10-Q 1 f69319e10-q.txt FORM 10-Q PERIOD ENDED DECEMBER 31, 2000 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON D.C. 20549 ----------------------------------------------- FORM 10-Q [X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. For the quarterly period ended December 31, 2000. [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. For the transition period from ________________to_______________. COMMISSION FILE NUMBER: 000-28372 CARDIAC PATHWAYS CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) ~~DELAWARE 77-0278793 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.)~~

~~995 BENECIA AVENUE, SUNNYVALE, CA 94085 (Address of principal executive offices) (Zip Code)~~

Registrant's telephone number, including area code: (408) 737-0505 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. [X] Yes [ ] No As of February 12, 2001 there were 9,002,240 shares of the Registrant's Common Stock outstanding. 1 2 CARDIAC PATHWAYS CORPORATION INDEX

~~PAGE NO.~~ PART I. FINANCIAL INFORMATION PAGE NO. Item 1. Financial Statements and Notes (Unaudited) Condensed Consolidated Balance Sheets as of ~~September~~December 3031, 2000 and June 30, 2000 ........................................................... 3 Condensed Consolidated Statements of Operations for the Three and Six Months Ended ~~September~~December 3031, 2000 and 1999 ........................................ 4 Condensed Consolidated Statements of Cash Flows for the ~~Three~~Six Months Ended ~~September~~December 3031, 2000 and 1999 ........................................ 5 Notes to Condensed Consolidated Financial Statements .................... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ................................................... 10 Item 3. Quantitative and Qualitative Disclosures about Market Risk 22.................................................................... 25 PART II. OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds ............................... 26 Item 4. Submission of Matters to a Vote of Security Holders...................... 26 Item 6. Exhibits and Reports on Form 8-K 23........................................ 26 SIGNATURES 24.......................................................................... 27

2 3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS AND NOTES CARDIAC PATHWAYS CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) (Unaudited)

~~September~~December 3031, June 30, 2000 2000 (1) ~~(unaudited)~~ ----------- --------- ASSETS Current assets: Cash and cash equivalents $ 628,~~021~~274 $ 8,488 Short-term investments 31,~~138~~492 4,137 Accounts receivable, net of allowance for doubtful accounts of $~~112~~177 at ~~September~~December 3031, 2000 and $139 at June 30, 2000 12,~~731~~332 1,271 Inventories 1,~~552~~825 2,095 Prepaid expenses ~~243~~290 227 Other current assets ~~104~~71 222 --------- --------- Total current assets 1234,~~789~~284 16,440 Property and equipment, net 4,~~104~~319 3,506 Notes receivable from related parties 100 100 Intangible assets, net of accumulated amortization of $~~467~~567 ~~and $367~~ at ~~September~~December 3031, 2000 and $367 at June 30, 2000 1,~~533~~433 1,633 Deposits and other assets 6181 86 --------- --------- $ 1840,~~587~~217 $ 21,765 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) Current liabilities: Accounts payable $ ~~792~~944 $ 980 Accrued compensation and related benefits 1,~~280~~542 1,196 Accrued clinical expenses ~~426~~319 527 Accrued stock issuance cost 2,047 -- Other accrued expenses ~~952~~1,143 907 Current obligations under capital leases ~~233~~191 258 Deferred income-current portion 300 400 --------- --------- Total current liabilities 36,~~983~~486 4,268 Long-term obligations under capital leases 4521 85 Deferred income 1,~~956~~881 2,031 Accrued Series B Preferred dividends 34,~~540~~288 2,784 ~~Stockholders'~~Redeemable ~~equity:~~Convertible Preferred ~~stock~~Stock, $.001 par value; 5,000,000 shares authorized and 27,250 issued and outstanding at ~~September~~December 3031, 2000 and at June 30, 2000; liquidation preference of $3031,~~791~~538 at ~~September~~December 3031, 2000 --26,828 --26,828 Receivable from stockholder (250) (250) Stockholders' equity (deficit): Common stock, $.001 par value; 630,000,000 shares authorized; 39,~~100~~002,~~991~~240 shares issued and outstanding at ~~September~~December 3031, 2000 and 3,078,486 issued and outstanding at June 30, 2000 39 3 Additional paid-in capital ~~108~~103,~~600~~951 ~~109~~82,~~267~~439 Receivable from stockholders (~~322~~72) (~~322~~72) Accumulated deficit (99102,~~218~~916) (96,351) --------- --------- Total stockholders' equity ~~9,063~~(deficit) 12972 (13,~~597~~981) --------- --------- $ 1840,~~587~~217 $ 21,765 ========= =========

(1) Derived from the Company's audited consolidated balance sheet as of June 30, 2000, as restated. See notes to condensed consolidated financial statements 3 4 CARDIAC PATHWAYS CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) (UNAUDITED)

Three months ended ~~September~~Six 30months ended December 31, December 31, ------------------------ ------------------------ 2000 1999 2000 1999 ------- ------- ------- ------- Net sales $ 3,~~042~~242 $ 1,~~381~~863 $ 6,284 $ 3,244 Cost of goods sold 2,~~488~~586 1,~~392~~535 5,074 2,927 ------- ------- ------- ------- Gross margin ~~(deficit)~~656 ~~554~~328 ~~(11)~~1,210 317 Operating expenses: Research and development 1,~~001~~141 1,~~928~~724 2,142 3,652 Selling, general and administrative 3,346 2,~~575~~067 15,~~627~~921 3,695 ------- ------- ------- ------- Total operating expenses 34,~~576~~487 3,~~555~~791 8,063 7,347 ------- ------- ------- ------- Loss from operations (3,~~022~~831) (3,~~566~~463) (6,853) (7,030) Other income (expense): Interest income ~~167~~153 ~~177~~341 319 518 Interest expense (86) (3513) (14) (48) Other, net (414) ~~120~~6 (17) 126 ------- ------- ------- ------- Total other income, net ~~155~~133 ~~262~~334 288 596 ------- ------- ------- ------- Net loss (23,~~867~~698) (3,~~304~~129) (6,565) (6,434) Preferred stock dividend ~~756~~749 ~~660~~880 1,506 1,540 Beneficial conversion feature related to the issuance of the Series B preferred stock -- -- -- 960 ------- ------- ------- ------- Net loss ~~applicable~~attributable to common stockholders $(34,~~623~~447) $(4,~~924~~009) $(8,071) $(8,934) ======= ======= ======= ======= Net loss per ~~common~~ share - basic and diluted ($ (1.1729) ($ 1.99) ($ 2.4547) ($ 4.44) ======= ======= ======= ======= Shares used in computing net loss per ~~common~~ share - basic and diluted 3,~~095~~451 2,~~008~~019 3,273 2,014 ======= ======= ======= =======

See notes to condensed consolidated financial statements 4 5 CARDIAC PATHWAYS CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)

