SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549
| FORM 10-K | ||
| |X| | Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended December 31, 2002 |
| |_| | Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 |
SONOSITE, INC.
(Exact name of registrant as
specified in its charter)
| Washington (State or other jurisdiction of incorporation or organization) |
91-1405022 (I.R.S. Employer Identification Number) |
21919 30th Drive SE
Bothell,
WA 98021-3904
(425) 951-1200
(Address
and telephone number of registrant’s principal executive offices)
| Title of each class None |
Name of exchange on which registered Not applicable |
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (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 |_|
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 the 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. |X|
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes |X| No |_|
The aggregate market value of the voting stock held by nonaffiliates of the registrant, based on the closing sale price of the registrant’s Common Stock on June 28, 2002, as reported on the Nasdaq National Market, was $169,485,083.
As of March 21, 2003, there were 14,216,446 shares of the registrant’s Common Stock outstanding.
The information required by Part III of this report, to the extent not set forth herein, is incorporated by reference from the registrant’s definitive proxy statement relating to the annual meeting of shareholders to be held in 2003, which definitive proxy statement shall be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates.
SonoSite® is the registered trademark of SonoSite, Inc. The stylized SonoSite logo, iLook™, SonoHeart ELITE™, SonoSite 180PLUS™, SiteStand™, SiteLink™, S.I.T.E.™, OnSite™ and SonoKnowledge™ are trademarks of SonoSite, Inc. All other brand names, trademarks or service marks referred to in this report are the property of their owners.
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Our disclosure and analysis in this report and in our 2002 Annual Report to shareholders, of which this report is a part, contain forward-looking statements. Forward-looking statements provide our current expectations or forecasts of future events. Forward-looking statements in this report include, without limitation:
| • | information concerning possible or assumed future results of operations, trends in financial results and business plans, including those relating to earnings growth and revenue growth; |
| • | statements about the level of our costs and operating expenses relative to our revenues, and about the expected composition of our revenues; |
| • | statements about our future capital requirements and the sufficiency of our cash, cash equivalents, investments and available bank borrowings to meet these requirements; |
| • | other statements about our plans, objectives, expectations and intentions; and |
| • | other statements that are not historical facts. |
Words such as “believe,” “anticipate,” “expect” and “intend” may identify forward-looking statements, but the absence of these words does not necessarily mean that a statement is not forward-looking. Forward-looking statements are subject to known and unknown risks and uncertainties, and are based on potentially inaccurate assumptions that could cause actual results to differ materially from those expected or implied by the forward-looking statements. You should not unduly rely on these forward-looking statements, which speak only as of the date of this report.
We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our future quarterly reports on Form 10-Q, current reports on Form 8-K and annual reports on Form 10-K. Also note that we provide a cautionary discussion of risks, uncertainties and possibly inaccurate assumptions relevant to our business under the caption “Important Factors That May Affect Our Business, Our Results of Operations and Our Stock Price” in this report. These are risks that could cause our actual results to differ materially from those anticipated in our forward-looking statements or from our expected or historical results. Other factors besides the risks, uncertainties and possibly inaccurate assumptions described in this report could also affect actual results.
We are a leading provider of point-of-care, high performance, all-digital ultrasound imaging systems for use in a variety of clinical applications and settings. Our proprietary technologies have enabled us to design point-of-care diagnostic ultrasound systems that combine all-digital, high-resolution imaging with advanced features and capabilities traditionally found on cart-based ultrasound systems. We believe that the portability, high quality and cost effectiveness of our products are expanding existing markets and will create new markets for ultrasound imaging by bringing ultrasound out of the imaging center to the point of care such as the patient’s bedside or the physician’s examining table.
The size and complexity of traditional ultrasound systems typically compel physicians to refer patients to a highly trained sonographer employed by an imaging center, such as a hospital’s radiology department. By providing ultrasound at the primary point of care, our easy-to-use systems can eliminate delays associated with the referral process and enable physicians to use ultrasound more frequently and in a wider variety of clinical settings. This increased accessibility creates the potential for enhanced patient care through earlier diagnosis of diseases and conditions.
We currently focus on six key market segments: radiology, obstetrics and gynecology, emergency medicine, surgery, cardiology and vascular medicine. Our current products include the SonoSite 180PLUS, for general ultrasound imaging, the SonoHeart ELITE, specifically configured for cardiovascular applications, and our newest products, the iLook 15, intended for ‘quick look’ diagnostics in areas such as emergency medicine, radiology, surgery or intensive care, and the iLook 25, designed to provide visual imaging for physicians and nurses while performing vascular access procedures. Our SonoSite 180PLUS and SonoHeart ELITE products are used together with any of our seven interchangeable handheld components, or transducers, that are designed for specific clinical applications. Our iLook products each have a single transducer for specific clinical applications.
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We were formerly a division of ATL Ultrasound, Inc., or ATL. On April 6, 1998, we were spun off as an independent, publicly owned Washington corporation to further the development and commercialization of point-of-care, high performance, all-digital ultrasound imaging systems. ATL retained no ownership in us following the spin-off. We entered into a technology transfer and license agreement with ATL pursuant to which we took ownership of certain ultrasound technology developed as part of a government grant and also patent rights, which had been established or were being pursued for that technology. As part of this agreement, we also entered into a cross-license whereby we have the exclusive right to use certain ATL technology existing on April 6, 1998 or developed by ATL during the three-year period following April 6, 1998 in ultrasound systems weighing 15 pounds or less, and ATL has the exclusive right to use our technology existing on April 6, 1998 or developed by us during the same three-year period in ultrasound systems weighing more than 15 pounds. On April 6, 2003, this cross-license becomes nonexclusive and, except for the patented technology of each party, extends to all ultrasound systems regardless of weight. We sold our first products in September 1999.
