,000, facilities related costs of $38,000, and liquidation service fees of $29,000.

As of June 30, 2004 approximately $538,000 of costs relating to the restructuring remain unpaid.

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NATUS MEDICAL INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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9—Discontinued Operations

In June 2004 the Company announced its intent to divest its Neogenesis line of products. The Company is currently seeking a buyer for the business. This component is accounted for as a discontinued operation in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Accordingly, amounts in the Company’s financial statements and related notes for all periods shown reflect discontinued operations accounting.

During the three months ended June 30, 2004, the Company also recorded charges of $376,000 to write-down the cost basis of certain capital assets of the Neogenesis business line and $50,000 to reduce inventory to market value.

The amounts of revenue and costs reported in discontinued operations are as follows (in thousands):

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ITEM 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

Natus’ trademarks include: AABR^®, Accuwell^™, Accuscreen^™, ALGO-1 Plus^® Newborn Hearing Screeners, ALGO1e^®, ALGO2^®, ALGO^®, ALGO DataBook^®, CEM^™, CMS^™, Dri-Prep^® Prepping Pads, Ear Couplers^® Earphones, Flexicoupler^® Earphones, Jelly Button^® Sensors, Jelly Tab^® Sensors, MiniMuffs^® Neonatal Noise Attenuators, MSDS^™, natus^®, neoBLUE^™ LED Phototherapy device, Neocoat^™, Neometrics^™, WebEBP^™, VRS^™. The Biliband^® Eye Protectors, Foldadome^™ oxygen hoods, Igloo^® neonatal heatshield, Oxydome^™, Oxypod^® and Oxy-Igloo^® products are duly licensed to Natus by Nascor Pty. Ltd.

Overview

The following discussion and analysis supplement the management’s discussion and analysis in the company’s Annual Report on Form 10-K for the year ended December 31, 2003, and presume that readers have read or have access to the discussion and analysis in the company’s Annual Report. Management’s discussion and analysis should be read in conjunction with the Company’s condensed consolidated financial statements and accompanying footnotes, the discussion below of certain risks and uncertainties, and the cautionary forward-looking statements at the end of this section.

Natus Medical is dedicated to addressing the needs of the newborn medical market, or as we define it, the period from conception to a child’s first birthday. Within that interval, we have initially focused on products used by clinicians as they provide care to newborns in the critical minutes and hours after delivery and prior to discharge from the hospital. We call this space the “delivery-to-discharge” segment of the newborn medical market. Natus currently develops, manufactures, and markets products used by clinicians for the detection, monitoring, treatment, and tracking of common medical disorders in newborns.

Our products are designed for use by clinicians as they provide care to newborns in the critical minutes and hours after delivery and prior to discharge from the hospital. We have identified the following six areas of assessment of the newborn performed by clinicians prior to discharge:

We currently sell products that address clinical needs of newborns in five of these six areas of neonatal clinical assessment. Additionally, our Neometrics data management applications are designed to allow clinicians, hospitals, and state and federal governments to better manage information on each newborn’s care, including in particular the information pertaining to metabolic and hearing screening results. Our research and development efforts have identified other product opportunities for us in this market segment and we intend to develop and acquire technologies, products, or businesses that enable us to market additional products and services in the “delivery-to-discharge” market segment.

Our principal product lines consist of our ALGO screening products for hearing screening, our neoBLUE LED Phototherapy device (“neoBLUE”) for the treatment of jaundice, our Neometrics newborn screening data management system, our MiniMuffs Neonatal Noise Attenuators (“MiniMuffs”) products for the attenuation of noise for newborns, and our line of neonatal oxygen delivery hoods and heatshields.

Our revenue is generated almost exclusively from the sale of supplies and services, which are generally recurring, and related devices and systems. Supplies and services revenue results from sales of supplies used with

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our ALGO medical devices, our product line of oxygen delivery hoods and heatshields, software maintenance agreements for our Neometrics data management system, as well extended service agreements on our medical devices. Devices and systems revenue results from the sale of our ALGO and neoBLUE medical devices, and our Neometrics’ newborn screening data management system.

Domestic sales accounted for 77% and 75% of our revenue during the three months ended June 30, 2004 and 2003, respectively, and 75% and 74% of our revenue during the six months ended June 30, 2004 and 2003, respectively. We intend to continue expansion of our international operations because we believe international markets represent a significant growth opportunity. We anticipate that international revenue will increase as a percent of revenue in the future. If international sales increase, we may not experience corresponding growth in operating income due to the higher cost of selling outside of the United States (U.S.) We sell our products through a direct sales force in the U.S., through our subsidiary in the United Kingdom (U.K.), and to distributors in approximately 30 other countries. International sales made to distributors are characterized by lower gross margins due to the discount the distributors receive from our list prices.

Our net income or loss can be markedly impacted by our decisions regarding the level of resources applied to our business. We make these decisions on the basis of sales forecasts, expected customer orders, economic conditions, and other factors. These costs are primarily personnel and facilities costs that are relatively fixed in the short-term and directly impact net income.

Application of Critical Accounting Policies

We prepare our financial statements in accordance with accounting principles generally accepted in the United Sates of America (“GAAP”). In so doing, we must often make estimates and use assumptions that can be subjective, and consequently our actual results could differ from those estimates. For any given individual estimate or assumption we make, there may also be other estimates or assumptions that are reasonable.