~~Three~~Six months ended ~~September~~December 3031, -------- --------~~-------~~ 2000 1999 -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES Net loss $ (26,~~867~~565) $ (36,~~304~~434) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization ~~600~~833 ~~404~~687 Amortization of deferred compensation -- 4584 Changes in operating assets and liabilities: Accounts receivable (~~460~~1,061) (~~295~~115) Inventories ~~543~~270 ~~(16)~~186 Prepaid expenses (1663) 50108 Other current assets ~~118~~151 (~~165~~176) Accounts payable (~~188~~36) ~~102~~(72) Accrued compensation and related benefits 84346 (~~202~~417) Accrued clinical expenses (~~101~~208) --(170) Other accrued expenses 452,336 ~~823~~722 Deferred income (~~175~~250) (75150) -------- -------- Net cash used in operating activities (24,~~419~~247) (25,~~633~~747) -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES Purchases of short-term investments -- (811,~~960~~120) Maturities ~~and sales~~ of short-term investments ~~999~~2,645 -- Purchases of property and equipment, net (1,~~097~~446) (~~125~~426) ~~Increase in notes receivable -- (7)~~ Purchase of rights to certain patents -- (2,000) Decrease (increase) in deposits and other assets 255 (1021) -------- -------- Net cash (provided by) used in investing activities ~~(73)~~1,204 (1113,~~102~~567) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES Principal payments under capital lease obligations (65131) (~~120~~201) ~~Payment of short-term debt obligations -- (3,000)~~ Proceeds from issuance of preferred stock, net of issuance cost -- 3128,500 Proceeds from issuance of common stock, 90net --of issuance cost 22,960 31 -------- -------- Net cash provided by financing activities 2522,829 28,~~380~~330 -------- -------- Net ~~(decrease)~~ increase in cash and cash equivalents (219,~~467)~~786 149,~~645~~016 Cash and cash equivalents at beginning of period 8,488 2,340 -------- -------- Cash and cash equivalents at end of period $ 628,~~021~~274 $ 1611,~~985~~356 ======== ======== SUPPLEMENTAL CASH FLOW INFORMATION Non-cash conversion of bridge loan financing to preferred stock $ -- $ 3,000 ======== ========

See notes to condensed consolidated financial statements 5 6 CARDIAC PATHWAYS CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2000 (UNAUDITED) 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the financial information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. The December 31, 2000 and June 30, 2000 balance sheets reflect the discount or beneficial conversion feature present in the convertible securities. The discount was being recognized as a return to the preferred stockholders (similar to a dividend) over the minimum period in which the preferred stockholders can realize a return, immediately for the Series B Convertible Preferred stockholders. The discount was accreted to additional paid in capital in the quarter ended September 30, 1999 balance sheet. Each share of Series B Convertible Preferred Stock is initially convertible into 218 shares of the Company's Common Stock, at the option of the holder. Each share of Series B Convertible Preferred Stock shall automatically be converted into the Company's common stock upon the election of a majority of the holders of the Series B Convertible Preferred Stock. Each share of Series B Convertible Preferred Stock shall entitle the holder thereof to that number of votes on all matters submitted to a vote of the stockholders of the Company equal to the number of shares of common stock into which the Series B Convertible Preferred Stock can be converted. The Series B Convertible Preferred Stock Purchase Agreement specifies that, when, as and if dividends are declared, the holder of Series B Convertible Preferred Stock are entitled to a cumulative dividend equal to 11% of the purchase price paid for each share of Series B Convertible Preferred Stock, per share, per year. At any time after May 31, 2004, the cumulative dividend will increase by 6 percentage points at the beginning of each year if the Company elects not to redeem the stock after a redemption request by the holders of a majority of the then outstanding shares of Series B Convertible Preferred Stock, voting as a single class. The Series B Convertible Preferred Stock has a liquidation preference equal to the initial purchase price plus any accrued and unpaid dividends upon the occurrence of a liquidation, a merger or the sale of all or substantially all of the Company's stock or assets. As a result of the liquidation preference, in the event of a liquidation, merger or the sale of substantially all of the Company's stock or assets, the holders of Series B Convertible Preferred Stock will receive their original purchase price plus any accrued and unpaid dividends prior to any distribution to the holders of common stock. After such payment, any remaining proceeds would be distributed ratably among the holders of Series B Convertible Preferred Stock and holders of common stock. As of December 31, 2000, the liquidation preference and redemption value of the outstanding 27,250 shares of Series B Convertible Preferred Stock is $31.5 million, which includes the original investment plus the accrued but unpaid dividends. In February 2001, the Company reclassified the Series B Convertible Preferred Stock to exclude it from total stockholder's equity due to the nature of the redemption features of the stock, and restated its condensed consolidated balance sheet at June 30, 2000. 6 7 The operating results for the three months and six months ended December 31, 2000 are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2001. The accompanying condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Cardiac Pathways Corporation (the "Company") Annual Report on Form 10-K/A for the fiscal year ended June 30, 2000. 2. CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS The Company considers all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents. All other liquid investments are classified as short-term investments. At December 31, 2000, all short-term investments were classified as available-for-sale. Available-for-sale securities are carried at fair market value with unrealized gains and losses, net of tax, reported as a separate component of stockholders' equity. To date, the Company has not experienced any significant unrealized gains or losses on available-for-sale securities and, accordingly, no adjustments have been made to stockholders' equity. The following is a summary of available-for-sale securities at cost, which approximates fair value:

~~Dollar~~DECEMBER ~~amounts in thousands SEPTEMBER 30~~31, JUNE 30, DESCRIPTION 2000 2000 ----------- ----------- -------- ~~Held~~(Dollar toamounts ~~maturity~~in thousands) Available-for-sale: U.S. government agency $ -- $ 1,000 Other government agency ~~1,000~~-- 1,000 ~~Available for sale:~~ Auction rate preferred stock ~~2,000~~-- 2,000 U.S. corporate obligations 528,~~795~~874 8,119 ------- ------- ~~8,795~~ 12,119 Amounts classified as cash equivalents 527,~~657~~382 7,982 ------- ------- Amounts included in short-term investments $ 31,~~138~~492 $ 4,137 ======= =======

There were no material realized or unrealized gains or losses as of or for the three-month and six-month periods ending December 31, 2000 and 1999. The cost of securities sold is based on the specific identification method. 7 8 3. CONDENSED CONSOLIDATED BALANCE SHEET COMPONENTS Certain balance sheet components are as follows:

~~SEPTEMBER~~DECEMBER 3031, JUNE 30, ~~Dollar amounts in thousands~~ 2000 2000 ------------ -------- (Dollar amounts in thousands) Inventories: Raw materials $ ~~753~~936 $1,057 Work-in-process ~~315~~285 204 Finished goods ~~484~~604 834 ------ ------ $1,~~552~~825 $2,095 ====== ======

~~Dollar~~DECEMBER ~~amounts in thousands SEPTEMBER 30~~31, JUNE 30, 2000 2000 ------------ ------- (Dollar amounts in thousands) Property and equipment: Equipment $ 910,~~421~~152 $ 8,320 Leasehold improvements 422 422 Equipment-in-process ~~900~~518 904 ------- ------- 1011,~~743~~092 9,646 Less accumulated depreciation and amortization 6,~~639~~773 6,140 ------- ------- $ 4,~~104~~319 $ 3,506 ======= =======