Ultrasound emerged as a safe and noninvasive method to provide real-time, dynamic images for medical, soft-tissue imaging purposes in the late 1950s. Ultrasound uses low power, high frequency sound waves to provide noninvasive, real-time images of the body’s soft tissue, organs and blood flow. Ultrasound can be cost effective by eliminating the need for more invasive and expensive procedures and allowing for earlier diagnosis of diseases and conditions. To generate an ultrasound image, a clinician places the transducer on the skin or in a body cavity near the targeted area. Tissues and bodily fluids reflect the sound waves emitted by the transducer, which also receives these reflections. Based on these reflections, the ultrasound system’s beamformer measures and organizes the sound waves and produces an image for visual examination, using digital or analog signal processing or a combination of the two. Digital signal processing technology, such as that used by our products, allows an ultrasound system to process greater amounts of information. Accordingly, digital ultrasound systems produce higher resolution images than analog and hybrid analog/digital ultrasound machines.
Standard ultrasound imaging produces a two-dimensional image that physicians use to diagnose and monitor disease states and conditions by analyzing the relative shading of tissues or organs. This is known as grayscale imaging or two-dimensional imaging. Colorization technology expands standard ultrasound imaging by generating an image showing the direction and extent of the relative velocity of blood flow through the body, including the chambers and valves of the heart.
Initially, ultrasound was used to assess the general shape, size and structure of internal soft tissues and organs. As ultrasound technology evolved, leading to improved functionality and image quality, ultrasound imaging expanded as a diagnostic tool in radiology, obstetrics and gynecology and cardiology. In recent years, technological advances have greatly improved the image quality of ultrasound systems and substantially increased their diagnostic utility, encouraging growth in ultrasound procedure volume. Our products enable high performance ultrasound imaging by traditional users at the point-of-care and expand point-of-care ultrasound to emergency medicine, surgery, anesthesiology and vascular medicine. Prior to our products’ availability, however, high quality images could be produced only by highly trained sonographers using heavier and more expensive traditional cart-based ultrasound imaging systems.
Our goal is to lead in the design, development and commercialization of point-of-care, high performance, all-digital ultrasound imaging systems. Our strategy to reach that goal consists of the following key elements:
| • | Maximize the productivity of our direct sales force in the U.S. and key European markets. As of December 31, 2002, we employed 50 direct sales representatives in the United States. We established direct sales operations in the United Kingdom and France in 2001, and in Germany and Spain in 2002. As of December 31, 2002, we had 19 direct sales representatives in Europe, and we expect to grow this team over the next 24 months. We also employ clinical application specialists who, by assuming responsibility for product demonstrations and customer support, have enabled our sales representatives to improve their efficiency. To further enhance the productivity of our direct sales force, we will continue to: |
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| • | invest in training, educating and mentoring our sales force; |
| • | expand our clinical application specialist staff; |
| • | expand our corporate account relationships; and |
| • | organize our sales force by clinical markets and geographic regions. |
| • | Raise market awareness of the SonoSite platform and brand name. We believe the opportunity exists to build the SonoSite name into a global brand synonymous with point-of-care, high performance, all-digital ultrasound imaging. Although we have sold over 10,000 units to date, our products are relative newcomers to the ultrasound market, the first having been introduced in September 1999. To raise market awareness of our brand and our technology, we intend to: |
| • | focus marketing efforts by clinical segment; |
| • | implement targeted local marketing efforts; |
| • | market to potential new users by promoting innovative uses and clinical applications of ultrasound; and |
| • | utilize education to market our products. |
| • | Maintain product and technology leadership. We believe our products represent the most advanced technology in point-of-care, high performance, all-digital ultrasound systems. We are committed to maintaining this technological advantage by continuing to enhance our existing products and to create new ones. As of December 31, 2002, we employed over 50 people in research and development dedicated to creating the next generation of SonoSite products. |
| • | Improve and expand our sales distribution channels. Outside of our core markets, we have also sold products to many other clinical segments and countries. We believe that these other markets offer opportunity for growth but will require enhancements to our sales distribution channels. Specifically, we intend to improve our distribution channel in Japan, establish a tele-sales capability, enter into new third party distributor arrangements and explore strategic partnerships to develop new markets within ultrasound or with ultrasound-dependent technologies. |
| • | Expand into new ultrasound markets. We believe that the portability, high quality and cost effectiveness of our products will result in the creation of new markets for us. We are bringing ultrasound out of the imaging center directly to the patient at the primary point of care, such as the emergency room, vascular access procedures, the physician’s office and other nontraditional ultrasound settings. We anticipate the development of an “imaging physical”—the use of ultrasound imaging in routine physical examinations. We believe that these new users and new applications of ultrasound offer us a significant potential for growth. |
We offer four types of point-of-care ultrasound imaging systems: the SonoSite 180PLUS, the SonoHeart ELITE, the iLook 15 and the iLook 25. The 180PLUS and Elite imaging systems each consist of an integrated color display, control panel, including navigational trackball, and alphanumeric keyboard. Both systems are built on the same hardware platform, which provides internal storage for over 100 images, clinical analysis packages, measurement tools and direct personal computer connectivity. The SonoSite 180PLUS and the SonoHeart Elite imaging systems weigh less than six pounds with a single transducer attached. The following is a summary of our four ultrasound imaging products and their major features:
| • | SonoSite 180PLUS. The SonoSite 180PLUS is a point-of-care ultrasound system for general diagnostic imaging and offers the following major features: |
| • | two dimensional, or B-mode, imaging, allowing real-time two-dimensional visualization of anatomic structures within the body; |
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| • | M-mode imaging, providing a display of motion versus time. M-mode is particularly useful for evaluation of fast-moving structures, such as valves within the heart; |