We believe that the following critical accounting policies require the use of significant estimates, assumptions, and judgments. The use of different estimates, assumptions, and judgments could have a material affect on the reported amounts of assets, liabilities, revenue, expenses, and related disclosures as of the date of the financial statements and during the reporting period.

Revenue Recognition

We recognize revenue, net of discounts, from sales of medical devices and related supplies, including sales to distributors, when a purchase order has been received, when title transfers (generally upon shipment), when the selling price is fixed or determinable, and when collection of the resulting receivable is probable. Terms of sales to distributors are EXW, an international incoterm, reflecting that goods are shipped “ex works,” in which title and risk of loss are assumed by the distributor at the shipping point. Payment terms are either open trade credit or export letter of credit. Revenue from our Neometrics newborn screening data management system, which is generally highly customized, is recognized on the percentage of completion basis over the development and implementation period of the associated installation, which typically ranges from six to eighteen months. Revenue from extended service and maintenance agreements, for both medical devices and data management systems, is recognized ratably over the service period. Payments received from customers prior to revenue recognition are recorded as deferred revenue and recognized as revenue as otherwise described above. We generally do not provide rights of return or price protection on products, whether sold by our direct sales force or distributors. We accept trade-ins of our own and competitive medical devices. Trade-ins are recorded as a reduction of the replacement medical device sale. Provisions are made for initial standard warranty obligations of one year, and post-sale training and customer support at the time the related revenue is recognized.

We must exercise judgment when assessing the sufficiency of our allowance for estimated uncollectible accounts receivable. Our estimates are based on our historical collection experience within the markets in which

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we operate as well as assessment of our average accounts receivable aging days and any other specific information of which we may be aware, such as bankruptcy filings or liquidity problems of our customers. Any future determination that our allowance for estimated uncollectible accounts receivable is understated could result in increased operating expense and adversely affect our results of operations.

At June 30, 2004 our deferred revenue under extended service and maintenance agreements, and billings in excess of recognized revenue on percentage-of-completion contracts was approximately $312,000. Other advance payments from customers were not material at June 30, 2004. Our allowance for estimated uncollectible accounts receivable was $421,000 at June 30, 2004.

Inventory is carried at the lower of cost or market value

We may be exposed to a number of factors that could result in portions of our inventory becoming either obsolete or in excess of anticipated usage. These factors include, but are not limited to, technological changes in our markets, competitive pressures in products and prices, and our own introduction of new product lines.

We regularly evaluate our ability to realize the value of our inventory based on a combination of factors, including historical usage rates, forecasted sales, product life cycles, and market acceptance of new products. When we identify inventory that is obsolete or in excess of anticipated usage we write it down to realizable salvage value or provide for inventory valuation reserves. The estimates we use in projecting future product demand may prove to be incorrect. Any future determination that our inventory is overvalued could result in increases to our cost of sales and decreases to our operating margins and results of operations.

Carrying value of intangible assets

We amortize intangible assets with finite lives over their useful lives, which range from 5 to 15 years for licensed technology, customer relationships, and tradenames, and 21 years for patents. Any future changes that would limit their useful lives or any determination that these assets are carried at amounts greater than their fair value could result in additional charges. We carry goodwill and any other intangible assets with indefinite lives at original cost but do not amortize them; any future determination that these assets are carried at amounts greater than their fair value could result in additional charges.

We test our goodwill and indefinite-lived intangible assets for impairment at least annually on October 1st of each year; however, this assessment may take place at any time in the event of changes in circumstances that indicate the carrying value of these assets may be impaired. Similarly, we test our definite-lived intangible assets whenever changes in circumstances indicate the carrying value of these assets may be impaired. Impairment indicators include, but are not limited to, net book value exceeding market capitalization, significant negative industry and economic trends, and significant underperformance relative to historical and projected future operating results. Impairment is considered to have occurred when the estimated undiscounted future cash flows related to the asset are less than its carrying value. Estimates of future cash flows involve consideration of many factors including the marketability of new products, product acceptance and lifecycle, competition, appropriate discount rates, and operating margins. If these estimates or their related assumptions change in the future, we may be required to record impairment charges which could have a significant impact on our operating results.

A portion of our goodwill is denominated in the local currency of our foreign subsidiaries, and may fluctuate in carrying amount from period to period as the result in the changes in exchange rates between the U.S. dollar and the respective local currency.

At June 30, 2004 we had intangible assets with a carrying value of approximately $4.6 million.

Liability for product warranties

Our medical device products are covered by standard one-year product warranty plans. A liability has been established for the expected cost of servicing our medical device products during these service periods. We base

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the liability in part upon our historical experience; however, estimates of the costs to honor our warranties are often difficult to determine due to uncertainty surrounding the extent to which new products will require servicing and the costs that will be incurred to service those products. Until we have historical experience of the cost to honor warranties on new products, we base additions to the reserve on a combination of factors including the standard cost of the product and other judgments, such as the degree to which the product incorporates new technology. The estimates we use in projecting future product warranty costs may prove to be incorrect. Any future determination that our product warranty reserves are understated could result in increases to our cost of sales and reductions in our operating margins and results of operations.

