Item 2.
Management’s Discussion and Analysis or Plan of Operations
The matters discussed in this Form 10-QSB contain certain forward-looking statements and involve risks and uncertainties (including changing market conditions, competitive and regulatory matters, etc.) detailed in the disclosure contained in this Form 10-QSB and the other filings with the Securities and Exchange Commission made by the Company from time to time. The discussion of the Company’s liquidity, capital resources and results of operations, including forward-looking statements pertaining to such matters, does not take into account the effects of any changes to the Company’s operations. Accordingly, actual results could differ materially from those projected in the forward-looking statements as a result of a number of factors, including those identified herein. This item should be read in conjunction with the financial statements and other items contained elsewhere in the report.
Critical Accounting Policies and Estimates
The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. These accounting principles require management to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the financial statements as well as the reported amount of revenues and expenses during the periods presented. Estimates are used when accounting for the allowance for uncollectible receivables, potentially excess and obsolete inventory, depreciation and amortization, warranty reserves, income tax valuation allowances and contingencies, among others. Actual results could differ significantly from those estimates. The Company believes that the estimates, judgments and assumptions upon which the Company rely are reasonable based upon information available at the time.
The Company believes the following accounting policies involve additional management judgment due to the sensitivity of the methods, assumptions and estimates necessary in determining the related asset and liability amounts. The Company sells its products directly to customers and through third-party dealers and distributors. Revenue is generally recognized at the time products are shipped and title passes to the customer. The Company estimates and records provisions for product installation and user training in the period that the sale is recorded.
Other than the bone densitometry systems, the Company’s products are covered by warranties provided by its vendors. Therefore, no warranty reserve is required on such products. In the United States and Canada, the Company offers one-year warranties covering parts and labor on both hardware and software components of its bone densitometry systems (except for computer systems, if any, which are covered under their respective manufacturers’ warranty). Outside of the United States and Canada, the Company only offers one-year warranties on parts; the labor warranty is provided by the distributors. The provision for product warranties represents an estimate for future claims arising under the terms of the various product warranties. The estimated future claims are accrued at the time of sale. To the extent that the Company provides warranty services for products that the Company does not manufacture, the Company invoices the manufacturer for the costs of performing such warranty services.
The Company has no obligations to provide any other services to any of its third party dealers or distributors or their customers.
The Company provides estimated inventory allowances for slow-moving and obsolete inventory based on current assessments about future demands, market conditions and related management initiatives. If market conditions are less favorable than those projected by management, additional inventory allowances may be required.
The Company provides allowances for uncollectible receivable amounts based on current assessment of collectability. If collectability is less favorable than those projected by management, additional allowances for uncollectability may be required.
9
ORTHOMETRIX, INC.
FORM 10-QSB SEPTEMBER 30, 2007
Item 2.
Management’s Discussion and Analysis or Plan of Operations
(Continued)
The Company accounts for deferred income taxes by recognizing the tax consequences of ‘‘temporary differences’’ by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities. The effect of a change in tax rates on deferred taxes is recognized in income in the period that includes the enactment date. The Company realizes an income tax benefit from the exercise of certain stock options or the early disposition of stock acquired upon exercise of certain options. This benefit results in an increase in additional paid in capital.
Liquidity and Capital Resources
The Company has financed operations for the past four years through the sale of equity securities and the issuance of debt. For the two years ending December 31, 2006 and 2005, the Company incurred aggregate net losses from operations of $4,368,456 and negative cash flow from operations of $3,068,682. During the nine months ended September 30, 2007, the Company incurred a net loss of $932,855 and negative cash flow from operations of $290,449. As of September 30, 2007, the Company had $9,569 in unrestricted cash and cash equivalents available for working capital purposes. These matters raise substantial doubt about the Company’s ability to continue as a going concern.
The Company’s continued existence is dependent upon several factors including obtaining substantial additional financing, increasing sales volume, achieving profitability on the sale of some products and developing new products. In order to increase cash flow, the Company is continuing its efforts to stimulate sales. In order to manage credit risk, the Company has begun to implement higher credit standards for customers and to emphasize the receipt of down payments from customers at the time their purchase orders are received. The Company has also begun to request more prepayments from customers and attempt to more closely coordinate the timing of purchases with the timing of orders for products. The Company cannot predict whether or to what extent these risk management functions may slow its ability to grow revenues.
On February 18, 2007, Kathy Smith, a leader in the health and fitness market, and her representatives on behalf of Kathy Smith Lifestyles (‘‘KSL’’) entered into a sales agreement with the Company. KSL agreed to promote the VibraFlex Home Edition through educational seminars, media appearances and its website, kathysmith.com, with emphasis on the female segment of the market. The agreement ends on December 31, 2007 and can be renewed for successive one year terms thereafter.