| • | pulsed wave, or PW, Doppler technology. PW Doppler imaging uses short, pulsing bursts of ultrasound waves to provide a quantitative assessment of the velocity of blood flow. The name of the technology refers to the Doppler effect, which is an apparent change in the frequency of the reflected ultrasound wave due to the relative motion between the reflector and transducer; |
| • | color power Doppler and directional color power Doppler, allowing two-dimensional visualization of blood flow patterns; |
| • | tissue harmonic imaging, or THI, a signal processing technique providing enhanced image quality by using high frequency information to enhance image resolution; and |
| • | basic echocardiogram, or ECG, capability. When visualizing the heart, it is often useful to visualize basic relationships between cardiac motion and cardiac electrical activity. ECG provides this capability. |
| • | SonoHeart ELITE. The SonoHeart ELITE is a point-of-care ultrasound system intended for use by cardiologists and other healthcare providers in the cardiology market. The SonoHeart ELITE has all the product features of the SonoSite 180PLUS, as well as the following: |
| • | continuous wave, or CW, Doppler technology. CW Doppler imaging uses continuous, reflected ultrasound waves to provide a quantitative assessment of the velocity of blood flow. CW Doppler, because it relies on a continuous stream of information, enables assessments of blood flow moving at speeds higher than PW Doppler is capable of assessing. |
| • | ILook 15. The iLook 15, with its fixed curved array transducer, provides imaging at the patient’s bedside for focused abdominal and cardiac applications. |
| • | ILook 25. The iLook 25, with its fixed linear transducer, provides superb image quality of a patient’s vessels to aid in vascular access applications. |
Both of these iLook products, which each weigh approximately three pounds, offer the following:
| • | a touch screen for data input; |
| • | a single point-to-point measurement tool; |
| • | ability to store over 70 images for off-line printing and review; |
| • | cine loop retains images for frame-by-frame review; |
| • | connectivity to a PC for image download through a docking station; |
| • | 2D and color power Doppler; and |
| • | The iLook 15 offers directional color power Doppler and harmonic imaging. |
We offer seven types of transducers. Each of our transducers may be used with either the SonoSite 180PLUS or SonoHeart Elite Systems. This interchangeability allows our customers to purchase a single point-of-care ultrasound system that can be used in a variety of clinical applications.
| • | Transducers. Our seven transducers are designed for use in the following clinical applications: |
| • | general abdominal and obstetrics imaging; |
| • | intracavitary and gynecological ultrasound imaging; |
| • | neonatal, vascular and pediatric imaging; |
| • | cardiac, thoracic and abdominal imaging, and trauma assessment; |
| • | breast, musculoskeletal, vascular, interventional and small-parts imaging; |
| • | intraoperative and superficial vascular imaging; and |
| • | musculoskeletal, obstetric and urological imaging for veterinarian applications. |
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We also offer the following related accessories and educational programs:
| • | Accessories. We sell the SiteStand mobile docking station and the SiteLink imaging software, both of which enable communication between our products and third-party output devices, such as printers, storage devices and networks. We also offer a high resolution, 12.1-inch flat panel monitor that may be physically connected with our SiteStand to increase the image size and allow easy consultation among healthcare providers. |
| • | Specialized training and education. We promote educational courses for physicians and other healthcare providers who currently do not use ultrasound imaging in order to educate them in the general use of ultrasound and the fundamental operation of our products. We offer an internal program, OnSite, as well as accredited programs developed by third-party providers. In addition, as we develop new and emerging markets, we continue to develop new accredited and market specific training materials, produced by leaders in ultrasound education. |
Initially, we sold and marketed our products through third-party medical product distributors worldwide. Currently, we have moved to a direct sales model in the United States, the United Kingdom, France, Germany and Spain. We rely on third-party distributors in those markets where we do not have a direct sales staff.
At December 31, 2002, we had 50 direct sales representatives in the United States along with 27 clinical application specialists, who provide product demonstration and support to our sales representatives. In addition, we focused our sales representatives on specific clinical markets in addition to geographic regions.
In the United States, we have complemented our direct sales efforts by entering into group purchasing agreements with major healthcare group purchasing organizations, or GPOs. Typically, a GPO negotiates with medical suppliers, such as us, on behalf of the GPO’s member healthcare facilities, providing such members with uniform pricing and terms and conditions. In exchange, the GPO identifies us as a preferred supplier for its members. Member facilities participating in the GPO’s purchasing program can consist of hospitals, medical group practices, nursing homes, surgery centers, managed care organizations, long term care facilities, clinics and integrated delivery networks. Currently, we have GPO supply agreements with AmeriNet, Inc., Kaiser Permanente, Novation, LLC, Premier, Inc., Broadlane, Inc., Consorta, Inc. and Aurora Health Care.
Elsewhere outside the United States, we continue to sell to other potential markets through third-party foreign distributors, such as Olympus Optical, our exclusive distributor in Japan. In the first half of 2003, Olympus will modify its distribution network to improve its sales of our products. They plan to add direct resources and redirect their dealer network in order to focus their efforts on the clinical segments with the greatest sales opportunities. In the United Kingdom, we have a supply agreement with the Purchasing and Supply Agency of the National Health Service, or NHS, which contracts on a national basis for products and services purchased by the NHS.
We derived approximately $42.6 million, or 58%, of our revenue from domestic sales in 2002. This compares to approximately $23.8 million, or 52%, and approximately $15.2 million, or 47%, in 2001 and 2000.
We derived approximately $30.4 million, or 42%, of our revenue from international sales in 2002. This compares to approximately $21.9 million, or 48%, and approximately $16.9 million, or 53%, in 2001 and 2000. Japan accounted for approximately $7.5 million, or 10%, of our revenue in 2002. This compares to approximately $7.8 million, or 17%, and approximately $8.3 million, or 26%, in 2001 and 2000. Other than Olympus, no other single customer or distributor accounts for more than 10% of our revenue. We attribute revenue to a foreign country based on the location to which we ship our products. However, products sold to the U.S. government but deployed in a foreign country are attributed to domestic revenue.