4. RECENT PRONOUNCEMENTS In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133 (FAS 133), "Accounting for Derivative Instruments and Hedging Activities", as amended by FAS 137, which is required to be adopted in years beginning after June 15, 2000. The Company has not in the past and does not anticipate in the future using derivative instruments, and the Company does not expect that the adoption of FAS 133 will have a significant impact on its financial condition or results of operations. In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101") that must be adopted in the quarter ended June 30, 2001. SAB 101 summarizes certain areas of the Staff's views in applying generally accepted accounting principles to revenue in financial statements. Although the Company believes that its current revenue recognition policies comply with SAB 101, additional guidance was issued by the SEC staff and the Company is in the process of evaluating the effect of adopting SAB 101. The Company does not expect that the adoption of SAB 101 will have a significant impact on its financial condition or results of operations. 8 9 5. STOCKHOLDER'S EQUITY On December 26, 2000, Cardiac Pathways issued and sold 5.9 million shares of common stock at a price of $4.25 per share for aggregate proceeds, net of issuance cost, of $22.8 million. The Company intends to use the net proceeds of this financing to expand sales, marketing and manufacturing capacity for its key product platforms, the Realtime Position Management (RPM) Tracking System and the Chilli(R) Cooled Ablation Catheter, and for working capital and general corporate purposes. The shares of common stock sold in the financing have not been registered under the Securities Act of 1933, as amended, and may not be sold in the United States absent registration, or an applicable exemption from registration. Under the terms of the financing, the Company has filed a registration statement for the purpose of registering these shares for resale under the Securities Act of 1933, as amended. 9 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. The Company's actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors that include, but are not limited to, the risks discussed in "Factors That May Impact Future Operations" as well as those discussed in the following "Overview" section. These forward-looking statements include the statement in the first paragraph of "Overview" relating to the expectations of operating losses, the statements in the second paragraph of "Overview" relating to the range of clinical utility for the RPM Tracking System and the potential reduction in procedure times, the statements in the third paragraph of "Overview" relating to the manufacturing, marketing and distribution of the Company's products, the statements in the last sentence of "Cost of Goods Sold" relating to expectations for gross margins, the statements in the last sentence of the first paragraph of "Impact of Adoption of New Accounting Standards" regarding FAS 133, the statements in the last sentence of the second paragraph of "Impact of Adoption of New Accounting Standards" regarding SAB 101, the statements in the first paragraph of "Liquidity and Capital Resources" regarding the Company's expected liquidity and capital needs, the statements in the last sentence of the third paragraph of "Liquidity and Capital Resources" regarding the Company's expected capital expenditures, the statements in the section of "Factors That May Impact Future Operations" entitled "Limited Operating History, History of Losses and Expectations of Future Losses" relating to expectations of operating losses and the statement in the third paragraph in the section of "Factors That May Impact Future Operations" entitled "Employees" relating to the Company's need to expand its operations and hire new personnel. OVERVIEW AND CURRENT EVENTS The Company is continuing its shift from a broad-based research & development (R&D) and clinical development oriented company to one focused on expansion of marketing, sales, distribution, customer support and manufacturing capacity. The Company has experienced significant operating losses since inception and as of December 31, 2000 had an accumulated deficit of approximately $102.9 million. The Company expects to continue operating at a loss at least through the end of fiscal year 2002 as it continues to expend substantial funds to establish commercial-scale manufacturing capabilities and to expand its sales and marketing activities. In December 2000, the Company completed the sale and issuance of 5.9 million shares of common stock at a price of $4.25 per share for aggregate proceeds, net of issuance cost, of $22.8 million. The company intends to use the net proceeds of this financing to expand sales, marketing and manufacturing capacity for its key product platforms, the RPM Tracking System and the Chilli Cooled Ablation Catheter, and for working capital and general corporate purposes. The shares of common stock sold in the financing have not been registered under the Securities Act of 1933, as amended. Under the terms of the financing, the Company has filed a registration statement for the purpose of registering these shares for resale under the Securities Act of 1933, as amended. The RPM Tracking System and Chilli Cooled Ablation Catheter with RPM tracking were introduced to the U.S. and European markets in May and June of 2000, respectively. The proprietary technology developed by the Company can be used in most diagnostic electrophysiology procedures for real-time visualization of catheters utilizing ultra-sound technology. The RPM Tracking System is expected to assist physicians in precisely manipulating catheters within the heart during procedures, offering the potential for reductions in procedure times and improved economic benefit to the hospital and physician. The RPM Tracking System and Chilli Cooled Ablation Catheter with tracking have received FDA clearance in the U.S. and CE Mark approval in Europe. 10 11 During the second quarter of fiscal 2001, the Company introduced version 3.1 software for its RPM Tracking System. The software integrates mapping of the heart's electrical signals and navigation tools that are designed to enable electrophysiologists to more easily identify and ablate abnormal electrical impulses in a patient's heart which are responsible for an arrhythmia. The software, already in use at selected centers in the United States and Europe, is an enhancement to the company's existing RPM Tracking System. In the new 3.1 software version, non-fluoroscopic catheter navigation has been enhanced with three-dimensional (3-D) mapping capability applied to a 3-D heart model. The system uses ultrasound ranging technology to accurately locate catheter positions within the heart, render 3-D graphical representations of the catheters and of their positions with respect to the heart wall, and view electrical sensing data (mapping) of specific electrode positions. These features enable the physician to more easily identify locations in the endocardium where ablation energy can be applied to treat the arrhythmia. The Company's increase in revenues for the quarter ended December 31, 2000 as compared to the quarter ended December 31, 1999 was driven by continued volume growth of sales of the Chilli Cooled Ablation Catheter in the U.S, placements of the RPM Tracking Systems and associated RPM catheter set revenues. The Company is focusing its resources on its two key platforms; the Chilli Cooled Ablation Catheter and the RPM Tracking System. For the Company's products that have recently obtained FDA clearance or approval, there can be no assurance that any such products will be successfully commercialized or that the Company will achieve significant revenues from either domestic or international sales. Although the FDA granted 510k clearance for the RPM Tracking System and PMA approval for the Chilli Cooled Ablation Catheters with RPM tracking, the Company has limited experience in manufacturing, marketing or selling these products in commercial quantities. In order to successfully implement its business plan, the Company must manufacture and sell the RPM and Chilli Cooled Ablation Catheters in commercial quantities and the Company will need to expend significant capital resources and develop manufacturing expertise to establish large-scale manufacturing capabilities. Manufacturers often encounter difficulties in scaling up production of new products, including problems involving production yields, quality control and assurance, component supply shortages, shortages of qualified personnel, compliance with FDA regulations, and the need for further FDA approval of new manufacturing processes. The Company intends to market its products primarily through a direct sales force in the United States and indirect sales channels internationally. Establishing a marketing and sales capability sufficient to support sales in commercial quantities will require significant management and financial resources. See "-- Factors That May Impact Future Operations." Due to the nature of the redemption features of the Company's Series B Convertible Preferred Stock, the accompanying Condensed Consolidated Balance Sheets as of December 31, 2000 and June 30, 2000 reflect a change in presentation to exclude the Preferred Stock from Stockholders' Equity (Deficit). In addition, the Company has amended its Quarterly Report on Form 10-Q for the period ended September 30, 2000 and its Annual Report on Form 10-K for the year ended June 30, 2000 to restate the consolidated balance sheets appearing therein to exclude the Series B Preferred Stock from Stockholders' Equity (Deficit). The Company is in discussions with the holders of the Series B Preferred Stock to amend the terms of the Series B Preferred Stock in a manner that would allow the Company to include the Series B Preferred Stock within the Stockholders' Equity (Deficit) section of future consolidated balance sheets. RESULTS OF OPERATIONS Net Sales. The Company's net sales increased 74% to $3.2 million for the three months ended December 31, 2000 compared to $1.9 million for the three months ended December 31, 1999. For the six months ended December 31, 2000, the Company had net sales of $6.3 million compared to $3.2 million for the six months ended December 31, 1999. The increase in net sales for the three and six months ended December 31, 2000 was driven by continued volume growth of the Chilli Cooled Ablation Catheter in the U.S, placements of the RPM Tracking Systems and associated catheter revenues in the U.S. and Europe. Increases in sales of all catheters for the three and six months ended December 31, 2000 compared to the three and six months ended December 31, 1999 were primarily related to unit volume increases rather than price changes. 