On May 1, 2007, Lamar Health Fitness & Sports (‘‘LHFS’’), a provider of innovative products to the home fitness market, entered into a licensing agreement with the Company. LHFS acquired from the Company a non-exclusive license to design, manufacture, market and service in the retail market, whole body vibration devices using the same patented technology that the Company uses for its VibraFlex
®
whole body vibration systems sold in the commercial market. LHFS also agreed to act as a non-exclusive distributor of the Company’s VibraFlex
®
models in the U.S. commercial market. As of September 30, 2007, the Company has not conducted any sales activity with LHFS and is evaluating certain modifications to the agreement.
The level of the Company’s cash and cash equivalents increased to $9,569 at September 30, 2007 from $4,011 at December 31, 2006. The Company expended $290,449 in cash for operations during the nine months ended September 30, 2007 which was offset by $295,621 in cash provided by financing activities during the nine month period. Through these financing activities the Company received $1,059,402 in loans from officers and directors, which were offset by the repayment of equipment loan payable of $22,792, repayment of borrowings of $391,054, and repayment of the HSBC line of credit of $350,000.
On February 1, 2007, the Company refinanced $1,623,000 of borrowings originating from 2005. The notes and advances were all replaced by a new note that bears interest at 12% and matures one
10
ORTHOMETRIX, INC.
FORM 10-QSB SEPTEMBER 30, 2007
Item 2.
Management’s Discussion and Analysis or Plan of Operations
(Continued)
year from the date of issuance. Of the refinanced borrowings, proceeds of $225,000 originated from 2005, $838,000 from 2006, and $560,000 from the first quarter of 2007. In addition to the refinancing, the Company borrowed $516,054 from certain officers and directors in 2007, of which, $331,054 were repaid. During the year ended December 31, 2006, the Company borrowed $1,358,000 in principal amount from related and unaffiliated parties, $633,000 of the borrowings were short term, interest bearing loans, of which $210,000 were repaid in 2006. The remaining $725,000 were notes issued in 2006 bearing interest at the JPMorgan Chase prime rate plus one (8.25% at December 31, 2006) all of which were refinanced on February 1, 2007 except for $250,000 which matured during June of 2007. The $250,000 note has not been extended. The Company continues to accrue interest at the prevailing interest rate.
For all of the notes, the Company is obligated to prepay the principal amount within 10 days upon the occurrence of either of two events; if it (i) receives at least $5,000,000 from an equity financing or (ii) sells substantially all of its assets.
Of the total note proceeds received or refinanced during the nine months ended September 30, 2007, $333,689 of the remaining proceeds received or refinanced were allocated to the warrants based on the application of the Black-Scholes option pricing model, with the remaining proceeds of $1,289,311 allocated to the notes payable. The value allocated to the warrants is being amortized to interest expense over the term of the notes. At September 30, 2007, the unamortized discount on the notes payable is $112,906. During the nine months ended September 30, 2007, amortization of discounts of $332,862 was recorded as interest expense.
During the nine months ended September 30, 2007, the Company’s board of directors approved a grant of stock options to employees, directors and independent consultants to purchase an aggregate of 890,000 shares of its common stock with exercise prices equal to or greater than the market price of stock on the date of grant. The options are 10-year options (with the exception of Mr. Bonmati, a 10% shareholder, whose options expire in 5 years) and vest over 4 years. The fair value of these issuances was estimated using the application of the Black-Scholes option pricing model. During the nine months ended September 30, 2007, $135,291 of non-cash compensation cost was recognized. Of that amount, $103,741 of options were recorded as non-cash compensation expense and additional paid-in capital. The remaining balance of $31,550 was recorded against Mr. Bonmati’s 2006 salary accrual and additional paid-in capital.
The Company had no backlog of orders as of September 30, 2007 and there are no material commitments for capital expenditure as of that date. The Company believes that they will need to raise substantial additional capital within the next twelve months in order to support the planned growth of the business. The Company may seek additional funding through collaborative arrangements and public or private financings. Additional funding may not be available on acceptable terms or at all. In addition, the terms of any financing may adversely affect the holdings or the rights of the Company’s stockholders. For example, if the Company raises additional funds by issuing equity securities, further dilution to existing stockholders may result. If the Company is unable to obtain funding on a timely basis, they may be required to significantly curtail one or more of the Company’s research or development programs. The Company also could be required to seek funds through arrangements with collaborators or others that may require the Company to relinquish rights to some of their technologies, product candidates or products which they would otherwise pursue on their own.