Our revenues from international sales may be adversely affected by a number of risks, including competition, currency rate fluctuations, reduced protection for intellectual property rights and longer receivables collection periods. Our revenues from international sales may also be adversely affected by the cost or difficulty of localizing products for foreign markets and complying with export laws, including license requirements, trade restrictions and tariff increases.
We rely on a combination of patent, copyright, trademark and trade secret laws and other agreements with employees and third parties to establish and protect our proprietary rights. We require our officers, employees and consultants to enter into standard agreements containing provisions requiring confidentiality of proprietary information and assignment to us of all inventions made during the course of their employment or consulting relationship. We also seek to enter into nondisclosure agreements with our commercial counterparties and limit access to, and distribution of, our proprietary information.
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We are committed to developing and protecting our intellectual property and, where appropriate, file patent applications to protect our technology. We hold eleven U.S. patents relating to various aspects of our products, including the weight of digital beamformers, beamforming capabilities, digital conversion circuitry, transceiver circuitry and circuit integration. We hold two foreign patents relating to our products, and we currently have numerous patent applications pending both in the U.S. and abroad. We consider all of our patents to be significant to our business.
We license ultrasound technology from our former parent, ATL, under a Technology Transfer and License Agreement executed at the time of our spin-off as a public company. Under that agreement, we took ownership of certain ultrasound technology developed as part of a government grant and also patent rights, which had been established or were being pursued for that technology. As part of this agreement, we also entered into a cross-license whereby we have the exclusive right to use certain ATL technology existing on April 6, 1998 or developed by ATL during the three-year period following April 6, 1998 in ultrasound systems weighing 15 pounds or less, and ATL has the exclusive right to use our technology existing on April 6, 1998 or developed by us during the same three-year period in ultrasound systems weighing more than 15 pounds. On April 6, 2003, this cross-license becomes nonexclusive and, except for the patented technology of each party, extends to all ultrasound systems regardless of weight.
Additionally, under the terms of our spin-off from ATL, the point-of-care ultrasound technology assigned to us by ATL remains subject to rights reserved or acquired by the U.S. government in connection with the original research funding provided to ATL by the U.S. Office of Naval Research to develop that technology. Specifically, under the standard patent rights afforded the U.S. government in connection with government-funded scientific research and included in ATL’s original development agreement with the Office of Naval Research, the U.S. government holds what are commonly known as “march-in” rights—a nonexclusive, nontransferrable, irrevocable, fully paid worldwide license to manufacture or have manufactured for use by the U.S. government any inventions conceived or first reduced to practice by ATL during the course of its government-funded research. As we expect to be able to fulfill anticipated purchases of our products by the U.S. government, we do not currently expect any exercise by the U.S. government of its march-in rights.
We hold a number of registered and unregistered trademarks, service names and domain names that are used in our business in the United States and overseas. Generally, federally registered trademarks offer protection for renewable terms of 10 years so long as the mark continues to be used in commerce.
On July 24, 2001, Neutrino Development Corporation filed a complaint against us, which alleged that our sale and manufacture of our point-of-care ultrasound systems infringed upon a patent held by Neutrino. We responded to the claim, asserting alternative defenses of noninfringement and patent invalidity. In addition, we filed a counterclaim seeking a declaratory judgment of noninfringement and invalidity regarding Neutrino’s patent. We defeated Neutrino’s request for a preliminary injunction preventing us from manufacturing and selling our products pending the ultimate disposition of the litigation. On February 20, 2002, in what is known as a “Markman” hearing, the parties presented their arguments regarding the proper construction of Neutrino’s patent claims. The court has not yet ruled on the issues presented in that hearing. On October 10, 2002, the court granted our motion to stay the proceedings until it issues its “Markman” order and rules on our summary judgment motion. Although we continue to vigorously defend ourselves against this claim, this litigation may result in an adverse judgment against us. Sales of the allegedly infringing products represented virtually all of our revenue for the years ended December 31, 2002, 2001 and 2000. We have been forced to incur substantial expenses in defense of this claim, and we may incur additional substantial litigation expenses until the claim is resolved.
We currently face competition from companies that manufacture cart-based and portable ultrasound systems. The dominant competitors in this industry are GE Medical Systems, a unit of General Electric Company, Siemens AG and Philips Medical Systems, a unit of Koninklijke Philips Electronics, N.V. that acquired two other competitors, Agilent Healthcare Solutions Group and ATL, our former parent company. In addition, as the market for point-of-care, high performance ultrasound systems develops, we expect competition to increase as potential and existing competitors enter the point-of-care market or modify their existing products to more closely approximate the combined portability, quality, performance and cost of our products. Our current competitors in the point-of-care market include GE Medical Systems, Agilent/Philips Medical Systems, Biosound Esaote, Inc., Medison America Inc., a subsidiary of Medison Company, Ltd., and Terason, a division of TeraTech Corporation. Other potential entrants to the point-of-care market include ZONARE Medical Systems, Inc. (formerly Novasonics, Inc.).
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We currently employ over 50 individuals in product development dedicated to the enhancement of existing products and development of new products. In 2002, 2001 and 2000, expenses attributable to research and development for our business totaled $12.1 million, $12.7 million and $11.8 million. We believe our products represent the most advanced technology in point-of-care, high performance, all-digital ultrasound imaging systems. We believe our technology gives us a competitive advantage, and we are committed to maintaining this advantage by continuing to enhance our existing products and create new ones. Accordingly, we intend to maintain our research and development expenses at levels we believe necessary to maintain this competitive advantage.