11 12 In December 1995, the Company received $3.0 million pursuant to a royalty agreement with Arrow International Inc. ("Arrow"). This amount was recorded as deferred royalty income and will be amortized to income for those Trio/Ensemble catheters that Arrow manufactures and sells or, at a minimum, ratably over the period for which the related technology patents expire. $75,000 of royalty income related to the Arrow agreement was recognized for the 3 months ended December 31, 2000 and 1999. A total of $150,000 of royalty income related to the Arrow agreement was recognized for both the six months ended December 31, 2000 and 1999. Cost of Goods Sold. Cost of goods sold primarily includes raw materials costs, catheter fabrication costs, system assembly costs and test costs. Cost of goods sold was $2.6 million and $1.5 million for the three months ended December 31, 2000 and 1999, respectively. For the three months ended December 31, 2000, the Company had a gross margin of $656,000, or 20% of revenue, compared to a gross margin of $328,000 in the year earlier period. For the six months ended December 31, 2000, the Company had a gross margin of $1.2 million, or 19% of net sales, compared to a gross margin of $317,000, or 10% of net sales, for the six months ended December 31, 1999. The improvement in the gross margins for the three and six months ended December 31, 2000 compared to the same periods in the prior year reflects the benefit of increasing product volume, process yield improvements and material cost reduction programs. The company is continuing to implement manufacturing process improvements, including continued enhancements to the assembly training program, which together with increases in product volume, process yield improvements and material cost reduction programs, are expected to have positive effects on gross margins. Research and Development. Research and development expenses include costs associated with product research, clinical trials, prototype development, design and testing, and costs associated with obtaining regulatory approvals. Research and development expenses decreased 34% to $1.1 million for the three months ended December 31, 2000 from $1.7 million for the three months ended December 31, 1999. Research and development expenses were $2.1 million for the six months ended December 31, 2000 compared to $3.7 million for the six months ended December 31, 1999. The decrease in research and development expenses for both periods was due primarily to the allocation of a greater share of facility costs to manufacturing and the continued refocusing of research and development resources on RPM and Chilli/7 French catheter development and product delivery initiatives. Selling, General and Administrative. Selling, general and administrative expenses include compensation and benefits for sales, marketing, senior management and administrative personnel, various legal and professional fees and costs of trade shows. Selling, general and administrative expenses increased to $3.3 million for the three months ended December 31, 2000 from $2.1 million for the three months ended December 31 1999. Selling, general, and administrative expenses were $5.9 million for the six months ending December 31, 2000 compared to $3.7 million for the six months ended December 31, 1999. Approximately $500,000 of non-recurring expenditures were incurred during the three months ended December 31, 2000 related to severance and employee relocation costs. Additional expense growth for the three and six months ended December 31, 2000 as compared to the three months and six ended December 31, 1999 resulted primarily from increased marketing and sales infrastructure supporting the North American and European markets. Other Income (Expense), Net. Net other income was $133,000 for the three months ended December 31, 2000, compared to $334,000 for the three months ended December 31, 1999. Net other income was $288,000 for the six months ended December 31, 2000 compared to $596,000 for the six months ended December 31, 1999. Other income consists primarily of interest income earned on cash balances for the respective periods. 12 13 Net Loss. The net loss attributable to common stockholders for the three months ended December 31, 2000 was $4.4 million or $1.29 per share compared to a net loss of $4.0 million or $1.99 for the three months ended December 31, 1999. The net loss attributable to common stockholders for the six months ended December 31, 2000 was $8.1 million or $2.47 per share, compared to a net loss attributable to common stockholders of $8.9 million, or $4.44 per share for the six months ended December 31, 1999. The net loss attributable to common stockholders for the three months ended December 31, 2000 and 1999, and the six months ended December 31, 2000 include the accrued Series B Preferred Stock dividend. The net loss attributable to common stockholders for the six months ended December 31, 1999 include the accrued Series B Preferred Stock dividend and beneficial conversion feature related to the issuance of the Series B Preferred Stock. Impact of Adoption of New Accounting Standards. In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133 (FAS 133), "Accounting for Derivative Instruments and Hedging Activities" which is required to be adopted in years beginning after June 15, 2000. The Company has not in the past used, and does not anticipate in the future using, derivative instruments, and the Company does not expect that the adoption of FAS 133 will have a significant impact on its financial condition or results of operations. In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101") that must be adopted in the quarter ended June 30, 2001. SAB 101 summarizes certain areas of the Staff's views in applying generally accepted accounting principles to revenue in financial statements. Although the Company believes that its current revenue recognition policies comply with SAB 101, additional guidance was issued by the SEC staff and the Company is in the process of evaluating the effect of adopting SAB 101. The Company does not expect that the adoption of SAB 101 will have a significant impact on its financial condition or results of operations. LIQUIDITY AND CAPITAL RESOURCES The Company closed its initial public offering in June 1996 and raised net proceeds of $43.1 million. In July 1999, the Company raised net proceeds of $31.5 million through a Series B Convertible Preferred Stock financing. In December 2000, the Company raised net proceeds of $22.8 million through the issuance and sale of common stock through a private placement. As of December 31, 2000, the Company had $29.8 million in cash, cash equivalents and short-term investments. The Company believes that current cash and investment balances are sufficient to fund operations for at least the next twelve months. Net cash used in operating activities was $4.2 million and $5.7 million for the six months ended December 31, 2000 and 1999, respectively. For each of these periods, the net cash used in operating activities resulted primarily from net losses. Net cash generated in investing activities was $1.2 million 13 14 for the six months ended December 31, 2000 compared to a use of cash for investing activities of $13.6 million for the same period in 1999. For the six months ended December 31, 2000, net cash provided by investing activities resulted primarily from maturity of short-term investments offset in part by the purchases of property and equipment. Net cash provided by financing activities was $22.8 million and $28.3 million for the six months ended December 31, 2000 and 1999, respectively. As of the end of December 31, 2000, the Company had capital equipment of approximately $11.1 million, less accumulated depreciation and amortization of approximately $6.8 million, to support its product development, manufacturing and administrative activities. A significant portion of the Company's capital expenditures resulted from the building and placements of RF Generators and RPM Systems in the U.S. The Company expects capital expenditures to increase over the next several years as it builds and places systems and acquires equipment to support manufacturing and development activities. FACTORS THAT MAY IMPACT FUTURE OPERATIONS Limited Operating History; History of Losses and Expectation of Future Losses The Company was founded in 1991 and to date has engaged primarily in researching, developing, testing and obtaining regulatory clearances for its products. The Company has experienced significant operating losses since inception. As of December 31, 2000, the Company had an accumulated deficit of $102.9 million. To date, the Company has generated only limited revenues from sales of its products and expects its operating losses to continue through at least the end of fiscal 2002 as it continues to expend funds to conduct its research and development activities, establish commercial-scale manufacturing capabilities and expand its sales and marketing activities. There can be no assurance that any of the Company's products for diagnosis and treatment of ventricular tachycardia and other arrhythmias, particularly the RPM Tracking System or Chilli Cooled Ablation Catheter, will be successfully commercialized or that the Company will achieve significant revenues from either international or domestic sales. In addition, there can be no assurance that the Company will achieve or sustain profitability in the future or meet the expectations of securities industry analysts. The Company's results of operations may fluctuate significantly from quarter to quarter or year to year and will depend on numerous factors, including actions relating to regulatory matters, progress of clinical trials, the extent to which the Company's products gain market acceptance, the scale-up of manufacturing abilities and the expansion of sales and marketing activities and competition. No Assurance that Company's Products will Prove to be Safe and Effective There can be no assurance that the Company's current or future products will prove to be safe and effective in clinical trials under applicable United States or international regulatory guidelines or that additional modifications to the Company's products will not be necessary. Furthermore, there can be no assurance that the Company will be successful in perfecting the design of the RPM Tracking System. With respect to the Chilli Cooled Ablation System, because ablation treatment of cardiac arrhythmias is relatively new, the long-term effects of radiofrequency ablation on patients are unknown. As a result, the long-term success of ablation therapy in treating ventricular tachycardia and other tachyarrhythmias will not be known for