Results of Operations
The Company had a net loss of $932,855 ($0.02 per share based on 45,205,211 weighted average shares) for the nine months ended September 30, 2007 compared to net loss of $1,042,579 ($0.02 per share based on 44,366,457 weighted average shares) for the nine months ended September 30, 2006.
11
ORTHOMETRIX, INC.
FORM 10-QSB SEPTEMBER 30, 2007
Item 2.
Management’s Discussion and Analysis or Plan of Operations
(Continued)
Revenue for the nine months ended September 30, 2007 decreased $294,507 (or 15.0%) to $1,672,883 from $1,967,390 from the comparable period of fiscal 2006. The decrease in revenue was primarily due to a decrease in Orbasone™ system sales during 2007.
Cost of revenue as a percentage of revenue was 56.3% and 35.1% for the nine months ended September 30, 2007 and 2006, respectively, resulting in a gross margin of 43.7% for the nine months ended September 30, 2007 compared to 64.9% for the comparable period of 2006. The decrease in gross margin was due to a decrease in Orbasone™ system sales in 2007, which maintains a large gross profit percentage, and the inventory write down of the value of the slow moving Orbasone™ systems.
Sales and marketing expense for the nine months ended September 30, 2007 decreased $585,297 (or 47.3%) to $651,521 from $1,236,818 for the nine months ended September 30, 2006. The decrease is due to the Company’s decrease in sales staff to market and sell the Orbasone™ and decreased trade show and travel expenses to market the Orbasone™.
General and administrative expense for the nine months ended September 30, 2007 decreased $368,865 (or 42.02%) to $508,993 from $877,858 for the nine months ended September 30, 2006. The decrease was due to a decrease in payroll expense associated with the exclusion of the Chief Executive Officer’s salary effective January 1, 2007.
Research and development expense for the nine months ended September 30, 2007 decreased $98,674 (or 94.3%) to $5,990 from $104,664 for the nine months ended September 30, 2006. The decrease was primarily due to the suspension of all research and development activities.
Interest expense increased $272,819 (or 125.1%) to $490,912 for the nine months ended September 30, 2007 from $218,093 for the nine months ended September 30, 2006. Interest expense increased due to the increase in borrowings bearing a higher interest rate.
Other income decreased $121,954 (or 105.8%) for the nine months ended September 30, 2007. The $75,000 reduction of the legal reserve in 2006 was reclassified to general and administrative expenses.
New Accounting Pronouncements
In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155 (‘‘SFAS 155’’), ‘‘Accounting for Certain Hybrid Financial Instruments’’ which amends Statement of Financial Accounting Standards No. 133 (‘‘SFAS 133’’), ‘‘Accounting for Derivative Instruments and Hedging Activities’’ and Statement of Financial Accounting Standards No. 140 (‘‘SFAS 140’’), ‘‘Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.’’ SFAS 155 simplifies the accounting for certain derivatives embedded in other financial instruments by allowing them to be accounted for as a whole if the holder elects to account for the whole instrument on a fair value basis. SFAS 155 also clarifies and amends certain other provisions of SFAS 133 and SFAS 140. SFAS 155 is effective for all financial instruments acquired, issued or subject to a re-measurement event occurring in fiscal years beginning after September 15, 2006. Earlier adoption is permitted, provided the Company has not yet issued financial statements, including for interim periods, for that fiscal year. Since the Company has no derivative instruments or hedging activities, the adoption of SFAS 155 did not have an impact on our financial position, results of operations or cash flows.
In July 2006, the FASB issued FASB Interpretation No. 48 (‘‘FIN 48’’), Accounting for Uncertainty in Income Taxes, which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the recognition, classification, interest and penalties, accounting in interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 are effective for reporting periods beginning after December 15, 2006. The
12
ORTHOMETRIX, INC.
FORM 10-QSB SEPTEMBER 30, 2007
Item 2.
Management’s Discussion and Analysis or Plan of Operations
(Continued)
Company is currently assessing the impact of the adoption of FIN 48 and its impact on its financial position, results of operations, or cash flows.
In September 2006, the FASB issued SFAS No. 157 ‘‘Fair Value Measures’’ (‘‘SFAS 157’’). SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements, however it does not apply to SFAS 123R. This Statement shall be effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company does not believe that SFAS 157 will have a material impact on its financial position, results of operations or cash flows.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (‘‘SFAS 159’’). SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities and to provide additional information that will help investors and other financial statement users to more easily understand the effect of the Company’s choice to use fair value on its earnings. Finally, SFAS 159 requires entities to display the fair value of those assets and liabilities for which the Company has chosen to use fair value on the face of the balance sheet. SFAS 159 is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. Early adoption is permitted. The Company does not believe that SFAS No. 159 will have a material impact on its financial position, results of operations or cash flows.