We manufacture our products in our facility in Bothell, Washington. We depend on suppliers, including some single-source suppliers, to provide highly specialized parts, such as custom-designed integrated circuits, cable assemblies and transducer components. We also depend on single-source suppliers to provide other components such as image displays, batteries, capacitors and cables. We maintain inventories of components to meet near term production requirements. While our suppliers have generally produced our components with acceptable quality, quantity and cost in the past, they have experienced periodic problems that have caused us delays in production. To date, these problems have not resulted in lost sales or lower demand.
The manufacture and sale of our products are subject to extensive regulation by numerous governmental authorities, principally the U.S. Food and Drug Administration, or FDA, as well as several other state and foreign agencies. The FDA requires that all medical devices introduced to the market be preceded either by pre-market notification clearance under Section 510(k) of the Federal Food, Drug & Cosmetic Act, or an approved pre-market approval application, or PMA. By granting 510(k) clearance, the FDA indicates agreement with an applicant’s determination that the product for which clearance has been sought is substantially equivalent to medical devices that were on the market prior to 1976 or have subsequently received clearance. A PMA is filed when the FDA has determined the company must submit clinical trial data and manufacturing quality assurance information to prove it is safe and effective for its labeled indications. The process of obtaining 510(k) clearance typically takes approximately two to three months, while the PMA process typically takes more than a year. To date, all our products have received 510(k) clearance and we have not been required to file any PMAs. We believe that our future generation point-of-care ultrasound systems will also require only 510(k) clearance. Foreign regulatory agencies also require similar pre-market clearance or registration before our products can be marketed or offered for sale in their countries. Any delays, or failures, in obtaining such clearances may result in lost sales and revenue.
In August 2001, the FDA classified as a class II field action a May 2000 software upgrade we issued to correct an error in an algorithm contained in one of our products. We appealed the FDA’s classification and have received verbal confirmation from the FDA that we satisfied their requirements to complete the field action. We are seeking final written closure of this matter from the FDA.
Our products and our product components are also subject to various domestic and foreign manufacturing standards and electrical safety and emission standards, such as those of Underwriters Laboratories and the ISO 9001 standards, described below. We and our suppliers are subject to FDA regulations governing registration of manufacturing facilities and compliance with the FDA’s Quality System Regulations, or QSR. The FDA performs periodic unannounced on-site inspections to determine compliance with such regulations. The FDA inspected our manufacturing facility in August 2001. In addition, the British Standards Institution (BSI) performed a management systems assessment of our manufacturing processes in May 2000, February 2001, June 2001, November 2001, January 2002 and July 2002.
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SonoSite also complied with the new Canadian Medical Device Regulation requirements for an independent audit in December 2002. We met the requirements defined in the Canadian Medical Device Conformity Assessment Scheme (CMDCAS) and BSI will be issuing a certification to these requirements. These inspections resulted in our submitting and implementing corrective action responses, and we believe those responses have been accepted by those agencies. We believe that we are currently in compliance with applicable QSR.
Our regulatory compliance programs encompass verification of our compliance with international standards for medical device design, manufacture, installation and servicing, known as ISO 9001:1994, ISO 13485:1996 and EN 46001:1996 standards. On September 13, 1999, we received Conformite Europeenne, or CE, Marking approval, signifying European Certification to the international quality system standards and to the European Medical Device Directive, which encompass ISO 9001 standards. The Certification allows us to distribute the SonoSite 180, 180PLUS, SonoHeart, SonoHeart PLUS and SonoHeart ELITE systems to the 19 countries of the European Union and the European Free Trade Association. The FDA harmonized in June 1998 its QSR for the United States with ISO 9001 and EN 46001 standards.
Our current products do not require any U.S. export control licenses in order to be sold overseas.
Our typical warranty period is one year and is included with the original purchase of our ultrasound imaging systems. However, the customer can purchase a service contract from us to extend the original warranty period or enhance its coverage. All returned products are diagnosed for cause of failure and for possible design improvements to incorporate in future products.
As of December 31, 2002, we had approximately 350 full-time employees, of which approximately 14% were engaged in research and product development, 33% in manufacturing, 43% in sales and marketing activities and the remaining 10% in administrative capacities, including executive, finance, legal, human resources, regulatory and information services and technology. Of these, approximately 320 are U.S. employees. There has never been a work stoppage and no employees are covered by collective bargaining agreements. We believe our employee relations are good.
We make available, free of charge, on our website copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, or Exchange Act, as soon as reasonably practicable after filing or furnishing the information to the Securities and Exchange Commission. The Internet address for the information is http://investor.sonosite.com/edgar.cfm.
If our products do not gain market acceptance, we will fail to generate sufficient revenue to maintain our business.
The market for point-of-care, high performance ultrasound systems is new and largely undeveloped. Our products represent a new technological alternative to traditional ultrasound examinations. We seek to sell our products to current users of ultrasound, as well as to physicians and other healthcare providers who do not currently use ultrasound, and our success will depend on the acceptance of our products by the medical community, patients and third-party payors as medically useful, safe and cost-effective. Competing point-of-care or traditional cart-based ultrasound systems may be more cost-effective than our products. Physicians and other healthcare providers may adopt our products at a slow rate, if at all. If the market fails to accept our products, we will be unable to generate sufficient revenue to maintain our business.
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If we are unable to compete effectively, we will fail to generate sufficient revenue to maintain our business.
We currently face competition from companies that manufacture cart-based and portable ultrasound systems. The dominant competitors in this industry are GE Medical Systems, a unit of General Electric Company, Siemens AG and Philips Medical Systems, a unit of Koninklijke Philips Electronics, N.V. that owns two other competitors, Agilent Healthcare Solutions Group and ATL, our former parent company. These competitors are very large, global organizations and have the following advantages over us:
| • | greater financial and infrastructure resources; |
| • | larger research and development staffs; |
| • | greater experience in product manufacturing, marketing and distribution; |
| • | greater brand name recognition; and |
| • | long-standing relationships with many of our potential customers. |
These manufacturers of cart-based and portable ultrasound systems could use their greater resources to increase and withstand competition through various means, including price and payment terms, product quality, market penetration, employee compensation, hospital systems integration and complementary services such as warranty protection, maintenance and product training. Existing product supply relationships between these companies and our potential customers could discourage widespread adoption of our products due to brand loyalty or preferred customer discounts. Competition from these companies for employees with experience in the primary point-of-care market could result in higher turnover of our employees. If we are unable to respond to competitive pressures from the cart-based and portable ultrasound markets, we could experience delayed or reduced market acceptance of our products, higher expenses and lower revenue.