several years 14 15 No Existing Market The Company's future success will depend upon the successful commercialization of the Chilli Cooled Ablation Catheter and RPM Tracking System. These products have only recently received FDA approval and clearance to be commercialized in the United States for the treatment of certain forms of cardiac tachyarrhythmias. The Company has to date demonstrated only limited ability to commercialize these new products. There can be no assurance that these products will gain any significant degree of market acceptance among physicians, patients, and health care payors. The Company believes that physicians' acceptance of procedures using the Company's RPM Tracking System will be essential for market acceptance of such system. Even though the clinical efficacy of the system has been established, electrophysiologists, cardiologists and other physicians may elect not to recommend the use of the RPM Tracking System for any number of reasons. There can be no assurance that this system will be successfully commercialized for the approved product set in the United States and Europe. There can be no assurance of the ability to obtain regulatory approval in any market where the Chilli Cooled Ablation Catheter and RPM Tracking System has not yet received approval. Currently, the Chilli Cooled Ablation Catheter and RPM Tracking System have been submitted for regulatory approval in Japan. The Company believes that, as with any novel medical technology, there will be a significant learning process involved for physicians to become proficient. Broad use of the system will require training of electrophysiologists, and the time required to complete such training could adversely affect market acceptance. Failure of the product to achieve significant market acceptance would have a material adverse effect on the Company's business, financial condition and results of operations. Even if the RPM Tracking System achieves market acceptance, the Company will be required to significantly ramp manufacturing operations to produce sufficient quantities of the product to satisfy customer demand. Any failure to manufacture the RPM Tracking System in quantities sufficient to satisfy demand will materially adversely affect the Company's business, financial condition and results of operations. Marketing and Distribution Establishing a marketing and sales capability sufficient to support planned sales growth will require substantial efforts and significant management and financial resources. There can be no assurance that the Company will be able to continue to expand its marketing staff or sales force, that the establishment of such a marketing staff or sales force will be cost-effective or that the Company's sales and marketing efforts will be successful. There can be no assurance that the Company will be able to maintain or enter into agreements with existing or new distributors, or that such distributors will devote adequate resources to selling the Company's products. Failure to establish appropriate distribution relationships could have a material adverse effect upon the Company's business, financial condition and results of operations. The Company currently sells its Chilli Cooled Ablation Catheters, Radii-T mapping and ablation catheters, Trio/Ensemble diagnostic catheters and RPM Tracking System Products through distributors in certain international markets. All sales of the Company's products to date have been denominated in U.S. dollars. In addition, the Company plans to market its other products in international markets, subject to receipt of required regulatory approvals. Changes in overseas economic conditions, currency exchange rates, foreign tax laws, or tariffs or other trade regulations could have a material adverse effect on the Company's ability to market its products internationally and therefore on its business, financial condition and results of operations. 15 16 We Rely on Major Distributors The Company currently relies upon international distributors of specialty cardiovascular products to market and sell its products. A large percentage of the Company's revenues are derived from sales to its Japanese distributor, Japan Lifeline. Sales to Japan Lifeline accounted for 49%, 52% and 80%, of the Company's net sales in fiscal 2000, 1999 and 1998, respectively. International sales accounted for 67%, 78% and 87% of the Company's net sales in fiscal 2000, 1999 and 1998, respectively. In fiscal 2001, the Company anticipates that Japan Lifeline will continue to account for a significant percentage of the Company's net sales. Sales to Japan Lifeline accounted for 34% of the Company's net sales for the six months ended December 31, 2001. The Company also relies on three distributors in Europe for a significant portion of its revenues. Ela Medical S.A. ("Ela") covers the territory of France, Italy, Greece, Turkey, Israel, Belgium, and Switzerland. Curative EP ("Curative") is the Company's distributor in Germany, while Izasa S.A. ("Izasa") distributes for the Company in Spain, Canary Islands and Portugal. The distributor agreements for Japan Lifeline, covering Japan, expires in May 2001. The Ela distributor agreement expires in June 2003. The distributor agreements for Curative and Izasa both expire in June 2002. If the Company's sales to any of its international distributors decline, the Company would experience a material decline in revenues. Even if the Company is successful in selling its products through new international distributors, the rate of growth of the Company's net sales could be materially and adversely effected if its current international distributors do not continue to sell a substantial number of the Company's products. If the Company's sales to its current international distributors decline, the Company cannot be certain that it will be able to attract additional distributors that can market its products effectively or can provide timely and cost-effective customer support and service. None of the Company's international distributors are obligated to sell the Company's products after its agreement with the Company has expired. Further, the Company cannot be certain that its current international distributors will continue to represent its products or that they will continue to devote a sufficient amount of effort and resources to selling the Company's products. Strategic Relationships The Company intends to pursue strategic relationships with corporations and research institutions with respect to the research, development, international regulatory approval, manufacturing and marketing of certain of its products. There can be no assurance that the Company will be successful in establishing or maintaining any such relationships or that any such relationship will be successful. Manufacturing A number of components for the Company's products are provided by sole source suppliers. For certain of these components, there are relatively few alternative sources of supply, and establishing additional or replacement vendors for such components could not be accomplished quickly. For some components, there is currently a long lead-time between purchases and the receipt of shipments. For those components from a single source, the vendor's inability to supply such components in a timely manner could have a material adverse effect on the Company's ability to manufacture the RPM Tracking System and other diagnostic and ablation catheters and therefore on its business, financial condition and marketing efforts. The Company has limited experience manufacturing its products in the volumes that will be necessary for the Company to achieve significant commercial sales, and there can be no assurance that reliable, high volume manufacturing capacity can be established or maintained at commercially reasonable costs. The Company needs to expend significant capital resources and develop manufacturing expertise to establish large scale manufacturing capabilities. Manufacturers often encounter difficulties in scaling up 16 17 production of new products, including problems involving production yields, quality control and assurance, component supply shortages, shortages of qualified personnel, compliance with FDA regulations, and the need for further FDA approval of new manufacturing processes. In addition, the Company believes that substantial cost reductions in its manufacturing operations will be required for it to commercialize its catheters and systems on a profitable basis. Any inability of the Company to establish and maintain large scale manufacturing capabilities would have a material adverse effect on the Company's business, financial condition and results of operations. The Company's manufacturing facilities are subject to periodic inspection by regulatory authorities, and its operations must undergo QSR compliance inspections conducted by the FDA. The Company is required to comply with QSR in order to produce products for sale in the United States and with ISO9001/EN46001 standards in order to produce products for sale in Europe. Any failure of the Company to comply with QSR or ISO9001/EN46001 standards may result in the Company being required to take corrective actions, such as modification of its policies and procedures. The Company has been granted by the State of California the required license to manufacture medical devices. If the Company is unable to maintain such a license, it would be unable to manufacture or ship any product, and such inability would have a material adverse effect on the Company's business, financial condition and results of operations. Patents and Proprietary Rights The Company's success will depend in part on its ability to obtain patent and copyright protection for its products and processes, to preserve its trade secrets and to operate without infringing or violating the proprietary rights of third parties. The patent positions of medical device companies, including those of the Company, are uncertain and involve complex and evolving legal and factual questions. The coverage sought in a patent application either can be denied or significantly reduced before or after the patent is issued. Consequently, there can be no assurance that any patents from pending patent applications or from any future patent application will be issued, that the scope of any patent protection will exclude competitors or provide competitive advantages to the Company, that any of the Company's patents will be held valid if subsequently challenged or that others will not claim rights in or ownership of the patents and other proprietary rights held by the Company. In addition, there can be no assurance that competitors, many of which have substantial resources and have made substantial investments in competing technologies, will not seek to apply