At June 30, 2004 our reserve for product warranties was approximately $200,000.

Valuation allowance for deferred tax assets

We record a valuation allowance against our deferred tax assets, which result primarily from net operating loss and credit carryforwards that expire over time, and temporary differences between book and tax results that will reverse in the future. In evaluating whether we would more likely than not recover these deferred tax assets, we have not assumed any future taxable income in the tax jurisdictions in which we operate. To the extent we establish a valuation allowance, or increase this allowance in a period, we include an offsetting expense within the tax provision in the consolidated statement of operations. Future income generation in these tax jurisdictions could lead to the reversal of these valuation allowances and additional income recognition.

At June 30, 2004, our net deferred tax assets were zero, net of a $9.3 million valuation allowance.

Results of Operations

The following table sets forth, for the periods indicated, selected consolidated statements of operations data as a percentage of total revenue. Our historical operating results are not necessarily indicative of the results for any future period.

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Three and Six Months Ended June 30, 2004 and 2003

Revenue

Our revenue is derived almost exclusively from the sale of supplies and services, which are generally recurring, and related devices and systems. Supplies and services revenue is derived from sales of disposable supplies for our ALGO hearing screening devices, our MiniMuffs, our line of neonatal oxygen delivery hoods and heatshields, software maintenance agreements for our Neometrics data management system, as well as extended service agreements on our medical devices. Devices and systems revenue is derived from the sale of our ALGO and neoBLUE medical devices, and our Neometrics newborn screening data management system.

Our revenue increased $1.3 million, or 19%, to $8.4 million in the three months ended June 30, 2004, from $7.1 million in the same period in 2003. The Neometrics business line contributed to $779,000 of this increase, with the remainder resulting primarily from increased sales of our ALGO hearing screening and neoBLUE devices. Our revenue increased $3.2 million, or 24%, to $17.0 million in the six months ended June 30, 2004, from $13.7 million in the same period in 2003.

Revenue from devices and systems increased $1.3 million, or 83%, to $3.0 million in the three months ended June 30, 2004, from $1.6 million in the same period in 2003. Revenue from devices and systems increased $2.5 million, or 73%, to $6.0 million in the six months ended June 30, 2004, from $3.5 million in the same period in 2003. Revenue from supplies and services was $5.3 million in both the three months ended June 30, 2004 and 2003. Revenue from supplies and services increased $711,000, or 7%, to $10.8 million in the six months ended June 30, 2004, from $10.0 million in the same period in 2003. Revenue from supplies and services were 64% of total revenue in the three months ended June 30, 2004, compared to 76% of total revenue in the same period in 2003. Revenue from supplies and services were 63% of total revenue in the six months ended June 30, 2004, compared to 73% of total revenue in the same period in 2003. For all of the amounts presented above, revenue from the Neogenesis product line has been excluded and is reported in discontinued operations.

Revenue from sales outside the U.S. was $1.9 million in the three months ended June 30, 2004, up from $1.8 million in the same period in 2003, and was $4.2 million in the six months ended June 30, 2004, up from $3.6 million in the same period in 2003. In the three months ended June 30, 2004, revenue from Europe and the United Kingdom increased $344,000 to $620,000, revenue from Asia decreased $188,000 to $1.1 million, and revenue from Oceania decreased $66,000 to $146,000. The reduction in revenue from Asia was primarily related to a change in our distribution method in Japan, where we now sell directly from the U.S. to our top-tier distributor in Japan, rather than through our Japanese subsidiary, which we had done prior to 2004. This change resulted in lower average selling prices of some of our ALGO hearing screening products. The reduction in revenue from Oceania resulted primarily from decreased unit sales of our ALGO hearing screening devices. In the six months ended June 30, 2004, revenue from Europe and the United Kingdom increased $1.1 million to $2.1 million, revenue from Asia decreased $92,000 to $1.8 million, and revenue from Oceania decreased $413,000 to $277,000. In the six months ended June 30, 2004, international sales of devices and systems increased $820,000 to $2,8 million, and international sales of supplies and services decreased $204,000, to $1.3 million, both compared to the same period in 2003.

No end-user customer or distributor accounted for more than 10% of our revenue in either the three or six months ended June 30, 2004 or 2003.

Cost of Revenue

Cost of revenue includes the cost of material, personnel expenses, packaging and shipping costs, other manufacturing costs, warranty expenses, and technology license fees. Our cost of revenue increased $900,000, or 32%, to $3.7 million in the three months ended June 30, 2004 from $2.8 million in the same period in 2003. Our cost of revenue increased $2.1 million, or 40%, to $7.5 million in the six months ended June 30, 2004 from $5.4 million in the same period in 2003. The increases in both periods were primarily attributable to incremental

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costs of our Neometrics data management systems. Cost of revenue as a percent of total revenue was 45% in the three months ended June 30, 2004, compared with 40% reported in the three months ended June 30, 2003. Cost of revenue as a percent of total revenue was 44% in the six months ended June 30, 2004, compared with 39% reported in the six months ended June 30, 2003. The increase in the cost of revenue percentage was primarily associated with cost overruns on several Neometrics data management system installations. In particular, during the three and six months ended June 30, 2004, we had a cost overrun in completing an upgrade of one data management system that was covered under a long-term maintenance agreement for which associated revenue had been recognized ratably during previous periods. During the three months ended June 30, 2004, we also recorded increases to reserves for inventory of $155,000, which contributed to the increased cost of revenue percentage. We did not record an increase to the reserve for inventory in the three months ended June 30, 2003.