In addition, as the market for point-of-care, high performance ultrasound systems develops, we expect competition to increase as potential and existing competitors enter the point-of-care market or modify their existing products to more closely approximate the combined portability, quality, performance and cost or our products. Our current competitors in the point-of-care market include GE Medical Systems, Agilent/Philips Medical Systems, Biosound Esaote, Inc., Medison America Inc., a subsidiary of Medison Company, Ltd., and Terason, a division of TeraTech Corporation. Other potential entrants to the point-of-care market include ZONARE Medical Systems, Inc. (formerly Novasonics, Inc.). These competitors may develop highly portable or point-of-care ultrasound systems that offer the same or greater reliability and quality, perform greater or more useful functions, or are more cost-effective than our products. Some of these competitors may also be able to use their marketing resources to gain a competitive advantage by more effectively building brand awareness of their products. If we are unable to compete effectively with new entrants to the point-of-care, high performance ultrasound market, we will be unable to generate sufficient revenue to maintain our business.
If our competitors develop and market medical imaging systems that render our products obsolete or noncompetitive, we will be unable to compete.
The life cycles of our products are difficult to estimate. Our products could become obsolete or unmarketable if:
| • | our competitors introduce ultrasound systems that are superior to ours; |
| • | other products using new technologies emerge; or |
| • | industry standards exceed our products’ capabilities. |
If we fail to enhance our existing products or develop and market new products, our products will become obsolete and we will be unable to compete.
If healthcare reimbursement practices or reform restricts coverage available to our customers for the use of our products, we may experience limited market acceptance of our products.
Market acceptance of our products depends in part on the extent to which our customers will receive reimbursement for the use of our products from governmental authorities such as Medicare, private health insurers and other third-party payors. Our customers generally have received reimbursement for ultrasound procedures performed using our products consistent with reimbursement criteria applicable to ultrasound procedures generally. The continuing efforts of governmental authorities, private health insurers and other third-party payors to contain or reduce the costs of healthcare through various means may, however, limit market acceptance of our products and, therefore, may affect our ability to market our current products, commercialize our potential products and become profitable. Reimbursement coverage, to the extent available, may not be adequate to enable us to achieve market acceptance of our products. In addition, we believe that third-party payors will attempt to reduce healthcare costs by limiting both coverage and level of reimbursement for new products cleared by the FDA or comparable foreign agencies. Our products enable new kinds of medical procedures involving novel ultrasound applications for which there is no reimbursement history. The efforts of government and third-party payors to contain or reduce the cost of healthcare could restrict physicians’ and other healthcare providers’ willingness to select our products and implement new ultrasound procedures, which could delay or reduce market acceptance of our products.
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We have recently become aware of notices issued by three state Medicare carriers to their clients in fifteen states that limits reimbursement under various Part B Medicare ultrasound CPT codes for certain ultrasound procedures conducted with “hand-carried ultrasound” systems. We are seeking clarification from these carriers of the meaning of these policy changes in an effort to determine the extent to which they may potentially impact our business. If such reimbursement practices continue in force or are adopted by additional health insurance providers, market acceptance of our products may be limited.
Additionally, there has been and will likely continue to be a number of federal and state proposals to implement government controls on pricing. The existence and adoption of these proposals could affect our ability to successfully market our current products and commercialize new products.
Changes in the health care industry may require us to decrease the selling price for our products or could result in a reduction in the size of the market for our products, each of which could have a negative impact on our financial performance
Trends toward managed care, health care cost containment, and other changes in government and private sector initiatives in the United States and other countries in which we do business are placing increased emphasis on the delivery of more cost-effective medical therapies which could adversely affect the sale and/or the prices of our products. For example:
| • | major third-party payers of hospital and pre-hospital services, including Medicare, Medicaid and private health care insurers, have substantially revised their payment methodologies during the last few years which has resulted in stricter standards for reimbursement of hospital and pre-hospital charges for certain medical procedures; |
| • | numerous legislative proposals have been considered that would result in major reforms in the U.S. health care system that could have an adverse effect on our business; |
| • | there has been a consolidation among health care facilities and purchasers of medical devices in the United States who prefer to limit the number of suppliers from whom they purchase medical products, and these entities may decide to stop purchasing our products or demand discounts on our prices; |
| • | there is economic pressure to contain health care costs in international markets; and |
| • | there are proposed and existing laws and regulations in domestic and international markets regulating pricing and profitability of companies in the health care industry. |
Both the pressure to reduce prices for our products in response to these trends and the decrease in the size of the market as a result of these trends could adversely affect our levels of revenues and profitability of sales, which could have a material adverse effect on our business.
Our single technological platform renders us less able to withstand adverse changes in the ultrasound market.
Although we market our products for use in a variety of clinical applications and settings, we have only a single technological platform upon which all our ultrasound systems are based. Any attempt to design a new platform for ultrasound imaging will require substantial amounts of time and money, and may not be successful.
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If our platform becomes obsolete, unmarketable or unaccepted by the ultrasound market for any reason, and we are unable or slow to develop a new platform to replace it, we will be unable to generate sufficient revenue to maintain our business.
If traditional providers of ultrasound examinations discourage potential new users from adopting our products, we could experience limited demand for our products.