for and obtain patents that will prevent, limit or interfere with the Company's ability to make, modify, use or sell its products either in the United States or in international markets. Litigation or regulatory proceedings, which could result in substantial cost and uncertainty to the Company, may also be necessary to enforce patent or other intellectual property rights of the Company or to determine the scope and validity of other parties' proprietary rights. There can be no assurance that the Company will have the financial resources to defend its patents from infringement or claims of invalidity. The Company currently holds issued and allowed patents and has pending patents and applications covering a number of fundamental aspects of the Company's Chilli Cooled Ablation System, RPM Tracking System and other products. The Company owns 65 United States issued patents and 4 foreign issued patents. The Company owns exclusive field-of-use license on 26 United States issued patents. In addition, the Company has 6 United States pending patent applications, of which two are licensed. The Company has also filed or licensed 22 corresponding foreign patent applications that are currently pending in Europe and/or Japan. Four of the pending foreign patent applications are Patent Cooperation Treaty ("PCT") applications, with Europe and Japan as designated countries for filing at the national phase. One of the PCT applications is licensed. The Company's 65 United States patents expire at 17 18 various dates ranging from 2012 to 2020 and the 4 foreign issue patents expire at various dates ranging from 2012 to 2015. The exclusive field of use license of 26 United States issued patents expires at various dates ranging from 2013 to 2020. The medical device industry has been characterized by extensive litigation regarding patents and other intellectual property rights, and companies in the medical device industry have employed intellectual property litigation to gain a competitive advantage. There can be no assurance that the Company will not become subject to patent infringement claims or litigation in a court of law, or interference proceedings declared by the United States Patent and Trademark Office ("USPTO") to determine the priority of inventions or an opposition to a patent grant in a foreign jurisdiction. The defense and prosecution of intellectual property suits, USPTO interference or opposition proceedings and related legal and administrative proceedings are both costly and time-consuming. Any litigation, opposition or interference proceedings will result in substantial expense to the Company and significant diversion of effort by the Company's technical and management personnel. An adverse determination in litigation or interference proceedings to which the Company may become a party could subject the Company to significant liabilities to third parties, require disputed rights to be licensed from third parties or require the Company to cease using such technology. Although patent and intellectual property disputes in the medical device area have often been settled through licensing or similar arrangements, costs associated with such arrangements may be substantial and could include ongoing royalties. Furthermore, there can be no assurance that necessary licenses from others would be available to the Company on satisfactory terms, if at all. Adverse determinations in a judicial or administrative proceeding or failure to obtain necessary licenses could prevent the Company from manufacturing and selling its products, which would have a material adverse effect on the Company's business, financial condition and results of operations. The Company is aware of certain patents owned or licensed by others and relating to cardiac catheters and cardiac monitoring. Certain enhancements of the Company's products are still in the design and pre-clinical testing phase. Depending on the ultimate design specifications and results of pre-clinical testing of these enhancements, there can be no assurance that the Company would be able to obtain a license to such parties' patents or that a court would find that such patents are either not infringed by the Company's enhancements or that the Company's patents are invalid. Further, there can be no assurance that owners or licensees of these patents will not attempt to enforce their patent rights against the Company in a patent infringement suit or other legal proceeding, regardless of the likely outcome of such suit or proceeding. Competition At present, the Company considers its primary competition to be companies involved in current, more established therapies for the treatment of ventricular tachycardia and atrial fibrillation, including drugs, external electrical cardioversion and defibrillation, implantable defibrillators, ablation accompanied by pacemaker implantation and open-heart surgery. In addition, several competitors are also developing new approaches and new products for the treatment and mapping of ventricular tachycardia and other arrythmias, including ablation systems using ultrasound, microwave, laser and cryoablation technologies and mapping systems using contact mapping, single-point spatial mapping and non-contact, multisite electrical mapping technologies. Many of the Company's competitors have an established presence in the field of interventional cardiology and electrophysiology, including Boston Scientific Corporation, C.R. Bard, Inc., Johnson and Johnson, St. Jude Medical, Medtronic, Inc. and Endocardial Solutions, Inc. Many competitors have substantially greater financial and other resources than the Company, including larger research and development staffs, more experience, capabilities in conducting research and development activities, testing products in clinical trials, obtaining regulatory approvals and manufacturing, marketing and distributing products. There can be no assurance that the Company will succeed in developing and marketing technologies and products that are more clinically efficacious and 18 19 cost effective than the more established treatments or the new approaches and products developed and marketed by its competitors. Furthermore, there can be no assurance that the Company will succeed in developing new technologies and products that are available prior to its competitors' products. The failure of the Company to demonstrate the efficacy and cost effective advantages of its products over those of its competitors or the failure to develop new technologies and products before its competitors, could have a material adverse effect on the Company's business, financial condition and results of operations. The Company believes that the primary competitive factors in the market for cardiac ablation and mapping devices are safety, efficacy, ease of use and price. In addition, the length of time required for products to be developed and to receive regulatory and, in some cases, third party payor reimbursement approval are important competitive factors. The medical device industry is characterized by rapid and significant technological change. Accordingly, the Company's success will depend in part on its ability to respond quickly to medical and technological changes through the development and introduction of new products. Product development involves a high degree of risk and there can be no assurance that the Company's new product development efforts will result in any commercially successful products. The Company believes it competes favorably with respect to these factors, although there is no assurance that it will be able to continue to do so. Government Regulation United States The design, pre-clinical and clinical testing, manufacture, labeling, sale, distribution and promotion of the Company's products are subject to regulation by numerous governmental authorities, principally the FDA and corresponding state and foreign regulatory agencies. Noncompliance with applicable requirements can result in, among other things, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, failure of the government to grant PMA clearance or PMA approval for devices, withdrawal of marketing authorization, a recommendation by the FDA that the Company not be permitted to enter into government contracts and/or criminal prosecution. The FDA also has the authority to request repair, replacement or refund of the cost of any device manufactured or distributed by the Company. Before a new device can be introduced into the market, a manufacturer must generally obtain marketing clearance through a premarket notification under Section 510(k) of the FDC Act or an approval of a PMA application under Section 515 of the FDC Act. Commercial distribution of a device for which a 510(k) clearance is required can begin only after the FDA issues an order finding the device to be "substantially equivalent" to a predicate device. If the Company cannot establish that a proposed device is substantially equivalent to a legally marketed predicate device, the Company must seek premarket approval of the proposed device from the FDA through the submission of a PMA application. The Company will be required to make a new 510(k) submission for any device that is cleared through the 510(k) process if the Company modifies or enhances the device in a manner that could significantly affect safety or effectiveness, or if those changes constitute a major modification in the intended use of the device. If the Company cannot establish that a proposed device is substantially equivalent to a legally marketed predicate device, the Company must seek premarket approval of the proposed device from the FDA through the submission of a PMA application. There can be no assurance that the FDA will act favorably or quickly on any of the Company's PMA applications. Significant difficulties and costs may be encountered by the Company in its efforts to obtain FDA clearance that could delay or preclude the Company from selling its products in the United States. Furthermore, there can be no assurance that the 19 20 FDA will not request additional data or require that the Company conduct further clinical studies, causing the Company to incur substantial cost and delay. In addition, there can be no assurance that the FDA will not impose strict labeling requirements, onerous operator training requirements or other requirements as a condition of its PMA approval, any of which could limit the Company's ability to market its systems. Labeling and promotional activities are subject to scrutiny by the FDA and, in certain circumstances, by the Federal Trade Commission ("FTC"). FDA enforcement policy strictly prohibits the marketing of FDA cleared or approved medical devices for unapproved uses. Further, if a company wishes to modify a product after FDA approval of a