Operating Expenses

Marketing and selling expenses consist primarily of salaries, commissions, travel, promotional, and advertising costs. Our marketing and selling expenses decreased $318,000, or 9%, to $3.1 million in the three months ended June 30, 2004 from $3.4 million in the same period in 2003. Our marketing and selling expenses decreased $404,000, or 6%, to $6.1 million in the six months ended June 30, 2004 from $6.5 million in the same period in 2003. In the three and six months ended June 30, 2004, we experienced reduced costs of operating our Japanese subsidiary of approximately $180,000 and $464,000 respectively. Additionally, we have completed a promotional offer to transition customers to our Flexicoupler earphones supply and patient cables for our ALGO newborn hearing screener, for which we incurred costs of $467,000 in the six months ended June 2003. These cost savings were offset by increased selling costs associated with our Neometrics data management system, including amortization of intangibles, as well as increased salaries and travel costs.

Research and development expenses consist of engineering costs to develop new products, enhance existing products, and validate the design of new or enhanced products. Our research and development expenses increased $252,000, or 31%, to $1.1 million in the three months ended June 30, 2004 from $820,000 in the same period in 2003. Our research and development expenses increased $127,000, or 7%, to $2.0 million in the six months ended June 30, 2004 from $1.9 million in the same period in 2003. We incurred increased costs relating to our Neometrics business lines. In addition, we wrote off the remaining cost basis of non-productive capital assets, primarily tooling and molds used in development activities. These cost increases were partially offset by a reduction in the cost of outside consultants.

General and administrative expenses consist of corporate, finance, information technology, human resources, administrative, and legal expenses. Our general and administrative expenses increased $1.3 million, or 98%, to $2.7 million in the three months ended June 30, 2004 from $1.3 million in the same period in 2003. During the three months ended June 30, 2004, and related to the departure of our former chief executive officer, which was announced in the first quarter of 2004, we recorded charges of $518,000 for salary and benefits costs, and $352,000 of stock compensation related to a modification of the terms of certain stock options granted to the individual. In addition, during the three months ended June 30, 2004, costs for outside services increased by $285,000 and insurance coverage costs increased by $87,000, both compared to the same period in 2003. We also incurred smaller increases in regulatory filing costs and local taxes. Our general and administrative expenses increased $1.5 million, or 62%, to $4.0 million in the six months ended June 30, 2004 from $2.5 million in the same period in 2003.

We recorded restructuring and other related costs of $776,000 during the three months ended June 30, 2004. The restructuring initiative, which was announced in June 2004, resulted in an immediate reduction of our workforce of 24 employees, and the accrual of severance and benefits related costs of $629,000. The remainder of the charge was related to the liquidation of our subsidiary in Japan, which we initiated in June 2004. Because we now sell directly from the U.S. to our top-tier distributor in Japan, we no longer need to maintain the Japan subsidiary.

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We recorded stock-based compensation expense of $342,000 and $65,000 in the three months ended June 30, 2004 and 2003, respectively. We recorded stock-based compensation of $357,000 and $129,000 in the six months ended June 30, 2004 and 2003, respectively. Included in the three and six month amounts for 2004 was a charge of $352,000 related to a modification of the terms of certain stock options granted to the Company’s former chief executive officer. For the three months ended June 30, 2004 and 2003 respectively, total stock-based compensation of none and $9,000, was included in cost of revenue, and $342,000 and $56,000, was allocated to operating expenses. For the six months ended June 30, 2004 and 2003 respectively, $1,000 and $17,000, was included in the cost of revenue and $356,000 and $112,000, was allocated to operating expenses.

Other income and expense consists of net capital gains and losses from our investment portfolio, net currency exchange gains and losses, and other miscellaneous income and expenses. We reported net other expense of $177,000 and net other income of $15,000 in the three months ended June 30, 2004 and 2003 respectively. We reported net other expense of $101,000 and net other income of $22,000 in the six months ended June 30, 2004 and 2003 respectively. We reported foreign exchange losses of $11,000 in the three months ended June 30, 2004, and reported foreign exchange gains of $1,000 in the three months ended June 30, 2003. We reported foreign exchange gains of $19,000 in the six months ended June 30, 2004, and reported foreign exchange losses of $2,000 in the six months ended June 30, 2003. Foreign exchange gains and losses resulted primarily from fluctuations in local currency equivalents of the U.S. dollar in the U.K. and Asia. Unrealized translation gains and losses are not included in net income, but are reported as a component of other comprehensive income.

In June 2004, we announced our intent to divest the operations of our Neogenesis reagent product line and to seek a buyer for the business. Operating results of this line, reflecting a loss of $767,000 are presented as discontinued operations. Included in these results are charges of $376,000 to write-down the cost basis of certain capital assets, and $50,000 to reduce inventory to estimated market value.