In traditional ultrasound practice, physicians and other healthcare providers typically refer patients to centralized locations where radiologists and other specialized personnel provide ultrasound examinations. Although our products are currently used by radiologists, our products also enable the delivery of ultrasound examinations at the primary point of care by the examining physician or healthcare provider. Radiologists and other ultrasound specialists have a professional and financial interest in maintaining traditional ultrasound practice. If these traditional providers of ultrasound examinations discourage other healthcare providers from adopting our products, we could experience limited demand for our products.
If the training and education necessary to conduct ultrasound examinations discourage new users from adopting our products, we could experience limited demand for our products.
We seek to sell our products to customers already experienced in ultrasound procedures, as well as to physicians and other healthcare providers who do not currently use ultrasound imaging systems or administer ultrasound examinations. Although customers who are experienced in ultrasound procedures will need little, if any, specialized training to use our products, any new users of ultrasound will require training and education to properly administer ultrasound examinations. If these potential customers are unable or unwilling to be trained due to cost, time constraints, unavailability of courses or other reasons, we could experience limited demand for our products.
If our suppliers, including our single-source suppliers, fail to supply us with the components that we need to manufacture our products on a timely basis, we could experience production delays, cost increases and lost sales.
We depend on suppliers, including some single-source suppliers, to provide highly specialized parts, such as custom-designed integrated circuits, cable assemblies and transducer components. We also depend on single-source suppliers to provide other components, such as image displays, batteries, capacitors and cables. We do not maintain significant inventories of components, and may experience an interruption of supply if a supplier is unable or unwilling to meet our time, quantity and quality requirements. There are relatively few alternative sources of supply for some of these components. An increase in demand for some parts by other companies could also interrupt our supply of components. We have in the past experienced supply problems in timeliness and quality, but to date these problems have not resulted in lost sales or lower demand. Nevertheless, if we experience an interruption of supply or are required to switch suppliers, the manufacture and delivery of our products could be interrupted, our manufacturing costs could substantially increase and we could lose substantial amounts of product sales.
In March 2003, one of our component suppliers, Philips Semiconductor (“Philips”), informed us that, commencing in September 2003, it would discontinue production of our integrated circuit chips using 0.35-micron technology. We have designed and implemented a new chip using 0.2-micron technology that will continue to be produced by Philips to replace all but one of the discontinued chips. We expect to design and implement an additional new chip to replace the remaining 0.35-micron chip by early 2005. Prior to the discontinuance, we expect to obtain supplies of 0.35-micron chips from Philips in an amount sufficient to supply us with enough components for our anticipated manufacturing needs until new chips have been incorporated in all of our products. Demand for our products, however, may exceed our forecasts, in which case we would require additional 0.35-micron chips to manufacture additional products. Conversely, if demand for our products falls short of our forecasts, we may experience excess inventory of 0.35-micron chips. If our actual demand for these chips varies significantly from our forecasted demand, we may experience delays in manufacturing, lost sales, a write-down of inventory, a deterioration in gross margin or lower revenue.
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If our suppliers or we fail to comply with U.S. and foreign governmental regulations applicable to our products and manufacturing practices, we could experience product introduction delays, production delays, cost increases and lost sales.
Our products, our manufacturing activities and the manufacturing activities of our third-party medical device manufacturers are subject to extensive regulation by a number of governmental agencies, including the FDA and comparable international agencies. Our third-party manufacturers and we are or will be required to:
| • | obtain prior clearance or approval from these agencies before we can market and sell our products; |
| • | undergo rigorous inspections by domestic and international agencies; and |
| • | satisfy content requirements for all of our sales and promotional materials. |
The manufacture and sale of our products are subject to extensive regulation by numerous governmental authorities, principally the FDA, as well as several other state and foreign agencies. The FDA requires that all medical devices introduced to the market be preceded either by pre-market notification clearance under Section 510(k) of the Federal Food, Drug & Cosmetic Act, or an approved pre-market approval application, or PMA. By granting 510(k) clearance, the FDA indicates agreement with an applicant’s determination that the product for which clearance has been sought is substantially equivalent to medical devices that were on the market prior to 1976 or have subsequently received clearance. The process of obtaining 510(k) clearance typically takes approximately two to three months. To date, we have not been required to file any PMAs and all of our products have received 510(k) clearance. In addition, foreign regulatory agencies also require similar pre-market clearance or registration before our products can be marketed or offered for sale in their countries. Any delays, or failures, in obtaining such clearances may result in lost sales and revenue.
In addition, the FDA requires us and our key medical device suppliers to demonstrate and maintain compliance with the FDA’s Quality System Regulation, or QSR, which covers the methods and documentation of the design, testing, production, control, quality assurance, labeling, packaging, shipping and servicing of our products. The FDA enforces the QSR through periodic inspections; the FDA inspected our manufacturing facility in August 2001. In addition, the British Standards Institution has performed several management systems assessments of our manufacturing processes. These inspections resulted in observations to which we submitted responses, and we believe these responses have been accepted by those agencies. Any failure to take corrective action in response to a QSR inspection could force a shutdown of our manufacturing operations, and a recall of, or field action relating to, our products. Also, in August 2001, the FDA classified as a class II field action a May 2000 software upgrade we issued to correct an error in an algorithm contained in one of our products. We appealed the FDA’s classification and have received verbal confirmation that we satisfied the requirements to complete the field action. We are seeking final written closure of this matter from the FDA.
Compliance with the regulations of these agencies, including the Environmental Protection Agency and the Occupational Safety and Health Administration, may require us to incur substantial costs and may delay or prevent the introduction of new or improved products. Although to date these actions by regulatory bodies have not required us to incur substantial costs or delay product shipments, we expect to experience further inspections and incur additional costs as a result of governmental regulation. If we fail to comply with the laws and regulations pertaining to our business, we may be subject to fines, sanctions, including the temporary or permanent suspension of operations, product field actions, criminal prosecution and marketing restrictions. Our third-party medical device manufacturers may also be subject to the same sanctions if they fail to comply with the laws and regulations, and, as a result, may fail to supply us with components required to manufacture our products.