PMA, including changes in indications or other modifications that could affect safety or efficacy, additional clearances or approvals will be required from the FDA. Failure to receive or delays in receipt of FDA clearances or approvals, including the need for additional clinical trials or data as a prerequisite to clearance or approval, or any FDA conditions that limit the ability of the Company to market its systems, could have a material adverse effect on the Company's business, financial condition and results of operations. International The European Union has promulgated rules which require that medical products distributed after June 14, 1998 bear the CE mark, an international symbol of adherence to quality assurance standards and compliance with applicable European medical device directives. Quality system certification is one of the CE mark requirements. The Company has received ISO9001/EN46001 certification by its ISO Certification Registrar, one of the CE mark certification prerequisites, for its manufacturing facility in Sunnyvale, California. Furthermore, in January 1998, the Company received the right to affix the CE mark to its Arrhythmia Mapping System and Chilli Cooled Ablation System. In April 1998, the Company received the right to affix the CE mark to its Radii catheters. In July 1998, the Company received the right to affix the CE mark to its Trio/Ensemble catheters. In April 2000, the Company received CE mark certification for the RPM tracking system, and for its Chilli Cooled Ablation Catheters incorporating Real-time Position Management navigation technology. While the Company intends to satisfy the requisite policies and procedures that will permit it to receive the CE Mark Certification for other products, there can be no assurance that the Company will be successful in meeting the European certification requirements and failure to receive the right to affix the CE mark will prohibit the Company from selling these and other products in member countries of the European Union. The time required to obtain approval for sale in foreign countries may be longer or shorter than that required for FDA approval, and the requirements may differ. Export sales of medical devices that have not received FDA marketing authorization are subject to FDA export requirements. In accordance with the FDA Export Reform & Enforcement Act of 1996, such devices may be exported to any country provided that the device meets a number of criteria including marketing authorization in one of the "Tier I" countries identified in that Act. If the device has no marketing authorization in a Tier I country, and is intended for marketing, it may be necessary to obtain approval from the FDA to export the device. In order to obtain export approval, the Company may be required to provide the FDA with documentation from the medical device regulatory authority of the country in which the study is to be conducted or the purchaser is located, stating that the device has the approval of the country. In addition, the FDA must find that the exportation of the device is not contrary to the public health and safety of the country in order for the Company to obtain the permit. The Company currently has marketing authorization in one or more Tier I countries for all its clinically used products. The RPM Tracking System products are currently undergoing the process and clinical trials necessary to obtain regulatory approvals in Japan. 20 21 Third-Party Reimbursement and Uncertainty Related to Health Care Reform In the United States, health care providers, including hospitals and physicians, that purchase medical products for treatment of their patients, generally rely on third party payors, principally federal Medicare, state Medicaid and private health insurance plans, to reimburse all or a part of the costs and fees associated with the procedures performed using these products. The Company's success will be dependent upon, among other things, the ability of health care providers to obtain satisfactory reimbursement from third party payors for medical procedures in which the Company's products are used. Third party payors may deny reimbursement if they determine that a prescribed device has not received appropriate regulatory clearances or approvals, is not used in accordance with cost-effective treatment methods as determined by the payor, or is experimental, unnecessary or inappropriate. Third party reimbursement is generally provided on the basis of the procedure's DRG code as established by the HCFA. The failure of the procedures in which the Company's products are used or an insufficient level of reimbursements for such procedures would have a material adverse effect on the Company's business, financial condition and results of operations. In addition, medical equipment reimbursements have been mandated by statute to be reduced in the past, and there can be no assurance that any such reimbursements with respect to the Company's products will be adequate or provided at all. Failure by hospitals and other users of the Company's products to obtain reimbursement from third party payors, or changes in government and private third party payors' policies toward reimbursement for procedures employing the Company's products, would have a material adverse effect on the Company's business, financial condition and results of operations. Moreover, the Company is unable to predict what additional legislation or regulation, if any, relating to the health care industry or third party coverage and reimbursement may be enacted in the future, or what effect such legislation or regulation would have on the Company. Reimbursement systems in international markets vary significantly by country and by region within some countries, and reimbursement approvals must be obtained on a country by country basis. Many international markets have government managed health care systems that control reimbursement for new products and procedures. In most markets, there are private insurance systems as well as government managed systems. Market acceptance of the Company's products will depend on the availability and level of reimbursement in international markets targeted by the Company. There can be no assurance that the Company will obtain reimbursement in any country within a particular time, for a particular amount, or at all. Regardless of the type of reimbursement system, the Company believes that physician advocacy of the Company's products will be required to obtain reimbursement. The Company believes that less invasive procedures generally provide less costly overall therapies as compared to conventional drug, surgery and other treatments. In addition, the Company believes that treatment with the Company's products will be more efficacious than currently available therapies. The Company anticipates that hospital administrators and physicians would justify the use of the Company's products by the attendant cost savings and clinical benefits that the Company believes would be derived from the use of its products. However, there can be no assurance that this will be the case. There can be no assurance that reimbursement for the Company's products will be available in the United States or in international markets under either government or private reimbursement systems, or that physicians will support and advocate reimbursement procedures using the Company's products. 21 22 Product Liability and Insurance The development, manufacture and sale of medical products entail significant risk of product liability claims and product failure claims. The Company has only limited commercial sales to date and does not yet have, and will not have for a number of years, sufficient clinical data to allow the Company to measure the risk of such claims with respect to its products. The Company faces an inherent business risk of financial exposure to product liability claims in the event that the use of its products results in personal injury or death. The Company also faces the possibility that defects in the design or manufacture of the Company's products might necessitate a product recall. There can be no assurance that the Company will not experience losses due to product liability claims or recalls in the future. In addition, the Company will require increased product liability coverage if any of its potential products are successfully commercialized. Such insurance is expensive, difficult to obtain and may not be available in the future on acceptable terms, or at all. Any claims against the Company regardless of their merit or eventual outcome could have a material adverse effect upon the Company's business, financial condition and results of operations. We Rely on a Continuous Power Supply to Conduct Our Operations, and California's Current Energy Crisis Could Disrupt Our Operations and Increase Our Expenses California is in the midst of an energy crisis that could disrupt our operations and increase our expenses. In the event of an acute power shortage, that is, when power reserves for the State of California fall below 1.5%, California has on some occasions implemented, and may in the future continue to implement, rolling blackouts throughout California. We currently do not have backup generators or alternate sources of power in the event of a blackout, and our current insurance does not provide coverage for any damages we or our customers may suffer as a result of any interruptions in our power supply. If blackouts interrupt our power supply, we would be temporarily unable to continue operations at our facilities. Any such interruption in our ability to continue operations at our facilities could damage our reputation, harm our ability to retain existing customers and to obtain new customers, and could result in lost revenue, any of which could substantially harm our business and results of operations. Employees The Company's ability to operate successfully depends in significant part upon the continued service of certain key scientific, technical, clinical, regulatory and managerial personnel, and its continuing ability to attract and retain additional highly qualified scientific, technical, regulatory and managerial personnel. Competition for such personnel is intense, and there can be no assurance that the Company can retain such personnel or that it can attract or retain other highly qualified scientific, technical, clinical, regulatory and managerial personnel in the future, including key sales and marketing personnel. The loss of key personnel or the inability to hire and retain qualified personnel could have a material adverse effect upon the Company's business, financial condition and results of operations. The Company's management has recently gone through a significant restructuring. The Company's new President and Chief Executive Officer, Thomas M. Prescott, joined the Company in May 1999. In addition, the Company's Chief Financial Officer, Vice President, Operations and Vice President, Sales each joined the Company in January 2000. The Company also hired a new Vice President of Human Resources who joined the Company in July 2000 and a new Vice President, Operations who joined us in December 2000. There can be no assurance that these newly hired officers of the Company will be able to operate effectively with that portion of the management team that was retained. 