As a result of the factors discussed above, we reported a net loss of $3.6 million, or $0.22 per diluted share for the three months ended June 30, 2004, as compared to a net loss of $1.1 million, or $0.07 per diluted share for the same period in 2003. We reported a net loss was of $4.1 million, or $0.24 per diluted share, for the six months ended June 30, 2004, as compared to a net loss of $2.1 million, or $0.13 per diluted share, for the same period in 2003.

Liquidity and Capital Resources

As of June 30, 2004, we had cash, cash equivalents, and short-term investments of $38.6 million, stockholders’ equity of $49.1 million and working capital of $42.1 million, compared with cash, cash equivalents, and short-term investments of $37.6 million, stockholders’ equity of $52.6 million and working capital of $44.7 million as of December 31, 2003.

Net cash provided by operating activities was $1.4 million for the six months ended June 30, 2004, compared with net cash used in operating activities of $1.7 million for the same period in 2003. Our net loss for the six months ended June 30, 2004 was $2.0 million greater than the loss during the comparable period in 2003, however, at June 30, 2004, inventories and accounts receivable were reduced by $1.4 million and $1.3 million respectively, compared to December 31, 2003. The reduction in inventories resulted primarily from carrying less of our ALGO Flexicoupler disposable supply product at June 30, 2004 than at the end of 2003, when we temporarily increased inventory levels of the product because our primary supplier was in the process of moving their production facility. Additionally, accrued liabilities increased by $1.1 million in the six months ended June 30, 2004, which was primarily related to our restructuring initiative.

Net cash used in investing activities was $5.0 million for the six months ended June 30, 2004 compared to $3.1 million for the same period in 2003. Net cash used in investing activities in both periods was primarily the result of purchasing short-term investments in excess of those that were redeemed. Because of our investment policy, the types of investments we may make are limited. Primarily all of our short-term investments are

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available-for-sale securities with maturities of less than fifteen months, and fluctuations between cash equivalents and short-term investments are often attributable to investment decisions.

We had no material capital expenditure commitments as of June 30, 2004.

Pursuant to the terms of the transition agreement between the Company and its former chief executive officer, we recorded an obligation of approximately $518,000 that is payable over an eighteen month period beginning in April 2004. As a result of our restructuring in June 2004, we have an additional obligation at June 30, 2004 for employee termination and employee-benefit related costs of $629,000, of which $373,000 is payable over a period of eleven months beginning in July 2004. We expect the remainder of the restructuring costs will be paid during the three months ending September 30, 2004.

Net cash provided by financing activities was $142,000 for the six months ended June 30, 2004, compared to $356,000 for the same period in 2003. Net cash provided by financing activities for both periods resulted from the proceeds of sale of our stock to employees pursuant to our stock option and employee stock purchase plans.

Our future liquidity and capital requirements will depend on numerous factors, including:

We believe that our current cash and cash equivalent balances, including short-term investments, any cash provided by or used in operations, and from current or future debt financing will be sufficient to meet our operating and capital requirements for at least the next 18 months. However, it is possible that we may require additional financing within this period. We intend to continue to invest in the development of new products, and enhancements to our existing products, and in both existing and new product distribution domestically and overseas. The factors will affect our future capital requirements and the adequacy of our available funds. In addition, even if our current funds are sufficient to meet our anticipated cash needs during the next 18 months, we may need to raise additional funds beyond this time, particularly if we invest significant amounts in the acquisition of businesses and products. We may be required to raise those funds through public or private financings, strategic relationships or other arrangements. Any additional equity financing may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants.

Risk Factors

We have a history of losses, variable quarterly results, and seasonality in the sale of our products, and may not attain profitability in the future

Since our inception, we have incurred significant net losses including net losses for the years 2001, 2002 and 2003, and we may incur net losses in the future. As of June 30, 2004, we had accumulated deficits of approximately $38.6 million. Additionally, our revenue and operating results have varied significantly from quarter to quarter in the past and may continue to fluctuate in the future. The following are among the factors that could cause our revenue, operating results, and margins to fluctuate significantly from quarter to quarter:

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Many of these factors are beyond our control, and we believe that you should not rely on our results of operations for interim periods as an indication of our expected results in any future period. Further, we cannot be certain that we will achieve profitability in the future. In addition, we experience seasonality in the sale of our products. For example, our sales typically decline from our fourth fiscal quarter to our first fiscal quarter, due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers, many of which are government agencies. We may also experience declining sales in the third fiscal quarter due to summer holiday and vacation schedules. We anticipate that we will continue to experience these seasonal fluctuations, which may lead to fluctuations in our quarterly operating results.

We anticipate that our expenses may increase substantially in the foreseeable future as we:

As a result of these possible increased expenses, we may need to generate significantly higher revenue to achieve profitability. We cannot be certain that we will achieve profitability in the future or, if we achieve profitability, sustain it.

If we do not meet our restructuring objectives, we may have to implement additional plans in order to reduce our operating costs, and we cannot assure you that we will not be adversely affected by our restructuring activities.