Our reliance on a single manufacturing facility may impair our ability to respond to natural disasters or other unforeseen catastrophic events.
Our sole manufacturing facility is located in a single building in Bothell, Washington. Despite precautions taken by us, a natural disaster such as an earthquake or other unanticipated catastrophic events at this building could significantly impair our ability to manufacture our products and operate our business. Our facility and certain manufacturing equipment would be difficult to replace and could require substantial replacement lead-time. Such catastrophic events may also destroy any inventory of product or components. While we carry insurance for natural disasters and business interruption, the occurrence of such an event could result in losses that exceed the amount of our insurance coverage, which would impair our financial results.
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We have a history of losses, we expect future losses and we may never achieve sustained profitability.
With the exception of the fiscal quarter ending December 31, 2002, we have incurred net losses in each quarter since we commenced operations. As of December 31, 2002, we had an accumulated deficit of approximately $86 million. Although we expect to continue to incur additional losses in the fiscal quarter ending March 31, 2003, we expect to achieve profitability on an annual basis in 2003. Even if we do achieve one or more profitable periods, however, we may be unable to sustain or increase future profitability on a quarterly or annual basis. Additionally, our losses may increase if we cannot increase or sustain our revenue. With the exception of the fiscal quarter ending December 31, 2002, our revenue from product sales has been insufficient to cover our expenses. We expect that our operating expenses will substantially increase in the foreseeable future as we expand our sales and marketing infrastructure, our administrative support and possibly our product development activities. Our expansion efforts, to be successful, may require more funding than we currently anticipate. Accordingly, we will need to generate significant additional revenue in the future before we will be able to sustain or increase profitability. If we cannot generate such revenue, we may never be profitable. If we fail to achieve sustained profitability, the market price for our common stock will likely fall.
A failure to manage our growth could impair our ability to achieve our business objectives.
We have experienced rapid growth since our inception as a stand-alone company. Our revenue increased from $32.0 million in 2000 to $45.7 million in 2001 and $73.0 million in 2002. During 2002, we added over 100 new employees, primarily in manufacturing and sales and marketing. During 2002, we introduced five new products and continued our expansion into Europe. We expect continued significant growth as we continue to develop, manufacture, market and sell our products. Our growth could strain our existing management, operational and financial resources. In order to manage our growth effectively, we will need to expand our manufacturing and quality assurance staff, our sales staff and our manufacturing capabilities. In addition, we will need to improve the productivity and efficiency of our existing operational, financial and management resources and information systems. We may be unable to hire and retain the personnel necessary to operate and expand our business. We also may be unable to increase the productivity and efficiency of our existing resources. If we fail to timely improve or augment our existing resources in response to our growth, we may be unable to effectively manage our business and achieve our objectives.
Our foreign distributors may be unwilling or unable to devote sufficient resources to market and sell our products, which could delay or reduce market acceptance and sales of our products outside the United States.
We currently depend on foreign distributors to help promote market acceptance and demand for our products in countries in which we do not have a direct sales force. For example, sales to our distributor in Japan, Olympus, represented 10% of our revenue in 2002 and 17% of our revenue in 2001. Foreign distributors that are in the business of distributing other medical products may not devote the resources and support required within these countries to generate awareness of our products and grow or maintain product sales. If these distributors are unwilling or unable to market and sell our products, we could experience delayed or reduced market acceptance and sales of our products outside the United States.
In Japan, we have not achieved revenue growth the past two fiscal years. In late 2002, we examined the market for our product and confirmed a significant market opportunity that was not being realized by Olympus and their dealer network. In an effort to develop this market opportunity, Olympus will add direct resources and redirect the efforts of its dealers in the first half of 2003. We expect that this transition will result in reduced revenues in Japan in the first half of fiscal 2003 compared with the same period in 2002.
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Our lack of customer purchase commitments and our limited order backlog make it difficult to predict sales and plan manufacturing requirements, which can lead to lower revenues, higher expenses and reduced margins.
We do not generally have volume purchase commitments with our customers, who typically order products on a purchase order basis. In limited circumstances, customer orders may be cancelled, changed or delayed on short notice. Lack of significant order backlog makes it difficult for us to forecast future sales with certainty. Varying sales cycles with our customers make it difficult to accurately forecast component and product requirements. These factors expose us to a number of risks:
| • | if we overestimate our requirements, we may be obligated to purchase more components or third-party products than is required; |
| • | if we underestimate our requirements, our third-party manufacturers and suppliers may have an inadequate product or product component inventory, which could interrupt manufacturing of our products and result in delays in shipments and revenues; |
| • | we may also experience shortages of product components from time to time, which also could delay the manufacturing of our products; and |
| • | over or under production can lead to higher expense, lower than anticipated revenues, and reduced margins. |
Our creation, maintenance and expansion of direct sales and distribution operations in Europe and Asia will require a significant investment of our financial and management resources and may fail to generate a substantial increase in sales.
We have historically relied on third-party distributors to sell our products in Europe and Asia. In 2001, we commenced operations in the United Kingdom and France, and in 2002, we commenced operations in Germany and Spain to sell our products directly in each of those countries. In 2002, we began the process of terminating a joint venture that distributed our products in China, which we expect to have completed in 2003 along with the formation of a joint venture with a new partner that has greater financial and marketing resources. We expect our foreign direct sales operations to grow. Establishing, maintaining and expanding these operations will require us to:
| • | substantially increase our costs of operations; |
| • | temporarily divert existing management resources; |
| • | establish an efficient and self-reliant local infrastructure; |
| • | attract, hire and train qualified local sales and administrative personnel; |
| • | comply with additional local regulatory requirements; and |