22 23 In order to manufacture and market its products in commercial quantities, the Company believes that it will be required to expand its operations, particularly in the areas of manufacturing and sales and marketing and, in connection therewith, to have new personnel to work in these areas. There can be no assurance that the Company's officers and its sales and marketing personnel will be able to build a successful sales force or that they will be able to operate effectively with the existing management team. As the Company expands its operations in these areas, such expansion will likely result in new and increased responsibilities for management personnel and place significant strain upon the Company's management, operating and financial systems and resources. To accommodate any such growth and compete effectively, the Company will be required to implement and improve information systems, procedures, and controls, and to expand, train, motivate and manage its work force. Any failure to implement and improve the Company's operational, financial and management systems or, to expand, train, motivate or manage employees as required by future growth, if any, could have a material adverse effect on the Company's business, financial condition and results of operations. Potential Volatility of Stock Price The market price of shares of Common Stock, like that of the common stock of many medical product and technology companies, has in the past been, and is likely in the future to continue to be highly volatile. Factors such as fluctuations in the Company's operating results, proportion of ownership between common stockholders and Series B Convertible Preferred stockholders, announcements of technological innovations or new commercial products by the Company or competitors, government regulation, changes in the current structure of the health care financing and payment systems, developments in or disputes regarding patent or other proprietary rights, release of reports by securities analysts, change in securities analysts recommendations, economic and other external factors and general market conditions may have a significant effect on the market price of the Common Stock. Moreover, the stock market has from time to time experienced extreme price and volume fluctuations which have particularly affected the market prices for medical products and high technology companies and which have often been unrelated to the operating performance of such companies. These broad market fluctuations, as well as general economic, political and market conditions, may adversely affect the market price of the Company's Common Stock. In the past, following periods of volatility in the market price of a company's stock, securities class action litigation has occurred against the issuing company. There can be no assurance that such litigation will not occur in the future with respect to the Company. Such litigation could result in substantial costs and a diversion of management's attention and resources, which could have a material adverse effect on the Company's business, operating results and financial condition. Any adverse determination in such litigation could also subject the Company to significant liabilities. Significant Rights attaching to Series B Convertible Preferred Stock The Company has 27,250 shares of Series B Convertible Preferred Stock outstanding which are convertible, at the option of the holder, into 5.95 million shares of the Company's common stock. The holders of Series B Convertible Preferred Stock are entitled to significant rights, preferences and privileges over holders of common stock including the right to elect three of five directors to the board of directors of the Company, to a preferential cumulative dividend, to certain redemption rights and to a substantial liquidation payment preference over the Company's common stock which is also payable upon any transaction or series of transactions (including, without limitation, any merger, reorganization or consolidation) involving a transfer of 50% or more of the outstanding voting power of the Company. The holders of Series B Convertible Preferred Stock are also entitled to certain registration rights and 23 24 enjoy certain protective rights in that their consent is required to effect certain corporate transactions including, but not limited to, amending the Company's certificate of incorporation or by-laws, issuing common or preferred stock, declaring dividends or selling all or substantially all of the Company's stock or assets. It is likely that the preferences and rights enjoyed by the holders of Series B Convertible Preferred Stock has a negative impact the market price of the common stock of the Company. Also, if these holders, by converting their Series B Convertible Preferred Stock into common stock and then exercising their registration rights, cause a large number of securities to be registered and sold in the public market, such sales could materially and adversely affect the market price for the Company's common stock. In addition, if the Company were to include in a registration statement shares held by these holders pursuant to the exercise of their registration rights, such sales may impede the Company's ability to raise needed capital. For a more complete description of the rights, preferences and privileges attaching to the Series B Convertible Preferred Stock refer to the section of "Item 5. Market for Registrant's Common Equity and Related Stockholder Matters" entitled "Recent Sales of Unregistered Securities" in the Companys' Form 10-K/A for the year ended June 30, 2000. Significant Control by Holders of Series B Convertible Preferred Stock The holders of Series B Convertible Preferred Stock beneficially own an aggregate of approximately 54.2% of the outstanding voting stock of the Company and are entitled to elect three of five directors to the Company's Board of Directors. These stockholders, if acting together, will be able to significantly influence all matters requiring approval of either the Board of Directors or the stockholders of the Company, including the approval of significant corporate transactions. This concentration of ownership may also delay, deter or prevent a change in control and may make some transactions more difficult or impossible to complete without the support of these stockholders. 24 25 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company does not use derivative financial instruments in its investment portfolio. The Company places it's investments in instruments that meet high credit quality standards as specified in the Company's investment policy. The Company also limits the amount of credit exposure to any one issue, issuer or type of investment. The Company does not expect any material loss with respect to its investment portfolio. 25 26 CARDIAC PATHWAYS CORPORATION PART II. OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS Recent Sales of Unregistered Securities On December 26, 2000 the Company issued and sold 5,858,823 shares of its common stock at a purchase price of $4.25 per share to a limited number of accredited investors. The aggregate offering price was $24.9 million. Pursuant to the foregoing sale, the Company agreed to register the shares under the Securities Act on Form S-3 for resale to the public. Dain Rauscher Wessels acted as placement agent for the transaction and received a placement agent fee of $1.75 million. The foregoing transaction did not involve any public offering, and the Company believes that the transaction was exempt from the registration requirements of the Securities Act by virtue of Section 4(2) thereof or Regulation D promulgated thereunder. The recipients in the foregoing transaction represented their intention to acquire the securities for investment only and not with a view to or for resale in connection with any distribution thereof, and appropriate legends were affixed to the share certificates and instruments issued in the foregoing transaction. All recipients had adequate access, through their relationships with the Company, to information about us. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the Company's Annual Meeting of Stockholders on December 15, 2000 the stockholders approved the following actions: A. Election of directors M. Fazle Husain & Mark J. Brooks For: 8,198,761 Against: 73,997 B. The approval of the 2000 Stock Plan with 500,000 shares of Common Stock reserved for issuance thereunder. For: 7,429,834 Against: 107,375 Abstain: 844 Broker Non-vote: 734,705 C. The amendment of the 1998 Employee Stock Purchase Plan to provide for a one-time increase to the amount of shares of Common Stock reserved for issuance thereunder and to modify the annual increase provisions. For: 7,488,139 Against: 49,045 Abstain: 869 Broker Non-vote: 734,705 D. The approval of the issue and sale of 5,882,353 shares of Common Stock to certain investors of Cardiac Pathways. For: 7,509,209 Against: 26,900 Abstain: 1,944 Broker Non-vote: 734,705 E. Ratification of the appointment of Ernst & Young LLP as independent auditors of the Company for the fiscal year ending June 30, 2001. For: 8,259,278 Against: 12,222 Abstain: 1,258 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) The exhibits listed on the accompanying Exhibit Index are filed as a part hereof. (b) On November 8, 2000 the Company filed a report on Form 8-K announcing that it had entered into a common stock purchase agreement with certain investors. On December 28, 2000 the Company filed a report on Form 8-K announcing that it had closed the common stock financing disclosed in the November 8, 2000 report on Form 8-K. 26 27 CARDIAC PATHWAYS CORPORATION SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. DATE: FEBRUARY 13, 2001 CARDIAC PATHWAYS CORPORATION /S/ THOMAS M. PRESCOTT ----------------------------------------- THOMAS M. PRESCOTT PRESIDENT AND CHIEF EXECUTIVE OFFICER /S/ ELDON M. BULLINGTON ----------------------------------------- ELDON M. BULLINGTON VICE PRESIDENT OF FINANCE AND CHIEF FINANCIAL OFFICER 27

EXHIBIT NO. EXHIBIT DESCRIPTION PAGE NO. ----------------- ----------------------- ---------- 27.1 Financial Data Schedule 25

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