In the second quarter of 2004, we implemented a restructuring plan to more closely align our cost structure with our revenue. The plan included primarily the reduction of our workforce. The benefits that we expect to achieve from this restructuring are estimates only, and we may not achieve the full amount of cost savings that we have planned. If we do not meet our restructuring objectives, we may have to implement additional plans to reduce our operating costs, which could have an adverse effect on our financial results. Further, as part of the restructuring we terminated the employment of many employees who provided valuable services to us, and we cannot be assured that those employees who remain will be able to perform all of the functions that remain to be filled within the company without adversely affecting our business.

We have relied, and expect to continue to rely, on sales of our ALGO hearing screening product family for the majority of our revenue, and a decline in sales of these products could cause our revenue to fall

We expect that the revenue from our ALGO hearing screening product family will continue to account for a majority of our revenue for at least the next eighteen months. Any factors adversely affecting the pricing of our

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ALGO hearing screening devices and related supplies or demand for our ALGO hearing screening products, including physician acceptance or the selection of competing products, could cause our revenue to decline and our business to suffer.

Our operating results may decline if we do not succeed in developing, acquiring, and marketing additional newborn products or improving our existing products

We intend to develop and acquire additional products and technologies for the detection, treatment, monitoring and tracking of common medical conditions in infants and pregnant women. Developing and acquiring new products, and improving our existing products, to meet the needs of neonatologists, audiologists, pediatricians and nurses requires significant investments in research and development. If we fail to successfully sell new products and update our existing products, our operating results may decline as our existing products reach the end of their commercial life cycles.

We have very limited experience selling and marketing products other than our ALGO hearing screening products, and our failure to develop and manage our sales force or to effectively market and sell our Neometrics products and services, our neoBLUE phototherapy device, or our other products could limit our revenue growth

Our sales force has limited experience selling our Neometrics newborn screening data management system, our neoBLUE phototherapy device, and our other products, and we cannot predict how successful our sales force will be in selling them, and other products we may develop or acquire, in the future. In order to successfully introduce and penetrate the market for these and other products, we must successfully sell them to hospital administrators and government agency purchasing managers who may not be familiar with our ALGO hearing screening products and who may make purchasing decisions on factors that are different from those that our sales people are accustomed to. We market almost all of our newborn hearing screening products in the U.S. through a direct sales force. There are significant risks involved in building and managing our sales force to effectively sell more diverse lines of products and services. We may be unable to hire and retain a sufficient number of qualified sales people with the skills and training to sell our product line effectively.

In order to accurately recognize revenue on long-term development and implementation contracts associated with our Neometrics newborn screening data management system, we must be able to accurately estimate the total cost of completing a project. In arriving at these estimates, we must make assumptions about future costs that may prove to be inaccurate.

We recognize revenue from our Neometrics newborn screening data management system, which is generally highly customized, on the percentage of completion basis over the development and implementation period of the associated installation. The development and implementation period typically ranges from six to eighteen months. In order to determine percentage of completion, we must be able to accurately estimate the total cost of the development and implementation process. If our estimates of the future costs to be incurred are understated, our future gross margin would be negatively impacted, and the impact could be material to our results of operations.

If we fail in our efforts to educate physicians, government agency personnel, and third-party payors on the effectiveness of our products we will not achieve future sales growth

It is critical to the success of our sales efforts that we educate a sufficient number of clinicians, hospital administrators, and government agencies about our products and the costs and benefits of their use. The commercial success of our products depends upon physician, government agency, and other third-party payor confidence in the economic and clinical benefits of our products as well as their comfort with the efficacy, reliability, sensitivity, and specificity of our products. We believe that physicians may not use our products unless they determine, based on published peer-reviewed journal articles, long-term clinical data, and experience,

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that our products provide an accurate and cost-effective alternative to other means of testing or treatment. For instance, there are currently alternative neonatal hearing screening products which may be less expensive or may be quicker on a per test basis than our ALGO devices. With respect to our neoBLUE phototherapy device, initial data from clinical research suggests that the device may be more effective in treating hyperbilirubinemia than other currently marketed phototherapy products. However, we cannot be certain that clinical studies will produce results that are favorable to our neoBLUE product. Physicians are traditionally slow to adopt new products, testing practices, and clinical treatments, partly because of perceived liability risks and the uncertainty of third-party reimbursement. If more clinicians, government agencies, and hospital administrators do not adopt our products, we may be unable to sustain our revenue or achieve and maintain profitability. Factors that may affect the medical community’s acceptance of our products, some of which are beyond our control, include:

The domestic market for our ALGO screening products is maturing, and our plan to expand our international operations will result in increased costs and is subject to numerous risks; if our efforts are not successful, this could harm our business

The domestic market for our ALGO screening products is maturing and we plan to expand our international sales and marketing efforts to increase sales of our products in foreign countries. We must expand the number of distributors who sell our products, or increase our direct international presence, to significantly penetrate international markets. We have only begun over the past three years to significantly develop our distributor and direct sales force outside the U.S., where we currently maintain a direct sales force only in the U.K., and increasing our direct sales presence in the U.K. or elsewhere will require us to incur higher personnel and operating costs that may not result in additional revenues. A higher percentage of our sales to international distributors could also impair our revenues due to discount prices that we customarily make available to distributors. We may not realize corresponding growth in revenue from growth in international sales, due to the higher costs of sales outside of the U.S. Even if we are able to successfully expand our international selling efforts, we cannot be certain that we will be able to create or increase demand for our products outside of the U.S. Our international operations are subject to other risks, which include:

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If guidelines requiring universal newborn screening do not continue to develop in foreign countries and governments do not require testing of all newborns as we anticipate, or if those guidelines have a long phase-in period, our revenues may not grow

The demand for our screening products depends, in part, upon governments’ adoption of universal screening requirements for the disorders for which our products screen. In the U.S., 38 states have now adopted some form of universal hearing screening requirement, and all states have had mandates for metabolic screening in place for some time. To date, there has been only limited adoption of newborn hearing screening prior to hospital discharge by foreign governments, and the phase-in period varies from several months to several years. Even fewer foreign countries have adopted rules mandating universal metabolic screening prior to hospital discharge. The widespread adoption of these guidelines depends, in part, on our ability to educate foreign government agencies, neonatologists, pediatricians, third-party payors, and hospital administrators about the benefits of universal newborn screening as well as the use of our products to perform the screening and monitoring. Our revenues may not grow if governments do not require universal newborn screening prior to hospital discharge, or if physicians or hospitals are slow to comply with those guidelines, or if the government provides for a lengthy phase-in period for compliance.

Because we rely on distributors or sub-distributors to sell our products in some markets outside of the U.S. and the U.K., our revenues could decline if our existing distributors reduce the volume of purchases from us, or if our relationship with any of these distributors is terminated

We currently rely on our distributors or sub-distributors for a majority of our sales outside the U.S. Some distributors also assist us with regulatory approvals and education of physicians and government agencies. We intend to continue our efforts to increase our sales in Europe, Japan and other developed countries. If we fail to sell our products through our international distributors, we would experience a decline in revenues unless we begin to sell our products directly in those markets. We cannot be certain that we will be able to attract new international distributors to market our products effectively or provide timely and cost-effective customer support and service. Even if we are successful in selling our products through new distributors, the rate of growth of our revenue could be harmed if our existing distributors do not continue to sell a large dollar volume of our products. None of our existing distributors are obligated to continue selling our products.

If we terminate our relationships with distributors for poor performance, as we have done in the past, we may be subject to foreign laws governing our relationships with our distributors. These laws may require us to make payments to our distributors even if we terminate our relationship for cause. Some countries require termination payments under local law or legislation that may supercede our contractual relationship with the distributor. These payments could be equal to a year or more of gross margin on sales of our products that the distributor would have earned. Any required payments would adversely affect our operating results.

Our operating results may suffer because of foreign currency exchange rate fluctuations or strengthening of the U.S. dollar relative to local currencies

Prior to January 2001, substantially all of our sales contracts provided for payment in U.S. dollars. However, from 2001 through 2003 our revenue and expenses in Japan and the U.K. were denominated in the applicable foreign currency. While we have recently begun requiring payment in U.S. dollars from our reseller in Japan and have significantly reduced our Yen-denominated operating expenses, we have a significant amount on deposit in

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Yen-denominated accounts, and we continue to be subject to expenses in the U.K. that are denominated in GB Pounds. To date we have not undertaken any foreign currency hedging transactions and, as a result, our future revenue and expenses may be unpredictable due to exchange rate fluctuations that could result in foreign exchange gains and losses associated with the translation of assets denominated in foreign currencies. Furthermore, a strengthening of the dollar could make our products less competitive in foreign markets where our sales contracts call for payment in U.S. dollars.

If health care providers are not adequately reimbursed for procedures conducted with our devices or supplies, or if reimbursement policies change adversely, we may never achieve significant revenue

Physicians, hospitals, and government agencies are unlikely to purchase our products if clinicians are not adequately reimbursed for the procedures conducted with our devices or supplies. Unless a sufficient amount of positive, peer-reviewed clinical data about our products has been published, third-party payors, including insurance companies and government agencies, may refuse to provide reimbursement. Furthermore, even if reimbursement is provided, it may not be adequate to fully compensate the clinicians or hospitals. Some third-party payors may refuse adequate reimbursement unless the infant has demonstrable risk factors. If health care providers cannot obtain sufficient reimbursement from third-party payors for our products or the screenings conducted with our products, it is unlikely that our products will ever achieve significant market acceptance. Acceptance of our products in international markets will depend upon the availability of adequate reimbursement or funding within prevailing health care payment systems. Reimbursement, funding and health care payment systems vary significantly by country. Although we intend to seek reimbursement or funding approvals in international markets, we may not obtain these approvals in a timely manner or at all.

Even if third-party payors provide adequate reimbursement for procedures conducted with our products, adverse changes in reimbursement policies in general could harm our business. We are unable to predict changes in the reimbursement methods used by third-party health care payors, particularly those in countries and regions outside the U.S. For example, some payors are moving toward a managed care system in which providers contract to provide comprehensive health care for a fixed cost per person. We cannot assure you that in a managed care system the cost of our products will be incorporated into the overall payment for childbirth and newborn care or that there will be adequate reimbursement for our products separate from reimbursement for the procedure. Unless the cost of screening or treatment is reimbursed as a standard component of newborn care, universal screening is unlikely to occur and the number of infants likely to be screened with our products will be substantially reduced.

If we lose our relationship with any supplier of key product components or our relationship with a supplier deteriorates or key components are not available in sufficient quantities, our manufacturing could be delayed and our business could suffer

We contract with third parties for the supply of some of the components used in our products and the production of our disposable products. Some of our suppliers are not obligated to continue to supply us. For certain of these materials and components, relatively few alternative sources of supply exist. In addition, the lead-time involved in the manufacturing of some of these components can be lengthy and unpredictable. During 2002, we experienced delays on the part of a supplier to provide us with volume production of our ALGO 3 screening Flexicoupler supplies. If these suppliers become unwilling or unable to supply us with components meeting our requirements, it might be difficult to establish additional or replacement suppliers in a timely manner, or at all. This would cause our product sales to be disrupted and our revenue and operating results to suffer.

Replacement or alternative sources might not be readily obtainable due to regulatory requirements and other factors applicable to our manufacturing operations. Incorporation of components from a new supplier into our products may require a new or supplemental filing with applicable regulatory authorities and clearance or approval of the filing before we could resume product sales. This process may take a substantial period of time, and we cannot be assured that we would be able to obtain the necessary regulatory clearance or approval. This could create supply disruptions that would harm our product sales and operating results.

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There is only one Natus approved supplier that provides hydrogel, the adhesive used in many of our disposable products. A disruption in the supply of this adhesive could negatively affect our revenue. If we were unable to locate another supplier, it could significantly impair our ability to sell our products. In addition, we may be required to make new or supplemental filings with applicable regulatory authorities prior to our marketing a product containing new materials or produced in a new facility. If we fail to obtain regulatory approval to use a new material, we may not be able to continue to sell the affected products and revenue and operating results could suffer.

Our sales efforts through group purchasing organizations and sales to high volume purchasers may reduce our average selling prices, which would reduce our revenue and gross profits from these sales

We have entered, and may in the future enter, into agreements with customers who purchase high volumes of our products. Our agreements with these customers may contain discounts off of our normal selling prices and other special pricing considerations, which could cause our revenue and profit margins to decline. In addition, we have entered into agreements to sell our products to members of group purchasing organizations, which negotiate volume purchase prices for medical devices and supplies for member hospitals, group practices and other clinics. While we make sales directly to group purchasing organization members, the members of these group purchasing organizations now receive volume discounts off our normal selling price and may receive other special pricing considerations from us from time to time. Sales to members of one group purchasing organization, Novation, LLC, accounted for approximately 22%, 29% and 25% of our total revenue in the twelve months ended December 31, 2003, 2002 and 2001 respectively. Sales to members of group purchasing organizations accounted for approximately 39%, 47% and 35% of our total revenue in the twelve months ended December 31, 2003, 2002 and 2001 respectively. Other of our existing customers may be members of group purchasing organizations with which we do not have agreements. Our sales efforts through group purchasing organizations may conflict with our direct sales efforts to our existing customers. If we enter into agreements with new group purchasing organizations and some of our existing customers begin purchasing our products through those group purchasing organizations, our revenue and profit margins could decline.

We rely on sales to existing customers for a majority of our revenue, and if our existing customers do not continue to purchase products from us, our revenue may decline

We rely on sales of additional screening products to our existing customers for a majority of our revenue. If we fail to sell additional products to our existing customers directly or indirectly, we would experience a material decline in revenue.

Our failure to obtain necessary FDA clearances or approvals or to comply with FDA regulations could hurt our ability to commercially distribute and market our products in the U.S., and this would harm our business and financial condition

Unless an exemption applies, each medical device that we wish to market in the U.S. must first receive one of the following types of FDA premarket review authorizations:

The FDA’s 510(k) clearance process usually takes from three to 12 months, but can take longer. The process of obtaining premarket approval is much more costly, lengthy and uncertain. Premarket approval generally takes from one to three years, but can take even longer. We cannot assure you that the FDA will ever grant either 510(k) clearance or premarket approval for any product we propose to market. Furthermore, if the FDA concludes that these future products using our technology do not meet the requirements to obtain 510(k) clearance, we would have to seek premarket approval. We cannot assure you that the FDA will not impose the

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more burdensome premarket approval requirement on modifications to our existing products or future products, which in either case could be costly and cause us to divert our attention and resources from the development of new products or the enhancement of existing products.

Our business may suffer if we are required to revise our labeling or promotional materials or the FDA takes an enforcement action against us for off-label uses

We may not promote or advertise the ALGO screener, MiniMuffs, or neoBLUE phototherapy device products, or any future cleared or approved devices, for uses not within the scope of our clearances or approvals or make unsupported promotional claims about the benefits of our products. If the FDA determines that our claims are outside the scope of our clearances or are unsupported it could require us to revise our promotional claims or take enforcement action against us. If we were subject to such an action by the FDA, our sales could be delayed, our revenue could decline, and our reputation among clinicians could be harmed.

Our business would be harmed if the FDA determines that we have failed to comply with applicable regulations or we do not pass an inspection

We are subject to inspection and market surveillance by the FDA concerning compliance with pertinent regulatory requirements. If the FDA finds that we have failed to comply with these requirements, the agency can institute a wide variety of enforcement actions, ranging from a public warning letter to more severe sanctions such as: